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FEBRUARY 13, 2012

CREDIT POLICY

CROSS SECTOR RATING METHODOLOGY

How Sovereign Credit Quality May Affect Other Ratings


Summary

Table of Contents: SUMMARY IMPLICATIONS FOR CURRENT RATINGS DECLINING SOVEREIGN CREDIT QUALITY HAS BROAD NEGATIVE EFFECTS ON OTHER ISSUERS RATING FUNDAMENTAL CREDITS ABOVE THE SOVEREIGN NON-FINANCIAL CORPORATES, INCLUDING UTILITIES AND INFRASTRUCTURE FINANCIAL INSTITUTIONS SUB-SOVEREIGNS STRUCTURED FINANCE MOODYS RELATED RESEARCH 1 2

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Deterioration in sovereign credit quality can directly affect the credit standing of other issuers domiciled within the sovereign, and, more generally, tends to be associated with macroeconomic and financial market trends that are unfavourable for all issuers. In this report, we outline broad principles that we apply in assessing the credit linkages between sovereign ratings and the ratings of other rated issuers, including non-financial corporates, financial institutions, sub-sovereign entities and structured finance transactions. These broad principles, which apply globally, are being enumerated to enhance transparency around the corresponding rating actions likely to be taken in other sectors when sovereign ratings change. While many ratings will be affected to some degree, there are differences in issuers credit sensitivity to changes in sovereign ratings. The following examples illustrate some likely impacts of a sovereign downgrade: Ratings directly linked to the sovereign rating will generally move in unison with a sovereign rating action. Examples include ratings based upon a guarantee or other credit enhancement by the sovereign, and structured transactions for which collateral consists primarily of securities issued by the sovereign or directly-linked entities. Such issuers are generally positioned at or slightly below the sovereign bond rating. Government-Related Issuers (GRI) whose ratings incorporate substantial uplift based upon assumptions of government support are more likely to be downgraded, even when these issuers are already rated below the sovereign. Issuers with substantial asset exposure to sovereign securities or sovereign linkedentities, or with substantial exposure to counter-parties that weaken along with the sovereign, are more likely to be downgraded.

Analyst Contacts:
LONDON +44.20.7772.5454

Alastair Wilson +44.20.7772.1372 Managing Director-CCO EMEA alastair.wilson@moodys.com William Coley +44.20.7772.8799 Senior Vice President william.coley@moodys.com Katherine L. Frey + 44.20.7772.5521 Managing Director-Structured Finance katherine.frey@moodys.com David Rubinoff +44.20.7772.1398 Managing Director Sub-sovereign david.rubinoff@moodys.com SYDNEY +612.9270.8100

Brian Cahill +612.9270.8105 Managing Director Asia Pacific Corporates & Financial Institutions brian.cahill@moodys.com
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CREDIT POLICY

Issuers and transactions that are exposed to similar pressures to the sovereign and/or to the macroeconomic and financial market conditions likely to accompany, or to result from, a change in sovereign creditworthiness will also suffer rating pressure. Examples include sub-sovereign regional and local governments, through the associated impact on expenditures and revenues; banks through the expected increase in asset impairments; non-financial corporates through the impact on revenue; structured instruments through the impact on collateral performance and creditworthiness of servicing agents; and all such issuers through the impact on funding conditions and on the availability of debt finance and bank credit. In most cases, non-financial corporates, insurance companies and sub-sovereigns will not be rated more than two notches above the sovereign, and banks not more than one notch, due to multiple channels of shared exposure and contagion for issuers in the same sovereign environment. Exceptions do, however, exist. In most cases these issuers have reliable external support, or sufficient access to assets, revenues and financing resources that are domiciled outside their home sovereign environment. There also may be exceptions when the sovereign is lowly rated (typically B1 or lower), there is greater clarity over the impact of a sovereign default and the likely default scenarios are expected to have a more limited impact on defaults by other issuers. Sovereign credit quality impacts structured finance and covered bonds ratings primarily through the performance of underlying collateral and the credit quality of counterparties. Structured finance and covered bond securities benefit from revenue diversification, credit enhancement and other structural features. As a result they can achieve higher ratings than other non-structured issuers and may, where certain conditions are met, exceed the sovereign by a limited number of notches, subject always to the constraint of the relevant country ceiling.

