Credit Ratings as an Investor Protection Mechanism? Anita Goulding, Head of Rating Advisory, Asia 4 November 2005

CONTENTS Importance and Use of Credit Ratings Assigning Credit Ratings Role of Rating Agencies Development of the Asian Bond Markets Will Asias Bond Market emulate Australias Bond Market? Corporate Hybrids

Importance and Use of Credit Ratings

What is a Credit Rating? A rating is an opinion on the future ability and the legal obligation of an issuer to make timely payments of principal and interest on a specific fixed income security or other financial obligation Comparability/Transparency Consistent, uniform and globally comparable grading system; provides independent peer comparisons Measures the relative risk of investing in a security (ie probability of default) There is a strong correlation between short-term and long-term ratings. Short-term ratings typically require back-up liquidity Supports disclosure and transparency Forward-looking Expected to remaining stable over 2 to 4 years Modified only for significant and permanent changes in financial and/or operating performance

Major Uses of Credit Ratings Counterparty Ratings Bank Loan Ratings Project Finance Listings Bond Issues Global and domestic bond issues Straight and convertible bonds Ratings used to assist IPO process Example is CNOOC Project finance ratings for toll roads and IPP Power Projects General creditworthiness assessments Assists with negotiations Bank loan ratings increasingly in demand

Benefits of a public credit rating Funding stability and liquidity The international markets are very deep and liquid. Highly rated companies can easily place debt that is 1 day to 30 or more years in maturity The major capital markets have rarely been closed for a highly rated corporate. Although price may be an issue, access is not Diversified funding sources A rating enables an issuer to access a broader range of funding sources other than bank finance such as cross border investors in bonds, MTNs and commercial paper A third party opinion expressed in terms of a rating gives investors comfort over longer maturities Better pricing A wider investor base is likely to create more competition for a borrowers issue, driving down pricing to the cheapest level A rating acts as a pricing guide to investors perhaps unfamiliar with an issuers business and financial condition Wider investor base Many US institutional investors and an increasing number of European fund managers can: only buy paper that is rated allocate a higher percentage of their portfolio to higher rated paper New BIS rules will require banks to allocate capital based on ratings

Wider access to the global capital markets Diversification of investor base Means of communicating creditworthiness to key counterparties Internal management tool to assist financial and strategic planning Independent benchmark to help determine balance considerations of bondholders and shareholders A Rating helps to optimise funding Benefits of a Rating - Issuers

Benefits of a Rating - Investors Independent indicator of credit quality Enhances transparency and disclosure Pricing benchmark Facilitates secondary market liquidity Strategic tool for portfolio management techniques Leading Institutional Investors Rely on Ratings

Industry/Criteria knowledge (investigate new methodology, eg JDA) Quantitative and qualitative approach Long term focus Client Feedback Continuous monitoring Confidentiality Independent A transparent rating process Why do Issuers and Investors Rely on Ratings?

Additional Issues to Consider Should ratings be mandatory or discretionary? poor financial disclosure of SMEs in Asia Rating Compression and Investment Guidelines Development of secondary bond market Solicited vs Unsolicited Ratings IOSCO Code of Conduct Use of International Ratings (local and foreign currency) vs National Ratings need to distinguish

Comparison of Thai Bank Ratings Moodys ratings on the top banks in Thailand are at same rating as sovereign and could move up in line with sovereign rating Moodys will soon revise its bank rating methodology to better reflect bank default statistics. This could result in a significant uplift for leading banks in the region and narrow the gap between international ratings and local/national ratings.

Assigning Credit Ratings

Management Management BusinessRisk influences determines FinancialRisk Quantitative and qualitative approach Corporate Ratings the Three Pillars

Rating Analysis Factors for Corporates Industry Characteristics maturity cyclicality Diversification geographic product Competitive Position market share technology efficiency Management credibility experience strategies Financial Policy financial strategy risk tolerance Profitability level and volatility trends of key measures Cash Flow Protection Debt service capacity Capital Structure asset quality leverage Financial Flexibility availability of internal and external funds potential asset disposals Financial RiskBusiness Risk

Corporate governance Concern over related party transactions Group and accounting transparency Inter-group holdings, transactions and guarantees Internal controls Risk management regarding investments Liability management Sovereign ceiling not only factor likely to hold back ratings

RATING Band Performance Incorporating Expected Variations in Performance Time Ratings Look Through the Economic Cycle

