Effects of Credit Rating Changes to Corporate Financial Soundness
As capital is the life blood of any corporate existence this is acquired through a few ways equity, loans, bond issues, derivatives, and if allowable, even through investments. The financial soundness of a corporation is always a good basis for its performance. In terms of its credit, however, what is being gauged is its creditworthiness. Creditworthiness is gauged by credit rating companies upon request by a corporation or any entity for that matter.
Credit rating companies go through a lot of data and trace the present and past financial performance of the corporation, how it deals in its market, and the delivery of payables, credit history, and a lot of other parameters that a credit rating agency will require to do its job. Once all of these are done, a credit rating report and recommendation is submitted for review. The final grade will be decided from this exercise, and the rating is awarded to the requesting entity.
Credit ratings are forward-looking opinions that address just one characteristic of fixed income securities their creditworthiness.
Creditworthiness
Credit rating is an assessment by a third party of the creditworthiness of a requesting entity. In the corporate scenario, this informs investors the likelihood of a company default, or non-payment, of its financial obligations or vice-versa. Credit analysis is the financial tool used to determine the creditworthiness of an issuer. Credit rating agencies examine the capability of a borrower, or issuer of financial obligations, to repay the amounts owed on schedule.
Establishing the creditworthiness of a borrower is one of the established financial activities. The act of lending funds has been accompanied by an examination of the ability of the borrower to repay the funds. Medieval bankers in Europe were thorough in their examination of their clients and often decided the outcome of wars and the fate of monarchies with their financing. As modern accounting and finance developed, banking and lending grew to a larger scale and became more systematic. Just as governments developed sophisticated bureaucracies to deal with the complexities, larger banks and financial houses grew to cope with the demands of international trade.
Modern credit analysis developed in the late 1800s when the credit markets began to issue and trade bonds, particularly by the United States. As lenders were purchasing bonds of countries and companies that they had little knowledge of, third party credit rating agencies such as Duff Phelps, Inc., Moodys Investors Service, and Standard and Poors were founded to fulfil the need for the assessment of the creditworthiness of bond issuers. These companies developed scoring systems that inform investors of the creditworthiness of corporations and sovereigns. Each rating agency has its own grading system that ranks the risks of issuers. The ranking begins with the highest quality, such as AAA, with very low probability of default, and descends to risky or speculative ratings, such as BB, where the risk of default is high.
Credit ratings have been extensively used by bond investors, debt issuers, and governments as a measure of risks. These are determinants of risk premiums and even the marketability of bonds.
Credit ratings are typically very costly to obtain. Companies require agencies such as Standard and Poors and Moodys to invest a lot of amount of time and human resources to perform deep analysis of the companys risk status based on various aspects ranging from strategic competitiveness to operational details. As a result, not all companies can afford updated credit ratings, and credit rating predictions are quite valuable to the investment community.
Although rating agencies emphasize on the importance of subjective judgment in determining credit ratings, many researchers have obtained good results on credit rating prediction applying different statistical and Artificial Intelligence (AI) methods. The assumption is that financial variables extracted from public financial statements, such as financial ratios, contain a large amount of information about a companys credit history and risk. These financial variables, combined with historical ratings, have in them valuable information for expert examination of the companies credit risk levels. The objective of credit rating prediction is to build models that can extract knowledge of evaluation from historical observations and apply these to evaluate credit risk on a broader scope. Besides the prediction, the modelling of the rating process also provides valuable information to investors. By determining information used by financial analysts, these studies can help study the fundamental characteristics of different financial markets.
Credit risk analysis
There are two types of credit ratings one is for specific debt issues or other financial instruments, and another is for debt issuers. The former is the one most frequently used and can be referred to as a bond rating. It is an attempt to inform the public of the investor receiving the promised principal and interest payments associated with a bond issue. This is the information of an issuers capacity to pay, which is the issuers creditworthiness. It studies the issuers ability and history at meeting its financial commitments on time. This rating can be referred to as default or issuer credit rating. Both types are important to the investment community. A lower rating indicates higher risk, which can affect the interest yield of the issue.
Besides this, regulatory requirements for investment or financial decision in different countries are specifically based on such credit ratings requirements. Agencies advise investments only in companies having the top four investment grade ratings. Evidence in the finance and accounting literature is of prime importance in credit ratings. A company contacts a rating agency requesting that an issue rating be assigned to a companys new debt issue. Annual reports for past years, latest quarterly reports, income statement and balance sheet, most recent prospectus for debt issues, and other specialized information and statistical reports are submitted by the issuer for the process to commence. The rating agencys team of financial analysts conduct research on the characteristics of the company and the proposed issue. After meeting with the issuer, the head analyst prepares a rating report for the rating committee, together with the rating recommendations. The committee reviews the documentation and discuss the recommendation with the analysts involved. They make the final decision on the credit rating and are responsible for the rating results.
Literature review
Substantial literature can be found in rating prediction history. I categorised the methods used into statistical and machine learning methods.
Statistical methods
The use of statistical methods in rating prediction can be traced back to 1959, when Fisher utilised ordinary least squares (OLS) in his attempt to explain the variance of a bonds risk. Further studies used OLS to predict bond ratings. Pinches and Mingo utilised multiple discriminant analysis (MDA) to yield a linear discriminant function relating a set of independent variables to a dependent variable to better suit the ordinal nature of bond-rating data to increase classification accuracy.
Other researchers also used the logistic regression analysis and profit analysis. These studies use different data sets, and the prediction results were between 50 and 70. The financial variables selected included measures of size, financial leverage, long-term capital intensiveness, return on investment, short-term capital intensiveness, earnings stability, and debt coverage stability. The conclusion from bond rating prediction using statistical methods was that with a small list of financial variables, it could classify about two-thirds of a holdout sample of bonds. The problem with applying these methods to bond-rating prediction is that the multivariate assumptions for independent variables are, sometimes, incongruent with financial data sets, which makes these methods theoretically inefficient for the samples.
Artificial intelligence methods
Recent Artificial Intelligence (AI) techniques case-based reasoning systems and machine learning techniques, such as neural networks, have been used to support analysis. The machine learning techniques extract information from a data set and construct a different model to explain the data set. The difference between traditional statistical methods and machine learning methods is that statistical methods imposes structures to different models constructs the model by estimating parameters to fit the data, while machine learning techniques gets to learn of the particular structure of the model from the data. As a result, the structures of the models used in statistical methods are simple and easy to interpret, while models obtained in machine learning methods are very complicated and difficult to explain. Statistical methods use models that are simple and tend to misfit the data while in machine learning methods these generate complex models and tend to overwhelm the data. .
The most used AI method is the back propagation neural networks. Previous studies compare the performance of neural networks with statistical methods and other machine learning techniques. Dutta and Shekhar started investigating the applicability of neural networks to bond rating in 1988. They got a prediction accuracy of 83.3 classifying AA and non-AA rated bonds.
Singleton and Surkan used the back propagation neural network to classify bonds of the 18 Bell Telephone companies in 1982. The work was to classify bonds of Aaa or A1, A2 and A3 by Moodys. They obtained 88 testing accuracy. They also compared a neural network model with multiple discriminant analysis (MDA) and demonstrated that neural networks achieved better performance in predicting direction of a bond rating than what discriminant analysis could.
Kim used the neural network approach with linear regression, discriminant analysis, logistic analysis, and a rule-based system for bond rating. His team found that neural networks achieved better performance compared to other methods in terms of accuracy. The data set was prepared from Standard and Poors Compustat financial data, and the prediction work was on six rating categories. Moody and Utans used neural networks to predict 16 categories of S P rating ranging from B- and below (3) to AAA. Also tested was the system with 5-class prediction and 3-class prediction and obtained accuracies of 63.8 and 85.2 in two studies.
Maher and Sen compared the performance of neural networks on bond-rating prediction with logistic regression. They used data from Moodys Annual Bond Record and Standard and Poors Compustat financial data. The best performance they obtained was 70.
Other researchers explored building case-based reasoning systems to predict bond ratings and provide better user interpretability. The basic principle of case-based reasoning is to match a new problem with the closest previous cases and try to learn from experiences to solve the problem.
Shin and Han proposed a case-based reasoning approach to predict bond rating of firms. They used inductive learning for case indexing, and used nearest-neighbour matching algorithms to retrieve similar past cases. They demonstrated that their system had higher prediction accuracy (75.5) than the MDA (60) and ID3 (59) methods. Other researchers studied problems on default prediction and bankruptcy.
In summary, previous documents consisted of extensive efforts to apply neural networks to the bond-rating prediction problem and comparisons with other statistical methods and machine learning methods have been conducted by researchers. The conclusion was neural networks outperformed conventional statistical methods and inductive learning methods in most studies. For studies classified into more than five classes, accuracy was between 55 and 75. The financial variables and sample sizes used by such studies covered wide ranges. The number of variables used ranged from 7 to 87 and the sample size ranged from 47 to 3886. Past research in bond-rating prediction has mainly been conducted in the United States.