Implications for Current Ratings


The transmission of credit risk from a sovereign to other issuers domiciled in that country has become increasingly evident during the financial crisis which began in 2008, and has been most acute more recently during the European sovereign crisis. The linkage between sovereign credit risk and the credit risk of other issuers is a global issue and the guidance discussed in this document does not reflect a significant change in our existing rating approach. Further, it should be noted that the broad guidance in this document is not intended to have a formulaic application to every rating situation. Ratings of each issuer consider its specific circumstances in addition to the factors discussed in this document. However, there are currently approximately 60 issuers, primarily banks, in 11 different countries whose ratings are outside of the guidelines discussed in this report for the number of notches an issuer can generally be rated above its sovereign of domicile. The application of the guidance in this Rating Implementation Guidance document may result in downward adjustments to the ratings for many of these issuers. However, before initiating any reviews for downgrade we will solicit comments from interested market participants in the most affected countries to determine if there is basis for any country-specific exceptions for the guidance described in this report. We expect to complete the consultation process and initiate ratings reviews where appropriate within the next 60 days.

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CROSS SECTOR RATING METHODOLOGY: HOW SOVEREIGN CREDIT QUALITY MAY AFFECT OTHER RATINGS

CREDIT POLICY

Declining Sovereign Credit Quality Has Broad Negative Effects on Other Issuers
Sovereign defaults typically are associated with severe disruptions in the economic environment. The vast majority of past sovereign defaults have been accompanied by economic recessions. Sovereign defaults are also usually preceded by a loss of investor confidence and by capital outflows, frequently culminating in a systemic banking crisis and/or a foreign exchange crisis. Deterioration in the operating and financial environment usually results in large increases in default rates in all sectors and lower recovery rates.1 All issuers in the same sovereign environment are exposed to some degree to the transmission of shocks across sectors in the economy and the domestic banking system. In addition, they are subject to defensive sovereign actions that can include austerity measures, changes in tax or regulatory policies, and interference during a crisis. Sovereign crises have been shown to promote financial distress in other sectors through a number of channels2: slowing or contracting economic activity; liquidity constraints and higher financing costs resulting from diminished investor confidence and credit availability; capital outflows leading to a foreign exchange and/or a systemic banking crisis; government austerity measures that reduce or delay government payments and may depress the general level of economic activity; unfavourable changes or restrictions to movements in exchange rates, interest rates or price levels; government interference or changes in regulation, and changes in tax policies; and increased risks of political uncertainty and civil or labour unrest.

These influences are felt, albeit as lower probability outcomes, even at high rating levels; experience demonstrates that highly rated issuers are not immune to the wider pressures that accompany a decline in sovereign credit quality.

Rating Fundamental Credits above the Sovereign


As a result, most non-structured locally-domiciled issuers are rated at or below the level of the sovereign because they operate in the same economic and financial environment and are therefore vulnerable to the same broad credit pressures as the sovereign. Sovereigns are often viewed as the lowest risk credit in their local market or currency. In order to be rated above the sovereign, an issuer needs not only to be fundamentally stronger than the sovereign from a credit perspective, but also to demonstrate a degree of insulation from the domestic macroeconomic and financial disruption which generally accompanies a sovereign default. As a general rule, only issuers with low default dependence with the sovereign, with a substantial share of revenues, cash flows, assets and capital derived from sources outside the affected sovereign environment, would be able to demonstrate that kind of resilience and therefore would be able to
1

See Moodys Special Comments The Causes of Sovereign Defaults: Ability to Manage Crises Not Merely Determined by Debt Levels, 2 November 2010 and Emerging Market Corporate and Sub-Sovereign Defaults and Sovereign Crises: Perspectives on Country Risk, February 2009. See Special Comment Emerging Market Corporate and Sub-Sovereign Defaults and Sovereign Crises: Perspectives on Country Risk, February 2009.

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CROSS SECTOR RATING METHODOLOGY: HOW SOVEREIGN CREDIT QUALITY MAY AFFECT OTHER RATINGS

CREDIT POLICY

exceed the sovereign rating, in most cases by only one or two notches. For issuers with credit fundamentals that are much stronger than the sovereign, a rating one notch above the sovereign may be considered even when default dependence with the sovereign is viewed as moderate rather than low. Very substantial multinational characteristics, or reliable external support independent of the sovereign environment, such as support from a strong foreign owner, can result in ratings more than two notches above the sovereign. A somewhat more distant rating relationship with additional notches above the sovereign can also exist in circumstances where the sovereign is rated in the B1 to C range, if there is greater clarity over the likely impact of a sovereign default and the general operating environment for other issuers is not expected to be substantially affected by a government default.