Ratings reflect priority or preference among obligations (Contd) Issue Ratings Issue ratings also take into account the recovery prospects associated with the specific debt being rated. Junior debt (subordinated debt) is rated below the corporate credit rating and preferred stock is rated still lower Well-secured debt can be rated above the corporate credit rating

The case for Notching UP Key principles For investment grade ratings, focus is on timeliness rather recovery Well-secured bank loans or a first mortgage bond will be rated ONE notch above a rating in the BBB or A rating categories but enhancement would be TWO notches in the case of a BB or B corporate The following guidelines relate more to the speculative grade portion of the rating spectrum. At the upper end, notching is generally less generous

The case for Notching DOWN Key principles Where priority claims exist, lower-ranking obligations are at a disadvantage because a smaller pool of assets will be available to satisfy remaining claims Subordinated debt can be rated up to TWO notches BELOW a non-investment grade corporate credit rating but ONE notch at most if rating is investment grade Notching can arise if a company conducts its operations through one or more legally separate subsidiaries but issues debt at the holding company level (ie structural subordination)

Role of Rating Agencies

Defaults by Rating after 1, 5, 10, and 15 years Cumulative Average Default Rates 1981 to 2004 (%)

Defaults on Rated Debt

Capital Markets Corporate Issuers Corporate Issuers Regulators Bank Trading Desks Institutional Investors Institutional Investors Fixed Income Sales Force Fixed Income Sales Force Secondary trading Market information New issue pricing Transaction feedback Market information SEC Government Placement Structure feedback Rating Agencies Portfolio monitoring Risk assessment Market information Role of Ratings and Rating Agencies

#1 Credit ratings are for investor protection #2 A BBB rating is investment grade #3 Harmonization of rating standards Rating Myths

Non-rating requirements for Asian Bond Markets High accounting and disclosure standards Fair and transparent capital markets regulations and supervision A legal environment that instills confidence among investors to participate in financial transactions Efficient trading mechanisms and clearing/settlement systems that are safe and low-cost

Development of the Asian Bond Markets

Excessive dependency on banking sector Underdeveloped domestic capital markets Undisciplined foreign currency borrowings Lack of adequate disclosure and transparency Inadequate risk management practices Lessons from 1997 Asian Crisis

Source of Funds Use of Funds Depositors Borrowers Bank provides liquidity Bank undertakes credit assessments Bank assumes credit risk Bank Intermediated Bank Market

Source of Funds Use of Funds Investors Borrowers Market provides liquidity Investors assume credit risk Credit rating service provides measure of credit risk MARKET Disintermediated Market

Provide local issuers with alternative sources of finance Provide local investors with new investment opportunities Attract foreign issuers Attract foreign investors Be an integral part of the global financial markets Goals of Domestic Fixed Income Markets

Relative Maturity of Asian Domestic Debt Markets Effective but underused Hong Kong Singapore Effective but not efficient Korea Malaysia Taiwan, China India Indonesia Philippines Thailand Semi-effective or blocked Based on Transparency, Liquidity, Depth, Role of Govt., # of active participants Hong Kong Institute for Monetary Research

Asia Capital Markets Update FY 04 vs YTD 05 Issuance Volume by Region Issuance Volume by CurrencyIssuance Volume by Tenor Source: Bondware

Asia Capital Markets Update (Contd) # Deals by SizeIssuance Volume by Rating FRN vs FXVolume by Industry Sector Source: Bondware

Currency risk : who will bear Transparency and disclosure Protection of creditor rights Ratings: Which standards and criteria to adopt One pan Asian rating scale Rating compression Independence and objectivity Affects competitive dynamics How will Pan Asian rating agency be monitored Issues for Regional Bond Market

Will Asias Bond Market emulate Australias Bond Market?

Issuance volumes in the Australian domestic market have experienced a fundamental change during the period 2000-2005. Starting from annual issuance levels of approximately A$18-A$20bn during the beginning of this period, issuance has surpassed A$40bn during each of 2004 and 2005 ytd. Strong investor demand has enabled primary market activity to consistently surpass volumes for corresponding periods in previous years. This unprecedented volume of issuance has been readily absorbed by the market as secondary spreads remain at or near historic lows. Third quarter issuance of nearly A$20bn has been a highlight of the year. Issuance in this period was timed to correspond with the record A$8bn of corporate redemptions matched to the 15 July 2005 Australian Government Bond. Growth of the A$ market Issuance Summary Issuance levels have increased from A$17.7bn in 2000, to A$45.5bn in 2005 ytd. Issuance Volumes