Bond-rating prediction is viewed as researchers efforts to model rating behaviour by using publicly available financial information. By statistical methods for bond-rating prediction problem, researchers show that historical and publicly available data are excellent for the highly complex and subjective bond-rating process.
These methods provide relatively higher prediction accuracy than simple interpretations of the bond-rating process. The use of Artificial Intelligence (AI) techniques to the bond-rating prediction achieves high accuracy levels with more sophisticated models. One technique is the neural network, which achieves best results in studies. Due to difficulty in interpreting neural network models, however, most focus on prediction accuracy.
Analytical methods
Documents of bond-rating prediction show that back propagation neural networks achieved a better accuracy level than other statistical methods and machine learning algorithms.
Back propagation neural network
Back propagation neural networks are popular for their learning capability and have shown to perform well in different applications. Typical back propagation neural network consists of a three-layer structure input-layer nodes, output-layer nodes, and hidden-layer nodes. Back propagation networks are fully connected, layered, fed-forward models. Activations flow from the input layer through the hidden layer, to the output layer. A back propagation network starts out with a random set of weights. The network adjusts its weights each time it sees an input-output pair. Each pair is processed at two stages, a forward pass and a backward pass. The forward pass involves showing a sample input to the network to let activations flow to reach the output layer. During the backward pass, the networks output is compared with the target output and error estimates are computed for the output units. The weights connected to the output are then adjusted to reduce the errors. The error estimates are then used to derive estimates for the units in the hidden layer. Finally, errors are propagated back to the connections coming from the input units. The back propagation network updates its weights until the network stabilizes.
Support vector machines
Recent advances in statistics, generalization theory, computational learning theory, machine learning, and complexity have provided new guidelines and insights in the characteristics and nature of the model building process. Researchers pointed out that statistical and machine learning models are not at all that different. New computational and machine learning methods infer parameter estimation in statistics.
Of these new methods, Support Vector Machines have attracted most interest. Support vector machine (SVM) is a learning machine introduced by Vapnik. It is based on the Structural Risk Minimization principle from the computational learning theory. Hearsts position on the SVM algorithm at the learning theory and practice is
it contains a large class of neural nets, radial basis function (RBF) nets, and polynomial classifiers as special cases yet it is simple enough to be analyzed mathematically, because it show that it corresponds to a linear method in a high-dimensional feature space nonlinearly related to input space.
Support vector machines, therefore, are for combining the strengths of theory-driven and easy to analyse conventional statistical methods and more data-driven, distributory, and robust machine learning methods.
Substantial developments have been achieved in different aspects of support vector machine usage. These include theoretical understanding, algorithmic strategies, and real-life applications. SVM has produced excellent inference performance on a wide range of problems. The SVM approach has been applied in financial applications mainly in the area of time series prediction and classification. A study investigated the use of the SVM to select bankruptcy predictors. SVM is competitive and outperforms other classifiers.
The work of supervised learning methods is to learn from observations. Vapnik showed how using a support vector machine for pattern recognition can lead to a quadratic optimisation issue with bound constraints and one linear equality constraint. The quadratic optimisation issue belonged to a type that is understood well, and due to a number of training examples, it determines the size of the problem. Using standard quadratic problem solvers will easily make the computation possible for large sized training sets. Different solutions were proposed to solve the quadratic programming problem in SVM. The standard SVM formulation solves only the binary classification problem. Several binary classifiers have to be used to construct a multi-class classifier to make changes to the original formulation to consider all classes at the same time.
Credit Rating
Credit rating is designed to evaluate risk of a business creditworthiness accurately and objectively. Credit rating is the criteria used by most banks and fund managers when establishing the suitability of a bond as an investment. These days, market situation changes very quickly and so can credit ratings.
There are two parts to a credit rating. The first is a credit limit guideline in the currency the country operates for example, pounds sterling guideline in the UK. The second is a 1 to 100 risk scale. The scale gives a consistent benchmark for assessing the risk by placing a company on the scale relative to other companies. It is the credit scale that predicts the likelihood of business failure or success allowing decision makers of a company to make credit decisions faster and even to reduce bad debts. Using credit report of a company, it is possible to judge the appropriate amount of credit to extend.
A credit rating report contains information on risk evaluation, adverse payment records, and financial statements. It helps to analyse the strength of a company. It also confirms the identity of the directors and shareholders. Using credit rating report, it facilitates financial decision makers to make confident business decisions and reduce credit risk.
Credit quality is a measure of the issuers ability to service and repay its debt. In the case of UK bonds, US Treasury bonds, and other high-quality government debt, this can be viewed as a certainty. However, for other issuers, the investor must do some homework. Credit rating is assigned to issuers by a credit rating agency which deploys considerable resources to assess both the issuer and the bond issue. It is in the interest of bond issuers to obtain these ratings. Without this rating grade, bonds will be very difficult to sell. Most institutional investors will find it difficult to purchase a bond that does not have a rating.
There are two main international credit ratings agencies frequently used to assess credit risks Moodys and Standard Poors. It is worth bearing in mind that prices in the markets will typically lead to changes in regard to changes in credit ratings.
News is always available when a large company is upgraded or downgraded. The reason these stories make news is due to the fact that the companys financial health has been examined. Downgrades mean that based on historical calculations, firms in similar financial condition have been more likely to default on their obligations. Upgrades of course mean the opposite.
The layman, normally, is unaware of what credit ratings really mean. Moodys rating is based on statistical calculations of a companys likelihood to default. Parameters are arrived at to give meaning for the ratings, such as Aaa Highest Rating Available or Ba Low Grade, the first level of Below Investment Grade or the first level of Junk Bonds. These grades seem useless without the parameters of determining what a Highest Rating Available is or Below Investment Grade are in terms of the likelihood of default on repayment or not. What is important is to note is if a company is going to default or not and the percentage of companies that default within a given rating. Moodys calculates this information.
The chart on the following page shows the Moodys Debt Rating system along with the data that Moodys calculated for the default rate of bonds within one year between 1970-2001. It can be noticed that under the grade Aaa, no company has defaulted within one year or zero occurrences It can also be observed that only 1.21 of companies with a Ba (Below Investment Grade or Junk Rating) have defaulted within a year of having that rating.
Moodys Rating
Average Default Rate Within One Year of Rating (1970-2001)
Definition
Notes
Aaa
0.00
Highest Rating Available
Investment grade bonds.
Aa
0.02
Very High Quality
A
0.01
High Quality
Baa
0.15
Minimum Investment Grade
Ba
1.21
Low grade
Below investment grade. Junk Bonds
B
6.53
Very speculative
Caa
24.73
Substantial Risk
Ca
Very poor quality
C
Imminent default or in default
The ratings from Aa to Ca by Moodys may be modified by the addition of a 1, 2, or 3 to show relative standing within the category where the highest within the rating is 1 and the lowest is 3.
There is also need to monitor the ratings as they change over time. Just because a company may have a low chance of default within one year does not mean that their rating cannot change. Ratings change and affect the market due to the increased or decreased likelihood of default. The graph on the succeeding page shows the default rate of companies based on their rating at the time the bonds were issued. It can also be noted that the Aaa bonds have very low default rates even over extended periods of time. Also note that bonds belonging to the Ba grade have a steady increase in default rate as the years go by. Caa-C bonds also have a very great chance of defaulting virtually over all the time periods. Aaa bonds that never defaulted within a year, as the chart below shows, but defaulted over the 15- and 20-year mark may have been downgraded at some point along the way.
Source Understanding Moodys Corporate Bond Ratings and Rating Process, May 2002
On the average, Aaa bonds will not default within one year. Moodys looks at ratings for a number of months before defaults occur and determines the average rating of these defaults. Moodys has rated at Ba3 bonds for up to 60 months before a default occurs, after which, on the average, there were steady downgrades that typically accelerated defaults. In general terms, there is a warning before a bond defaults. Usually, it hits Junk status between 3 and 5 years before it defaults, but not always, since these are only averages.
Here are some other reasons to watch for the ratings. Market reaction to the increase or decrease of ratings suggests a likelihood of default when ratings change. The lower the credit rating is, the higher the interest rate a given security will pay to entice investors. Some people think that an increase in the price of a bond will mean that they will be paid higher interest payments. That is not the case. Whatever the interest coupon of a bond issue is, it will be its interest payable at maturity. It is only in the selling of a bond where the price is decreased or increased dependent on credit rating. That is the risk involved. If an investor plans to hold a bond till maturity, there will be no changes to interest, unless the bond defaults. If a bond is upgraded, again the interest coupon payments stay the same, but the selling price for the bond will increase. Of course, there are a host of other factors that can lead to a gain or loss of capital in bonds acquisitions.
