What’s Up with Ratings?

CFA Society of OrlandoCitrus Club Downtown

November 20, 2013

James H. Gellert, Chairman and CEO@JamesHGellert, @RapidRatings

AGENDA

• Ratings – how we got here

• What’s happened to the industry?

• How it is changing (or not)?

• Competition

• Approaching things differently – Rapid Ratings

• Efficacy, case studies

• Immediate capital markets’ importance

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What we’ll cover

BRIEF HISTORY

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• It’s old!What’s With This Industry?

BRIEF HISTORY

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• It’s old!- Fitch 1923; Moody’s 1900; Standard & Poor’s 1906 and 1860- Rating ability to pay back debt, default probability and loss given default- Was “subscriber-paid,” then turned to “issuer-paid” in the 1970s

• The stated objective, and the rub- To help investors. But they are most particularly a help to issuers- Myriad problems result

• Legislative and regulatory scrutiny- Senate:

2002, 2005, 2006, 2009- House of Representatives:

2007, 2008, 2009, 2011, 2012 - SEC:

2002, 2003, 2008, 2009, 2013

What’s With This Industry?

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• The industry has been “oligopolized”- Institutionalized, embedded in regulation and in practice- Arbitraged, manipulated, encouraged- Incumbents have had ethical and procedural lapses- Standards abandoned for commercial objectives- Incumbents creatively inhibit competition

• Solutions, sort of…- 2006 Credit Rating Agency Reform Act - Nationally Recognized Statistical

Ratings Organizations (“NRSRO”)- Dodd-Frank’s ratings language

939A, Franken Amendment- But… NRSRO codification, protection of the incumbents, window dressing,

competition-hindering requirements, admin and compliance burdens, increased legal liability

Many problems, not many solutions

Problems and Solutions(?)

IRONY OR HYPOCRISY?

Department of JusticeOffice of Public Affairs

FOR IMMEDIATE RELEASETuesday, February 5, 2013

Department of Justice Sues Standard & Poor’s for Fraud in Rating Mortgage-Backed Securities in the Years Leading Up to the Financial Crisis

Complaint Alleges that S&P Lied About its Objectivity and Independence And Issued Inflated Ratings for Certain Structured Debt Securities.

6*http://www.calpers.ca.gov/eip-docs/about/pubs/cafr-2012.pdf; page 5

• Joined by 16 states: AZ, AR, CA, CO, CT, DE, DC, ID, IL, IA, ME, MS, MO, NC, PA, TN & WA (and NJ followed recently)

• BUT CA, CO, IA, PA, TN, NJ all mandate the use of S&P; e.g.:

“From the most general perspective, 88 percent of the total fixed income portfolio must be invested in investment grade securities.

Investment-grade securities are those fixed income securities with a Moody’s rating of Aaa to Baa or a Standard & Poor’s rating of AAA to BBB.

Each portfolio is required to maintain a specified risk level.”*

COMPETITION

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• NRSROs- 10 NRSROs after 2006 CRA Reform Act - How many now?

• Different models- Issuer-paid, user-paid, investor-owned, public utility, and others

• Different strategies- Replicate the traditional model- Approach differently

• Asset class makes a difference- Structured products are the most different of all

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THE BIG THREE PLUS

RAPID RATINGS

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• User-paid, not issuer-paid• Independent, quantitative, scalable, timely • Three years earlier than Moody’s• Debt issuers and non-debt issuers rated• Financials only, no management input, no market signals

• Financial Health Ratings• Non reductionist approach• Wide variety of performance measures

• Public & private companies globally rated on apples-to-apples bases• Currently rating:

• 12,000 public firms globally, and growing• 10,000 private firms for clients on a confidential basis, and growing

DIFFERENT BUSINESS MODEL, NEW PERSPECTIVE

BUSINESS SEGMENTS AND USES

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Lenders’ credit decisions and oversight

Credit & equity risk management

Credit & equity investing

Insurance underwriting

Assessing CLOs

Broker/dealer trading

M&A analysis

Indexing

Vendor risk management

Commercial tenant risk assessments

Single name, sector & portfolio analysis

Fiduciary & regulatory oversight

Enterprise risk management

Investment portfolios

Counterparty risk

A/R management

New customer evaluation

Acquisition due diligence

Supply chain risk management

FINANCIAL SERVICES SEGMENT CORPORATE SERVICES SEGMENT

Traditional Ratings Research

Corporate Risk Portfolio Analytics

PERFORMANCE VS. DEFAULT

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Through the Financial Crisis’ High Volatility, FHRs Continued to Perform Exceptionally Well as Predictors of Corporate Health and Failure

Very High Risk High Risk Medium Risk Moderate Risk Low Risk

0 to 19 20 to 39 40 to 59 60 to 79 80 to 100

At default…

25 was the average FHR

90% of firms were High Risk or below

99% were below investment grade

66% were consistently rated High Risk or Very High Risk for at least 18 months prior

33% experienced a significant downgrade of 10 or more points in the 18 month period prior

US Industrial Defaulters, 1991 to 2012

Red shows 1,124 industrials under coverage that defaulted or filed for bankruptcy.

