4.3.1 External and Internal Ratings

Credit Risk Measurement and Management

1. External and Internal Credit Rating

1.1 External Ratings

1.1.1 Rating Agencies

Credit ratings answer the question: "How likely is an entity to default on its obligations? "

Rating agencies are organizations provide independent opinions on credit risk, based on specified criteria.

• Issue-specific credit ratings: specific obligations or instruments.
• Issuer credit ratings: an issuer’s general creditworthiness.

1.1.2 Rating Scales

Long-term ratings: The ratings for bonds are termed long-term ratings.

Investment Grade Ratings
Interpretation	S&P/Fitch	Moddy	Interpretation
Highest rating: Extremely strong capacity to meet obligations	AAA	Aaa	Highest quality, with minimal credit risk.
Capacity to meet its financial obligation is very strong.	AA+	Aa1	High quality and subject to very low credit risk
	AA	Aa2
	AA-	Aa3
Capacity to meet obligation still strong but susceptible to adverse changes in economic conditions	A+	A1	Considered upper-medium grade and subject to low credit risk
	A	A2
	A-	A3
Exhibits adequate protection parameters	BBB+	Baa1	Subject to moderate credit risk
	BBB	Baa2
	BBB-	Baa3

Speculative Grade Ratings
Interpretation	S&P/Fitch	Moddy	Interpretation
Less vulnerable to non-payment than other speculative issues but faces major ongoing uncertainties.	BB+	Ba1	Judged to have speculative elements and are subject to substantial credit risk.
	BB	Ba2
	BB-	Ba3
More vulnerable to non-payment than "BB" but has current capacity to meet financial obligation.	B+	B1	Considered speculative and are subject to high credit risk.
	B	B2
	B-	B3
Vulnerable to non-payment.	CCC+	Caa1	In poor standing.
	CCC	Caa2
	CCC-	Caa3
Highly vulnerable to non-payment.	CC/C	Ca	Highly speculative, likely to default.
In payment default.	D	C	Lowest rated bonds-typically in default, with little prospect for recovery.

Short-term ratings: The ratings for money-market instruments are termed short-term ratings.

Moddy's	S&P	Fitch
Investment Grade
P-1	A-1+	F1+
	A-1	F1
P-2	A-2	F2
P-3	A-3	F3
Non-Investment Grade
NP	B	B
	C	C
	D	D

1.1.3 Rating Process

An instrument is usually first rated when it is issued, and the rating is reviewed periodically.

The rating agency is paid by the issuer even though the product it provides is used by the purchaser.

The rating is based on a mixture of analysis and judgement.

• Quantitative factors: financial ratios, etc.
• Qualitative factors: governance framework, business fundamentals, etc.

Outlooks: indicates the most likely direction of the rating over the medium term.

• Positive outlook: a rating may be raised.
• Negative outlook: a rating may be lowered.
• Stable outlook: a rating is not likely to change.
• Developing (or evolving) outlook: while the rating may change in the medium term, the agency cannot (as of yet) determine.

Watchlists: indicates a relatively short-term change is anticipated (usually within three months).

• Positive: a review for a possible upgrade
• Negative: a review for a possible downgrade

1.1.4 Ratings Transition Matrix

Ratings Transition Matrix shows the probability of a bond issuer migrating from one rating category to another during a one-year period.

$D$ denotes default
$NR$ denotes that the issuer was not rated at the end of the year.

表格从左向右看，纵坐标是初始评级

	AAA	AA	A	BBB	BB	B	CCC/C	D	NR
AAA	87.5	9.03	0.53	0.05	0.08	0.03	0.05	0	3.17
AA	0.52	86.82	8	0.51	0.05	0.07	0.02	0.02	3.99
A	0.03	1.77	87.79	5.33	0.32	0.13	0.02	0.06	4.55
BBB	0.01	0.1	3.51	85.56	3.79	0.51	0.12	0.18	6.23
BB	0.01	0.03	0.12	4.97	76.98	6.92	0.61	0.72	9.63
B	0	0.03	0.09	0.19	5.15	74.26	4.46	3.76	12.06
CCC/C	0	0	0.13	0.19	0.63	12.91	43.97	26.78	15.39

Based on the rating transition matrix, please calculate the two period cumulative probability that an A-rated firm would default.

