The Global Credit Crunch – What does it mean for Income Investing?

Andrew SmithManaging Director - Australia and New Zealand11th June 2008

Fitch locations

What are Credit Ratings?

An opinion on an entity’s ability to

meet its financial commitments on a timely basis

– Interest

– Repayment of Principal

– Preferred dividends

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 entity’s soundness

- not if it is a good buy

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

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

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.

>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.

Fitch Long Term Ratings – Speculative Grade

How investors use ratings

cumulative default statistics

0

5

10

15

20

25

30

35

1 2 3 4 5 6 7 8 9 10

Years After Original Rating

Cum

ulat

ive

rate

of

defa

ult

(%)

A BBB BB B

How investors use ratings

Transition matrices

AAA AA A BBB BB B

AAA 95.74 4.26 0.00 0.00 0.00 0.00

AA 0.00 98.80 1.20 0.00 0.00 0.00

A 0.00 2.66 93.98 3.01 0.35 0.00

BBB 0.00 0.46 6.49 90.27 2.67 0.12

BB 0.00 0.00 0.49 12.93 77.56 8.78

B 0.00 0.00 0.00 0.96 12.98 84.13

Source: Fitch

Corporate Finance Migration Rates for 2006 (%)

The basics of RMBS

Housing Loans

Senior Debt

AAA

Very safe assetsInvestors like security of AAA rating

Junior debt(‘first loss tranche’)often acquired by bankLikely level of

loss

BBB

BH

P B

illiton

Wal-M

art

RM

BS

- BB

B

Nestle

To

kyo E

lectric

Senior Tranche

Subordinated Tranche

Junior Tranche(1st loss Piece))

The Basic CDO

Savers

Borrowers

BanksBond

Markets

Professional Money Market Investors

Bond Insurers

Mortgage Insurers

Residential Mortgage Backed

Securities

Non-Bank Mortgage Originators

Commercial Mortgage Backed

Securities

Asset Backed Securities

- credit cards- mv financing- student loans

Collateralised Debt Obligationsguarantees

Structured Investment Vehicle

issues short-term CP

Provide liquidity back-up

Hold in trading book

The subprime virus in an interconnected financial system

The Aftershock Scenario

IKB

LBSachsen

Northern Rock

US Subprime

Conduits & SIVs

LBOs

Earnings

CDO of ABS

Monolines

Merrill Lynch

UBS

WestLB

Citigroup

Bear Stearns

Societe Generale

RAMS

Centro

Flight to Treasuries, not other AAA

3

4

5

6

7

8

9

2000 2001 2002 2003 2004 2005 2006 2007 2008

10-year US Treasury AAA corporate BBB corporate(%)

Bond Yields in US Market

Source: Federal Reserve Board

Similar pattern in the Australian market

4

5

6

7

8

9

2004 2005 2006 2007 2008

Commonwealth AAA corporate A corporate(%)

Bond Yields in Australian Market*

* 5-year Commonwealth Treasury Bond, 1-5 year corporate bondsSource: CEIC, RBA

Australian Residential Mortgage Performance

Australian postcode report

The Structured Finance Pendulum

June 2007

acceptable m

arket p

roduct

CDOs Squared Syntheti

c CDOs Cash CDOs CMBS

ABS

RMBS<20bp

more volatile less volatile

The Structured Finance Pendulum

February 2008 acceptable market product

CDOs Squared Syntheti

c CDOs Cash CDOs CMBS

ABS

RMBS>150bp

more volatile less volatile

The Structured Finance Pendulum

February 2009?

acce

ptab

le m

arke

t pro

duct

CDOs Squared Syntheti

c CDOs Cash CDOs CMBS

ABS

RMBS

more volatile less volatile

Fitch Ratingswww.fitchratings.comwww.fitchratings.com.au

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