The Use of Credit Scoring Models and the Importance of a Credit Culture

Dr. Edward I. Altman Stern School of Business New York University

Evolution of Scoring Systems

Qualitative (Subjective) Univariate (Accounting/Market Measures) Multivariate (Accounting/Market Measures)
Discriminant, Logit, Probit Models (Linear, Quadratic) Non-Linear Models (e.g.., RPA, NN)

Discriminant and Logit Models in Use

Consumer Models - Fair Isaacs Z-Score (5) - Manufacturing ZETA Score (7) - Industrials Private Firm Models (eg. Risk Calc (Moodys), Z Score) EM Score (4) - Emerging Markets, Industrial Other - Bank Specialized Systems
2

Evolution of Scoring Systems

(continued) Artificial Intelligence Systems
Expert Systems Neural Networks (eg. Credit Model (S&P), CBI (Italy))

Option/Contingent Claims Models

Risk of Ruin KMV Credit Monitor Model

Blended Ratio/Market Value Models

Moodys Risk Cal Bond Score (Credit Sights) Z-Score (Market Value Model)

Problems With Traditional Financial Ratio Analysis 1 Univariate Technique 1-at-a-time 2 No Bottom Line 3 Subjective Weightings 4 Ambiguous 5 Misleading
4

Forecasting Distress With Discriminant Analysis Linear Form Z = a1x1 + a2x2 + a3x3 + + anxn Z = Discriminant Score (Z Score) a1 x1 an = Discriminant Coefficients (Weights) xn = Discriminant Variables (e.g. Ratios)
x x x x x x x x x x x x x x x x x x x x x xx x x x x x x x x x x x x x x x x

Example
EBIT TA

EQUITY/DEBT

Z Score Component Definitions Variable

X1

Definition
Working Capital Total Assets

Weighting Factor
1.2

X2

Retained Earnings Total Assets

1.4

X3

EBIT Total Assets

3.3

X4

Market Value of Equity Book Value of Total Liabilities

0.6

X5

Sales Total Assets

1.0
6

Z Score Bankruptcy Model

Z = .012X1 + .014X2 + .033X3 + .006X4 + .999X5 e.g. 20.0%

Z = 1.2X1 + 1.4X2 + 3.3X3 + .6X4 + .999X5 e.g. 0.20

X1 = Current Assets - Current Liabilities Total Assets X2 = Retained Earnings Total Assets X3 = Earnings Before Interest and Taxes Total Assets

X4 = Market Value of Equity Total Liabilities X5 = Sales Total Assets (= # of Times

e.g. 2.0x)

Zones of Discrimination: Original Z - Score Model

Z > 2.99 - Safe Zone 1.8 < Z < 2.99 - Grey Zone Z < 1.80 - Distress Zone

Average Z-Score by S&P Bond Rating S&P 500: 1992 - 2001

1996-2001 # Average Firms Z Score SD 66 6.20 3.06 194 519 530 538 390 9 4.73 3.74 2.81 2.38 1.80 0.33 2.36 2.29 1.48 1.85 1.91 1.16 1995 1994 1993 1992 Average Average Average Average Z Score SD Z Score SD Z Score SD Z Score SD 5.02 1.60 4.38 1.38 4.51 1.50 5.26 2.19 4.30 3.61 2.78 2.45 1.67 1.91 2.26 1.49 1.62 1.23 4.05 3.47 2.70 2.28 1.88 1.83 2.01 1.58 1.69 1.52 4.03 3.61 2.84 2.19 1.96 1.89 2.18 1.74 1.63 1.72 4.23 3.92 2.60 2.10 1.96 2.09 3.26 1.54 1.54 2.33

Rating AAA AA A BBB BB B CCC+CC

Estimating Probability of Default and Probability of Loss Given Defaults

Credit scores on new issues to estimate Bond ratings equivalents on new issues and then, Utilize mortality rates to estimate annual and cumulative defaults

10

Marginal and Cumulative Mortality Rate Equation MMR(t) =

Total value of defaulting debt in year (t) total value of the population at the start of the year (t)

MMR = Marginal Mortality Rate

One can measure the cumulative mortality rate (CMR) over a specific time period (1,2,, T years) by subtracting the product of the surviving populations of each of the previous years from one (1.0), that is,

CMR(t) = 1 - SR(t) ,

t=1

here

CMR (t) = Cumulative Mortality Rate in (t), SR (t) = Survival Rate in (t) , 1 - MMR (t)

11

Mortality Rate Concept (Illustrative Calculation)

For BB Rated Issues
Security No. 1 2 3 4 5 6 7 8 9 10 Total Amount Start of Period Marginal Mortality Rate Cumulative Rate
NE = No longer in existence SF = Sinking fund