PERFORMANCE VS. EQUITIES

ENHANCED RETURNSRapid Ratings constructed a blue-chip portfolio and evaluated its performance using FHRs against a broad equity index (the S&P 500) to determine our performance. Result:

2012 3-year 10-year 2000 – 2012

RRI Low Volatility Portfolio 13.62% 31.63% 101.85% 73.73%

S&P 500 13.41% 27.90% 62.10% -2.93%

Difference .21% 3.73% 39.75% 76.66% 11

CFA TEST

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MF GLOBAL

RAPID RATINGS GAVE MORE THAN 2 YEARS OF EARLY WARNING

Rapid Ratings’ FHR on Twitter is 19. Facebook was rated 73 at IPO, and LinkedIn 69.

To understand Twitter’s IPO, we created an IPO profile to match it against Bubble-era companies versus contemporary IPOs.

Twitter’s profile more closely matches the IPOs of the 1997-2000 period than any time since, making Twitter indeed a Bubble-era type IPO.

Tracking Twitter’s Financial HealthTracking Twitter’s Financial Health

TWITTER

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INDIVIDUAL COMPANY ANALYSIS

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“The rating continues to depict a Very High Risk credit profile as overall profitability, debt service management, cost structure and sales performance are at low levels relative to the global data set.

“The bottom line: Notwithstanding the recent upgrade, Patriot Coal Corp is situated in our Very High Risk group, displays weakness in four of our six performance categories and demonstrates significant underperformance in ROCE. This suggests that to those for whom Patriot Coal Corp represents an existing exposure, such exposure should be very closely monitored. For those considering Patriot Coal Corp as a new or increased exposure, great caution is needed.”

FHR REPORT

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US HIGH YIELD COMPARISON GRAPH, Q4'09 TO PRESENT

Bond Market – Maturity Wall

LEV LOANS: MATURITY WALL

LEVERAGED LOANS INDEX MATURITY PROFILE ($MN)

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SUMMARY

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• Ratings are an entrenched part of the capital markets• Banks will deemphasize use, but pensions will drive change• The markets need new ways of looking at risk• Some change is happening, but it’s slow

- More competition is needed and awareness of unintended consequences- More access to data/information- Less focus on administration/compliance - Less focus on legal liability

• Competition can grow and succeed irrespective• New players must be nimble and prove value• Ethical standards are needed to restore confidence

AN INDUSTRY IN NEED OF CHANGE

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James H. GellertChairman and CEO

Rapid Ratings International Inc.86 Chambers Street, Suite 701New York, NY 10007Tel: 646-233-4600gellert@rapidratings.com@JamesHGellert, @RapidRatings

Disclaimer: A Financial Health Rating (FHR™) or equity recommendation from Rapid Ratings™ is not a recommendation or opinion that is intended to substitute for a financial adviser's or investor's independent assessment of whether to buy, sell or hold any financial products. The FHR™ is a statement of opinion derived objectively through our software from public information about the relevant entity. This information and the related FHR’s™ and related analysis provided in the reports by Rapid Ratings™ do not represent an offer to trade in securities. The research information contained therein is an objective and independent reference source, which should be used in conjunction with other information in forming the basis for an investment decision. Rapid Ratings™ believes that all of its reports are based on reliable data and information, but Rapid Ratings™ has not verified this or obtained an independent verification to this effect. Rapid Ratings™ provides no guarantee with respect to the accuracy or completeness of the data relied upon, nor the conclusions derived from the data. Each FHR™ is a relative, probabilistic assessment of the credit risk of the relevant entity and its potential to meet financial obligations. It is not a statement that default will or will not occur given that circumstances change and management can adopt new strategies. Reports have been prepared at the request of, and for the purpose of, the subscribers to our service only, and neither Rapid Ratings™ nor any of our employees accept any responsibility on any ground whatsoever, including liability in negligence, to any other person. Finally, Rapid Ratings™ and its employees accept no liability whatsoever for any direct, indirect or consequential loss of any kind arising from the use of its ratings and rating research in any way whatsoever, unless Rapid Ratings™ is negligent in misinterpreting or manipulating the data, in which case, our maximum liability to our client is the amount of our fee for the report.

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