The Global Credit Crunch What does it mean for Income Investing Andrew Smith Managing Director Austr

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The Global Credit Crunch What does it mean for
Income Investing?Andrew SmithManaging
Director - Australia and New Zealand11th June
2008
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Fitch locations
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What are Credit Ratings?

• An opinion on an entitys ability to
• meet its financial commitments on a timely basis
• Interest
• Repayment of Principal
• Preferred dividends

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Credit Ratings are not recommendations to buy
or sell - we do not comment of the value
aspects

• Credit Ratings are
• like a building inspection
• - we opine on an entitys soundness
• - not if it is a good buy

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What rating agencies do

• Rating Agencies look for downside risk
• Bondholders are risk averse
• We are Professional Pessimists
• Pessimists - always looking for the downside
• Professional - assessing it systematically

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The difference between bonds and shares

• Shares
• Participate in growth (profits, dividends and
  share price can grow)
• Are prepared to take risks if growth prospects
  are good
• Bonds
• Do not participate in growth (a bondholder will
  only get back their principal) , but may
  participate in losses.
• Do not like companies taking risk if it means
  they may go bankrupt
• Rating agencies look at companies ability to pay
  back bonds, if things go wrong

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Fitch Long Term Ratings Investment Grade

• AAA - Highest Credit Quality
• AAA ratings denote the lowest expectation of
  credit risk. They are assigned only in case of
  exceptionally strong capacity for timely payment
  of financial commitments. This capacity is
  highly unlikely to be adversely affected by
  foreseeable events.
• AA - Very High Credit Quality
• AA ratings denote a very low expectation of
  credit risk. They indicate very strong capacity
  for timely payment of financial commitments.
  This capacity is not significantly vulnerable to
  foreseeable events.
• A - High Credit Quality
• A ratings denote a low expectation of credit
  risk. The capacity for timely payment of
  financial commitments is considered strong. This
  capacity may, nevertheless, be more vulnerable to
  changes in circumstances or in economic
  conditions than is the case for higher ratings.
• BBB - Good Credit Quality
• BBB ratings indicate that there is currently a
  low expectation of credit risk. The capacity for
  timely payment of financial commitments is
  considered adequate, but adverse changes in
  circumstances and in economic conditions are more
  likely to impair this capacity. This is the
  lowest investment-grade category.

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Fitch Long Term Ratings Speculative Grade

• BB - Speculative
• BB ratings indicate that there is a
  possibility of credit risk developing,
  particularly as the result of adverse economic
  change over time however, business or financial
  alternatives may be available to allow financial
  commitments to be met. Securities rated in this
  category are not investment grade .
• B - Highly Speculative
• B ratings indicate that significant credit risk
  is present, but a limited margin of safety
  remains. Financial commitments are currently
  being met however, capacity for continued
  payment is contingent upon a sustained,
  favourable business and economic environment.
• CCC, CC, C - High Default Probability
• Default is a real possibility. Capacity for
  meeting financial commitments is solely reliant
  upon sustained, favourable business or economic
  developments. A CC rating indicates that
  default of some kind appears probable. C
  ratings signal imminent default.
• RD - Default
• Indicates an entity that has failed to make due
  payments (within the applicable grace period) on
  some but not all material financial obligations,
  but continues to honor other classes of
  obligations.
• D - Default
• Indicates an entity that has defaulted on all of
  its financial obligations.

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How investors use ratingscumulative default
statistics

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How investors use ratings

• Transition matrices

Corporate Finance Migration Rates for 2006 ()
Source Fitch
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• The basics of RMBS

BBB
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The Basic CDO

Senior Tranche
Subordinated Tranche
Junior Tranche (1st loss Piece))
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SaversBorrowers
The subprime virus in an interconnected financial
system
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The Aftershock Scenario
US Subprime
Conduits SIVs
LBOs
Northern Rock
Monolines
IKB
Centro
Societe Generale
LBSachsen
WestLB
UBS
RAMS
CDO of ABS
Bear Stearns
Merrill Lynch
Citigroup
Earnings
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Flight to Treasuries, not other AAA
Bond Yields in US Market
Source Federal Reserve Board
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Similar pattern in the Australian market
Bond Yields in Australian Market
5-year Commonwealth Treasury Bond, 1-5 year
corporate bonds Source CEIC, RBA
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Australian Residential Mortgage Performance
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Australian postcode report
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The Structured Finance Pendulum

• June 2007

acceptable market product
CDOs Squared
RMBS
Synthetic CDOs
lt20bp
Cash CDOs
ABS
CMBS
less volatile
more volatile
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The Structured Finance Pendulum

• February 2008

acceptable market product
CDOs Squared
RMBS
Synthetic CDOs
gt150bp
Cash CDOs
ABS
CMBS
less volatile
more volatile
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The Structured Finance Pendulum

• February 2009?

acceptable market product
CDOs Squared
RMBS
Synthetic CDOs
Cash CDOs
ABS
CMBS
less volatile
more volatile
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