Issued Amount 50 50 100 100 150 150 200 200 250 250 1,500 1,500

Year 1 Default -50 --------50

Call --100 -------100 175

SF 5 -----20 ---25

Year 2 Default -NE NE 100 ------100

Call -NE NE ----200 --200

SF 5 NE NE -15 -20 ---40

Year 1

1,325 Year 2

- 340

985

50/1,500 = 3.3% 3.3%

100/1,325 = 7.5% 1 - (SR1 x SR2 ) = CMR2 1 - (96.7% x 92.5%) = 10.55%

12

Mortality Rates by Original Rating

All Rated Corporate Bondsa 1971-2003
1 AAA Marginal Cumulative Marginal Cumulative Marginal Cumulative Marginal Cumulative Marginal Cumulative Marginal Cumulative Marginal Cumulative 0.00% 0.00% 0.00% 0.00% 0.01% 0.01% 0.40% 0.40% 1.22% 1.22% 3.06% 3.06% 2 0.00% 0.00% 0.00% 0.00% 0.11% 0.12% 3.45% 3.84% 2.52% 3.77% 3 0.00% 0.00% 0.33% 0.33% 0.02% 0.14% 1.58% 5.38% 4.44% 7.98% 4 Years after Issuance 5 6 0.03% 0.03% 0.00% 0.50% 0.05% 0.28% 0.98% 7.64% 0.00% 0.03% 0.00% 0.50% 0.10% 0.38% 0.56% 8.16%

7 0.00% 0.03% 0.00% 0.50% 0.06% 0.44% 0.28% 8.98%

8 0.00% 0.03% 0.00% 0.50% 0.21% 0.65% 0.25% 9.11%

9 0.00% 0.03% 0.03% 0.53% 0.11% 0.75% 0.16% 9.25%

10 0.00% 0.03% 0.02% 0.55% 0.06% 0.82% 0.42% 9.63%

0.00% 0.00% 0.17% 0.50% 0.09% 0.23% 1.45% 6.73%

AA

BBB

BB

2.05% 2.55% 1.10% 1.65% 0.88% 1.72% 3.70% 9.87% 12.17% 13.14% 14.57% 15.15% 16.61% 19.69%

6.92% 7.48% 8.58% 6.08% 4.18% 3.74% 2.31% 2.00% 0.88% 9.77% 16.52% 23.69% 28.32% 31.32% 33.89% 35.41% 36.70% 37.26%

CCC

8.18% 15.57% 19.15% 12.18% 4.26% 10.25% 5.65% 3.15% 0.00% 4.28% 8.18% 22.48% 37.32% 44.96% 47.30% 52.70% 55.37% 56.78% 56.78% 58.63%

(a) Rated by S&P at Issuance Based on 1,719 issues Source: Standard & Poor's (New York) and Author's Compilation

13

Mortality Losses by Original Rating

All Rated Corporate Bondsa 1971-2003
1 AAA Marginal Cumulative Marginal Cumulative Marginal Cumulative Marginal Cumulative Marginal Cumulative Marginal Cumulative Marginal Cumulative 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.28% 0.28% 0.73% 0.73% 2.13% 2.13% Years after Issuance 5 6 0.00% 0.00% 0.00% 0.12% 0.02% 0.11% 0.65% 5.45% 1.40% 8.08% 0.00% 0.00% 0.00% 0.12% 0.06% 0.17% 0.37% 5.80% 0.75% 8.78%

2 0.00% 0.00% 0.00% 0.00% 0.04% 0.04% 2.54% 2.81% 1.51% 2.23%

3 0.00% 0.00% 0.06% 0.06% 0.01% 0.05% 1.15% 3.93% 3.24% 5.40%

7 0.00% 0.00% 0.00% 0.12% 0.02% 0.19% 0.47% 6.24% 0.99% 9.68%

8 0.00% 0.00% 0.00% 0.12% 0.04% 0.23% 0.15% 6.38%

9 0.00% 0.00% 0.03% 0.15% 0.08% 0.31% 0.10% 6.48%

10 0.00% 0.00% 0.02% 0.17% 0.00% 0.31% 0.29% 6.75%

0.00% 0.00% 0.06% 0.12% 0.04% 0.09% 0.94% 4.83% 1.46% 6.78%

AA

BBB

BB

0.28% 0.94% 1.18% 9.93% 10.78% 11.83%

5.05% 5.60% 6.00% 4.56% 2.51% 2.74% 1.64% 1.10% 0.67% 7.07% 12.38% 17.54% 21.30% 23.38% 25.00% 26.23% 27.04% 27.53%