The effect that credit ratings have on the interest payable at maturity for a bond is obvious. The chart shows the yield spread for corporate bonds over treasury bonds for different credit ratings. Note the dramatic decrease in prices of bonds as the rating decreases. The table is indicative of what the financial world refers to as basis points. One basis point is 1100th of a percent. 100 Basis Points are equal to 1. The spreads quoted are in addition to the going rate for Treasury bonds.
There are a number of other rating services available. The table on the following page gives the equivalent ratings by different rating services.
Equivalent Credit RatingsCredit RiskMoodysStandard PoorsFitch IBCADuff PhelpsINVESTMENT GRADEHighest qualityAaaAAAAAAAAAHigh quality (very strong)AaAAAAAAUpper medium grade (strong)AAAAMedium gradeBaaBBBBBBBBBNOT INVESTMENT GRADELower medium grade (somewhat speculative)BaBBBBBBLow grade (speculative)BBBBPoor quality (may default)CaaCCCCCCCCCMost speculativeCaCCCCCCNo interest being paid or bankruptcy petition filedCCCCIn defaultCDDDSource The Bond Market Association
The ratings from Aa to Ca by Moodys may be modified by the addition of a 1, 2 or 3 to show relative standing within the category.
Sourcewww.blaha.netFinance Corporate Debt Rating.php
How Credit Ratings Determine Corporate Strategies
Credit rating is decided by the management of an entity that has the need for it.
Those with high ratings need more capital and investment associated with equity required to maintain the high ratings. Study shows that small and risky companies tend to have lower credit ratings, whereas firms with high growth opportunities and more equity tend to have higher ratings.
Firms in small boards tend to have lower ratings. The capital structure of a company is a determinant to its creditworthiness. When ratings are lower, managers tend to make security issuance and repurchase decisions that reduce leverage. However, firms are more likely to increase dividend payouts when they have higher ratings and are less likely to make acquisitions when they have low ratings.
In 2006, Time Warner can be taken as an example. Time Warner was targeted by Carl Icahn. He accumulated a large block of shares in the firm then demanded that Time Warner repurchase shares, increase the number of independent directors on the board, and split up the company into four. His view was that the firm was wasting its value. Icahn explicitly criticized management for protecting the companys credit quality as compared to managing a lower credit rating. Management buckled down and agreed to buy back shares and start paying quarterly dividends. In response to this announcement, on February 22, 2006, Fitch, a credit rating agency, downgraded Time Warners credit rating one notch from a BBB to a BBB. Two weeks later (March 6, 2006), Moodys lowered Time Warners ratings to a Baa2 from a Baa1.
Credit Rating Changes Their Costs and Implications
Other factors affect credit rating changes as a result of exogenous events that have nothing to do with management choices. This view is expressed in a recent research report by Standard Poors that states that Events largely beyond managements control such as recession, increased competition, or other business challenges often trigger ratings downgrades, but concluded that a recent trend towards lower ratings is largely driven by the fact that companies choose to adopt a less conservative financial position, usually to pursue acquisitions or increase returns to shareholders. A report cites a number of reasons behind this trend including shareholder activism and the greater alignment of management compensation with shareholder interests and concludes that the higher, the better rating is not consistent with an optimal capital structure policy. A firms credit rating has the advantage that it provides a single measure of financial leverage that aggregates the different aspects of the capital structure decision, such as the maturity and seniority structure of the debt and the amount of debt.
However, there are also reasons to believe that ratings may not provide the best measure of capital structure. The rating agencies are known to be slow about updating the ratings that they assign.
The credit rating choice is determined by a trade-off of costs and benefits that are likely to affect different firms differently. Some companies sometimes find it more beneficial to choose a high rating that allows them to be viewed more favourably by major stakeholders. In addition, since credit ratings affect the firms access to additional financing, firms that are likely to raise capital in the future may maintain higher ratings to retain their financial flexibility.
The costs of achieving a higher credit rating are also likely to vary cross-sectionally. These costs, which arise because a higher rating requires firms to include more equity in their capital structures, are related to the differences in the costs of debt versus equity financing as well as the extent to which management believes that the firms shares are under or overvalued.
For example, it may be more costly for small firms to achieve higher ratings as the required amount of additional equity may be higher for such firms. Managers may benefit from the prestige associated with being highly rated and may prefer the low default probabilities that are associated with higher ratings. Managers may also prefer to alleviate the pressure that comes with interest payment commitments, or may benefit from opportunities associated with managing a more highly rated firm that can more easily raise investment capital. In contrast, if there is a possibility of a hostile takeover, managers may prefer a lower rating if it reduces the potential acquirers gain and makes a takeover less likely.
We find that rating agencies tend to assign higher ratings to firms with smaller stock ownership, larger board size and fewer outside directors. The rating agencies consider future intentions as well as the firms current capital structure when they assign ratings. In particular, it suggests that managers with more discretion over their firms capital structure wants higher ratings because they are more likely to make choices on issues like equity, which improves a firms balance sheet when they are doing poorly. In contrast, a firm managed in the interests of equity holders will be reluctant to make such a choice because of wealth transfers to debt holders will be assigned a lower rating.
As was mentioned at the outset, although firms choose what rating to target, exogenous shocks to their profitability risk and other factors may result in deviations from their target ratings. Firms may be slow to offset negative shocks that led them to be underrated because of debt overhang issues and transaction costs. In addition, firms may be slow to offset positive shocks that lead them to be overrated because of governance issues.
Nevertheless, if managers take these target ratings seriously, the deviation between their current ratings and their targets are likely to influence future investment and financing choices. Below is a table which shows the corporate decisions for above and below target ratings of firms. The table below shows the corporate decisions for above rating and below rating firms.
Above Target RatingBelow Target RatingFirms are more likely to increase dividend payoutsFirms make financing, payout, and acquisition choices that decrease their leverageLess likely to make acquisitionsMake choices that increase their leverageManagers tend to make security issuance and repurchase decisions that reduce (increase) leverage
Firms tend to repurchase equity rather than retire debt and tend to increase rather than decrease their dividends.Tend to issue equity rather than debt, tend to retire debt rather than repurchase equity, and tend to temper their growth through acquisitions. The ratings from Aa to Ca by Moodys may be modified by the addition of a 1, 2 or 3 to show relative standing within the category.
Sourcewww.blaha.netFinance Corporate Debt Rating.php
Moodys Analytical Approach
Moodys analytical methodologies, which are published and freely available on their web site, consider both quantitative and qualitative factors. Specifically, in rating a mortgage-backed securitization, Moodys estimates the amount of cumulative losses that the underlying pool of mortgage loans is expected to incur over the lifetime of the loans (that is, until all the loans in the pool are either paid off, including refinancing, or default). Because each pool of loans is different, Moodys cumulative loss estimate, or expected loss, will differ from pool to pool.
These publications include a wide variety of metrics, including a measure of the accuracy of ratings as predictors of the relative risk of credit losses. See, for example, the following Moodys Special Comments, Default and Recovery Rates of Corporate Bond Issuers, 1920-2005 (January 2007), The Performance of Moodys Corporate Bond Ratings March 2007 Quarterly Update (April 2007), Default Loss Rates of Structured Finance Securities 1993-2006 (April 2007), and The Performance of Structured Finance Ratings Full-Year 2006 Report (May 2007).
Initially, investors (who were primarily institutional, rather than individual) used credit ratings as an objective, second opinion against which to gauge their own views. In other words, credit ratings constituted an additional source of information that either supported or refuted, but did not supplant, the investors own research, analysis, and opinions. In general terms, the attributes of ratings that these investors found useful were as follows
1.1. Independence While investors might disagree with CRAs opinions, they believed that these opinions were not biased toward a particular set of interests.
1.2. Reliable, predictive content Over time, the ratings performance of certain CRAs demonstrated that their ratings generally served as reliable predictors of relative credit quality.
1.3. Simplicity Rating symbols condensed a great deal of research into easy-to-use symbols.
1.4. Breadth of coverage Globally active CRAs published ratings on a large and diverse group of entities and obligations. This breadth of coverage enables investors to compare and rank credit quality across industry sectors, asset classes and jurisdictions.
1.5. Rating stability As they begin incorporating ratings-based criteria into their investment and portfolio composition guidelines, most investors also came to value not only rating accuracy (i.e., predictive content) but also rating stability for the securities they owned.
Evolving Perceptions about the Role and Function of Rating Agencies
The main and proper role of credit ratings is to enhance transparency and efficiency in debt capital markets by providing an independent opinion of relative credit risk, thus reducing the information asymmetry between borrowers and lenders. It is believed that this function is beneficial to the market, as it enhances investor confidence and allows creditworthy borrowers broader marketability of their debt securities. Demand for and use of credit ratings has grown tremendously in Europe over the past two decades. Advances in information technology, globalisation, economic integration, de-regulation, and asset securitisation are all well-chronicled drivers behind this growth. Less frequently identified but arguably no less important are some basic attributes of ratings themselves such as their expression as simple, widely understood symbols, their predictive content and their broad, public availability, to name a few.
