Select Committee on Treasury Written Evidence

Memorandum from Moody's


  1.  Moody's is a credit rating agency and publishes credit ratings and research reports on fixed income securities and issuers of fixed income securities. Moody's credit ratings are forward-looking opinions that address solely the probability that a debt instrument will default and the amount of loss the debt-holder will incur in the event of default.

  2.  Our ratings are expressed according to a simple system of letters and numbers, on a scale that has 21 categories ranging from Aaa to C. The lowest expected credit loss is at the Aaa level.

  3.  Our credit ratings do not address many other factors in the investment decision process, including the price, term, likelihood of prepayment, liquidity risk or relative valuation of particular securities.

  4.  When rating a bank, Moody's analyses the intrinsic financial strength of the bank on a stand-alone basis and then factors in the likelihood and extent of external support in the event of financial difficulty.

  5.  Moody's has been rating Northern Rock since 1996 and maintains a published rating opinion on the bank. Prior to this summer's market turmoil, Northern Rock was rated Aa3 for deposits and senior bonds. The bank specific factors that supported this opinion were the nationwide mortgage franchise of the bank, its good asset quality, a history of stable earnings and satisfactory profitability. We identified the funding model and the maintenance of its asset quality standards as the two main challenges to the credit quality of Northern Rock. Moody's rating also factored in the possibility of support from the UK Government.

  6.  Following the announcement by Northern Rock on 14 September, Moody's placed Northern Rock's rating on review, direction uncertain. This rating action reflects Moody's opinion that the arrangements put in place by the Bank of England would mitigate the liquidity problems and recognises the uncertainties associated with the future of Northern Rock.

  7.  The turmoil in the credit markets that began this summer has adversely impacted investor confidence. Moody's is in favour of initiatives that would lead to enhanced market transparency and improved market practices in order to restore confidence.

  8.  For our part, Moody's continues fully to support measures that enhance transparency in the credit rating agency industry and we therefore welcome the EU's endorsement of the international standards for rating agencies which have been implemented in the EU through a self-regulatory framework for rating agencies. The implementation of this framework is monitored by the Committee of European Securities Regulators.


  9.  Rating agencies occupy a narrow but important niche in the investment information industry. Our role is to disseminate information about the relative creditworthiness of, among other things, financial obligations of corporations, banks, governmental entities, and pools of assets collected in securitised or "structured finance" transactions.

  10.  Moody's is the oldest bond rating agency in the world, having introduced ratings in 1909. Today, we are one of the world's most widely utilised sources for credit ratings, research and credit risk analysis. Our ratings and analysis track debt covering more than 100 sovereign nations, 12,000 corporate issuers, 29,000 public finance issuers, and 96,000 structured finance obligations. We maintain offices in most of the world's major financial centres and employ approximately 3,000 people worldwide, including more than 1,000 analysts.

  11.  Moody's is a subsidiary of Moody's Corporation (MCO), a listed company on the New York Stock Exchange.

  12.  Moody's credit ratings are forward-looking opinions that address just one characteristic of fixed income securities—the likelihood that debt will be repaid in accordance with the terms of the security. They reflect an assessment of both the probability that a debt instrument will default and the amount of loss the debt-holder will incur in the event of default. In assigning our credit opinions, Moody's analysts adhere to published rating methodologies, which we believe promote transparency and consistency of our global ratings.

  13.  Our ratings are expressed according to a simple system of letters and numbers, on a scale that has 21 categories ranging from Aaa to C. The lowest expected credit loss is at the Aaa level, with a higher expected loss rate at the Aa level, an even higher expected loss rate at the A level, and so on down through the rating scale. (See Annex 1 for more details). Moody's rating system is not a "pass-fail" system. After all, if we could know the future, we would have only two ratings: "will not pay" or "will pay". Rather our ratings are an assessment of the relative risk of credit loss as measured by the increasing probability of such loss with each lower rating level.

  14.  Moody's credit ratings are widely and publicly available at no cost to investors and the general public. We publicly disseminate our ratings through press releases and also make them available on our website. They are simultaneously available to all market participants regardless of whether or not they purchase products or services from Moody's. The public availability of ratings helps "level the playing field" between, for example, large and small investors, enhances the transparency and efficiency of financial markets, and allows the market and all users of ratings to assess independently the aggregate performance of our rating system.

