Memorandum by Moody's Investors Service
(LAI 40)
INTRODUCTION TO
MOODY'S
INVESTORS SERVICE
("MIS")
1. MIS 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. Additional
information about the company is available at www.moodys.com.
THE ROLE
OF CREDIT
RATING AGENCIES
2. Rating agencies occupy an important but
narrow niche in the information industry. Our role is to disseminate
opinions about the relative creditworthiness of, among other things,
bonds issued by corporations, banks and governmental entities,
as well as pools of assets collected in securitized or "structured
finance" obligations. By making these opinions broadly and
publicly available, rating agencies help to level the playing
field between borrowers (debt issuers) and lenders (debt investors).
Specifically, rating agencies serve the market by reducing information
asymmetry between borrowers and lenders. We sift through the vast
amount of available information, analyze the relative credit risks
associated with debt securities and/or debt issuers and provide
our analysis to the investing public for free.
THE LIMITS
AND ATTRIBUTES
OF CREDIT
RATINGS
3. MIS ratings provide predictive opinions
on one characteristic of an entity—its likelihood to repay
debt in a timely manner. Our ratings of corporate issuers (including
financial institutions) are based primarily on analysis of financial
statements, as well as assessments of management strategies, industry
positions and other relevant information. Our ratings of structured
finance bonds[12]
are based primarily on analysis of the transaction's legal structure,
the cash flows associated with the assets on which the deal is
based and other risks that may affect the bonds' cash flows. Our
analysis necessarily depends on the quality, completeness and
veracity of information available to us, whether such information
is disclosed publicly or provided confidentially to MIS's analysts.
4. The heart of our service is expressing
opinions on the relative credit risk of long-term, fixed-income
debt instruments, expressed on a 21-category rating scale, ranging
from Aaa to C.[13]
In the most basic sense, all bonds perform in a binary manner:
they either pay on time, or they default. If the future could
be known, we would need only two ratings for bonds: "Default"
or "Won't Default". Because the future
cannot be known, credit analysis necessarily resides in the realm
of opinion. Therefore, rather than being simple "default/won't
default" statements, our ratings are opinions about the risk
of outcomes in the future with degrees of uncertainty.
5. Moreover, our opinions are about the
relative credit risk of one MIS-rated bond versus other MIS-rated
bonds. In other words, MIS's ratings provide a perspective on
the relative rank ordering of credit risk, with the likelihood
of loss increasing with each downward step on the rating scale.
The lowest expected loss is at the Aaa level, with higher expected
losses at the Aa level, yet higher expected losses at the single-A
level, and so on.
6. The predictive value of MIS's ratings
is demonstrated in our annual default studies and periodic ratings
performance reports, which we post on our website, www.moodys.com.
These default studies show that both our corporate and our structured
finance ratings have been reliable predictors of default over
many years and across many economic cycles.
THE APPROPRIATE
USE OF
CREDIT RATINGS
7. We believe it is essential for investors
and others to understand the role of rating agencies and what
credit ratings can and cannot do. MIS has always been clear that
our ratings should be used primarily as a gauge of relative default
probabilities and expected credit loss. We discourage people from
using our ratings as indicators of price, as measures of liquidity,
or as recommendations to buy or sell securities—all of which
are regularly influenced by factors unrelated to credit. MIS's
ratings are not designed to address any risk other than credit
risk and should not be assigned any other purpose. In this regard,
our Code of Conduct states that:
8. "Credit Ratings are Moody's current
opinions of the relative future credit risk of entities, credit
commitments, or debt or debt-like securities. … Credit
Ratings do not address any other risk, including but not limited
to: liquidity risk, market value risk, or price volatility. Credit
Ratings are not statements of current or historical fact. Credit
Ratings do not constitute investment or financial advice, and
Credit Ratings are not recommendations to purchase, sell, or hold
particular securities. Credit Ratings do not comment on the suitability
of an investment for any particular investor. Moody's issues its
Credit Ratings with the expectation and understanding that each
investor will make its own study and evaluation of each security
that is under consideration for purchase, holding, or sale."
9. In each document that MIS publishes,
the disclaimer language includes the following:
10. "Each rating or other opinion
must be weighed solely as one factor in any investment decision
made by or on behalf of any user of the information contained
herein, and each such user must accordingly make its own study
and evaluation of each security and of each issuer and guarantor
of, and each provider of credit support for, each security that
it may consider purchasing, holding or selling."
THE ISSUER-PAYS
BUSINESS MODEL
AND CONFLICTS
OF INTEREST
11. The only parties likely to pay for ratings—whether
issuers, investors or governments—are parties directly interested
in the outcomes. So long as credit rating agencies compete for
business, potential conflicts of interest will exist and attempts
to persuade rating agencies about their credit perspectives could—and
historically have—come very democratically from all sectors.