Rating demand also benefited from the favourable conditions that prevailed during much of the 1990s and should continue to benefit in the coming years from, among other things
Low inflationary expectations and low interest rates by historical measures in many developed economies
Advances in new risk transfer instruments and enabling legislation for asset securitisation and
Ongoing adoption of ratings by regulators seeking common risk benchmarks and financial system stability, and by the private sector for securities selection and portfolio composition guidelines.
Limitations to Uses of Ratings
Obligations carrying the same rating are not claimed to be of absolutely equal credit quality. In a broad sense, they are alike in position, but since there are a limited number of rating classes used in grading thousands of bonds, the symbols cannot reflect the same shadings of risk which actually exist.
As ratings are designed exclusively for the purpose of grading obligations according to their credit quality, they should not be used alone as a basis for investment operations. For example, they have no value in forecasting the direction of future trends of market price. Market price movements in bonds are influenced not only by the credit quality of individual issues but also by changes in money rates and general economic trends, as well as by the length of maturity, etc. During its life, even the highest rated bond may have wide price movements, while its high rating status remains unchanged.
The matter of market price has no bearing whatsoever on the determination of ratings, which are not to be construed as recommendations with respect to attractiveness. The attractiveness of a given bond may depend on its yield, its maturity date, or other factors for which the investor may search, as well as on its credit quality, the only characteristic to which the rating refers.
Since ratings involve judgements about the future, on one hand, and since they are used by investors as a means of protection, on the other, the effort is made when assigning ratings to look at worst possibilities in the visible future, rather than solely at the past record and the status of the present. Therefore, investors using the rating should not expect to find in them a reflection of statistical factors alone, since they are an appraisal of long-term risks, including the recognition of many non-statistical factors.
Though ratings may be used by the banking authorities to classify bonds in their bank examination procedure, Moodys ratings are not made with these bank regulations in mind. Moodys Investors Services own judgement as to the desirability or non-desirability of a bond for bank investment purposes is not indicated by Moodys ratings.
Moodys ratings represent the opinion of Moodys Investors Service as to the relative creditworthiness of securities. As such, they should be used in conjunction with the descriptions and statistics appearing in Moodys publications. Reference should be made to these statements for information regarding the issuer. Moodys ratings are not commercial credit ratings. In no case is default or receivership to be imputed unless expressly stated.
Moodys long-term obligation ratings are opinions of the relative credit risk of fixed-income obligations with an original maturity of one year or more. They address the possibility that a financial obligation will not be honoured as promised. Such ratings reflect both the likelihood of default and any financial loss suffered in the event of default.
As set forth more fully on the copyright, credit ratings are, and must be construed solely as, statements of opinion and not statements of fact or recommendations to purchase, sell or hold any securities. 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, 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, selling or holding.
1 Medium-Term Note Ratings
Moodys assigns long-term ratings to individual debt securities issued from medium-term note (MTN) programs, in addition to indicating ratings to MTN programs themselves. Notes issued under MTN programs with such indicated ratings are rated at issuance at the rating applicable to all pari passu notes issued under the same program, at the programs relevant indicated rating, provided such notes do not exhibit any of the characteristics listed below
Notes containing features that link interest or principal to the credit performance of any third party or parties (i.e., credit-linked notes)
Notes allowing for negative coupons, or negative principal
Notes containing any provision that could obligate the investor to make any additional payments
Notes containing provisions that subordinate the claim.
For notes with any of these characteristics, the rating of the individual note may differ from the indicated rating of the program.
For credit-linked securities, Moodys policy is to look through to the credit risk of the underlying obligor. Moodys policy with respect to non-credit linked obligations is to rate the issuers ability to meet the contract as stated, regardless of potential losses to investors as a result of non-credit developments. In other words, as long as the obligation has debt standing in the event of bankruptcy, we will assign the appropriate debt class level rating to the instrument. Market participants must determine whether any particular note is rated, and if so, at what rating level. Moodys encourages market participants to contact Moodys Ratings Desks or visit www.moodys.com directly if they have questions regarding ratings for specific notes issued under a medium-term note program. Unrated notes issued under an MTN program may be assigned an NR (not rated) symbol.
2 Corporate Family Ratings
Moodys Corporate Family Ratings are generally employed for speculative grade corporate issuers. A corporate family rating is an opinion of a corporate familys ability to honour all of its financial obligations and is assigned to a corporate family as if it had
1. A single class of debt
2. A single consolidated legal entity structure.
A corporate family rating does not reference an obligation or class of debt and thus does not reflect priority of claim. It applies to all affiliates under the management control of the entity to which it is assigned. Moodys employs the general long-term rating scale for Corporate Family Ratings.
A Universal Approach to Credit Analysis
Because it involves a look into the future, credit rating is by nature subjective. Moreover, because long-term credit judgments involve so many factors unique to particular industries, issuers, and countries, it is believed that any attempt to reduce credit rating to a formulaic methodology would be misleading and would lead to serious mistakes.
That is why Moodys uses a multidisciplinary or universal approach to risk analysis, which aims to bring an understanding of all relevant risk factors and viewpoints to every rating analysis. We then rely on the judgment of a diverse group of credit risk professionals to weigh those factors in light of a variety of plausible scenarios for the issuer and thus come to a conclusion on what the rating should be. Several analytical principles guide that reasoning process.
1 Some Basic Principles
1.1. Emphasis on the Qualitative Quantification is integral to Moodys rating analysis, particularly since it provides an objective and factual starting point for each rating committees analytical discussion. Those who wish further information on the numerical tools we use may consult our written research on industries and specific issuers.
However, Moodys ratings are not based on a defined set of financial ratios or rigid computer models. Rather, they are the product of a comprehensive analysis of each individual issue and issuer by experienced, well-informed, impartial credit analysts.
1.2Focus on the Long-Term Since Moodys ratings are intended to measure long-term risk, our analytical focus is on fundamental factors that will drive each issuers long-term ability to meet debt payments, such as a change in management strategy or regulatory trends. As a rule of thumb, we are looking through the next economic cycle or longer.
Because of this, our ratings are not intended to ratchet up and down with business or supply-demand cycles or to reflect last quarters earnings report. In our view, it would be punitive to rate a security conservatively because of poor short-term performance if we believe the issuer will recover and prosper in the long-term.
1.3. Global Consistency Our approach incorporates several checks and balances designed to promote the universal comparability of rating opinions. Internationally, ratings are normally limited to the sovereign ceiling rating of the nation in which the issuer is domiciled. Our analytical team approach also supports consistency by including Moodys directors, along with global industry specialists and analysts with regional and other perspectives, in every rating decision.
1.4. Level and Predictability of Cash Flow In every sector, the foundation of Moodys rating approach rests on the answer to one question What is the level of risk associated with receiving full and timely payment of principal and interest on this specific debt obligation and how does that risk compare with that of all other debt obligations When we speak of risk to timely payment, we are measuring the ability of an issuer to generate cash in the future. Our analysis focuses, therefore, on an assessment of the level and predictability of an issuers future cash generation in relation to its commitments to repay debt holders.
Our main emphasis throughout the rating analysis is on understanding strategic factors likely to support future cash flow while identifying critical factors that will inhibit future cash flow. The issuers capacity to respond favourably to uncertainty is also the key. Generally, the greater the predictability of an issuers cash flow and the larger the cushion supporting anticipated debt payments, the higher the rating will be.
1.4.1. Reasonably Adverse Scenarios In coming to a conclusion, rating committees routinely examine a variety of scenarios. Moodys ratings deliberately do not incorporate a single, internally consistent economic forecast. They aim rather to measure the issuers ability to meet debt obligations against economic scenarios reasonably adverse to the issuers specific circumstances.
1.4.2. Seeing Through Local Accounting Practices Moodys analysts deal frequently with different accounting systems internationally we are not bound to any particular one. For the purpose of fixed-income analysis, we regard them as languages with differing strengths and weaknesses.
In examining financial data, Moodys focuses on understanding both the economic reality of the underlying transactions and on how differences in accounting conventions may or may not influence true economic values. For example, in the analysis of assets, the concern is with their relative ability to generate cash, not with the value as stated on a balance sheet.
Sector-Specific Analysis
Specific risk factors likely to be weighed in a given rating will vary considerably by sector. In the following sections, we provide a very rough outline of typical rating considerations for two types of issuers an industrial enterprise and a structured financing.
Moodys publishes more in-depth overviews of our rating approach for each of these sectors and many others e.g., sovereign nations, sub-national governments, public utilities, banks, insurance companies, mutual funds, and project financings, along with general obligation bonds and revenue bonds issued by U.S. municipalities.