Non-Financial Corporates, Including Utilities and Infrastructure


Consistent with the description above, in most cases, only non-financial corporates which have the following characteristics are rated above the sovereign: Revenues are derived from non-government sources or have a substantial international component. Where the reliance on domestic revenue sources is significant, the financial profile must be strong with limited risk of deterioration due to the impact of weak domestic economic fundamentals. Limited reliance on domestic banks or capital markets for funding, usually because the company has substantial free cash flow and flexibility to make adjustments (such as reductions in dividends or capex) to maintain its financial profile in a deteriorating environment. Ratings of strong entities are likely to be more than 2 notches above the sovereign when a substantial majority of revenues, cash flow and assets are derived from foreign sources and there is no reliance on local market funding. At the extreme where virtually all operations are outside the nominal headquarters country, the sovereign rating may have little relevance to the rating of a multi-national company. Strong support from a foreign parent may also result in ratings that are well above the sovereign, although timely and reliable support is more likely for a wholly-owned strategic subsidiary than a minority-owned affiliate. Contractual guarantees can result in ratings being equalized with the rating of the guarantor.

A number of issuers particularly in the infrastructure and utility sector are closely related to the government. For those issuers, linkage may arise through direct reliance on the government for funding or revenues, through reliance on licences which lie within the gift of the government, through reliance on revenues (e.g. regulated tariffs) which are susceptible to government influence, or through vulnerability to direct interference by government. Such issuers even those rated below the government may see their ratings reduced following a sovereign downgrade. Action may also be taken in relation to any non-financial corporate issuers which are exposed to significant loss of revenue or profitability or to increased funding pressures as a consequence of the macroeconomic and financial disruption that can accompany a reduction in sovereign creditworthiness. As noted above, issuers may be rated more than 2 notches above the government where the sovereign is rated in the B1 to C range and there is greater clarity over the likely impact of its default on the

FEBRUARY 13, 2012

CROSS SECTOR RATING METHODOLOGY: HOW SOVEREIGN CREDIT QUALITY MAY AFFECT OTHER RATINGS

CREDIT POLICY

general operating environment. However, this will be rare, in part because of the impact of widespread economic and financial disruption and credit dislocation on the severity of losses expected in the event of issuer defaults.

Financial Institutions
Similar general considerations apply. The standalone credit strength of financial institutions is closely linked to sovereign credit risk via operating and investment exposures which imply high default correlations. The support factored into many banks ratings also implies a direct linkage between sovereign strength and bank ratings; while the policy framework in many countries remains supportive at present given the painful repercussions of large, disorderly bank failures and the difficulty of effecting orderly resolutions of complex, interconnected institutions, a weakened government has fewer resources to extend to banks. The confidence-sensitivity of financial institutions particularly banks and their reliance on market funding sources strengthens the linkage to the sovereign. Large, interconnected banks, which are typically highly leveraged with significant reliance on market funding sources, are especially sensitive to sovereign-related concerns. This is in large part because they often benefit from implicit or explicit government support in a variety of forms, including central bank emergency liquidity facilities, regulatory forbearance, government-funded recapitalisation and other measures. That said, the correlating factors can be offset somewhat by foreign ownership, geographically diversified balance sheets and income sources, and product characteristics.
Direct Exposure to Government Debt In general, it would be difficult for a financial institution with a significant level of direct exposure to domestic sovereign debt, measured relative to its equity in the case of insurance companies and Tier 1 capital in the case of banks, to obtain a rating higher than the sovereign rating. Our analysis of this type of investment concentration risk also recognises the broader correlation between the macroeconomic factors that affect financial institutions asset quality and the sovereigns credit risk, and takes into account other assets whose risk profile is likely to be correlated with the sovereigns. Product Characteristics It is, however, important to recognize that some non-banking products contain features which mitigate concentrations of exposure to a particular sovereign. For example, some life insurance products allow for investment losses to be passed on to policyholders in part or in full a credit positive put option. Moreover, not all products sold by financial institutions particularly insurance companies have the same sensitivity to the macroeconomic factors that influence sovereign risk. Issuers which generate a material share of revenue through products with demand characteristics that are less dependent on the underlying economic environment, such as required insurance coverage, have a looser link to the sovereign credit profile. Foreign Ownership Structure Foreign ownership by a committed parent also may serve as a buffer against country-level stress. As well as formal agreements of support, we evaluate the intrinsic strength of the support provider and its capacity and willingness to provide support. However, in instances where the potential support provider is weaker than the subsidiary or when the subsidiary represents a substantial portion of the

