Moody's affirms ratings on RBS consortium members, cites restructuring challenges

Ratings Action - ABN AMRO Bank N.V.
Moody's comments on Consortium's acquisition of ABN AMRO following transaction closing

(Moody's) London, 17 October 2007 -- Moody's Investors Service today affirmed the ratings of the members of the consortium following the closing of their offer for ABN AMRO. Moody's also affirmed ABN AMRO's Aa2/P-1 debt and deposit ratings, changing the outlook on the long-term debt ratings to developing from stable. ABN AMRO's B- bank financial strength rating ("BFSR") was affirmed but its outlook was changed to stable from positive. The outlook on all other ABN AMRO ratings is stable.

The members of the bidding consortium ("the Consortium") include the Royal Bank of Scotland Group ("RBSG"), Banco Santander and the Fortis Group. (Please see Moody's press releases dated 17 July 2007 and 30 May 2007 for previous rating actions on this transaction.)

RATING AFFIRMATIONS -- OVERVIEW

Moody's affirmed the Aaa/P-1/B+ ratings of the Royal Bank of Scotland plc and National Westminster Bank plc as well as the Aa1/P-1 ratings of the Royal Bank of Scotland Group plc. The outlook on the BFSRs and long-term debt and deposit ratings remains negative. Moody's also affirmed the ratings of Ulster Bank Ltd (Aa2/P-1/C+), Ulster Bank Ireland (Aa2/P-1/C+) and First Active plc (Aa2/P-1/C) with their stable outlook.

Separately, Moody's affirmed the Aa2/P-1/B ratings of Citizens Financial Group's rated US bank subsidiaries. The outlook is negative on the long-term deposit and debt ratings and stable on the BFSR.

The ratings of Banco Santander (senior at Aa1/P-1/B) and all of the ratings of the Fortis Group and Fortis Bank were affirmed at their current levels with stable outlook. Fortis SA/NV and Fortis NV have issuer ratings of Aa3/stable while the main funding holding companies of the group have senior/subordinated and preferred debt ratings of Aa3/A1/A2/stable. Fortis Bank is rated Aa2/P-1/B-/stable.

Moody's affirmed the Aa2/P-1 ratings of ABN AMRO Bank N.V. but changed the outlook on the bank's BFSR of B- to stable from positive and the outlook on the long-term debt ratings to developing from stable. The outlook on all of the bank's other ratings is stable.

The ratings of Banca Antonveneta ("Antonveneta", A1/P-1/C- stable) and its subsidiary Interbanca (A3/P-2/D+ stable) as well as Banco ABN AMRO Real (foreign currency ratings of Ba2/NP/C stable) were also affirmed.

COMMENTARY ON FORTIS RATINGS

In affirming Fortis' ratings, Moody's noted the good strategic fit with ABN AMRO's businesses to be acquired as well as the expected reasonable impact of the funding package on the capital structure, capitalisation and underlying fundamentals of the group.

"With this deal, there is a clear potential for Fortis to significantly enhance its franchise in the Benelux region," said Jose Morago, a Moody's Assistant Vice-President/Analyst. "Our stable outlook is predicated on the expectation that Fortis will continue to deliver satisfactory operating results, maintain its risk profile and restore its capital position and financial flexibility in the coming months. However, there are material challenges in the short-to-medium term, given the size, complexity and amount of resource necessary for Fortis to integrate and extract value from the new ABN AMRO businesses," Mr Morago added.

Moody's noted that a key factor supporting the success of this transaction has been that relevant components of Fortis' approximately EUR24 billion funding package are already in place, despite the current level of volatility in the capital markets. More particularly, Fortis successfully placed an approximately EUR13.2 billion rights issue last week, issued EUR2 billion of Conditional Capital Convertible Notes (CCENs) over the summer and sold over EUR1.4 billion of non-core assets (i.e. its stake in BCP and 50% of Caifor).

COMMENTARY ON BANCO SANTANDER, ANTONVENETA AND BANCO ABN AMRO REAL RATINGS

In its affirmation of the Aa1/P-1/B ratings of Banco Santander, Moody's cites: (i) the strategic fit of this acquisition, which is fully consistent with Santander's international strategy; (ii) the bank's proven strong track-record of integrating large-scale acquisitions and extracting cost efficiencies from them, (iii) the limited negative implications for pro-forma profitability, both pre- and post-provisions; (iv) the fact that the larger contribution from more volatile markets (Latin America) does not change the group's existing risk profile materially; and (v) Santander's proven prudent management of its economic solvency.