1 The Credit Rating Agency Reform Act of 2006
In September 2006, the Credit Rating Agency Reform Act (Reform Act) was passed into law. It created a voluntary registration process for rating agencies willing to have their ratings used in federal securities laws by being designated as a nationally recognised statistical rating organisation (NRSRO). The Reform Act also authorised the Securities and Exchange Commission (SEC) to oversee such NRSROs. The objective of the Reform Act is to improve ratings quality for the protection of investors and in the public interest by fostering accountability, transparency and competition in the credit rating agency industry. It aims to
a) Enhance accountability by providing the SEC with oversight authority to assess the continued credibility and reliability of an NRSRO
b) Promote competition through a clear process by which a rating agency can apply for NRSRO designation and
c) Improve transparency by requiring registered NRSROs to make publicly available most of the information and documents submitted to the SEC in their applications.
In June 2007, the SEC published its rules to implement the Reform Act and ensure rigorous oversight of the credit rating industry and on September 24, 2007 Moodys became a registered NRSRO pursuant to the new Reform Act rules. The rules include the following
Registration Requirements (17g-1) Implements the registration requirements for NRSROs.
Recordkeeping (Rule 17g-2) Ensures that an NRSRO makes and retains records to assist the SEC in monitoring, through its examination authority, an NRSROs compliance with the provisions of the Statute.
Financial Reporting (Rule 17g-3) Requires NRSROs to furnish the SEC with audited financial statements and associated schedules on an annual basis to allow the SEC to monitor the NRSROs financial resources and assess its ability to support robust credit analysis activities.
Protection of Material Non-Public information (Rule 17g-4) Requires an NRSRO to have procedures designed to prevent potential misuses of material non-public information.
2 Credit Rating Agency Reform Act of 2006, Preamble.
Managing Conflicts of Interest (Rule 17g-5) Requires an NRSRO to disclose and manage those conflicts of interest that arise in the normal course of engaging in the business of issuing credit ratings.
Prohibition of Unfair, Coercive, or Abusive Practices (Rule 17g-6) Prohibits NRSROs from engaging in certain acts or practices relating to the issuance of credit ratings that the SEC has determined to be unfair, coercive, or abusive.
3 Role of Credit Rating Agencies in the Structured Finance Market
The use of securitization as a financing tool has grown rapidly both in the U.S. and abroad since its inception approximately 30 years ago. Today, it is an important source of funding for financial institutions and corporations. Securitisation is essentially the packaging of a collection of assets into a fixed income security that can then be sold to investors. The underlying group of assets is also called the pool or collateral. A securitisation does not simply transform a loan pool into a single security it leads to the creation of two (or more) bonds. One of the bonds may be deemed nearly risk-free from default and rated Aaa, but the others are often quite risky because the payments generated by the underlying pool are first used to make required payments to the Aaa-rated bond investors before making funds available to the holders of the other securities. Residential mortgage-backed securities are bonds whose principal and interest payments are made from the mortgage payments received on thousands of mortgage loans. In considering the role of rating agencies in this market, it is important to recognise that we are one of many players with historically well-defined roles in the market. Moodys comes into the residential mortgage securitization process well after a mortgage loan has been made to a homeowner by a lender and identified to be sold and pooled into a residential mortgage-backed security by an originator and or an investment bank. We do not participate in the origination of the loan we do not receive or review individual loan files for due diligence and we do not structure the security. Rather, we provide a public opinion (based on both qualitative and quantitative information) that speaks to one aspect of the securitisation, specifically the credit risk associated with the securities that are issued by securitisation structures. Consequently, our role in the structured finance market is fundamentally the same as the role Moodys has played over the last hundred years in the corporate bond market. As discussed in greater detail below, the rating processes are, in fact, very similar in the two sectors. Ratings are assigned by committees when securities are first issued and then monitored over the life of those securities. Upward or downward rating adjustments result from deviations in performance from the expectations held at the time of the initial rating expectations regarding the performance of the underlying asset pool in the case of securitisations and expectations regarding the realised business or financial plan in the case of corporations. Moodys ratings performance reports posted on our web site, www.moodys.com indicate a high degree of consistency between structured finance and corporate ratings.
Effects of Credit Rating Changes
1 Bond RecallDelay
To hypothesise, if an issuer possessed information regarding its financial prospects, it would either call its bonds early or result in an early redemption, in the case of an anticipated credit rating upgrade. This redemption allows the company to get new financing with the old rating and lock in a lower interest rate before an upgrade. Delaying a call would allow the company to refinance at a more favourable rate after the upgrade has been announced.
This is similar for firms with outstanding callable bonds. If a firm is anticipating an upgrade, it will delay calling its debt until the credit transition reveals the new information to the credit markets. The firm can then refinance at lower rates, thus effectively using the outstanding callable as a short-term financing vehicle. Therefore, an upgrade is expected to occur shortly before the call announcement, and firms with upgrades preceding their call announcement should have longer delays. Conversely, a firm anticipating a downgrade would call its bonds later in order to take advantage of the current (lower) bond spread before its credit transition reveals new information. In this case, we would expect downgrades to follow calls, and firms with subsequent downgrades to have shorter delays.
Issuers with downgrades prior to their calls have greater delays in calling their bonds. It also shows that there is a connection between the rating transition in the quarter or year following a call announcement and the time of delay of the call.
2 Credit Ratings and Capital Structure
Ratings can provide information to investors and act as a signal of firm quality. If the market regards ratings as information, firms will be pooled together by rating and thus a ratings change would result in changes in a firms cost of capital. Rating change can also trigger events that result in discrete costs (benefits) to a company, such as in the repurchase of bonds and access to loans. When a company decides to redeem its bond issue through the market due to availability of cash, at a lower price from its selling and taking into consideration the discount it will earn, it will consider its downgraded rating more suitable for its bond redemption rather than when an upgrade is announced and the bond matures. In an upgrade, an issuer will have access to the capital market at cheaper interest rate and higher selling price for its issue. It is also a fact that a higher credit rating will require a bigger amount of equity.
3 Regulatory Intervention
Several regulations are specific to the investment-grade vis--vis speculative-grade designation. Considerations would be in high gear on this change if these regulations are significant for decision making. Liquidity issues are most significant for speculative-grade bond which would declare that firms with speculative-grade ratings are more concerned with ratings effects than investment-grade firms. Several regulations relating to financial institutional investments and other intermedial investments in bonds are directly tied to credit ratings. The effect of credit ratings to regulatory provisioning is direct.
4 Cost
Different bond ratings impose direct costs on companies. A companys rating affects operations of the firm, access to other financial markets such as commercial paper, disclosure requirements for bonds (a speculative-grade bond has more compelling disclosure requirements), and bond stipulations may contain ratings provisions where a ratings change can result in changes in coupon rates or a forced repurchase of the bonds.
Credit ratings and effects on corporations
Credit ratings are the benchmarks on whether individuals are corporations can be considered as credit risks or credit worthy. In a nutshell, if the person or company displays a negative credit rating, banks tend to look upon the entity as a risk, and may not extend loans or financial assistance to that entity if the person or company is considered credit worthy, then it will be easier for the entity to access the loans from the bank. By definition, a credit rating will examine and define the credit worthiness of a company or person (Elite Loan Capital 2010). Ratings are determined via the evaluation of the person or companys financial chronology, inclusive of debt repayment records and may also include assets and liabilities of the individual or corporation (Capital 2010).
Credit ratings have various effects based on the individual or company seeking to acquire such. For individuals, it will establish basis whether the lenders will be able to pay back the money heshe loaned from them. In the case of companies, it is not for the purposes of establishing basis for debt payment. Rather, it will tell investors on the risk that they will encounter when they opt to invest in a particular company (Capital 2010).
In the credit market, the credit rating of a company is of crucial importance. The rating will determine the ease of the company to acquire debt and the rate that the companys investors will ask for a return on the debt issued to the company. At present, there are several companies that issue ratings on the credit standards of companies. These organizations issue ratings for company credit (e How 2010).
In the wake of the rise of the global business arena, investors are finding it difficult to gauge the worth of a particular company with regard to their capacity to be sound financial investment areas. At present, there are three credit rating organizations that issue ratings and are widely accepted and respected in the financial arena, namely Moodys, Fitch IBCA and Standard and Poors (SP) (Ream Heakel 2010). But there have been intense debates on the validity and soundness of the present rating mechanism. Critics argue that the credit rating system failed in the wake of the 2007 sub prime crisis, when highly rated securities were discovered to be of dubious value (Chris Henderson).
More often than not, the issuance of credit ratings is for the purposes of assessing long term debt obligations of companies. These ratings can be divided into three areas investment ratings, speculative and special use. Each of them possesses various degrees of risk for companies and investors, investment grades are usually rated through Aaa through Baa3. As shown in the graph below, the various grades and ratings are defined with their corresponding investment grades (Henderson).
