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Read This Before Your Borrowers Do What Loan Rating Refinements Mean to Lenders
Reprinted from the July/August 2006 Issue, Vol. 4, No. 6
�2006 ABF Journal, 409 East Lancaster Avenue Wayne, PA 19087. All rights reserved. Reproduction in whole or in part is not permitted without written permission.
C
redit markets are growing in sophistication as lenders desire and
regulators require greater clarity of the risks surrounding bonds
and loans. Ratings agencies have taken a big stride toward better
discerning the different risks inherent in bank loans and bonds through
its new updated bank loan methodology. In particular, Moodys Inves-
tors Services new methodology is an important attempt to reconcile the
complexity inherent in capturing two factors with one rating and is very
likely to have important ramifications for the asset-based and middle-
market lending communities.
Before embarking on an analysis of what the new methodology means
for asset-based and middle-market lenders, it may first be helpful to briefly
review the new approach. Moodys has historically tried to reflect loss given
default and default probability through one rating per instrument. These
are the familiar ratings that range from AAA down to C and the 1, 2, 3
refinements within each category. A rating across all asset classes indicates
the same combined probability of loss and loss given default.
Moodys has now refined this process with the addition of a separate
loss given default rating (LGD) that will be combined with a probability of
default rating (PDR) to determine an overall loss rating. LGD ratings will
range from 1 to 6 will have corresponding recovery rates. The six LGD
ratings will span recovery from 0% to 100%, although the bands will not
be identical. For example, the lowest band, LGD1, will reflect a recovery
rate of 0% to 9% and the highest band, LGD6, will reflect recovery of 90%
to 100%. The bands in between will have recovery rates of 20%. The PDR
will be driven by the corporate family rating (CFR), which is determined
through the standard credit scorecard and application of metrics that
Moodys has published for most of its industries. The CFR is really the
foundation for the PDR as cross default clauses generally equalize default
rates across asset classes.
The true innovation to this methodology, the LGD portion, is derived
first by determining the net assets available to be distributed in liquidation.
This valuation is then applied the LGD percentage corresponding to the
LGD rating to determine the recoverable assets. The recoverable assets
are then apportioned according to the priority of claims. Moodys does not
take into account debtor-in-possession facilities or administrative fees, as
these are difficult to predict and require too many distorting assumptions.
One key to this recovery analysis
valuation of net available assets
depends on the issuers proximity to
default. A company closer to default
will be valued according to standard
industry enterprise valuation metrics.
A company further from default will
be assumed to have an enterprise
value equal to 100% of its liabilities.
(Moodys recognizes that standard
metrics for a healthy company are poor indicators for enterprise value in
distress.) The assumed recoverable assets for a healthy company (apart
from utilities) will fall along a truncated normal distribution with a standard
deviation of 20% and a mean of 50%. This distribution curve reflects
Moodys empirical research findings.
This all sounds rather complicated, and it can be. However, such a
refinement is extremely powerful because it codifies what senior lenders
have known for some time: security attributes, collateral and voting
rights in a loan often yield far better recovery rates for loans than for
bonds. Moodys own research has revealed that loans tend to default
at approximately 80% the rate of bonds and recover from two to four
times that of bondholders. Bond ratings and loan ratings were historically
different, but this empirical research shows mounting evidence of a greater
difference in default rates and recovery values between bonds and loans
than was previously believed.
In general, this new approach comports with the type of credit analysis
performed by senior and second lien lenders. The use of a waterfall is a
Read This Before Your Borrowers Do
What Loan Rating Refinements Mean to Lenders
Ratings agencies have taken a big stride toward better discerning the different risks inherent in bank loans and bonds
through its new updated bank loan methodology. In particular, Moodys Investors Services new methodology is an
important attempt to reconcile the complexity inherent in capturing two factors with one rating and is very likely to
have important ramifications for the asset-based and middle-market lending communities.
By Tod Trabocco
While liquidity and transparency are
important virtues for any financial
market, they can undermine some
lenders strategies.
LGC Recovery Probabilities
LGD1 . . . . . . . 0%9%
LGD2 . . . . . 10%29%
LGD3 . . . . . 30%49%
LGD4 . . . . . 50%69%
LGD5 . . . . . 70%89%
LGD6 . . . . 90%100%
Source: Moodys Investors Service �2006 ABF Journal, 409 East Lancaster Avenue Wayne, PA 19087. All rights reserved. Reproduction in whole or in part is not permitted without written permission.
tested method for understanding recovery. Nevertheless, certain aspects of
this new methodology will need to be tested in practice. The first of these
aspects involves the use of two different valuation techniques. The use of
EBITDA multiples for firms closer to financial distress is understandable
and reflects standard restructuring practice. Given the depth of analysis
that Moodys will perform on firms in distress, the accuracy of recovery
estimates is likely to be greater than for firms that are further from distress.
Moreover, firms that hover around default may have ratings of varying
accuracy and quality.
For healthy firms, it appears that Moodys will use a standard
enterprise value (EV) of 100% of liabilities and a LGD range based on
the truncated normal distribution mentioned above. While this assumption
may be statistically defensible, it will likely offer little comfort to lenders
struggling to cope with a healthy borrowers idiosyncratic risk. From what
Moodys has offered in its published methodologies, it sounds as though
most borrowers in most sectors will have a very similar LGD when healthy.
The insight that loan ratings provide may be more limited and useful for
companies not in financial distress.
The second aspect relates to the first and involves the timing of the
switch from one valuation method to the other. Moodys will face the
challenge of determining a uniform time as to when the EV approach
in distress will be triggered. The source of this challenge will arise from
Moodys different approach to credit analysis among industries and the
economic peculiarities among industries. In the case of the former, a
survey of individual industry methodologies published by Moodys reveals
differences in the application of the credit scorecard methodology. In
other words, different ratios mean different things in different industries.
These differences may create different trigger points for the distressed
EV valuation approach. In the case of the latter, industries can move
into distress at different rates. Some move quickly when confronted with
disruptive competitive threats or severe supply dislocations while others
may linger as the individual enterprises wrestle with input costs and pricing
pressures. Calibrating the trigger for the EV valuation may take time.
Finally, the assumption of an EV as 100% of total liabilities for companies
not in financial distress may fail to account accurately for the equity cushion
enjoyed by junior debt holders. As a result, this shortcut valuation for healthy
companies, while sensible from the perspective of recovery probability, may
overstate the credit risk confronting junior lenders.
Nevertheless, these are challenges that confront all lenders and
credit analysts and Moodys will undoubtedly adapt a