Memorandum from Moody's
EXECUTIVE SUMMARY
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.
INTRODUCTION TO
MOODY'S
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.
MOODY'S
APPROACH TO
RATING BANKS
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.
NORTHERN ROCK
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.
OVERALL FUNCTIONING
OF FINANCIAL
MARKETS
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.
REGULATION OF
RATING AGENCIES
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.
EU
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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