  15.  While Moody's ratings have done a good job predicting the relative credit risk of debt securities and debt issuers, as validated by various performance metrics including published rating accuracy ratios and default studies, they are not statements of fact about past occurrences or guarantees of future performance. Furthermore, ratings are not investment recommendations. The likelihood that debt will be repaid is just one element, and in many cases not the most material element, in an investor's decision-making process for buying credit-sensitive securities. Credit ratings do not address many other factors in the investment decision process, including the price, term, likelihood of prepayment, liquidity risk or relative valuation of particular securities.


  16.  In forming an opinion on the relative creditworthiness of a bank (ie the risk to bank depositors and bondholders of a default and the extent of loss in the event of such default) Moody's considers first the intrinsic financial strength of a bank on a stand-alone basis. This is set out in a Bank Financial Strength Rating (BFSR) on a scale of A to E with A being the highest intrinsic financial strength. Full details of the rating scale can be found in Annex 1.

  17.  Based on this analysis, we next assess the likelihood and extent of external support being provided to the bank in the event the bank's stand-alone financial strength is insufficient to prevent a default. Such support may come from a variety of sources, including a parent company, a regional government or a central government.

  18.  When forming an opinion on the stand-alone financial strength of a bank, Moody's analysis, as set out in a publicly available methodology, considers five key factors:

    (a)  Franchise value. This analysis focuses on the bank's market share, geographical diversification and the stability and diversification of its earnings.

    (b)  Risk positioning. Management's approach to managing risks—be they credit, market, trading, reputation, or operational, to cite a few—underpins the strategic decisions and the chance of such decisions succeeding. We look to see to what extent risk discipline is aligned with the bank's strategy.

    (c)  Regulatory environment. A strong regulatory environment combining effective regulations, active supervision, and aggressive and prompt enforcement can promote sound banking practices and limit excessive risk taking.

    (d)  Operating environment. A bank's performance is frequently constrained by its operating environment and, where conditions are particularly difficult, banks could often be said to be the victims of their environments.

    (e)  Financial fundamentals. This analysis focuses on the bank's profitability, liquidity, capital adequacy, efficiency and asset quality.

  19.  When forming an opinion on the likelihood of external support from the government being provided to the bank, Moody's analysis would involve a two step process:

    (a)  First, to identify the overall willingness of the government to support troubled banks. Moody's determination of system-wide support focuses on the country's history of bank-deposit defaults, as well as the importance of the banking system to the national economy and the overall strength of the banking system.

    (b)  The second step is to evaluate the probability and extent of support that would be provided to an individual bank. Moody's examines the significance of the bank's role in the payments system, its overall importance to the national economy, and the size of the bank's deposit and loan market shares.

  20.  In order to arrive at a credit rating opinion, both dimensions of Moody's analysis are presented to a rating committee of Moody's analysts. Credit ratings are determined through rating committees, by a majority vote of the committee's members, and not by any individual analyst. The composition of the rating committee varies based on the nature and complexity of the credit rating being assigned. It includes the Chair, who acts as the moderator of the committee, the lead analyst, who presents his or her recommendation and the analysis supporting it, and other participants, which can include support analysts, other specialists or senior-level personnel, as are deemed appropriate.

  21.  Once a credit rating is assigned, it is then disseminated to the market and subsequently monitored, as necessary, to ensure that it continues to reflect Moody's opinion of the creditworthiness of the bank.


  22.  Northern Rock has been publicly rated by Moody's since 1996, initially as a building society and subsequently as a listed bank. Before this summer's market turmoil, its long term debt and deposit ratings were rated Aa3 by Moody's, which means a very low credit risk to depositors and senior bond holders as compared to other entities rated on our 21 scale rating system. In arriving at this opinion, Moody's factored in the possibility of support from the UK Government in the event of difficulties, based on the systemic importance of the bank to the UK economy.

  23.  Moody's opinion on the stand-alone financial strength of Northern Rock, which excludes all elements of external support, was B-.[16] In our view, the factors that supported the rating were the solid mortgage origination franchise of the bank, its good asset quality, and a history of stable earnings and satisfactory profitability.

  24.  We identified Northern Rock's funding model, with its reliance on the wholesale markets and its inability to match asset growth with retail deposits, as one of the weaknesses of the bank. As at end 2006, retail deposits accounted for 24% of total funding compared to 43% for securitisation, 7% for covered bonds and 26% for other non-retail sources. Based on the analysis of the financial fundamentals, this meant a "liquidity score" of D+ for Northern Rock with E being the lowest possible score.

