Rating Transitions and Serial Dependence

Rating Transitions and Serial Dependence Exhibit 8 depicts historical average one-year rating transition rates for senior unsecured obligations of cor- porate bond issuers. The table shows the average one-year transition rates for annual cohorts formed between 1970 and 2001, where each annual cohort is weighted by its size (the number of issuers).

Exhibit 8 reveals some important features of the behavior of ratings and Moody’s rating process over one-year horizons. Higher ratings have generally been less likely than lower ratings to be revised over a one- year period. For example, the inertial frequency for Aaa-rated issuers, was 89% — i.e., the ratings of 89% of Aaa-rated issuers did not change within one year. By contrast, an issuer that began the year within the broad B rating category ended the year with that same broad rating only 78% of the time. We also note that, for issuers holding ratings in the middle of the rating scale, the likelihood of a rating upgrade and a rating down- grade is roughly symmetrical. Of course, Aaa-rated issuers can only migrate down the rating scale (or exit the pool via default or withdrawn ratings (WR)), while Caa-rated issuers can only migrate up the rating scale (or exit the pool via default or a withdrawn rating).

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Exhibit 8 presents a so-called “unconditional” rating transition matrix, treating all issuers with a specific rating the same, regardless of how they came to have that rating (either through their initial rating assign- ments, downgrades or upgrades).

Exhibit 7

Average Debt Prices As a Percent of Face Value One Month After Default, 1982-2001 Senority Recovery

Sr. Secured Bank Loans 64% Sr. Unsecured Bank Loans 48% Equipment Trust Certficates 66% Sr. Secured Bonds 53% Sr. Unsecured Bonds 40% Sr. Subordinated Bonds 32% Subordinated Bonds 31% Jr. Subordinated Bonds 22%

Exhibit 8

One-Year Average Rating Transition Matrix, 1970-2001 Rating to: Aaa Aa A Baa Ba B Caa-C Default WR

Rating from:

Aaa 89.09% 7.15% 0.79% 0.00% 0.02% 0.00% 0.00% 0.00% 2.94% Aa 1.17% 88.00% 7.44% 0.27% 0.08% 0.01% 0.00% 0.02% 3.01% A 0.05% 2.41% 89.01% 4.68% 0.49% 0.12% 0.01% 0.01% 3.21% Baa 0.05% 0.25% 5.20% 84.55% 4.51% 0.69% 0.09% 0.15% 4.51% Ba 0.02% 0.04% 0.47% 5.17% 79.35% 6.23% 0.42% 1.19% 7.11% B 0.01% 0.02% 0.13% 0.38% 6.24% 77.82% 2.40% 6.34% 6.67% Caa-C 0.00% 0.00% 0.00% 0.57% 1.47% 3.81% 62.90% 23.69% 7.56%

7. See Default & Recovery Rates of Corporate Bond Issuers, February 2002, and LossCalc: Moody’s Model for Predicting Loss Given Default, February 2002, for a full discussion.

Exhibit 9

One-Year Conditional Rating Transitions, 1984-2001 One-Year Conditional Default Rates, 1984-2001 Following These Rating Actions During Following These Rating Actions During

Rating Changes Previous Year Initial Rating Previous Year Over One Year Upgraded Unchanged Downgraded Level Upgraded Unchanged Downgraded

Upgraded 16.17% 8.83% 7.46% Ba1 0.00% 0.87% 1.09% Unchanged 76.23% 76.73% 66.43% Ba2 0.35% 0.60% 1.79% Downgraded 6.86% 13.34% 20.33% Ba3 2.31% 2.59% 3.53% Default 0.74% 1.10% 5.78% B1 1.86% 3.97% 3.96%

100.00% 100.00% 100.00% B2 0.85% 5.25% 10.47% B3 11.70% 8.41% 23.00% Caa-C 11.86% 9.92% 32.38%

Moody’s Special Comment 11

Exhibit 9 reveals that, in fact, historical rating transition frequencies vary sharply, depending on whether a company’s rating was downgraded, unchanged, or upgraded in the previous year. Companies that have recently been upgraded are roughly twice as likely to be upgraded again during the following year, as com- pared with companies that have recently been downgraded or have experienced no recent rating change at all. Similarly, over the following year, companies that have recently been downgraded are: (a) almost one and one-half times more likely to be downgraded and five times more likely to default than companies that expe- rienced no prior rating change; and (b) three times more likely to be downgraded and nearly eight times more likely to default than companies that have recently been upgraded.

These differences in rating transitions for issuers that had been previously downgraded or upgraded should be considered in a broader context. Although they appear to be substantial in the short run, the dif- ferences are likely to be less pronounced over longer horizons. Moreover, the differences are likely to be considerably smaller for issuers that are assigned stable outlooks following a rating change. On the other hand, these differences are likely to be more pronounced for issuers who either (1) remain on review for downgrade or are assigned a negative outlook following a rating downgrade, or (2) remain on review for upgrade or are assigned a positive outlook following a rating upgrade.

