Credit Rating

Whenever an investor desires to invest in a debt

instrument like a corporate debenture, Public
Deposit or bond he normally has two things in
his mind:

A. Whether the Company where he is putting
money will pay the stated returns regularly.

B. Whether or not the Company shall honour its
commitment on maturity.

Now with so many companies in the market it
becomes difficult for the investor to decide
where he should put his money.
At this point credit rating comes to his rescue.



Credit Rating
Credit rating is a symbolic ( alphanumeric )
indicator of the current opinion of the issuer to
service the debt issued by a Company in timely
fashion i.e. whether the Company shall be timely
and regular in payment of interest and also the
payment of principal on maturity.

Credit Rating
Points to be noted
1. The rating agency rates the debt or the instrument of the Company and not
the Company as a whole.
2. Rating given by a rating agency cannot be considered as a recommendation
for the purchase or sale of the security of the Company rated.
The probability that the rating given by the rating agency does not comes out
to be true is not zero. i.e. rating cannot be foolproof)
4. Rating agency carries out a detailed analysis of the Company from various
angles only on the basis of the published information and also information
provided by the Company.
5. It is left to the Company concerned whether it accepts the rating of the
rating agency or not.
Credit Rating
Method of Rating: The request has to come from the
Company

After the request is made the employees of the rating
agency visit the Company
Obtain the necessary data & make a detailed study of
following:-

a. Business Angle : The assessment includes
Market Position of the Companys products:
Demand for the Companys products today and their likely
demand in future,
number of players
existing distribution channels, etc.
Credit Rating
b. Financial Angle: The financial angle is assessed by examining the financial
statements.
Assessment of the Company is normally from the three different angles;
the present profitability and operating efficiency of the Company,
the liquidity position of the company and
thirdly the Companys long term solvency. The technique of ratio analysis is
normally employed for this purpose


Upon completion of this exercise the agency can get some idea about the
strengths and weaknesses of the Company which is very useful in arriving at
the final rating for the Company.

Credit Rating
Operational Efficiency of the Company :
Prospects of expansion and modernisation
Availability of required raw material
throughout the year
Location of the plant
Plants proximity to various critical inputs,
Capacity Utilisation etc.

Credit Rating
c. Management Angle:
The track record of the promoters
Performance of the other Companies of the same
group.
Corporate governance Assessment : Whether the
Company is following such practices which are
consistent with the norms laid down by the regulator
and takes care of interests of investors, employees,
customers and general public at large.
Assessment about the average age of the staff of the
Company and their training
NO FIXED FORMULA
There is no fixed mathematical formula where we can put the results
obtained from above and obtain a final rating.
Some experts have tried to develop some kind of formula but such
formulas cannot be applied to all situations
Now after the final rating is arrived it is shown to the Company and it is
only after the Company accepts the rating is made public.
However the work of the rating agency does not end with that and it
has to periodically monitor the rating of the Company.
This is because new developments keep on taking place and hence it is
the job of the rating agency to monitor these developments to enable it
to revise the original rating. The revision can be upwards, downwards
or no change from the original rating.
Is lower rating bad

What if a Co gets lower rating: Is it a bad signal
Many times the ambitious growth plans of Companies do
result in lower credit rating.
To fund the expansion plans many companies resort to more of
debt , and as debt increases the credit profiles tend to weaken
resulting in lower rating.
Globally companies like Unilever and Philip Morris have been
comfortable with lower ratings.
That is why there is a good business for Junk Market in the
world or in developed markets there is great interest in low rate
papers.
Retail Loans and Credit Rating
Credit Rating and Individual Credit Scores
The retail loan segment has grown exponentially in the recent
past. From a 19 % growth rate in 1999 , the growth rate climbed
up to 51 % in just five years
Retails loans mainly comprise of hosing loans, consumer
durables loan, personal loan etc.
A study by FICCI on housing loans found that the average
borrowers age was in mid thirties.
Another study with respect to auto loans has shown that almost
60 % of the new Car purchases are from bank loans and 35 % of
the two wheelers are financed from bank loans.
The percentage of housing loans financed through bank loans
may still be higher.

