Credit Rating IBFSModule 7

MeaningThe process of assigning a symbol with specific reference to the instrument being rated, that acts as an indicator of the current opinion on relative capability on the issuer to service its debt obligation in a timely fashion, is known as credit rating.Credit Rating is an alphabetical or alphanumerical representation of the credit worthiness of the individual, business or instrument of a business. However Ratings merely express an opinion on the credibility of the entity and cannot be considered to be a recommendation.

The evaluation of the credit worthiness of the anything is based on several premises, most important of them being: Ability to pay Willingness to pay

Definition Credit ratings help investors by providing an easily recognizable simple tool that couples a possibly unknown issuer with an informative and meaningful symbol of credit quality.- Standard & Poor

What is credit rating? (QP)Assessment of the capacity of an issuer of debt security : Represents probability of defaultRepresents credit quality: quickest way of identifying companys financial conditionsRepresents an opinion of rating agencyDone for specific debt security & not for a company as a wholeIt is an ongoing appraisal not one time evaluation

Some of the renowned rating agencies are: Standard & Poors Moodys Investor Service Fitch Rating Agency In India CRISIL (Credit Rating and Information Services (India) Limited) first in India ICRA Limited (Investment information and Credit Rating Agency of India Limited) CARE (Credit Analysis and Research Limited) Fitch Rating India Pvt LtdWhat can be rated?

1. Bonds/ debentures- [the main product]2. Commercial paper 3. Structured finance products4. Bank loans5. Fixed deposits and bank certificate of deposits6. Mutual fund debt schemes7. Initial Public Offers (IPOs)How does credit rating help investors ? (QP)

Advantages of Credit Rating to InvestorsInformation service about credit qualitySystematic Risk Evaluation methods followed by credit rating agencyEstablishes a link between risk and return Easy to understand & Helps in making investment decision Helps in Efficient portfolio management for institutional investorsEncourages corporates to maintain discipline, improve their financial structure and operating risks to get a better rating

Benefits of Credit rating to companies (QP)Index of faithWider Investor baseBenchmarkCredit rating is a way to expect returns

Features of credit RatingGuidance, not recommendationBased on assumptions(board parameters)relativitySpecificityNo guarantor

Credit rating symbols

Moodys Global Rating ScaleCredit rating symbols

Standard & Poor's investment grade ratings in order from the highest to the lowest are: AAA, AA+, AA, AA-, A+, A, A-, BBB+, BBB and BBB-. BB+, BB, BB-, B+, B, B-, CCC+, CCC, CCC- CC, C, D and SD. ( from BB+ to SD consider as non-investment grade ratings)The sign of + (plus) or (minus) with rating symbols indicates their relative position within the rating categories concerned.

Credit rating symbolsICRA(Investment Information and Credit Rating Agency of India Limited)Long-term Debt- Debenture, Bonds and Pre.SharesSYMBOLS INDICATORPROFILELAAA Highest safetyrisk negligibleLAA High safety modest & slight riskLB Risk prone obligation not metLD Default Extremely default in payment SEBI rating symbols

Process of credit rating:

Credit Rating Agency enters into an agreement with the client whose securities are to be ratedRights and liabilities of the parties are definedFees charged is specified3. Tenure for periodic review of the rating is specified4. The client shall disclose the credit rating received for its listed securities and disclosed the same in its offer document whether or not it is accepted by him.Ensure confidentiality of all the information disseminated by the clientThe rating agency shall exercise due diligence to ensure that the rating assigned is fair and appropriate2. Rating agencies on the basis of several premises assign the credit rating and communicate to the client/ issuer.

Process of credit rating:

3.The issuer can make one request for review of the rating based on fresh facts and clarifications.4.Then the final rating is assigned and the same is published along with the definition of the concerned rating along with the symbol.5. A copy of the rating is filed with the Board along with any modifications and additions made thereafter6. The rating agency will also publish the rationale behind the rating assigned and the justification to the premises considered, favorable assessment and factors constituting risk7. Once accepted, it is disclosed and put in the surveillance process thereafter

Process of credit rating:

8. Surveillance: Continuous review of the ratings assigned to the rating agency. Frequency of the reviews may vary from quarterly to annually as per the agreement9. Credit Watch: In case of any event taking place, that may result in major deviations from the expected trends and which are likely to impact the credibility, rating of the entity, such instruments are put on credit watch, until the impact of the event is not evident or clear10. Investments in investment grade: Investors are advised to invest in securities upto investment grade level, which is BBB (S&P) and Baa (Moodys). Securities rated below the investment grade are referred to as speculative grade or junk bonds

Credit Ratings MethodologyBusiness Risk Profile AnalysisFinancialRisk Profile Analysis