CCC

5.48% 11.68% 15.37% 9.72% 3.20% 8.21% 4.80% 2.52% 0.00% 3.22% 5.48% 16.52% 29.35% 36.22% 38.26% 43.37% 46.05% 47.41% 47.41% 49.10%

(a) Rated by S&P at Issuance Based on 1,535issues Source: Standard & Poor's (New York) and Author's Compilation

14

Classification & Prediction Accuracy Z Score (1968) Failure Model*

1969-1975
Year Prior To Failure 1 2 3 4 5 Original Sample (33) 94% (88%) 72% 48% 29% 36% Holdout Sample (25) 96% (72%) 80% Predictive Sample (86) 82% (75%) 68% -

1976-1995
Predictive Sample (110) 85% (78%) 75% -

1997-1999
Predictive Sample (120) 94% (84%) 74% -

*Using 2.67 as cutoff score (1.81 cutoff accuracy in parenthesis)

15

Z Score Trend - LTV Corp.

3.5 2.99 3 2.5 1.8 2 1.5 1 0.5 0 -0.5 -1 -1.5 Z Score

Safe Zone Grey Zone Distress Zone

1980

1981

1982

1983 Year

1984

1985

1986
Bankrupt July 86

16

International Harvester (Navistar) Z Score (1974 2001)

3.5 3 2.5 2 1.5 1 0.5 0 -0.5
Safe Zone

Z Score

Grey Zone

Distress Zone

'74 '76 '78 '80 '82 '84 '86 '88 '90 '92 '94 '96 '98 '00 Year
17

Chrysler Corporation Z Score (1976 3Q 1998*)

4 3.5 3 Z Score 2.5 2 1.5 1 0.5 0 '76
Govt Loan Guarantee Consolidated Co. Grey Zone Operating Co. Safe Zone

'78

'80

'82

'84

'86

'88 Year

'90

'92

'94

'96

'98

*Third quarter figures for 1998 are annualized 18

IBM Corporation Z Score (1980 2001)

6 5.5 5 4.5 4 3.5 3 2.5 2 1.5 1 0.5 0

Operating Co. Safe Zone Consolidated Co. Grey Zone

BBB BB B

Z Score

July 1993: Downgrade AA- to A

1/93: Downgrade AAA to AA-

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000

Year
19

Enron Credit Risk Measures

EDF Equivalent Rating
CC CCC

B BB

BBB

A AA AAA

Source: A. Saunders and L. Allen, Credit Risk Measurement; J. Wiley, 2002

20

Worldcom Credit Risk Measures

Z" SCORES AND EDF'S FOR WORLDCOM (Q4'1999 - Q1'2002)
7.00 0.01 AAA

S&P Rating
6.00

A-

BBB BBB
AA

BEQ*
5.00

Z" Scores

BBB+

BB B+

0.10

BBB

Z" Score

4.00

EDF
CCC+

BB 1.00 B

3.00

CCC2.00

CC

10.00 CCC D

1.00

0.00 Q4'99 Q1'00 Quarter- Year

D
Q2'00 Q3'00 Q4'00 Q1'01 Q2'01 Q3'01 Q4'01 Q1'02 Q2'02

100.00 Q3'02

Z" UnAdj

Z" Adj:3.85B

Z" Adj:7.2B&50B

EDF

*BEQ = Z" Score Bond Equivalent Rating

Sources: Compilation by the author (E. Altman, NYU Stern), the KMV (Moody's) Website and Standard & Poor's Corporation.

EDF Score

21

Key Industrial Financial Ratios U.S. Industrial Long-term Debt

Three Year (1998-2000) Medians EBIT interest coverage (x) EBITDA interest coverage (x) Funds from operations/total debt (%) Free operating cash flow/total debt (%) Pretax return on capital (%) Operating income/sales (%) Long-term debt/capital (%) Total debt/capitalization (%) Companies AAA 21.4 26.5 128.8 84.2 34.9 27.0 13.3 22.9 8 AA 10.1 12.9 55.4 25.5 21.7 22.1 28.2 37.7 29 A BBB 6.1 3.7 9.1 5.8 43.2 30.8 15.0 8.5 19.4 13.6 18.6 15.4 33.9 42.5 42.5 48.2 136 218 BB 2.1 3.4 18.8 2.6 11.6 15.9 57.2 62.6 273 B CCC 0.8 0.1 1.8 1.3 7.8 1.6 -3.2 -12.9 6.6 1.0 11.9 11.9 69.7 68.8 74.8 87.7 281 22

Standard & Poor's, Corporate Ratings Criteria, Ratings and ratios.