Credit Rating and Individual Credit
Scores


There is an urgent need for giving individual loan seekers a
credit score.
Such credit score helps to determine whether the individual
in question should be advanced loan or not.
According to ICRA the competition in the retail segment
especially the housing segment is increasing amongst the
lenders which can lead to the danger of lending to sub
prime borrowers.
Moreover certain changes have taken place in the Indian
retail loan markets which have actually resulted in increase
of default risk like :-
Credit Rating and Individual Credit
Scores
(i) relaxation in the eligibility criteria whereby one
can borrow much more with the same income that
he would have done it a few years ago.
(ii) introduction of floating interest rates also
increase the risk of default. The risk however is the
failure of the borrower to pay the installment when
the rates of interest go up as the floating rates
would also rise. So the banks should assess
amongst other things the individuals current and
potential capacity to pay in both normal and
abnormal conditions.

Credit Rating and Individual Credit
Scores
Banks in India have been assessing the repayment
capacity in the past too but such an exercise was
being carried out without a sequential research.
However the mounting NPAs, competition and
pressures from RBI have forced many banks to
rework their entire loan giving process is carried
out.
Questionnaire Method is quite popular
Bank has been using this method in screening
personal loan applicants.


A simplified version of a questionnaire . Parentheses indicates the
percentage of borrowers in each who subsequently defaulted
Do you have?
1 or more telephones: (0.7)
No telephone? (7.0)
Do you:
Own your home? (0.7)
Rent a House? (2.2)
Rent a room? (7.3)
How long did you spend in your last job?

6 months? (3.2)
7 to 60 months? (1.5)
More than 60 months? (0.9)
What is your marital status:
Single? (1.6)
Married? (1.0)
Divorced? (2.9)
A simplified version of a questionnaire cont
What is your monthly income:
Below 20,000 (2.3)
20000 to 50000 (1.1)
More than 50000 (0.7)
What is your age:
25 or under? (1.5)
26 to 39? (1.8)
More than 40? (1.0)
How many members are there in your family:
One (1.6)
Two to seven? (1.1)
Eight or more? (2.6)
(Source: P.F. Smith, Measuring Risk on Consumer Instalment Credit Management
Science No.11, PP 327-340)

A simplified version of a questionnaire
The first question asks Do you have: one of more
telephone (0.7) or No Telephone (7). Figure given in the
parenthesis show the percentage of loan defaulters.
Clearly the past data tells us that those individual borrowers
who owned telephone had a much lesser chance of default
than those who did not have a telephone.
Now suppose a borrower says No Telephone to this
question we give him a score of 7%.
In the same way a number of questions are asked and their
corresponding probabilities of default are noted.
For every loan seeker a total of these probabilities are
calculated and then the bank can work out its own index of
default.
Say an index of default for a particular bank can be not to
lend money to any borrower if his score crosses x %
(default risk).

Analysis of data collected
Some banks go a step further and they put weight on each of the
parameters too.
In India traditionally banks have relied more on the income of the
individual and on the age of the borrower and therefore weightage
given to these parameter must be higher in the Indian Context.
Let us now suppose a bank has only two parameters whereby it has to
decide whether a borrower should be given a loan or not.
The first parameter being the monthly income of loan seeker ( say a)
and second the number of months the loan seeker stayed in his last job
( say b)
Let us now try to plot a graph between the two parameters on the basis
of historical data
Every single individual who had taken the loan in the past, whether
defaulting or not shall be represented by a point on the graph.
Analysis of data collected
We then try to draw an arbitrary line, which
separates the defaulters from non-defaulters;
we may not be able to draw the dividing line
exactly
but roughly we may get the divider which
represents an equation which shall be in our case
4 a + b = X ;
where a is the monthly income of the borrower
and b is the number of months he spends in his
last job. (Note take any two values on this line say
a= 4, then b shall be 8, the equation gives X= 4 x4
+ 8 = 24)
Thus we can safety say that if X> 24 for any
borrower he/she is not likely to default