  25.  However, while we expressed concerns about the funding model, we saw the diversity of secured and unsecured wholesale funding available to the bank, including securitisation and covered bonds, as a mitigating factor. We attached a very low probability to a scenario of prolonged and complete shutdown of the wholesale markets, importantly including the structured finance market.

  26.  The maintenance of good asset quality was also flagged as a credit challenge in the light of the rapid growth of the mortgage book and the shift in origination toward riskier products.

  27.  On Friday 14 September, Northern Rock announced that, in the light of the continuing extreme conditions in global liquidity, it had reached an agreement with the Bank of England that it could raise such amounts of liquidity as might be necessary by either borrowing on a secured basis from the Bank of England or entering into repurchase facilities with it.

  28.  At 7 am on Monday 17 September, Moody's published a rating action on Northern Rock. With the availability of emergency liquidity support from the Bank of England, Moody's believed that Northern Rock would be able to meet obligations as they fell due.

  29.  Moody's announced that the long term rating of Aa3 was placed on review, "direction uncertain". By indicating "direction uncertain", Moody's signalled to the market that within the next three months there was a possibility of the rating either being upgraded or downgraded. The direction would depend on whether or not an acquisition took place, the financial profile of any such acquirer and the stand-alone credit profile of Northern Rock under a revised business model.

  30.  At the same time, the stand-alone financial strength rating was downgraded from B- to C- (see footnote 1 above). This downgrade reflected Moody's opinion about the impact of the rescue on Northern Rock's stand-alone credit profile, including the impairment to its franchise and the challenges the bank would face in reconfiguring its business model, which Moody's believes is likely to lead to a significant decline in overall profitability going forward.

  31.  Moody's rates Northern Rock's residential mortgage backed securitisation issues, most of which are undertaken through its special purpose vehicle—Granite Master Issuer. Northern Rock also uses the securitisation market to protect itself against losses on its mortgage book and securitisations through its Graphite and Whinstone issues respectively. Moody's rates some of the tranches of these issues. Moody's also rates the eight covered bonds issued by Northern Rock with total outstandings on the bonds of £8.6 billion as at end September.


  32.  Over the past 40 years, the global financial system has evolved from a slow paced world of fixed exchange rates, capital controls, bank-dominated financial flows and modest domestic and international capital markets into one in which capital flows freely across borders, investors and borrowers invest and borrow globally, and capital is allocated by the securities market rather than by banks.

  33.  Deregulation, disintermediation and financial innovation have created a financial system that is vastly more efficient than before, and which allow excess savings in one country or region to finance investment in a completely different location. Such free flow of capital has contributed significantly to the growth of the global economy.

  34.  Prior to the disintermediation of the markets, credit crunches occurred when the central bank brought the official rate above the time deposit interest rate ceiling to slow the economy. This action caused funds to flow out of the banking system, which in turn forced banks to restrict credit.

  35.  Modern credit crunches are caused by an unexpected exogenous shock that destroys market confidence eg: a geopolitical event—the Iraq conflict (1990-91); a sovereign default and the near-collapse of a big hedge fund (1998); major accounting frauds and associated defaults—the technology bubble (2001-02); or the unexpected re-valuation of a large asset class—U.S. sub-prime bubble (2007). The transmission mechanism in the modern credit crunch is not bank credit or interest rates, but rather sudden changes in market risk premia as expressed in credit spreads and credit availability.

  36.  The 2007 shock relating to U.S. subprime mortgages and consequent global credit market liquidity problems have, as with previous shocks, invited comment about the role, function and performance of credit rating agencies. Many recognise the unprecedented combination of forces driving mortgage delinquencies in the U.S.: the decline and eventual reversal in home price appreciation, the sharp contraction in credit available for refinancing, the deterioration in mortgage underwriting processes and the now-apparent extent of misrepresentation in the mortgage application process.

  37.  Recent events have again proven that markets can change rapidly and dramatically. The opportunity to improve market practices, including credit analysis and credit-ratings processes, must be pursued vigorously and transparently if confidence in, and the healthy operation of, credit markets are to be restored.