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consolidated parents operations, it would be unusual for the financial institutions rating to be lifted above its own intrinsic strength.
Diversification Financial institutions that generate the majority of their revenue and earnings within a single country are considered more tied to the fortunes of that country and would be unlikely to be positioned above the sovereigns rating in the case of banks, and more than one notch in the case of non-banks, even if they maintain only a moderate amount of direct investment exposure to the sovereign. Conversely, banks with geographically diversified balance sheets (many large banks hold diversified securities portfolios and operate in many jurisdictions) are less likely to be weakened by a sovereign downgrade. Even there, though, our analysis will take into account the credit quality of the non-home sovereigns in which the financial institution operates, the intrinsic creditworthiness of the operations outside the home sovereign, as well as the liquidity and asset/liability profile of those operations.

Consequently, in the absence of the mitigating factors outlined above (external sources of support or exceptionally high geographic diversification or low investment exposure), even the strongest banks will be unable to exceed the rating of the domestic sovereign by more than one notch. Insurance companies, which are by the nature of their products and balance sheets better able to withstand confidence and asset shocks, may exceed the sovereign rating by up to two notches.
Money Market Funds and Bond Funds

The risk profile of money market funds and bond funds can also be closely linked to the credit standing of sovereigns and banks. As direct investors in sovereign and financial institution debt, money market funds and bond funds may be negatively impacted by declines in these sectors. Volatile credit conditions can also create indirect pressure on money market funds, since increased volatility can lead to higher levels of redemptions activity, draining funds liquidity. Rating downgrades may be appropriate for funds that are materially exposed to sovereigns or banks whose credit standing is under pressure, or for money market funds that experience significant redemptions.

Sub-Sovereigns
Sub-sovereign issuers tend to be highly exposed to the same macroeconomic and financial sectors pressures which affect the central government, whose credit quality therefore typically anchors most sub-sovereign issuers ratings. Exceptions exist for example the Italian provinces of Trento and Bolzano and the Spanish Basque governments, all of which exhibit a high degree of independence from the sovereign. Even there, however, limits apply to their ability to be rated above the sovereign. Sector specific considerations in rating these issuers higher than the sovereign include the presence or absence of constitutional protections that create a formal separation of powers and a very high degree of fiscal autonomy between sovereign and sub-sovereign governments, including revenue-setting policies and collection and spending decisions. These issuers typically display low reliance on funding from the sovereign, low correlation of revenue bases, and limited need to access capital markets or bank funding. However, despite their healthy financials and fiscal flexibility, they remain vulnerable, albeit to a lesser extent, to similar macroeconomic challenges and sovereign contagion and are typically rated no more than 1-2 notches higher than the sovereign. For sub-sovereigns rated below the sovereign, case by case considerations will apply. Since all will be affected by the sovereign operating environment to some degree, downward rating pressure can be

FEBRUARY 13, 2012

CROSS SECTOR RATING METHODOLOGY: HOW SOVEREIGN CREDIT QUALITY MAY AFFECT OTHER RATINGS

CREDIT POLICY

expected across the rating spectrum. Equally, not all will be affected to the same degree: stronger credits may be relatively more immune to economic and financial disruption, and the weakest credits may already have relatively more pessimistic assumptions about their susceptibility to external disruption. Overall, therefore, some rating compression would be expected, at least among the lower rated sub-sovereign issuers.