Analysis of data collected
This technique is called Multiple Discriminate Analysis and is
one of the many techniques used for rating purposes.
Other popular techniques are Linear Probability Method (LPM),
Probit and Logit methods.
The LPM technique uses regression analysis with one of the
variable being a dummy which is taken as dependent variable.
Let us now examine how the data on defaulters and non
defaulters monthly income can be formulated into a model.
The following table borrowers with their monthly incomes. Out
of these those which defaulted in payment of loan are given
number 0 and those which did not default are given number 1.
Monthly Income of the Borrower (X)
Default (0) or Did Not Default (1)

8000 0
16000 1
18000 1
11000 0
12000 0
19000 1
20000 1
15000 1
22000 1
Analysis of data collected
We can now run a regression equation with
Dummy Variable ( 1 or 0) as dependent variable
and monthly income of the borrower as
independent variable and we get the following
equation :

Yi = - 0.808 + 0.00009412 Xi
R2 = 0.75, F as 21.33
Interpretation of data collected
Interpretation:
the Intercept is negative which is not possible we treat it as zero which shows
that when the monthly income of the borrower is zero, probability of his not
defaulting is zero or he is sure to default.
The slope of 0.00009412 shows that with a unit (1 %) increase in his monthly
income the chance that he shall not default in the payment rises by 0.009 %.
R2 of 0.75 shows that monthly income explains the default characterstics of
the borrower to the extend of 75 % or only 25 % is the default probability
not arising due to monthly income and can be due to other factors like age,
marital status etc.
F test of 21.33 shows that the relationship between the two variables i.e. the
default probability and the monthly income is statistically significant or we
reject the null hypothesis.
Sensitivity Analysis :
The method determines the likely probability of default by the corporate
borrower.
Here first the borrower is first asked to compute the Net Present Value(
NPV) of his project.
Then the banker usually estimates the sensitivity of the key variables or
factors and if the sensitivity of the key factors is found to be low, the bankers
usually reject the loan. The following example makes it clear.
Example : The proposed borrower has summarized his proposal to the
banker in the following manner :
Initial Outlay for the Project = Rs.12000 , Cash flows for four years =
Rs.4500 p.a.,
Cost of Capital which may be used as the discount rate = 14 %.
Project Life = 4 years , Scrap Value is nil. Show how will the banker react to
the proposal.
Analysis of data collected

Solution :The projects NPV is calculated as follows :-
NPV = -12000 + 4500 x PVIFA ( 14,4) =NPV = Rs.1112

The banker will then calculate the sensitivity of Projects NPV to different factors
(i) Sensitivity with respect to Annual Cash flows : What a banker is interested in knowing at
what cash flow the NPV of the project shall be zero. This can be known by taking annual cash
flow as A in the NPV equation given above i.e.
NPV = -12000 + A x PVIFA ( 14,4) = 0 or A = Rs.4118. But since the projected cash flow is
Rs 4500 , even if it falls by Rs 382 it shall still mean NPV is not negative, but a fall more than that
shall make it negative and this is what the bankers dont want. In other words the Annual Cash
Flow has a sensitivity of 382/4500 or 8.5 %.
(ii) Sensitivity with respect to initial outlay : Again the banker may feel that initial outlay may
escalate and may affect the NPV and therefore a margin on Initial Outlay must be calculated
which is 9.4 % i.e. x % on Rs12000 =1112 , x = 9.4 %. even if the initial outlay of the project increases
by 9.4 %, still the NPV continues to be positive territory.

Now it is for the banker to decide what shall be the acceptable level of sensitivity with respect to various factors.
Analysis of data collected
Expected Loss : The bankers also use the technique of expected loss which
is nothing but the mean or average loss and is given by the product of the
following three factors ; the money lent, probability of default and percentage
of recovery in case of default. This can be explained with the following
example : Calculate the expected loss for AA+ borrower who wants to
borrow Rs 100 crores from the bank. The default probability for AA+
borrowers in the past has been 0.25 % only and the recovery rate from the
defaulters has been 50 %. The expected loss on a loan of Rs. 100 crores shall
be 100 x 0.0025 x 0.5 = Rs.12,50,000 . Expected loss is considered as a
normal loss and many banks while granting loan make provisions for it
.Clearly the actual loss can be more or less than the expected loss, any loss
higher than the expected loss is called unexpected loss and for covering such
unexpected loss banks usually use the statistical approach of building up a
confidence level