"Although the acquisition will likely increase the group's leverage -- core capital levels are expected to fall to 5.3% from 6.97% -- we expect to see leverage levels restored within 12-18 months," said Maria Cabanyes, a Moody's Senior Vice President and Regional Credit Officer.

Commenting further, Moody's also cautioned about the challenges of turning around Antonveneta and integrating the Brazilian operations, which will double its existing size.

With reference to the rating affirmation on Antonveneta, Moody's said that the ratings already incorporate the expectation of improvements and that the likely positive impact of the acquisition by Santander will not be clear for some time. The rating agency added that the positive effect of expected support from a higher-rated bank appears counterbalanced by the expectation of an only moderate probability of support from its new parent. As regards Interbanca, Moody's commented that there appears to be a degree of uncertainty on the bank's strategic positioning and that the rating affirmation is based on the assumption that this entity will remain a subsidiary of Antonveneta.

With regard to the Brazilian subsidiary, Banco ABN AMRO Real, Moody's decided to affirm the C BFSR and Ba2/NP foreign currency deposit ratings, which the rating agency believes adequately reflect ABN Real's current market positioning and the competitive economic environment in the country.

COMMENTARY ON ABN AMRO RATINGS

In revising the outlook on ABN AMRO's B- BFSR to stable from positive, Moody's said that this rating action followed the withdrawal of the bid by Barclays Bank plc to acquire all of the bank (please see press release of 8 October), as well as the narrower franchise of ABN AMRO following its sale of LaSalle Bancorp to Bank of America (see Moody's press release of 1 October). In Moody's opinion, the sale of LaSalle has weakened the bank's franchise value in terms of geographic diversification and stability of earnings and has marginally increased its risk profile. Prospectively ABN AMRO's franchise will be further narrowed and changed as the break-up of the bank takes place over a period of up to three years as the Consortium plans to separate ABN AMRO into three parts once the Dutch regulators, the DNB, have approved the break-up plan which the Consortium is expected to submit before year-end 2007.

Nevertheless, Moody's recognises ABN AMRO's generally solid financial fundamentals and expects its operating efficiency and quality of earnings to show continued improvement under its new management. Furthermore, Moody's expects that its core Tier 1 and Tier 1 ratios will be maintained at the bank's stated near-term target of 6% and 8% respectively and 6.5% and 8.5% over the medium term, net of the one-time impact from the proceeds of the sale of LaSalle.

The BFSR outlook change also incorporates Moody's expectation that remaining regulatory issues with the US regulators stemming from past weakness in internal controls will be resolved in the near future. The rating agency notes that the Dutch regulator lifted its regulatory action in July 2007.

The change in outlook on ABN AMRO's Aa2 long-term debt rating to developing from stable reflects the lack of clarity regarding the future allocation of the company's outstanding debt, which has yet to be announced by the Consortium.

In affirming ABN AMRO's Aa2/P-1 debt and deposit ratings, Moody's said these are based on the bank's baseline credit assessment of A1 (which is mapped from the BFSR of B-) but also on Moody's assessment that the probability of systemic support in the Netherlands is very high given the bank's importance in its home market. Moody's expects that this systemic importance will continue notwithstanding the break-up of the bank's operations, which will primarily impact its foreign operations -- principally in Italy and Brazil -- and its Global Wholesale and International Retail client businesses, and the integration of its BU Netherlands with those of Fortis Bank Nederland (Holding), rated Aa2/P-1/B-, stable.

COMMENTARY ON RBSG RATINGS

With reference to RBSG, Moody's said that the maintained negative outlook on the ratings reflects the integration challenges in relation to ABN AMRO's Global Wholesale Businesses and International Retail Businesses, as well as the negative short-term impact of the proposed transaction on the quality of RBSG's capital and historically strong earnings as the bank integrates ABN AMRO's under-performing Global Clients unit. Moody's commented that, of the three Consortium banks, the integration challenges are, in its opinion, greatest for RBSG. The negative outlook also incorporates the ongoing uncertainty with regard to the performance of all banks involved in leveraged finance and related capital markets activities given the recent market turmoil.