  38.  Moody's continuously reviews and enhances its working practices to take account of experience. There are four areas where Moody's is currently considering making changes within its own business:

    (a)  Increasing market awareness of the meaning and limitations of Moody's ratings. A Moody's rating assesses solely the risk of credit loss. This is an important element of the risks facing investors when they buy a security. However, the price of a security is affected by many factors other than credit, including liquidity risk, interest rate risk and currency risk. Therefore, a Moody's rating is an imprecise and incomplete proxy for the price of a security[17] if used alone.

    (b)  Enhancing our transparency. Moody's will explore enhancements in particular in relation to our assumptions about macroeconomic factors and scenarios and our opinions on third parties and their documentation that Moody's relies on when rating transactions.

    (c)  Developing additional measurement tools. Moody's is developing potential supplemental tools for investors to assess risks beyond expected credit loss, including valuation and pricing services for the structured finance market. Such tools would enhance transparency and strengthen secondary markets for structured products.

    (d)  Further strengthening of conflict of interest protections. Moody's has a number of measures in place to protect the integrity of our rating opinions. These protections are described in our Code of Professional Conduct, which is attached to this submission. While we believe these protections are robust and transparent, we also believe that we should continually work to enhance the means through which we avoid or mitigate the potential conflicts of interest inherent in our business model.

  39.  There are also potential market-level changes that Moody's believes would further facilitate the restoration of market confidence and mitigate future credit market disruption.

    (a)  Disclosure requirements. In a number of areas, Moody's believes that disclosure requirements should be reviewed, particularly in relation to:

    (i)  the assets held by unregulated but systemically important institutions;

    (ii)  the performance of asset pools underlying securitisation transactions;

    (iii)  valuation practices; and

    (iv)  bank exposures to off-balance sheet vehicles.

    (b)  Accounting issues, particularly in relation to the consolidation of off-balance sheet funding vehicles.


  40.  In December 2004, the International Organisation of Securities Commissions ("IOSCO") adopted its Code of Conduct Fundamentals for Credit Rating Agencies (the "IOSCO Code"). It provides a global framework of principles for the behaviour of credit rating agencies and for transparent disclosure of their procedures, rating methodologies and rating performance metrics.

  41.  In June 2005, Moody's adopted its Code of Professional Conduct, which was closely modelled on the IOSCO Code. In October 2007, Moody's issued an updated version of its Code of Professional Conduct. The changes made reflected Moody's continuing efforts to clarify and enhance its policies and processes for ensuring the integrity, objectivity and transparency of its ratings processes, in a manner consistent with the IOSCO Code.


  42.  In Europe, regulators supported the IOSCO Code. Following an evaluation in 2005 by the Committee of European Securities Regulators ("CESR"), the European Commission (the "Commission") issued a communication in March 2006.[18] The communication favoured self-regulation by credit rating agencies based on the standards of the IOSCO Code and the provisions of relevant EU securities laws that apply to all market participants, including rating agencies. Furthermore, the Commission asked CESR to monitor the rating agencies and their adherence to the IOSCO Code and to report back to the Commission on an annual basis.

  43.  CESR's first report on rating agency adherence to the IOSCO Code was published in January 2007. In this report CESR concluded that the rating agency "codes comply to a large extent with the IOSCO Code".[19] In undertaking its review, CESR consulted with market participants as well as the credit rating industry.

  44.  CESR has commenced its 2007 review. CESR is evaluating the areas identified in its 2006 report, which include the impact of the US Reform Act on the credit rating business in the European Union, and the role of rating agencies in the structured finance process. The report will also respond to specific questions sent to CESR by Commissioner Charlie McCreevy following this summer's market turmoil. CESR plans to publish a draft of its 2007 report in February 2008 for consultation. The final report is due to be published in May 2008.

November 2007

16   Banks rated in the B range (B+, B, B-) are considered to possess strong intrinsic financial strength. Typically, they will be institutions with valuable and defensible business franchises, good financial fundamentals, and a predictable and stable operating environment. Please see Annex 1 for Moody's Bank Financial Strength Rating Scale and definition. Back

17   When interest rates rise 0.25%, the price of government bonds will generally fall. The credit risk of the government bonds will be unchanged. Back

18   Communication from the Commission on Credit Rating Agencies (2006/C 59/02). Back

19   CESR's Report to the European Commission on the compliance of credit rating agencies with the IOSCO Code Ref: CESR/06-545. Back

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