The Australian corporate bond market has experienced dramatic growth over the last 2 years. Following a period of relatively stable issuance activity, issuance levels in 2004-2005 have been more than double the 20002003 average. This growth has been driven by a combination of factors. In March 2004 the Reserve Bank of Australia extended the criteria for repo eligible issuers. A number of Supranational and Agency borrowers such as Eurofima, KFW, LBBW and Rentenbank were made repo eligible, significantly increasing the attractiveness of these issuers to Australian investors. These entities have now become among the most active issuers in the Australian market, together with domestic banks. Issuers who are rated AAA and have explicit or very strong government guarantees can apply for eligibility. Drivers of growth in the A$ market Regulatory Changes Regulatory Changes Rapid Growth 2000-05 Rapid Growth 2000-05

Bond/swap spreads moved to historically wide levels in early 2004 and remain at similar levels. This means that sub-swap product, for which there has traditionally been little demand, has now became more attractive on a yield basis. Investors saw this as an opportunity to move out of Government and Semi-government bonds. In addition, the widening of the AUD/USD basis during this period made A$ issuance more attractive to offshore borrowers. Kangaroo issuance increased from 29% of domestic issuance in 2003 to 46% in 2004, and 47% for 2005 ytd. Drivers of growth in the A$ market AUD/USD Basis Bond/Swap Spreads Supportive Technicals Supportive Technicals

Issuance trends Issuance by Rating Issuance by Sector AA rated borrowers make up a greater proportion of the market, driven by large volume issuance from domestic and offshore AA banks such as Wells Fargo, Citigroup and Bank of America. 2005200420032002 Banks have consistently been the dominant borrowers in Australia. Supranational and agency issuance has increased at the expense of corporates.

The increasing sophistication of the domestic investor base has made for improving issuance conditions in the Australian market. As a result, a greater variety of issue types and structures are now available to issuers. For example, an increasing proportion of issuance is made up of long dated transactions: 23% of 2005 ytd issuance is of a maturity of 8 or more years compared to 12% in 2001 and 10% in 2002. In addition, the domestic corporate hybrid market has seen investors willing and able to invest in lower rated instruments. Since December 2000, A$17.7bn of hybrid instruments have been issued, nearly A$7bn of which has been unrated. Consistently improving issuance conditions The increasing sophistication of the Australian market means that a greater variety of structures, tenors and volumes has become available to issuers. Issuance conditions have become increasingly favourable with issue spreads at or near historic lows. A$ Hybrid Issuance

Issue spreads have contracted considerably over recent years. 5 yr domestic bank issuance is the best example, as there are a number of such issues each year and the credit rating of the major Australian banks have been stable over this time. Average issue swap spread for an AA- rated 5 yr domestic issue has decreased from around +20bps in 2002 to +15bps currently. Similarly, 5 yr A / A- rated corporate issue spreads have also contracted markedly since 2000. Consistently improving issuance conditions (Contd) 5 yr Bank Issue Spreads5 yr Corporate Issue Spreads

2005 Australian market highlights

2005 issuance characteristics Bank Issuance Dominates The dominant sector of issuance has been the banking sector, with 30% of YTD issuance coming from domestic banks, and 22% from offshore banks and brokers. Supranational Taps Continue Supranational and agency issuers combined make up 22% of domestic issuance. These issuers have tended to access the market via A$100-200m taps to existing issues when basis and bond/swap spreads are favourable. Corporates Remain Relatively Absent Corporate issuance has been light this year, however has grown to now be 9% of issuance. This has been driven by three factors: Many Australian corporates pre-funded much of their short term needs during the favourable issuance conditions that prevailed during 2004. Corporates in general hold large cash balances and have low Cap-Ex needs. A number of Australian corporates have gone offshore to the Euro or US Markets for tenor or volume. Strong Demand For FRNs Strong demand for FRNs has been driven by investors concerned over the pace of rate hikes earlier this year. FRN demand is more prominent in transactions for 20% risk weighted borrowers. 2005 Issuance Statistics