Nevertheless, notwithstanding the additional complexities presented by the integration of parts of ABN AMRO, Moody's recognises RBSG's strong track record in integrating past acquisitions and the group's robust core earnings capacity and internal capital generation. The rating agency also acknowledges other transaction benefits including enhancing RBSG's presence in Asia-Pacific and diversification of earnings, as well as expanding the reach of its corporate and institutional banking franchise, noting that the enlarged group will have market-leading positions in products such as international bonds and international cash management. Moody's cautions, however, that the increased contribution from wholesale banking operations could introduce a greater element of earnings volatility, which could have negative rating implications.

Moody's said that progress in integrating ABN AMRO and rebuilding RBSG's core capital and profitability in line with its current BFSR within 12-18 months could ultimately lead to the rating outlook being changed back to stable. Conversely, failure to resolve these issues within the same timeframe could lead to negative rating actions.

COMMENTARY ON TERMS OF FINAL OFFER

Commenting on the terms of the Final Offer, Moody's said that the total consideration for the transaction was approximately Eur 70 billion of which 94% was paid in cash with the balance paid with new RBS shares. Other features of the transaction remained unchanged from the previous announcement. Moody's noted that the Consortium has nominated management from the three banks to the Supervisory and Management Boards of ABN AMRO.

Moody's noted that the transaction is subject to various conditions including the following:

1) The Dutch Ministry of Finance, in issuing its 17 September Declaration of "No Objection" to the transaction, stipulated that the Consortium maintain the "status quo" with regard to the bank until it has acquired sufficient control and filed a Transition Plan with the regulator as well as Capital and Liquidity Plans. It also imposed measures on Fortis Bank Nederland (Holding). The Consortium will only be able to begin the formal integration of the bank once the regulator has approved these plans, which is expected by year-end 2007.

2) The European Commission's approval to Fortis to acquire ABN AMRO's BU Netherlands (BU NL) is subject to the divestment of certain assets of the BU including Hollandsche Bank Unie NV, 13 advisory branches and two Corporate Clients departments and the sale of the Dutch factoring company IFN Finance B.V.

As discussed above, a major uncertainty for ABN AMRO's bondholders is the future allocation of the company's outstanding debt, which has yet to be announced by the Consortium. Moody's will take appropriate rating actions when the details are made public. Moody's will also comment further on the prospective profile of ABN AMRO and the implications for the relevant rated legal entities of the Consortium once the transition plan has been approved by the relevant authorities. Furthermore, Moody's will monitor any uncertainties surrounding the due diligence process to be carried out by the members of the Consortium during 45 days after the closing in terms of initial asset and liability valuations.

COMPANY BACKGROUND

As of 30 June 2007, ABN AMRO Bank NV reported total assets of EUR1,120 billion, while the banking operations of Fortis had total assets of approximately EUR918 billion, RBSG had total assets of GBP1,011 billion and Banco Santander had total assets of EUR886 billion.

A good article explaining differences between ratings models

RATING OF CDO TRANCHES: THE CATWALK OF MODELS
By Vinod Kothari
Full article found at: http://www.vinodkothari.com/cdoratingmodels.htm

The CDO business is reaching out to banks, investors and high net worth individuals all over the World. Investment banks and CDO structurers from London, Paris, New York, Singapore or Sydney would put together a CDO of roughly 100 obligors, achieve some kind of a model-driven diversification, achieve a convenient first loss piece of x% that is sufficiently rewarded by the inherent arbitrage earnings of the CDO, and lo, the CDO is in the market. If it is a single tranche transaction, as most CDOs today are, you don't need to wait until all the tranches are sold off, as just one tranche is enough to successfully sell the CDO in the market.

Inherently, all the CDOs are cast in a model - unlike the portfolio of a usual balance sheet transaction, CDO portfolios are completely synthetic. "Synthetic" is close to "unreal", that is, the portfolio is completely virtual. It is constructed not by actually originating credits, but simply by synthetically selling protection on the target names. Therefore, the idea of a synthetic CDO is that of calendar beauty - it is perfect in every respect. It is an idealized portfolio where everything is only as much as you would love to have. This idealized perfection is attained to fit into rating agency models that compute the expected losses of the CDOs, and therefore, in a not very discrete way, it is the rating agency models that have been instrumental in the spurt of CDOs in the market.