Structured Finance
Declining sovereign credit quality impacts structured finance and covered bonds ratings primarily by increasing loss expectation or volatility related to the underlying assets and by reducing the quality or availability of third party support. By construction, most structured finance transactions and covered bonds benefit from diversification of revenue sources, as well as for senior tranches from credit enhancement. The benefits of diversification are nevertheless constrained by the fact that collateral assets and or underlying obligors are generally located in the same jurisdiction and therefore affected by the same macroeconomic and financial pressures which affect the sovereigns rating. Structured finance transactions and covered bonds also rely on banks to provide servicing functions and other financial roles (such as account banks, swap counterparties, cash managers), and are vulnerable to a general loss of credit quality across the banking sector. Up to a point, credit quality can be maintained by changing the structure of transactions to replace downgraded counterparties (mitigating operational and counterparty risk and by increasing credit enhancement levels to mitigate deteriorating collateral performance). However, as sovereign creditworthiness declines, and the uncertainty around collateral performance and counterparty risk rises, there comes a point when increased country risk cannot be fully mitigated by structural features and thus the highest ratings are no longer achievable. The relationship between the sovereigns rating and structured finance ratings depends on many factors. Structured finance ratings may, where certain conditions are met, exceed the sovereign by a limited number of notches, subject always to the constraint of the relevant country ceiling. A wider gap may be permitted when a sovereign is near default and the consequences of its default on structured finance transactions can be better anticipated. To maintain senior ratings above the sovereigns rating, Moodys assesses the credit quality and geographic location of the counterparties providing key roles in the transactions, the various structural features and whether these structured finance securities have sufficient credit enhancement. Increased uncertainty around future asset performance due to country risk factors affects all tranches in a structured transaction, possibly to different degrees, and could move ratings at every level. In covered bonds, our ratings may also register the impact of declining sovereign credit quality. This impact usually flows indirectly through the issuing bank rating and is integrated in our Timely Payment Indicator (TPI), as the stresses on the sovereign and financial system may mean refinancing is less readily available to allow a covered bond programme to make timely payments to covered bondholders upon an issuing bank default.

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Moodys Related Research


Special Comments:

The Causes of Sovereign Defaults: Ability to Manage Crises Not Merely Determined by Debt Levels, November 2010 (127952) Moody's Rating Approach for European Infrastructure & Utility Companies in an Environment of Declining Sovereign Credit Quality, November 2010 (128915) Portuguese Issuers: Credit Implications Associated with a Weakened Sovereign, September 2011 (134238) Emerging Market Corporate and Sub-Sovereign Defaults and Sovereign Crises: Perspectives on Country Risk, February 2009 (113931) Why Global Bank Ratings Are Likely to Decline in 2012, January 2012 (139205) Euro Area Debt Crisis Weakens Bank Credit Profiles, January 2012 (137981) European Banks: How Moodys Analytic Approach Reflects Evolving Challenges, January 2012 (139207) Assessing the Impact of the Eurozone Sovereign Debt Crisis on Structured Finance Transactions, April 2011 (SF243137)

To access any of these reports, click on the entry above. Note that these references are current as of the date of publication of this report and that more recent reports may be available. All research may not be available to all clients.

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contacts continued from page 1

Report Number: 139495

Analyst Contacts:
PARIS +33.1.7070.2229 Authors Daniel Gates Alastair Wilson Elena Duggar William Coley Mark LaMonte Jeffrey Berg Benedicte Andries Yaron Ernst Production Associate Masaki Shiomi

Myriam Durand +33.1.5330.1049 Managing Director-EMEA Corporate Finance myriam.durand@moodys.com FRANKFURT +49.69.70730.700

Carola Schuler +49.69.70730.766 Managing Director-Banking carola.schuler@moodys.com NEW YORK +1.212.553.1653

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Daniel Gates +1.212.553.7923 Managing Director-CCO Corporate Finance daniel.gates@moodys.com Anne Van Praagh +1.212.553.3744 Managing Director-CCO Public Finance anne.vanpraagh@moodys.com Mark LaMonte +1.212.553.0455 Managing Director-CCO Financial Institutions mark.lamonte@moodys.com Celina Vansetti-Hutchins +1.212.553.4845 Managing Director-Banking celina.hutchins@moodys.com Nicolas Weill + 1.212.553.3877 Managing Director-CCO Structured Finance nicolas.weill@moodys.com

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CROSS SECTOR RATING METHODOLOGY: HOW SOVEREIGN CREDIT QUALITY MAY AFFECT OTHER RATINGS