Demand for corporates remains strong Despite the unprecedented large volume of issuance since July, demand for corporates in particular remains buoyant for two reasons: A breakdown of bonds maturing in July 2005 against those issued in the same month reveals that investors replaced their higher yielding corporate paper with a large volume of lower yielding financial supply. The regular SMR DB Money Manager survey conducted fortnightly reveals that investors are still holding high levels of cash on a historical basis, despite the unprecedented level of issuance during July September 2005. Corporate activity has been buoyant recently with several issuers coming to market in September. Santos (BBB+), Alinta (AAA wrapped) and Woolworths (A-) all issued during the week of September 19 and were extremely well received by investors. The tight levels achieved by these issuers of different ratings and for different maturities highlight the demand for corporate paper. July 2005 Redemptions vs IssuanceInvestors Cash Holdings True corporate borrowers were relatively absent early in the year, exacerbating the already present supply/demand imbalance. Despite increased corporate issuance in Q3, demand for corporates remains high amongst the large volume of bank supply.

Corporate Hybrids

Benefits of hybrid capital Hybrid capital combines features of both debt and equity and accordingly, can provide issuers with specific benefits of both debt and equity Hybrids are highly flexible and may be tailored to achieve specific accounting, tax, rating agency and legal outcomes and provide issuers with combined benefits Hybrids provide benefits of debt Fixed, tax deductible payments No dilution of earnings or voting rights No shareholder approval required Repurchase flexibility (call rights) Equity credit from rating agencies Improve balance sheet ratios Increase debt capacity, covenant relief Deferral of payment obligations without default Hybrids provide benefits of equity Non-dilutive capital to fund growth / M&A that also provides ratings support Opportunity to improve financial ratios (e.g. WACC & EPS) via buyback Access to a new investor base Buy time with rating agencies in need Positive signal to rating agencies Capital structure flexibility

Hybrid capital inexpensive equity Issuers are now viewing hybrid capital as a non-dilutive form of equity that is significantly below the cost of equity Hybrid capital is widely accepted as an equity substitute for up to 15% of an issuers capital base An analysis of recently issued hybrids indicates that hybrid capital is approximately 56% less expensive than issuing equity on an after-tax basis see below

Recent hybrid transactions & issuance rationale Notching from senior rating Rating Agency Credit Basket D 75% 50% Basket D 75% 60% Basket C 50% 50% Basket D 75% 50% n/a Basket C 50% 50% Moody s S&P Moody s S&P Moody s S&P Moody s S&P Moody s S&P Moody s S&P -2 -3 -2 -3-2 -3 n/a -2 Baa2 BBB- Baa1 BBB-Baa3 BBB-Baa2 BBB n/a Baa3 BBB- Hybrid rating Highlights First hybrid following rating agency developments 700m issued 1b issued Book in excess of 2b 1.1b issued Book in excess of 3b Largest hybrid to date 1.3b issued Book in excess of 5b Unrated hybrid 150m issued Most recent hybrid offering 500m issued Rationale for issuance Company under ratings pressure Both equity and hybrid securities issued Hybrid equity credit improved capital structure and cost of equity Unlisted & wholly owned by Swedish government Issuer unable to access traditional equity capital markets Hybrid provided significant equity credit and no dilution of government stake Unlisted & wholly owned by Danish government Issuer unable to access traditional equity capital markets Hybrid provided significant equity credit and no dilution of government stake Hybrid provided additional headroom for growth within current ratings band Hybrid accessed additional equity without dilution of existing shareholders Ratings support and financial liquidity

Equity credit reflected in both balance sheet and income statement All balance sheet (leverage) ratios are adjusted based on equity credit designation Full interest / dividend (servicing cost) ratios also adjusted based on equity credit designation Moodys approach - overview An assessment of equity credit will focus on the extent to which a hybrid contains three equity-like attributes: Payment relief ability to omit payments, eliminate the potential for payment default Permanence long term effective maturity Loss absorption provides creditors a cushion in bankruptcy Primary variables Equity credit designation Replacement language (vs non- replacement) Mandatory deferral (vs. optional) Non-cumulative payments (vs. cumulative) Basket A 100% debt Basket B 75% debt / 25% equity Basket D 25% debt / 75% equity Basket C 50% debt / 50% equity Basket E 100% equity Moodys approach Basket D 3 out of 3 primary variables Basket C 2 out of 3 primary variables Basket B 1 out of 3 primary variables