Briefly, the extent of credit enhancement at any tranche level of a CDO is such as to reduce the probability of the defaults exceeding the level of subordination to an equivalent of the probability of losses at that tranche level. For instance, if Moody's idealized probability of default for a Baa2 piece is 1.58%, there must be such credit enhancement (meaning subordination) at the BBB piece level that the probability of wiping out the same is reduced to 1.58%.

Each rating agency has its own model to work out this probability distribution.

Arguably, the most transparent of the rating methodologies has been the Moody's binomial expansion technique (BET). The binomial expansion method comes from probability distributions where there is a definite number of outcomes of an event. For example, if we are tossing a fair coin, there is 50% chance of getting a head, and 50% of getting a tail. If we toss it 50 times, what is the probability of getting n heads, say, 7 heads? This is given by the binomial distribution. One may mathematically compute the probability using a formula, or find it on Excel with function binomdist.

When we have n number of harmomised obligors in a pool, there is a probability, for every one of these obligors, that the obligor may be in a state of default or state of performance. Therefore, there are two possible outcomes per obligor, and the probability of default of each of the obligors is given by the estimated probability. That probability of default per obligor may itself be drawn from several sources - such as historical probabilities implied by the rating transition histories, or prevailing cash market spreads, or structural study of each obligor based on financial data, such as in Merton model.

If n number of obligors default, and there is a loss (1-recovery rate) per obligor of x amount, then the total amount of loss of the CDO is nx. As long as nx is not more than the subordination at the tranche level, there is no default as for the tranche. So, the magic of the model lies in computing the probability of nx exceeding the level of subordination.

The critical inputs that go into estimating the probability of the losses exceeding the level of subordination for the tranche are:

Probability of default of each obligor
The notional value each obligor - in synthetic transactions, the notional value per obligor is harmonized
The recovery rate, which is reciprocal of the loss per obligor

The inter-obligor correlation, that is, the degree to which losses of one obligor will be associated with losses in other obligors too.
Moody's single binomial methodThe simplest of approaches is the Moody's single binomial expansion. This is by far the most simple approach. It reconstructs the actual CDO portfolio into an idealized portfolio that completely zeroes out the correlation in the pool. This is done by computing the diversity score of the portfolio. The diversity score having been computed, it is as if there are as many obligors in the pool as indicated by the diversity score. For example, if in a portfolio of 100 obligors of $ 10 million each (notional of $ 1 billion), the diversity score is 45, we assume as if there are 45 obligors in the pool with a notional of $ 1000/45 million. All the obligors have no correlation, and have the same probability of default.

Now, we know from the binomial distribution the probability of n number of defaults out of 45, from which we may compute the probability that losses will exceed a particular level. The cumulative probability for say, 5 defaults out of 45 will indicate the probability that the losses will be limited to the loss of 5 obligors, and the tail risk is that the probability that the loss will exceed 5 obligors.
Moody's multiple binomial methodLater, Moody's came out with its multiple binomial method. Here, it is still the binomial method, but with the pool broken into several subsets with different probabilities of defaults for each sub set. This method marked an improvisation, as, instead of assuming the probabilities of default of each obligor in the harmonized pool to be the same, the multiple binomial method allows for different probabilities per subset.

The multiple binomial method reflected the tail risk inherent in the CDO as the higher probabilities of default inherent in lower-rated obligors were not being adequately considered in the single binomial method. The tail risk of the sub-sets was more than that of the whole.

Moody's correlated binomial methodRecently, the rating agency came out with a correlated binomial methodology. A special report of August 10, 2004 (Moody's Correlated Binomial Default Distribution) explains the method. Unlike the earlier assumption where, the diversity score having been computed, the correlation in the pool was taken to be zero, this model allows for a correlation to be present even after computation of the diversity score. The new method is obviously triggered by one of the most dreaded problems in CDOs - fat tails. "Fat tail" implies a more than nominal probability of losses at the far end of the distribution - that is, high degree of probability of several defaults in the pool.

The diversity score itself has been adjusted after taking into account the correlation, that is to say, the correlated diversity is higher than the independent diversity score.

