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2 ENRON: The Movie Hollywood will find a way to make this story an “entertainment” But at its core it was a scheme to enrich management through a complex web of lies and misrepresentations Next Page Previous Page

3 WELCOME TO THE REAL WORLD BEFORE ENRON, ALMOST ALL CREDIT RATERS BELIEVED THAT: When you asked management a direct question, you would receive a fundamentally honest answer Despite the potential conflicts of interest in providing both auditing and consulting services, accountants recognized that credibility rested on confidence in their independence, and acted accordingly

4 How Well Did The Rating Agencies Handle Enron?

5 LONG-TERM DEBT RATING SCALE INVESTMENT GRADE AAA/Aaa AA/Aa A/A BBB/Baa SPECULATIVE GRADE BB/Ba B/B CCC/Caa CC/Ca C/C D

6 What the Agencies Did Right! For years, Enron’s ratings were in the “BBB/Baa” range, only one category above speculative grade Met regularly with Enron management to perform normal due diligence Communicated their credit opinions to the market

7 What the Agencies Did Wrong! Didn’t recognize on a timely basis numerous “red flags” (i.e. extraordinary growth, lack of transparency, extreme corporate arrogance, inexplicable management changes) Were overly concerned about domino effect on Enron’s liquidity of a decision to downgrade out of investment grade When they finally acted, it didn’t matter!

8 After Enron the Agencies Considered Whether to: Apply a shorter perspective when assigning long-term debt ratings (no more “rating through the cycle”) Incorporate current market sentiment (i.e. market prices) directly into ratings Investor reaction was overwhelmingly negative, so more subtle changes have been adopted

9 Changes in Agency Attitudes & Practices More intense surveillance, particularly where there are liquidity and funding risks 1) recognize that changes in banking practices have altered liquidity risks 2) recognize that share and bond price changes can effect liquidity & funding risks (slide 1 of 3)

10 Changes in Agency Attitudes & Practices Ask more questions about ratings & equity price triggers & other contingent financial commitments Incorporate assessments of corporate governance into rating decisions (slide 2 of 3)

11 Changes in Agency Attitudes & Practices Publish opinions more frequently on individual credits of market interest and importance Use existing communication tools, including CreditWatch & Rating Outlooks, more effectively Have far less patience, especially when there are perceived liquidity & funding risks (slide 3 of 3)

12 Implications of Changes for Investors/Lenders The number of rating changes may increase Individual ratings may change more often Greater ratings volatility may cause larger swings in regulatory capital, demanding more cautious investing/lending approaches (slide 1 of 2)

13 Implications of Changes for Investors/Lenders If agencies become more proactive, it may not be so easy to anticipate their actions If agencies provide more predictive guidance, it will be necessary to become more of a “student” of ratings If agency research improves, internal credit research will have to improve (Slide 2 of 2)

14 Implications of Changes for Borrowers/Counterparties Need to convince agencies you’re not another Enron and are deserving of their trust Need for greater familiarity with the rating process and how different agencies work Need to establish and maintain open lines of communication with key agency personnel (slide 1 of 2)

15 Implications of Changes for Borrowers/Counterparties Need to understand rating criteria being applied to your industry and be able to address them when you meet the agencies Agencies have certain “hot buttons” - know what they are and how to address them Managing the rating process will be harder, but the benefits of doing so and the penalties for not doing so will be greater (slide 2 of 2)

16 Current Rating Agency “Hot Buttons” Corporate Governance Triggers & Contingent Financial Obligations Liquidity & Funding Risks

17 Corporate Governance Ownership Issues 1) transparency of ownership 2) owner’s influence Relationships with Financial Stakeholders 1) shareholder meeting & voting procedures 2) protection of owner’s rights Information Disclosure & Transparency 1) Quality of disclosure 2) Timeliness & ease of access to information 3) Independence & credibility of auditors Board of Directors 1) Structure 2) Responsibilities 3) Effectiveness

18 Triggers & Other Financial Contingencies Rating and equity price triggers Operating and synthetic leases Explicit and implicit commitments under structured financings Guarantees/commitments between affiliates Make-whole commitments to third parties

19 Liquidity & Funding Risks Internal liquidity Quality of external liquidity supports Dependence on asset/business unit sales to meet maturing debt Dependence on refinancing to meet maturing debt Magnitude and timing of contingent cash demands tied to performance triggers

20 Final Thoughts Enron has severely shaken investor confidence in capital markets Due to their role, the rating agencies reconsidered some long-standing policies They concluded that drastic changes were not called for and could be even more disruptive Still, the formal and informal changes are important for all users of ratings to understand

21 Roy P. Weinberger Credit Research, Advisory Consulting sm 1004 Monarch Circle 1004 Monarch Circle Statesboro, GA, USA Tel/Fax Tel/Fax