Business RiskCountry RiskCompany PositionIndustry FactorsProfitability / Peer GroupComparisons Political EconomicIndustry Specific factorsForeign exchangeIndustry TrendsIndustry StructureMarket SizeGrowth PotentialCyclicalityBases of CompetitionChanging TechnologyOperating RiskRegulatory EnvironmentCompetitive FactorsMarket positionKeys to SuccessSizeDiversificationManagementValidation of Company PositionTrendsQuality of Earnings & Analytical adjustmentsPeer Group Comparisons

FinancialRiskAccounting Cash Flow AdequacyGovernance RiskLiquidity / Short-term FactorsAccounting Regime Reporting & DisclosureAnalytical adjustmentsOwnershipBoard of directorsManagement practices Financial StrategyRisk ToleranceAccounting PracticesInternal controlsFocus on debt service capabilityAnalytical distinctions with profitabilityCash flow measures / ratiosOperating sources & uses Of liquidityOther potential calls on LiquidityDebt CharacteristicsBank credit facilitiesMajor Credit Rating Agencies(CRA)CRISIL (Credit Rating Information services of India LTD)

ICRA (Investment Credit Rating Agency of India Ltd)

CARE (Credit Analysis & Research Ltd)

FITCH Ratings India Pvt Ltd

SMERA (SME rating agency of India)

CRISIL LtdFirst credit rating agency in IndiaPromoted in 1987 jointly by ICICI Ltd & UTI. Other share holders include ADB,LIC, HDFC Ltd, GIC & several foreign & Indian bankIt pioneered the concept of rating services & innovated new concepts in rating servicesIt provides a broad range of servicesCredit ratingsAdvisory services in the area of energy, transport, urban infrastructure, capital markets, banking & financeGlobal data services: provide high quality, reliable & timely financial analysis of around 1500 Indian corporate.Credibility first: rating & evaluation services across the cross section of companies in small sized sector.Training servicesCRIS: CRISIL RESEARCH & INFORMATION SERVICES

CRISIL LtdIt has a strategic alliance with the US based rating agency, the Standard & poors rating services Relationship further strengthened with S&Ps acquiring 9.6% CRISIL stake

ICRA ICRA Limited (formerly Investment Information and Credit Rating Agency of India Limited) Promoted by IFCI Ltd, UTI,LIC,GIC, ILFS Ltd , EXIM Bank & otherEntered into a MOU with Moodys Investors Service ICRA is a Public Limited Company, with its shares listed on the Bombay Stock Exchange and the National Stock Exchange. ServicesRating servicesCredit assessment & advisory servicesGrading servicesInformation Services

SME rating agency of India (SMERA)is a joint initiative by SIDBI, Dun & Bradstreet Information Services India Private Limited (D&B), and several leading banks in the country.SMERA commenced its operations in 2005 as an exclusive credit rating agency for Micro, Small and Medium Enterprises (MSME) sector in the country. SMERA has assigned ratings to over 35678 MSMEs pan India so for.Objective is to enhance credit flow to credit-constrained SME sector. It was first of its kind in the world. The agency would rate any individual or company engaged in any field like manufacturing, trading, business and commerce but not the non banking finance corporations (NBFCs), chit funds and nidhis. Credit Analysis and Research (CARE) LtdA full service rating company that offers a wide range of rating and grading services across sectors.Incorporated in 1993 by consortium of Banks/financial institutions in India. The three largest shareholders of CARE are IDBI Bank, Canara Bank and State Bank of India.Registered with SEBI under the Securities & Exchange Board of India(Credit Rating Agencies) Regulations, 1999.CAREs Ratings are recognized by Govt. ofIndia and all regulatoryauthorities like RBI andSEBI.CARE is a founder member of Association of Credit Rating Agencies inAsia (ACRAA).

SECURITISATIONIntroductionSecuritization is simple terms means the conversion of existing or future cash in-flows of any person into tradable security, which then may be sold in the market.

The cash inflow from financial assets such as mortgage loans, automobile loans, trade receivables, credit card receivables, fare collections become the security, against which, borrowings are made.What is Securitization?Securitization is the packaging of a pool of financial assets into marketable securities.

Typically relatively illiquid assets are converted into securities.

The aim behind a securitization structure is to serve the risk of originator insolvency from the risk of the asset/ receivable performance, allowing the investor to rely on the asset risk rather the general corporate credit risk of an originator.