S&P's CDO Evaluator approachStandard and Poor's CDO Evaluator is based on a Monte Carlo simulation approach. As for the user, most of the underlying computations take place inside the "gray box". The required inputs the issuer's ID, par amount, industry classification, and S&P rating for the issuer. Internally, S& P assumes correlations - 30% intra industry.

Fitch VECTOR model:Fitch, on the other hand, uses a different sector-by-sector correlation on its Vector model. Fitch model is also based internally on Monte Carlo simulation. The default rates come from a new CDO Default Matrix (giving asset default rates by rating and maturity), which is based on historical bond default rates and can be modified to take account of "softer" default definitions when used for rating synthetic CDOs. Pairwise asset correlations, similar to what's done by Moody's, are based on estimates of cross- and intra-industry, and geographical correlations of equity returns. As a result, Fitch will assign an internal and external correlation for each of the 25 industry sectors used. In the past, Fitch did not explicitly model correlations, but applied penalties for high obligor, industry and country concentrations in CDO collateral pools.

The model riskIntuitively, it would not be difficult to understand that correlation is the key million-dollar input in estimating the expected loss probability at any tranche level. As we move up the correlation assumption, the loss distribution curve shifts its peak to the left, and the tail at the right hand becomes fatter and fatter. In case of CDOs, it is the tail that moves the dog - therefore, the real risk is the risk of fat tails.

Inherently, there are several risks still not being captured by the rating agency models. First, the probability of defaults of obligors are being mapped along the historical probabilities of given ratings. There is a huge difference between the historical probabilities of default, and those implied by the cash market spreads, and this difference becomes more acute for lower rated obligors. The intuitive argument for this widening difference is that the market tends to exaggerate the risks of default of lower rated obligors. While computing probabilities of default, the rating agencies are still influenced by the historical ratings.

Besides this, the credit spreads in the market for obligors of the same rating may be widely different. Motivated by arbitrage considerations, a CDO structurer may choose obligors on the upper fringes of credit spreads though with a given rating.

The CDO business is booming - structurers are adding inputs like interest rate swaps, equity default swaps, etc., in a bid to provide higher spreads to investors. Investors have looked at CDOs as not a part of a hard core investment pool but like a bit of venturesome portfolio allocated to provide a yield-kicker. In this environment of spread-peddling, it is likely that some one would like to play smarter than the investment bank next door, and this would lead to a race of outsmarting. The casualty may be that the rating agency models may be overexploited, which might eventually lead to a loss of credibility of the ratings information.

Call for greater transparency in leveraged loans

Call for greater openness in leveraged loans
By Stacy-Marie Ishmael

(FT June 13) Investors should demand more transparency and accountability from managers of collateralised loan obligations, according to a new report from Standard & Poor’s.

The rating agency said the the rising popularity of so-called covenant-lite loans imposed significant risks on investors in the opaque CLO market.

Demand for CLOs, complex financial instruments which repackage portfolios of loans, has surged recently. The products can offer investors better returns for a given rating than traditional fixed-income assets.

In the first quarter of 2007, global covenant-lite loan volume reached $48bn, compared with $24bn recorded for the whole of last year. The use of these loans to fund buy-outs is already well-established in the US and becoming more accepted in Europe.

But S&P said the absence of the traditional covenants that give creditors early warnings of financial problems diminished recovery prospects for such loans.

“Cumulative credit risk to lenders and players in the risk transfer chain is building as covenant strength is evaporating,” S&P said in its report. The agency said it was adjusting its CLO rating criteria to reflect the increased risk.

Abundant liquidity and the disproportionate power of borrowers, arrangers, and financial sponsors have allowed a growing segment of high-risk companies to issue covenant-lite loans, S&P said. Many of the loans are held in CLOs.

“We suggest that investors ask managers to disclose their cov-lite holdings in their investor letters or reports, and demand more traditional ‘cov-strong’ rather than ‘cov-weak’ protection,” S&P said.

Managers must also be held accountable if they extend credit to borrowers demanding weaker covenants. “We encourage investors to focus in now more than ever on a CLO manager’s ability to differentiate among debt structures, covenant protections, and asset coverage in their asset selection process,” S&P said.

“We feel we should raise awareness before the next cycle turn,” S&P said