But according to the 2000 Basel Committee Report in Banking Supervision, there are approximately 150 credit rating companies across the globe. But only a few are recognized on a national level as significant entities in the industry grouped together as the National Recognized Statistical Ratings Organizations (NRSRO), whose ratings are used by the Securities and Exchange Commission (SEC) in determining whether a particular security is to be registered with the agency. It is feared that due to the dearth in competition in the industry, the issuers may be under the compulsion from the credit agencies to force them to issue a favourable rating (Henderson).
1Carl Icahn
Carl Icahn had been a name known world wide since the late 1970s where in he started his scheme to take over different top producing companies in the United States. During the time where in the certain companies are successful and progressing, Carl Icahn utilize his own resources in order to acquire different stocks of companies. Moreover, the acquisition of these resources gave him power to have control over such companies. Within years of such scheme, he was able to attack companies such as RJR Nabisco, Philips Petroleum, Motorola, Time Warner, Marvel Comics, Revlon and more. The names of corporations he had encountered are countless. In fact, the all these companies had experienced almost the same process of acquisition. Through the scheme being done by Icahn and his team, the processes of conquering the corporation are very easy. In addition to this, through the acquisition of corporations, the companies create different kinds of methodologies to counter his actions. Most of the time, companies which are being targeted pay Icahn in order for his team and his schemes to stop their actions. Thus, the payments provided to Icahn costs more than what he had acquired from the company. Hence, it is also a risk for companies to provide monetary compensation for Icahn.
In an article written by Susi Gharib (2008) mentioned that the Icahn calls himself as a shareholder activist. The process of his activism used as a proxy fight or proxy battle were in he and his team is most seen to by the people as the process of purchasing as many stocks possible in order to acquire and to have various types of rights in the company. The frequent appeal of Icahn is for him to appoint two board members for the company to attain a certain percentage of control in the decision making of the corporation. Due to this, the former control of the company is changed and subjected to the requirements and desires of Icahn. Thus, the corporations opt to pay the desired amount of Icahn in order for them his team to relieve their actions.
The process of which Icahn had utilized is more of business processes where in he is able to communicate and negotiate with the current board members in order to present his own desires and intent. In terms of his proxy war, Icahn had successful got what he desired. In fact, he was able to help different people after his monetary acquisition. The money that he acquires from different companies had been utilized in creating homes for people and free education for under privilege students.
Furthermore, Icahn and his processes had been questioned by many. Some find his actions as immoral for he creates actions against companies in are a form of opportunity to get money. Hence, due to the negotiations and decisions of most companies to retain their former process and board members, the company is risking high amounts of money which is needed to be compensated through sacrifice of the employees of the company as well as the process of production.
2 Carl Icahn vs. Time Warner Management
In the span of more than 25 years, Carl Icahn has taken important positions in numerous companies, regardless whether it is a large or small business organization. In the process, he was able to make himself a burr in the side of management (New York Times 2008). In addition, he has also achieved success as one of the wealthiest men in the United States (New York Times 2008).
One of the most notable venture that he made as a corporate raider is his big fight with Time Warner in 2006. The stock of Time Warner had been stuck in neutral for a very long time, which to Icahns perspective did not contribute much to the interest of stockholders. In addition, the decision of Time Warner to combine business efforts with AOL, a merger and acquisition (MA) that is considered as one of the worst business transaction in modern history because it contributed to the loss of shareholders that amounted to billions of dollars in equity value (Dumon n.d.). Due to this, Carl Icahn led a group that demanded for the break-up of Time Warner into four various companies. In relation to this, the group also called for cost-cutting efforts of the company. Furthermore, the Icahn-led group also asked for a stock buyback that amounts to 20 billion (Dumon n.d.).
Icahn and his group also disapprove of the management of Time Warner, especially the poor implementation of its broadband offering. In relation to this, they also disagree with the sale of Comedy Central and Warner Music, as this is seen as a failure in making strategic acquisitions, which eventually led for the companys competitors to take ahead of them (Dumon n.d.). Based on the 343-page Icahn report, the proposal of their group would increase the value of Time Warner stock to an estimated 40 billion, which is equal to half of the market value of the company (Knowledge Wharton 2006).
Furthermore, Icahn emphasizes Time Warner needs a visionary leader in order to improve the situation of the company, which is clearly seen in his statement, A great company in the media business needs visionary leaders, not a conglomerate structure headquartered in Columbus Circle that second guesses (Knowledge Wharton 2006). Being the case, Icahn argued that it is through their demands that Time Warner would be able to improve its business operations and its overall value in the market.
Nevertheless, Carl Icahn and Time Warner reached an agreement wherein Icahn will forego of his bid to control the company and Time Warner will implement some of the recommendations of the shareholder. The agreement also entails that Icahn will no longer appeal for the companys slate of directors. In return, Time Warner will implement an increase in the share of repurchase program from the amount of 12.5 billion to 20 billion, which agrees with the proposal of Icahn. In addition, Time Warner also agreed to heighten its cost-cutting, which is also in accordance to the proposal of Icahn. In 2006, Time Warner informed the public that the company had already implemented 500 million worth of reductions in its operating plan. The efforts of Time Warner is approved by Icahn as he believed that this will substantially contribute in the attainment of his long-stated goal of creating value for all shareholders, which further proves the efficiency of shareholder activism (Levingston 2006).
Jessica Reif Cohen, an analyst at the Merrill Lynch Co., commented that the fast-pace collapse of Icahns campaign suggests that he committed a mistake in analyzing the sentiments of the Time Warners shareholder. Cohen stated that we did not anticipate significant support for a change in administration (Leveingston 2006). The rapid resolution in the case of Time Warner shows that Icahn did not establish a good connection with the other investors when it comes to the issue of management performance. Dick Parsons was able to maintain leadership in Time Warner and he asserted that the company is indeed in the right path and that it is delivering value to its investors. Nevertheless, Icahn emphasized that he will continue to convince Parsons to agree with his other recommendations (Levingston 2006).
3 Nabisco Group Holdings Corporations
For many years, RJR Nabisco Company had given different kinds of services in providing various kinds of products. It had been successful in its own field such that of making biscuits and the likes. Formerly, this company was a conglomerate of R.J. Reynolds Industries, Inc. which is mainly specializing in tobacco as well as food products. After issues regarding a tobacco lawsuit, the company had decided that there must be a separation of both corporations due to the issues at hand. In addition the image of the company is not synchronized with the products at hand which give a negative effect for the company.
After such controversies and issues, the company had stayed strong and had flourished in to a stronger company. After a few years, the company RJR Nabisco gained its stance in the industry. Thus, after the emergence of two companies it was owned by Kohlberg Kravis Roberts Co. therefore the companies had turned into RJR Nabisco (Hagstorm, 2004 165).
During the 1980s there was a new kinds of investment vehicle which is called the high-yield bond. This ideology was introduced to financial markets. In the view point of Buffett, he considers new high-yield bonds to be different from the first high-yield bonds from the beginning of such activities. In an earlier year, Kohleberg Kravis Roberts succeeded in purchasing RJR Nabisco for the price of 25 Billion which would be financed wholly by junk bonds and bank debt. It was stated that RJR Nabisco was meeting its financial obligations. Moreover, during 1989 as well as the 1990s different kinds of organization had acquired bonds. Although the situation of RJR Nabisco could be seen as stable due to the enough cash flow which had received by the company. Moreover, such cash flow was able to cover debts and payments necessary for the company to fully progress and process. In addition to this, RJR Nabisco had also gone to the industry of selling portions of their company. In this field, the company had been very successful for it had given attractive price to interested buyers. Through this system, RJR Nabisco provided their clients the best price while also addressing the issue with regards to their debt-to-equity ratio. In reality, the view of Warren Buffet mentioned that many companies had seen RJR Nabiscos credit is lower than the other companies. However, Buffet saw the potential and the high competitive ability of the company and he saw that its credit rating is higher than the usual. Hence, Buffet stated that The risks of investing in RJR and concluded that the companys credit was higher than perceived by other investors who were selling their bonds. RJR bonds were yielding 14.4 percent (a business-like return) and the depressed price offered the potential for capital gains. (Hagstorm, 2004 165)
Also during the same consecutive years, Buffet was able to acquire 440 million of RJR bonds. Accordingly in 1991, the company RJR Nabisco has announced that it shall retire all of the junk bonds through redeeming bonds by its face value. After such, the bonds of the company had risen to 34 percent which had created a gain of 150 million capital gain for the Berkshire Hathaway. (2004165)
In the 1990s KKR or the Kohlberg Kravis Roberts became one of the most important entities for RJR Nabisco. During those times, the RJR Nabisco was struggling to maintain its capability and power to rise over its competitions. Back in 1986, the KKR have recognized the same realization as Warren Buffet that Nabisco had a huge cash flow however, the company was poorly managed. Through this view point, the KKR was seen to have a huge potential for Nabisco to rise through changing the scope of its operations.