A few simple examples:
— Issuers: issuers are motivated to see
their ratings sustained or, ideally, upgraded.
— Short Investors (for example, hedge funds
that take a significant short position on a particular company):
as subscribers under an investor-pays model, they may be highly
motivated to encourage a negative rating action—and the
more negative and unexpected the action, the better.
— Long Investors: similar to their short
counterparts, long investors are understandably interested in
the outcome of rating actions. Before they purchase a security
they may prefer lower ratings to obtain higher yields; following
a purchase (especially for those who trade actively) they are
likely to want to have ratings maintained or raised rather than
lowered.
— Governments: governments, often faced
with competing financial market and social policy objectives,
may seek to have ratings "protect" nationally or systemically
important issuers such as large industrial employers or banks.
12. There is therefore, no conflict-free
business model for credit rating agencies. All of the parties
above may want ratings assigned and maintained in a manner that
is most beneficial to their interests, and those wishes might
sometimes conflict with the "right" rating. This tension
is understandable, expected by the credit rating agencies, and
must be managed appropriately and transparently.
13. Importantly, the significant advantage
offered by the issuer-pays model over any other model is the ability
of the credit rating agency to make its ratings freely and publicly
available to the market as a whole at the same time. This free
availability of information would be lost under an investor pays
model.
MIS'S APPROACH
TO RATING
BANKS
14. 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) MIS 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.
15. 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.
16. When forming an opinion on the stand-alone
financial strength of a bank, MIS 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.
17. When forming an opinion on the likelihood
of external support from the government being provided to the
bank, MIS analysis would involve a two step process:
(a) First, to identify the overall willingness
of the government to support troubled banks. MIS 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. MIS 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.
18. In order to arrive at a credit rating
opinion, both dimensions of MIS analysis are presented to a rating
committee of MIS 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.
19. 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 MIS opinion
of the creditworthiness of the bank.
REVIEW OF
THE CRA INDUSTRY
AT THE
INTERNATIONAL LEVEL
AND IN
THE EU
20. As some of the respondents indicated,
globally, the role and use of credit ratings is presently under
review. Analysis is being conducted by a number of entities, including,
the International Organisation of Securities Commissions ("IOSCO")
and the Financial Stability Forum ("FSF"). In
October 2007, the FSF was directed by the G-7 Finance Ministers
and central bank Governors to undertake an analysis of the current
market turmoil and to make recommendations for enhancing the resilience
of the markets and financial institutions. The FSF's final report
was delivered to the G-7 Finance Ministers and central bank
Governors at their meeting on April 11, 2008, at which meeting
the G-7 agreed to adopt the proposals and asked the FSF to
report on the implementation of the various recommendations at
the G-7's June meeting. With respect to the credit rating industry,
the FSF made the following general recommendations:
(a) Credit rating agencies should improve the
quality of the rating process and manage conflicts of interest
in rating structured finance products.
(b) Credit rating agencies should somehow distinguish
ratings on structured finance products from those on corporate
ratings[14]
and expand the initial and ongoing information provided on the
risk characteristics of structured products.
(c) Credit rating agencies should enhance their
review of the quality of the data input and of the due diligence
performed on underlying assets by originators, arrangers and issuers
involved in structured finance products.
(d) Investors should address their over-reliance
on ratings, and investor associations should consider developing
standards of due diligence and credit analysis for investing in
structured products. In addition, relevant authorities should
review the use of credit ratings in the regulatory and supervisory
framework to ensure investors make independent judgment of risks
and perform their own due diligence.
21. MIS supports these recommendations and
we will continue to support these and other efforts. We believe
that implementation of these measures globally can have a positive
impact in helping to address some of the issues about the use
of ratings that some of the respondents have identified. For our
part, we already have begun to adopt many of the recommendations
that are addressed specifically to the rating agency industry.[15]
22. In Europe, the European Commission published
a proposed regulation for the credit rating agency industry in
November 2008, which is currently subject to discussion and ultimately
voting by the European Parliament and the Council. The proposed
regulation establishes standards governing areas such as transparency,
governance and processes of credit rating agencies and pursuant
to the proposed regulation, credit rating agencies in the EU will
be subject to full supervisory oversight.
30 January 2009
12 In using the term "bonds", the memorandum
is referring to bonds and other types of debt instruments that
are rated by MIS. Back
13
MIS also assigns short-term ratings-primarily to issuers of commercial
paper-on a different rating scale that ranks obligations Prime-1,
Prime-2, Prime-3 or Not Prime. Back
14
For purposes of this memorandum, the term "corporate ratings"
encompasses ratings on industrial, utility, and financial institution
companies. Back
15
Please see MIS Special Comment, "Strengthening Analytical
Quality and Transparency: An Update on Initiatives Implemented
by Moody's Over the Past Eighteen Months," December 2008. Back
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