The Why of SecuritisationCompanies with low credit rating can issue asset backed securities at lower interest cost due to higher credit rating on such security. Relatively illiquid assets are converted into marketable securities providing liquidity and alternative funding sources.Removal of assets from the balance sheet under a true sale can improve capital adequacy. The operations in a particular business area/portfolio of assets can be increased while not increasing the total exposure to that area or assets.In case the originator also acts as the servicer /receiving and paying agent (RPA), it also gets the servicing fee.Features of Securitization (QP)MarketabilityCredit RatingsWide distributionHomogeneity Similar loans are bunched togetherIntegration and Differenciation

Securitisation How?Homogeneous Loans (assets) are pooled together by Co. AThe Pool is sold to SPV (Special Purpose Vehicle)SPV makes payment to Co. A at a DiscountSPV issues the pool certificate to Co. B collecting the sale proceeds and promising to pay Co. B installment and the interest regularly for a given period of timeSPV collects the payment from borrowers passes on the proceeds to Co. B after deducting its service chargesParties to securitisation transactionOriginatorObligorsSpecial purpose vehicle: single/ multipleTrusteesInvestorsMerchant banker/ underwriterCredit rating agencyServicing agent / receiving & paying agent(RPA)Basic process of securitisationOriginatorObligorsSPVspecial purpose entity

2.Assigns Cash flowInvestors1. Cash flow before securitisation4. Proceeds of issue of securities3. Issues securities/ notes5.Collection and servicing6.Passes over to SPV, less feesReinvestmentcontract7. Reinvestment/liquiditybuffer8. Reinvestmentproceeds/liquidityfacility9. Payments to investors4. Proceedsof sale of receivablesSecuritytrusteeIdentification stageTransfer stageIssue stageRedemption stageCredit rating stageStages involved in SecuritisationIdentification stage the bank or any other institution decide to go for Securitisation called originator. He pick up the pool of assets of homogenous nature, considering the maturities, interest rated involved and frequency of repayment and marketability.Stages involved in SecuritisationIdentification stageTransfer stageselected pool of asset is passed through the other institution which is ready to help the originator to convert those pools asset into securities. This institution called SPV. Stages involved in SecuritisationIdentification stageTransfer stageIssue process SPV split the packaged into individual securities of smaller values and they are sold to the investing public. The securities issued by SPV is called different names like pay through certificate, pass through certificate, interest only certificate, principal only certificate.Stages involved in SecuritisationIdentification stageTransfer stageIssue stageRedemption process the redemption and payments of interest on these securities are facilitated by the collections received by the SPV from securitized asset.Stages involved in Securitisation

Identification stageTransfer stageIssue stageRedemption stageCredit rating process since pass through certificate issued publically, required credit rating agency to rate so that it become more attractive.

Stages involved in SecuritisationThe Types of Securities StructurePass Through Certificates:Sale of asset to SPVInvestors purchase interest in the assets of SPVCash flow (interest and principal) passed through as and when occurred without any reconfigurationPayments made are most often on monthly basisReinvestment risk carried by investor

The Types of Securities StructurePay Through Certificates:Sale of assets to SPVSPV issues a debt security collateralized by asset cash flowsCash flows (interest and principal) reconfigured to suit the requirements of the investors i.e. based on the maturity period of the securityReinvestment risk carried by SPVEach trench is redeemed one at a timePayments would be at different time intervals than the flows from the underlying assets

Senior Notes, Junior Notes etcSPV can issue these notes in addition to Pass through Certificates and Pay through Certificates

Senior notes are paid interest and principal repayments first

Stripped Securities:Under this, the securities are classified as interest only (IO) securities or Principal Only securities;IO holders are paid back out of interest only and PO security holders are paid out of principal repayments only.These securities are highly volatile in nature and are least preferred by the investors.PO securities increase in value when interest rates go down because it becomes lucrative to prepay existing mortgages and undertake fresh loans at lower interest rates.Benefits to CompaniesIncreased Liquidity: illiquid assets are converted into tradable securities.

Higher Credit Quality: The structure of the instrument can be tailored in such a manner that a desired credit rating, which is higher that the rating of company holding the assets, is achieved.

Risk Diversification: securities allows the issuer its credit exposure to a particular borrow/ sectors and thus helps in risk diversification of asset portfolio.

Asset Liability Management: Securitisation offers an efficient way of matching of assets,

Funding Sources: Securitisation allows the issuer to find alternate sources of funding and also raise funds at low costs with improved credit rating.

In short, it is a total risk management on the balance sheet itself.

To InvestorLiquidity: instruments are freely tradable in the market.Safety: instruments are rated and backed by assets and collaterals. Bankruptcy of seller will not have any impact since SPV is in charge of assets and it will protect the interest of investors.Cash flows: flexible range of maturities to suit different cash flow requirements.Diversification: different types of instruments in different portfolios for risk mitigation.To MarketIt creates more depth in the market by adding more diversified instruments with different maturities.

More fee based income for financial institutions, since they may act as administrators.involves the Transfer of beneficial, and not the legal title.Cumbersome transfer processno secondary market for securitised debt.The market is unregulated and lacks transparency in terms of volume, price, parties to the transaction, etc.The settlement procedures are not clear.There are no standard accounting and valuation norms.Inadequate credit rating facility

Issues in securitization