Exhibit 9 also reveals that conditional one-year default rates by broad rating category may vary, depend- ing on whether or not an issuer experienced a rating change during the prior year. For some rating levels, the default rate for an issuer that experienced a downgrade during the prior year is almost double that for issuers holding the same rating but whose ratings were upgraded. Small sample sizes for upgraded B2, B3 and Caa-C rated issuers contribute to the anomalous results shown for these categories.

The ratings momentum demonstrated in Exhibit 9 is a natural consequence of our rating system-man- agement practices. These do two things in particular: (a) limit rating changes when there are substantial pos- sibilities of near-term rating reversals; and (b) dampen potential ratings volatility by incrementally adjusting ratings in response to changes in credit fundamentals, and by using other signals in the rating system to indi- cate likely additional rating changes (as described earlier). We will publish follow-up studies of these effects as we gather further information.

Conclusion In summary, credit ratings powerfully discriminate among relative long-term risks. They target multiple horizons, rather than a single, defined investment horizon. Moreover, they do not target constant, absolute expected credit-loss rates by rating category. Investors who wish to make the best use of credit ratings should understand these properties of the ratings.

Moody’s believes that our ratings system-management practices, as set forth above, are desired by both issuers and investors. Issuers want stability in ratings and the opportunity to make changes in their financial condition, if possible, to avoid changes in ratings. Investors want ample notice of potential rating changes, in part because of investment requirements and restrictions that may be placed on them by owners of funds or their representatives such as endowments and pension fund sponsors, and especially with respect to rating changes resulting in changes in indices against which the investors may be measured.

Moody’s has carefully considered whether our ratings system-management practices diminish the pri- mary social value or public good that rating agencies can produce, which is greater efficiency in capital mar- kets. We believe that ratings momentum, as we have described it, does not detract from capital market efficiency or permit transfer of wealth between sophisticated and unsophisticated investors.

In general, Moody’s does not believe that the information conveyed by rating outlooks, the Watchlist, or ratings themselves benefits one class of investors over another. Moody’s disseminates this information publicly and believes that market participants understand the information equally.

Moody’s also believes that our ratings system management does not benefit issuers or investment and commercial banks, which may have extended credit to issuers or have opportunities for important fees, over investors with existing or potential positions. Moody’s buy-side meetings have strongly confirmed that investors dislike downgrades as much as issuers, and probably more than investment bankers, who have many opportunities for additional fees, including opportunities from downgrades.

Moody’s also notes that corporate bonds are generally held by financial institutions or in investment vehi- cles — pension fund investments or mutual funds advised by institutional investors — rather than by individu- als, and believes that institutional investors are well aware of the attributes of Moody’s rating system.8 In addition, common market wisdom is that prices of corporate bonds generally adjust, based on changes in rating

12 Moody’s Special Comment

outlooks or the Watchlist, as well as on changes in the ratings themselves. Moody’s has not previously main- tained a database of our rating outlooks, but will do so in the future and will carefully monitor and make public an analysis of bond price changes following changes in rating outlooks, the Watchlist, and ratings. Finally, this Special Comment should better inform issuers, investors, and owners of funds or their representatives about Moody’s ratings system-management practices so that they can make any adjustments they desire in their uses of Moody’s rating system.

In order to promote a clearer understanding of Moody’s management of the rating system and the sig- nals conveyed by bond ratings, as well as other signals-rating outlooks and the Watchlist-of the rating sys- tem, we have detailed in this paper how Moody’s conducts and will conduct its corporate bond-rating activities, the intended meaning of Moody’s ratings, and their empirical attributes. Our dialog with the mar- ket suggests that improved transparency of our behavior and of the meaning and attributes of ratings may help users better utilize them in their financing, investment, and related decisions. Moody’s bond ratings are not high-frequency sources of information. Instead, they are based on careful, deliberate analysis and will sometimes appear to “lag the market.”

Nevertheless, we believe that a rating system expressing independent credit opinions derived from fun- damental analysis provides a valuable means of overcoming the asymmetry of information between borrow- ers and lenders in the global capital markets and contributes to investor protection and market efficiency. Our objective is to continue to manage the rating system in a way that best meets the needs of market partic- ipants and contributes to market efficiency.

Bibliography — Moody’s Special Comments 1. Default & Recovery Rates of Corporate Bond Issuers: A Statistical Review of Moody’s Ratings

Performance 1970-2001, February 2002. 2. Moody’s Rating Migration and Credit Quality Correlation, 1920-1996, July 1997. 3. Predicting Default Rates: A Forecasting Model for Moody’s Issuer-Based Default Rates, August 1999. 4. Debt Recoveries for Corporate Bankruptcies, June 1999. 5. An Historical Analysis of Moody’s Watchlists, October 1998. 6. Testing for Rating Consistency in Annual Default Rates, February 2001.

8. Moody’s will continue to monitor direct individual participation in the corporate bond market and notes that during 2001 there was significant issuance of structured notes for retail customers based on corporate bonds.

Moody’s Special Comment 13

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16 Moody’s Special Comment

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