Moodys approach required terms Optional discretionary Deferred payments cash cumulative Mandatory trigger based deferral Mandatory deferred payments non- cumulative on a cash basis (may be cumulative where payable by equity funded ACSM) Optional discretionary (cash cumulative) Deferral Minimum NC 5 Replacement language not required Step-up maximum 100bps Minimum NC 5 Replacement language required for corporates Step-up maximum 100bps Minimum NC 5 Replacement language required for corporates Step-up maximum 100bps Call / Replacement Language Perpetual / 100+years Perpetual / super long-dated (49+ years) Subordinated Maturity Subordination Perpetual / 100+ years Preferred security or junior subordinated Preferred security or junior subordinated with covenant to remain most junior Optional discretionary Deferred payments non-cumulative on a cash basis Cumulative payments that are payable by equity funded ACSM acceptable Basket DBasket CBasket B

Standard & Poors approach Standard & Poors has simplified its approach to hybrids with equity content assigned on the basis of 3 categories and formally adjusts financial ratios reflective of the hybrid The majority of recently issued corporate hybrids have achieved intermediate equity content The requirements to achieve high equity content are restrictive including legally binding replacement language and a tightly positioned trigger for mandatory deferral Hybrids with high equity content will be treated as equity for balance sheet and coverage ratios Hybrids with minimal equity content will be treated as debt for balance sheet and coverage ratios Hybrids with intermediate equity content will be treated both ways - alternatively as debt and equity for both balance sheet and coverage purposes (normally the analyst will then split the difference) High Equity Content (71% - 100%) Intermediate Equity Content (31% - 70%) Minimal Equity Content (0% - 30%) Previous Scale New Scale Common equity Mandatory conversion pfd - within 3 years 80% Mandatory conversion debt - within 3 years Convertible pfd 50% 60% Conventional perpetual pfd - 5 year no call Deferrable payment pfd (trust pfd) - 25+ years 40% Deferrable payment debt - 25+ years 30% Convertible pfd -15+ years 20% Deferrable payment debt - 10-15 years 0% Various pfd -15+ years 10% 70% 100% S&P equity content scale Intermediate equity content key features Interest Deferral Requires no on-going payment that could lead to default Nature of dividend stopper / pusher will be considered Subordination S&P favours preference share structures Where otherwise, hybrid must be economically equivalent to a preference share Maturity No maturity or repayment requirement Replacement language will provide S&P comfort Step-up limited to 100 bps at year 10

Technical & commercial considerations Direct issue structure Indirect issue structure Rating Agency considerations Possible to structure Moodys Basket C or D / S&P intermediate credit (via on-loan) (subject to jurisdiction where deduction claimed and potential tension with accounting and rating agency objectives) Tax deductibility Possible to structure as debt or equity Accounting considerations (requires debt classification) FX hedging

Accounting treatment Under IAS 32, hybrid securities are classified as 100% equity or debt depending on the issuers level of discretion over distributions and redemption Definition: a critical feature in differentiating a financial liability from an equity instrument is the existence of a contractual obligation of one party to the financial instrument (the issuer) either to deliver cash or another financial asset to the other party (the holder) Structuring a debt classifed hybrid Direct issue structure Indirect issue structure Hybrid structured as dated e.g. 100 years Hybrid distributions treated as interest expense Hybrid structured as dated e.g. 100 years Example: Bayer (100 year maturity) Hybrid distributions treated as interest expense Structuring an equity classifed hybrid Key requirement is to provide the issuer with discretion regarding the timing of both distributions and redemption Typical structural approach: Distributions are either deferrable in perpetuity or non-cumulative; and Perpetual maturity Hybrid distributions treated as dividends Key requirement is to provide the issuer with discretion regarding the timing of both distributions and redemption Typical structural approach: Distributions are either deferrable in perpetuity or non-cumulative; and Perpetual maturity Hybrid distributions treated as dividends (on consolidation)

Hedge accounting Equity classified instruments however, are not eligible to be a hedged item in a hedge accounting relationship Foreign exchange risk can however qualify for hedge accounting if the entity that issues the equity classified instrument on-lends the proceeds via an inter-company loan to another group entity The foreign exchange movements created between these entities (provided they have different functional currencies) do not eliminate on consolidation and may be hedged via a cross currency swap The indirect structure achieves hedge accounting based on these principles see discussion following page Achieving hedge accounting for a debt classified instrument is relatively straightforward Debt classified instruments are eligible to be a hedged item in a hedge accounting relationship this allows an issuer to designate cash flow hedges and fair value hedges where applicable Hedging debt classifed hybrids Hedging equity classifed hybrids

Documents

Credit Ratings as an Investor Protection Mechanism? Anita Goulding, Head of Rating Advisory, Asia 4 November 2005