In October 1988, Ross Johnson has decided that he will take up the whole company to him self privately. In order to make this happen, Johnson went to Shearson Lehman in order to help him in his desires. At first, Johnson assumed that RJR Nabisco was worth around 75 per share. But then, the bid was low. Due to this situation, Johnson had stated that, My job was to negotiate the best deal I can for my people. (Geisst, 2004216) To clarify this statement, the people whom he mentioned meant that it was for his buyout team and not the shareholders who should have the best interest. Moreover upon analysis of the team of Johnson, that the low price for the shares are in order for bidders to have an opportunity to increase the number of the sales and to give opportunity for people to have a share in the company for a lower price. Thus, the KKR had created a higher bid for each share. Thus, the value of the company had also increased by 20 billion. After this, RJR Nabisco had proven that they have attracted outside bidders which mostly included Ted Forstmann of Forstmann Little and First Boston. The bidding was played dramatically in the press. During this time, the RJR Nabisco became the 19th largest corporation that was attacked by a small boutique firm which was composed with only with six partners and a small number of employees.
Due to this scenario, people who were not aware of LBO (Leverage Buy Out) were very shocked with the situation at hand. Thus there was a huge confusion because no one have expected or seen such kind of financial capabilities since the time of the earlier parts of the century. Due to this, Ross Johnson was seen as a greedy CEO who wanted to seize the company regardless of the long-suffering of shareholders. Moreover, the issue which had been created by the plan to take over made waves that it was also able to be in the cover of Time Magazine with a headline stating A Game of Greed. Through his yearning to have the company many had already analyzed reason for the strong desire for the company. One of these reasons was the assumed 100 million which was huge money during those times. On the part of KKR the group looked like it was a white knight that was one who gave rescue to RJR Nabisco (Geisst, 2004 216).
With the situation of RJR Nabisco, there are MA advisers who had played a huge role with the situation. Bankers from Dillon Read and Lazard Freres had advised the RJR Nabisco board of directors and these advisers where fairly familiar with KKR since it was also the adviser of he company Beatrice during the past. In the end, the reputation of KKR had become a great influence and factors for them to win the bid (Geisst, 2004 216).
In the price of 109 per share which was lower than the last bid given by Shearson and Johnson of 112, the KKR was able to win the bid due to the strengths and debt of the investors. The total of the price was around 26 billon and had agreed that it would only be the entity to provide the debt of Nabisco which was around 5 billion. The complicated factors with the shareholders were to be paid in cash. Thus, there was a support coming from different lineage of banks by a large syndicate which supports the KKR lenders. In addition to this, the 90 percent of the deal had been financed through borrowed money. This had become clear for CEO Louis Gerstner. The plan of Gerstner was to begin the process of asset sale in order to reduce the debt at hand which led to downsizing of the company (Geisst, 2004 216).
Throughout these processes which had been experienced by Nabisco, there was the learning that there is such a thing as LBO where in the bidding process is very much possible. Therefore, no company is secured with its finances as well as its standing in the business community. (Geisst, 2004 217).
Previously, RJR Nabisco Incorporation is part of an American Conglomerate that resulted from the merger of the company with R.J. Reynolds Tobacco Company. However, in 1999, RJR Nabisco separated from R.J. Reynolds because of issues regarding tobacco lawsuit liabilities. Due to this, RJR Nabisco was renamed as Nabisco Holdings Corporation (Weekly corporate Growth Report 2000).
In 2000, Nabisco Group Holdings together with its sole asset the Nabisco Holdings Corporation put itself up for sale that started the bidding war among prominent and influential people and organizations in the business sector. Philip Morris Cos., Danone SA, and corporate raider Carl Icahn each place a preliminary bid for Nabisco Group Holdings Corporation. Philip Morris, which is recognized as a Tobacco giant in the United States as well in the international market was perceived to have an edge in the bidding war because of the financial power that the company has. In the year 2000, the current market capitalization of Nabisco Holdings Corporation amounted to 11.6 billion and the bankers speculated that the company has the potential to increase as much as 15 billion (Food and Drink Weekly 2000).
On the other hand, Frances Danone, which owns a large cookie business, is also among the bidders for this food while Britains Cadbury Schweppes PLC is interested in the non-cookie part of Nabisco. Among the bidders, it was only Carl Icahn who publicly revealed the details of his bid. Icahn said he is willing to pay 6.5 billion or 22 per share. He even added a two-year note that has a face value of 3 per share. The share of Icahn in Nabisco Group stock amounts to 9.5 percent (Food and Drink Weekly 2000).
Carl Icahn sent a proposal to the Nabisco Group Holdings Corporations board of directors wherein he stated that he is willing to acquire 100 million shares or approximately 30 percent of the common stock of the company with an offer of 13.00 per common share. Icahn will have a total share of 40 percent in Nabisco Group Holdings Corporation if the company will agree to his proposal. However, the proposal that Icahn made is subject to numerous conditions, which include (a) delaying the companys annual meeting, (b) approving Icahns offer under the Delaware annual merger statute, and (c) eliminating the shareholder rights plan of the company (Business Wire 2000).
The tender offer made by Carl Icahn in buying the Nabisco Group Holding Corporation for 13 a share paved the way for the substantial increase in the share price of the company by 221 percent, which amounts to 25.5625. Due to this many business organizations have been interested in buying the shares of Nabisco Group Holdings. In relation to this, the former subsidiary of the company, R.J. Reynolds once again came into the picture (Weekly Corporate Growth Report 2000).
After Icahn proposed to buy the Nabisco Group Holdings Corporation, the chairman of the company invited Icahn to join process of the financial advisers of the company in setting up the necessary steps in order to assure the shareholders of Nabisco that they are receiving the greatest possible value of their shares (Wollenberg 2000).
Chairman Steven F. Goldstone of Nabisco informed Icahn through a letter that he is allowed to acquire confidential information about the company. In addition, he will also be informed about the necessary procedures regarding the presentation of a formal bid (Wollenberg 2000). According to William Leach, an analyst for Donaldon Lurkin and Jenretter Securities, the stock of Nabisco has been so depressed that they are even saying Lets do it with regards to the sales of their shares. Furthermore, Leach also believed that Nabisco is calling the bluff of Icahn (Wollenberg 2000).
Carl Icahn sent a letter to the board of directors of Nabisco informing them that he wants to purchase the company on a friendly basis and that there should be no problem in facilitating the acquisition of Nabisco group Holdings (Wollenberg 2000 33). Moreover, he emphasized that the large amount of capital that his companies would invest in the transaction would make substantially increase the value of the companys shares (Wollenberg 2000).
Carl Icahn owns an estimated amount of 31 million worth of Nabisco Group shares. He expressed his preparedness in buying another 100 million shares for 13 per share but the company needs to agree with his conditions. In relation to this, he also expressed his dissatisfaction with the stock price of Nabisco. If he gained control of the company, Icahn will nominate his own slate for the board of directors and he also want to sell the company (Wollenberg 2000).
However, the Nabisco Group found the offer of Icahn as inadequate but the board of directors did not completely forego of the proposal, as the board authorized the management of the company to look into the possibilities of selling the company. In connection to this, the management of the company is also exploring the idea of selling 80.6 percent of the stake of Nabisco Holdings Corporation (Wollenberg 2000).
When Nabisco Group Holdings was still formerly known as RJR Nabisco Holdings, it decided to sell its international tobacco holdings, which is R.J. Reynolds Tobacco. R.J. Reynolds Tobacco is recognized as the second leading cigarette company in the United States. The sole asset of the United States Nabisco Group Holdings is its 81 percent stake in the countrys largest cookie and cracker maker, which is Nabisco Holdings (Weekly Corporate Growth Report 2000).
The pressure posed by Carl Icahn, who already owned 10 percent of Nabisco Group Holdings, forced the company to properly assess and decide upon the condition of the company. Due to this, Philip Morris Cos Inc. completely purchased the cookie and cracker maker of the company, Nabisco Holdings Corporation In the same manner, R.J. Reynolds Tobacco Holdings Inc. bought Nabisco Group Holdings Corporation, which is the previous parent of Nabisco Holdings Corporation. Philip Morris Cos Inc. gave 1.5 billion in cash in order to buy the Nabisco Holdings Corporation (Wohl 2000).
The decision of Philip Morris Cos Inc. to purchase Nabisco Holdings Corporation is clearly a smart move for the company because Kraft Foods Incorporation is recognized as a unit of Philip Morris. Kraft Foods incorporation holds the worlds second-largest food company with only the Swiss conglomerate Nestle ranking first. Being the case, the food unit of Philip Morris Cos Incorporation will be able to stock Nabisco Holdings products into their inventory. The company could cater Oreo cookies, Ritz crackers, Lifesavers candies, Grey Poupon mustard, and other goods to the market (Wohl 2000).