	A	B	C	D
A	94%	4%	2%	0%
B	4%	88%	6%	2%
C	1%	5%	80%	14%
D	0%	0%	0%	100%

$A\to D=0\%$
$A\to A\to D=0\%$
$A\to B\to D=4\%\times 2\%$
$A\to C\to D=2\%\times 14\%$

Two-period cumulative probability is $0\%+0\%+0.08\%+0.28\%=0.36\%$

If we assume rating changes in successive years are independent, we can calculate a transition matrix for n years using the transition matrix for one year.

Actual multi-year: Ratings momentum phenomenon

• If a firm has been downgraded in one year, it is more likely to be downgraded the next year.
• If a firm has been upgraded one year, however, it is more likely to be upgraded the next year.

1.2 Factors in Credit Ratings

1.2.1 Time Horizon and Economic Cycle

A firm’s probability of default changes in tandem with economic conditions.

A through-the-cycle ratings tries to capture the average creditworthiness of a firm over a period of several years, and should not be unduly affected by ups and downs in overall economic conditions.

A point-in-term rating provide the best current estimate of future default probabilities.

1.2.2 Geographic and Industry

Rating agencies use the same scales to characterize default risk across different industries and different countries. An important question is whether ratings are consistent.

Geographic
Five-year cumulative probabilities for United States, European, and emerging market in 2016 by S&P.

Initial Rating	U.S. Firms	European Firms	Firms in Emerging Markets
AAA	0.42	0	N.A.
AA	0.45	0.21	0
A	0.73	0.29	0.05
BBB	2.05	0.65	2.59
BB	8.38	4.2	6.26
B	19.57	13.86	12.59
CCC/C	51.31	48.01	25.88
Investment Grade	1.17	0.38	1.69
Speculative Grade	17	10.84	10.19
All Rated	7.57	2.54	6.53

European firm has historically been better than the same rating for a U.S.firm (particularly investment grade ratings).

For emerging markets, firms rated AA and A had a very low five-year default probability, and firms rated BBB fared slightly worse than U. S. Firms and much worse compared to European firms.

Industry
Banks with a given rating show higher default rates than non-financial corporations with the same rating. There has been less agreement among different rating agencies for banks than for other firms.

1.2.3 The Impact of Rating Changes

Stock and bond prices have asymmetric reactions to the rating changes.

The stock and bond market’s reaction to upgrades is much less pronounced.

The stock and bond markets’ reactions to downgrades are significant, this is especially true when the downgrade is from investment grade to non-investment grade.

It is possible that when a rating is moving down, new information is being provided to the market so that both the stock and bond prices decline while default swaps spreads increase.

1.2.4 Rating Failures of Structured Products in 2007-2008 Crisis

Rating difference of structured products: depends almost entirely on a model.

The rating agencies were quite open about the models they used.

The inputs to their models (particularly the correlations between the defaults on different mortgages) proved to be too optimistic.

Rating agencies were not as independent as they should have been - the reputation suffered as a result.

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1.3 Internal Ratings

1.3.1 Internal Ratings

Internal ratings: banks and other financial institutions develop their own internal rating systems based on several factors. In general, each factor is scored, and a weighted average score is calculated to determine the overall final rating.

Like external rating, internal ratings can be either through-the-cycle or point-in-time. There is a tendency for them to be point-in-time, but through-the-cycle ratings may be more relevant for relatively long-term lending commitments.

Banks must back-test their procedures for calculating

1.3.2 Machine Learning Approach

Some banks are currently trying to automate their lending decisions using machine learning.

• An algorithm is given a great deal of data on firms and whether they have defaulted.
• Come up with a rule for distinguishing between those firms that default from those that do not.

Altman Z-score is used to come up with a rule for distinguishing between those firms that default from those that do not.

For publicly traded manufacturing firms, the Z-score was:
$$Z=1.2X_1+1.4X_2+3.3X_3+0.6X_4+0.999X_5$$

• $X_1$:Woking capital to total assets
• $X_2$: Retained earning to total assets
• $X_3$: Earnings before interest and taxes to total assets
• $X_4$: Market value of equity to book value of total liabilities
• $X_5$: Sales to total assets

A Z-score above 3 indicated that the firm was unlikely to default.

As the Z-score was lowered, the probability of default increased to the point where a firm with a Z-score below 1.8 had a very high probability of defaulting.