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We Are Making Progress - Although Sometimes It’s Hard to Tell!

Presented October 23, 2007 in Quito, Ecuador, at the

seminar “Challenges for the Productive Sector”

organized by Ecuability S.A

Calificadora de Riesgos

Roy P. WeinbergerPresident of Ecuability S.A. &Principal of Credit Research, Advisory & Consulting

Change Can Be Good

but

it

may

take a

long

time

Until The Right Balance Is Found2

Select Credit Market Milestones• 1975 - reopening of US market to int’l borrowers

• 1980 - US market opens to first junk bonds

• 1983 - first structured finance issue placed

• 1986-88 - hostile takeovers force companies to focus on meeting shareholder expectations and more effectively managing corporate assets

• 1990s - globalization sees Europe catch up to US and emerging markets grow as new institutional investors create a demand for assets 3

But It’s Never A Smooth RideBecause of the Human Element

• Greed

• Hubris

• Dishonesty

• Incompetence• Human Error

4

The Sub-Prime Mess A Good Idea Gone Bad

•Sub-Prime Mortgage Pools can be viewed as great grandchildren of the residential mortgage pools that were created and sold in the 1980s

• Those original Pools were all ‘Prime’ - i.e. owner-occupied single-family residential properties, used standard FNMA/ FHLMC underwriting, were seasoned, were statistically diversified, and had solidly positive LTV ratios at origination.

(continued)5

• Independent firms developed the analytical modeling/cash flow software under the direction of the rating agency• Criteria was based on depression-era default data

6

The Sub-Prime Mess A Good Idea Gone Bad

7

‘Evolution’ of Mortgage Pools

• Non-conforming loans - i.e. jumbo loans, low or no LTVs, non-standard underwriting, second mortgages

• Less diversified, smaller pools

• Second homes, mobile homes, rental and commercial properties, etc.

• Sub-prime borrowers

• Piggy-back loans

8

Why Problems Were Inevitable

• Less rigorous underwriting process• Absence of historical performance data for

the asset class• Implicit belief in the power and accuracy of

quantitative models • “Easy money” fueling the market• Market participants all under performance

pressures

9

International Rating Agencies

• The ideal business model

• The reality

• Easy scapegoats

• Investors’ and other market participants’ responsibilities

• Rating agencies’ role in the sub-prime mess

(continued)

10

International Rating AgenciesThe Ideal Business Model

• The ideal business model for rating agencies would be for them

• a) to have no economic relationship with the entities they rate, and

• b) to be adequately compensated by the institutional investors and others who use their ratings

(continued)

11

International Rating AgenciesThe Reality

• The reality is that institutional investors and others who use ratings are not willing to compensate rating agencies at levels that would enable them to maintain trained staffs to adequately carry out their responsibilities.

• Even with today’s system, rating agencies are challenged to retain analysts due to competition from investment banks. (continued)

12

International Rating AgenciesEasy Scapegoats

• Investment bankers, loan originators, investors and, of course, regulatory authorities and politicians find the international rating agencies to be very easy scapegoats

• Their principal argument is that the rating agencies were “enablers,” leading investors into temptation with their high ratings

(continued)

13

International Rating AgenciesInvestors’ Responsibility

• Investors bear the ultimate responsibility for their decisions and, in the absence of fraud, cannot lay the blame on others.

• Unless they explicitly out-source their credit functions to third parties, who could be rating agencies, they must undertake appropriate “due diligence”. Otherwise, they must recognize and accept that ratings are only opinions.

(continued)

14

International Rating AgenciesOther Market Participants’ Responsibilities

• Investment bankers bear responsibility for demanding adequate disclosure from their clients

• Originators of assets bear responsibility for living up to the underwriting standards they have promised to follow

• Regulatory authorities bear responsibility for establishing relevant securities issuance standards, and for then allowing market participants to act

(continued)

15

International Rating AgenciesBlameless?

• Hardly! As with other market participants, the rating agencies placed undue and, as it turned out, unwarranted trust in the power of financial models as a counterweight to the shortage of historical performance data on new asset classes including sub prime

• They can also be criticized for a glaring inability to communicate concerns they claim to have had about disturbing patterns and trends. Their argument that ‘we didn’t want to act until the data was clear’ seems today like a very hollow excuse.

(continued)

16

International Rating AgenciesBlameless?

• Also, the international agencies have argued that they shouldn’t be blamed for loss of value and lack of liquidity of highly rated issues, as their ratings mainly focus on measuring probability of default. And actual defaults on long-term issues have, to date, been minimal, and negligible for highly rated ones.

• However, they conveniently forget the de facto defaults on highly rated asset-backed commercial paper, where rating methodologies did explicitly assume a correlation between rating, price stability and liquidity. Repayment of large amounts of these papers have been delayed .

17

STILL, WHATEVER THEIR FAULTS,

IF RATING AGENCIES DIDN’T EXIST,

THEY WOULD HAVE TO BE INVENTED

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HOWEVER, RATING AGENCIES DO

EXIST, SO

THOUGHTFUL MANAGERS WILL LEARN HOW TO

WORK WITH THEM AND TO BENEFIT FROM THE

RELATIONSHIP

19

QUESTION?If you’re going to have to be

rated, what rating level should you try to achieve?

ANSWER -THE RIGHT RATING!

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What is the Right Rating?

The “Right Rating” for any organization is the rating that allows it to implement its business strategy

without financial constraints.The “Right Rating” may well not be

the highest rating possible when good corporate governance is considered.

21

What are Most Likely to Score Points with Rating Agencies?

• Continuity of Policies/Balance

• Follow Through

• Transparency

• Contingency planning

• Interest in having a dialogue

22

Current Rating Agency ‘Hot Buttons’Financial Institutions

• Availability of liquidity and liquidity management

• Risk management - credit, market, operational, etc.

• Contingent liabilities

• Strategic management and diversification

• Quality of regulation

23

Current Rating Agency ‘Hot Buttons’Real Sector

• Corporate governance

• Repercussions of a weakening US economy

• Ability to compete internationally

• Off-balance sheet liabilities, including pensions

24

Rating Agency ‘Hot Buttons’Project Finance

• Political risks - legal and regulatory

• Commercial risks - completion, sponsor, operational, and demand

• Financial risks - overall debt leverage

25

Rating Agency ‘Hot Buttons’Structured Finance

• Quality of portfolio assets/ originator risks

• Cash flow adequacy -prepayments, investment returns

• Legal risks - structured finance versus secured finance

The Bottom Line•We will always live in ‘interesting times’ where much is beyond our control or, even, our comprehension.

•All we can do is control what we can, which on a day-to-day basis is quite a bit.

•Control over one’s credit profile is, to a fairly reasonable extent, possible. But it does take effort and focus.

•Hopefully I’ve given you some tools to do so if you wish. 26

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ROY P. WEINBERGER• ECUABILITY S.A.• BRC INVESTOR SERVICES S.A.• CREDIT RESEARCH,

ADVISORY & CONSULTING

1004 MONARCH CIRCLESTATESBORO, GEORGIA, USA 30458

TEL/FAX: 912 764 5073E-MAIL: rweinberger@frontiernet.netwww.frontiernet.net/~rweinberger/

THANKS FOR YOUR INTEREST AND ATTENTION