Philip Morris is recognized as the worlds largest cigarette company is regarded as one of the strongest bidders for Nabisco Holdings Corporation even during the beginning of the bidding war for this food business. The financial strength of Philip Morris enabled the company to pay about 14.58 billion together with the assumed amount of 4 billion in debt of Nabisco Holdings Corporations. The combined revenue of Kraft and Nabisco is believed to be a lucrative business because it creates a packaged food giant that has an expected income that will amount to 35 billion (Wohl 2000).
Every year, social conscience groups bombard various companies with their agenda on how the company should direct the resources at the companys disposal. Over at RJR Nabisco, the concerns of a sector of religious shareholders have been mixed with the financial muscle of powerful maverick stock holders that might put the 8.6 billion company on the defence rather than on offence. Nabisco has consistently put aside calls from moralist groups in the company to spin off the food part of the conglomerate from the core tobacco entity, averring that if the tobacco giant were to do so, that event would lead to severe repercussions and diminished credit ratings for the company. The legal prowess of the Nabisco team is ranged against two powerful individuals in the Nabisco shareholder fold, Carl Icahn and Bennett Le Bow (Glenn Collins 1995).
Le Bow and Icahn began their proxy battle in the company boardroom of the tobacco mogul to obligate the company to immediately separate the food business entity of the mogul form the core tobacco business. In this regard, the duo of Le Bow and Icahn submitted a list of nine people to compose the new board that would effectively oust the present composition of the board and hand over the control of the company to the two. Nabisco, not wishing to back down from the threat of the two, took the fight on the legal battlefield, assailing the two of infringing on securities statutes. According to the company, the two had impinged on laws on securities as they conspired in secret to form a block to purchase the controlling interest in the common stock of the company (Collins 1995).
Combined, Le Bow and Icahn own 4.8 of the company, equivalent to 13 million shares. Both have out forth a consent solicitation motion that would allow the nearly half a million Nabisco shareholders to vote on a divestiture of the company (Collins 1995). In the proposal, Icahn forwarded to the Nabisco board, he planned to acquire 100 million shares, equivalent to 30, of Nabisco common stock valued at 13 per common share. If the plan pushes through, Icahn would end up with 40, enough to have a substantial share of the company (Business Wire 2000).
If the proposal of both Icahn and Le Bow passes all legal obstacles, the two see the plan as a affording of a choice to the Nabisco shareholders at the annual April stock holders meeting. Both men have also indicated that they are willing to back off their threat of a proxy conflict if the company accedes to the proposal to spin off the food component of the conglomerate. Nabisco Holdings Corporation, which 80.5 belongs to RJR Nabisco. The intention of Le Bow and Icahn is to push the collective price of the companys stocks as they indicated that this is their main contention for the push for the immediate separation of the companies, thus gaining a major dividend payout for the companys shareholders.
Under the conditions put forth in the proposal, the company would agree to defer the annual April stock holders meeting, approval of the plan of Icahn under the applying statutes of Delaware law, and the removal of the shareholders rights plan that the company is currently implementation. Nabisco said that the proposal would have still have to undergo review by the companys board of directors and advised all shareholders of the company to defer any action until further updates are provided by the companys board (Business Wire 2000).
The corporate guns that were trained on Le Bow and Icahn proposing for the spin off the company is also coming from the religious group earlier mentioned in the paper. Two small organizations composed of Roman Catholic priests, belonging to New York- based Interfaith Centre on Corporate Responsibility, with a combined investment in the company of 980 shares, are also at the forefront of the proposal to spin off the companys food company from the tobacco giant. The priests have consistently asked that the company board table their proposal, to spin off the food business from the tobacco firm, for consideration by the companys stockholders at the meeting in April, but the company flatly denied the request the company tried to trade with the members of the clergy, which was in turn denied by the men of the cloth (Collins 1995).
After the priests spurned the companys proposal, the company turned to the Securities and Exchange Commission to block the priests proposal, saying that, among the other issues cited by the company, that the clergymens proposal was just a redundancy of the proposal put forth by Le Bow. In the opinion of the executive director of the Council of Institutional Investors Sarah Teslik, the situation has baffled many experts, since the priests plan would give their group an immense amount of power to wield. Teslik (1995) aver that the plan is unique in itself since it would be a rare event that a religious organization is providing a resolution of a scenario that moneyed individuals are also jousting over (Collins 1995).
Bonds of the tobacco and food conglomerate were particularly devastated with the ruling of credit rating agency Standard and Poors to place the company on the credit watch list coupled with the event that the credit rating of the company for senior debt could be downgraded could be put below investment grade (Jonathan Fuerbringer 1993). On occasion, an issuers capacity to settle interest or principal payments on their debts will be severely altered due to unforeseen events. These events may range from random events that are prone to occur in the particular sector or industry, inclusive of industrial mishaps or natural calamities, changes in the regulations or statutes in the industry, or in the case of Nabisco, corporate restructuring as a result of a corporate takeover. These examples can be classified as instances of event risk. If an event risk occurs to a particular company, the consequential result will be a downgrading of the issuer by the rating companies ( Mark Jonathan Paul Anson, Ren Raw Chen 2004 45).
In the event of a credit watch, the credit rating agencies may announce that they are in the process of evaluating the credit rating of a particular company, and may even include in their announcement that this review may lead to the upgrade or downgrade of the credit rating. More often, the end result of the review of the companies under credit watch by the credit rating companies will result in a downgrade the downgrade of the company, though there are instances that the credit watch review may result in the affirmation or even a possible upgrade of the credit rating of the company. In this phase, credit rating agencies release advisories to potential investors that they may invest in the company but must exercise a degree of some caution. Bond prices of the company undergoing review are expected to fall as many investors look to offload their holdings in the company (Anson, Chen 2004 45).
To cite an example of the effects of credit watch results, the government of Canada underwent credit watch for the countrys AAA credit ratings. Canada eventually lost its credit rating, resulting in a massive sell-off in Canadian Eurobonds even before the credit rating agencies had released the findings on the bonds (Anson, Chen 2004 45). Nabisco, impaired by the huge number of anti-smoking litigation and a huge debt load, has agreed to spin off the tobacco firm from the food business. The tobacco and food mogul also announced that they were looking to put up their foreign tobacco concern on the selling block for 8 billion. The dissolution of the company is seen as yet another sign of a social initiative coupled with a legal battle changing the fortunes of a large player in the market (James Peltz and Mayron Levlin 1999).
The leveraged buy out of the company came as a shock to most of the financial community, particularly those in the bond investment sector. As a result of the LBO, credit rating agencies immediately lowered RJR credit ratings on their bonds which resulted in a 17 drop of the value of the bonds in the market (Edgar Norton and Glenn Pettengill 1998). In the 1988 takeover of RJR Nabisco, estimated at 25 billion in a leveraged buyout (LBO) scheme. The resulting company acquired a significant debt load in order to finance the takeover. At the time of the takeover, the debt to equity figures of the company was 29.9 and 1.2 billion (Anson, Chen 2004 45).
Since the takeover would need to service a bigger debt load, the companys credit figures were subsequently downgraded. Credit rating agencies downgraded the companys credit rating from a stable A1 level to B3. As a result of the downgrade, the investors of the company had demanded a wider spread of the credit resulting from the new capital framework with the higher ratio of debt (Anson, Chen 2004 46). The sheer size of the buyout rippled through the bond markets, as bond investors began to speculate that other high profile bond issues might suffer a similar fate as that of the RJR bonds (Norton and Pettengill 1998).
Most companies and their management will agree that it is better to have a good credit rating. However, the cost that accompanies this is a hindrance to any issuer. In reality, very few firms have either an AAA or an AA rating the reason is the cost. A high rating requires companies to have a substantial amount of equity in its capital structure. Hence, high credit ratings are observed only for firms that are to benefit the most from a higher credit rating, e.g., growth firms, expected to raise substantial capital in the future. In contrast, smaller firms that may require more equity to achieve the same rating tend to have lower credit ratings.
Credit rating is also a management decision. Managers enjoy the prestige associated with having a high rating in their job security associated with low default probabilities. As a result, managers make choices that lead to higher ratings when their ownership and board structures provide them the discretion to do so.
Regulatory intervention is also a salient but beneficial protection for investors. It guards against spurious issues and schemes that erode investor confidence. With the work the CRAs do, it is a gauge of the creditworthiness of any issue that is revealed to the investing public. This makes a better playing field wherein risk is determine and graded for the purpose of initiating investments. In this, the investment market will be healthy.
Finally, firms are subject to exogenous shocks that lead them to deviate from their target ratings. It is expected for firms to make corporate finance decisions that offset these shocks and move the firm towards their targets. Also, veering away from objective leverage ratios and ratings targets influence debt vis--vis equity issuance and repurchase alternatives, dividend change, and acquisition efforts in ways that tend towards targets.
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