22

Xerox Credit Quality: Z Score Analysis 1998-2000

4.00 3.50 3.00
Z-Score

3.46

2.50 2.00 1.50 1.00 0.50 12/98

2.38

1.35

12/99

6/00

Bond Rating Equivalents: 12/98 A 12/99 BB 06/00 B

Actual Rating (S&P / Moodys): 12/98 A / A2 12/99 A / A2 07/00 A- / A3 12/00 BBB- / Ba1 5/02 BB / B1

23

Z Score Private Firm Model

Z = .717X1 + .847X2 + 3.107X3 + .420X4 + .998X5 X1 = Current Assets - Current Liabilities Total Assets X2 = Retained Earnings Total Assets X3 = Earnings Before Interest and Taxes Total Assets X4 = Book Value of Equity Total Liabilities X5 = Sales Total Assets
24

Z > 2.90 - Safe Zone 1.23 < Z < 2.90 - Grey Zone Z < 1.23 - Distress Zone

Z Score Model for Manufacturers, Non-Manufacturer Industrials, & Emerging Market Credits
Z = 6.56X1 + 3.26X2 + 6.72X3 + 1.05X4 X1 = Current Assets - Current Liabilities Total Assets X2 = Retained Earnings Total Assets X3 = Earnings Before Interest and Taxes Total Assets X4 = Book Value of Equity Total Liabilities Z > 2.60 - Safe Zone 1.1 < Z < 2.60 - Grey Zone Z < 1.1 - Distress Zone
25

AN EMERGING MARKET CORPORATE MODEL

US Bond Rating Equivalent Based on Adjusted Z Score Model Z=3.25+6.56X1+3.26X2+6.72X3+1.05X4

US Equivalent Rating AAA AA+ AA AAA+ A ABBB+ BBB BBBBB+ BB BBB+ B BCCC+ CCC CCCD Average EM Score Sample Size 8.15 8 7.6 7.3 18 7 15 6.85 24 6.65 42 6.4 38 6.25 38 5.85 59 5.65 52 5.25 34 4.95 25 4.75 65 4.5 78 4.15 115 3.75 95 3.2 23 2.5 10 1.75 6 0 14

27

An Emerging Market Credit Scoring System

Step 1- Calculate the EM Score and its Bond Rating Equivalent (BRE) compared

to the U.S. Bond Market

Step 2 -Adjust (modify) the Bond Rating Equivalent for Forex Revaluation Vulnerability High vulnerability = -1 rating class (3 notches) Neutral vulnerability = -1 notch Low vulnerability = no change

Step 3 -Adjust BRE for Risk of Industry in the Emerging Market vs. Risk of the Industry in the U.S. - 1 or 2 notches
28

An Emerging Market Credit Scoring System

Step 4 -Adjustment of BRE for Competitive Position Dominant firm in industry = +1 notch Average firm in industry = no change Poor competitive position = -1 notch

Step 5 -Special Collateral or Guarantees Impact on BRE

Step 6 -Assess the yield in the U.S. market on the modified BRE of the emerging Market credit, then add the sovereign yield spread. Finally, compare the resulting required yield with the yield in the market.

29

Z-Score Models and Bond Rating Equivalent Selected Auto and Telecom Companies

Date GM Ford Fiat Daimler Telefonica Deutsche Telecom Telecom Italia France Telecom 31/12/03 31/12/03 31/12/03 31/12/03 31/12/03 31/12/03 31/12/03 31/12/03

Z-Score 0.84 0.43 1.07 1.15 1.58 0.53 1.19 0.69

Equivalent Rating CCC+ CCC CCC+ CCC+ BCCC CCC+ CCC

Z"-Score 5.23 2.33 4.64 5.41 4.16 2.27 4.64 2.36

Equivalent Rating BB CCC B+ BB+ B CCC B+ CCC

Revised Rating BBBB BB+ BBB BB B BB+ B

S&P Rating BBB BBBBBBBB A BBB+ BBB+ BBB+

30

Z-Score Models and Bond Rating Equivalent General Motors Co.

Z-Score Dec 2003 Dec 2002 Dec 2001 Dec 2000 0.84 0.79 0.75 0.81

Equivalent Rating CCC+ CCC CCC CCC

Z''-Score 5.23 4.89 4.08 3.73

Equivalent Rating BB BBBCCC+

Revised Rating BBBBBBBBB+

31

Z-Score Models and Bond Rating Equivalent Ford Motors Co.

Z-Score Dec 2003 Dec 2002 Dec 2001 Dec 2000 0.43 0.44 0.36 0.53

Equivalent Rating CCC CCC CCC CCC

Z''-Score 2.33 2.44 1.87 1.93

Equivalent Rating CCC CCC CCCCCCB B BB-

Revised Rating

32

Z-Score Models and Bond Rating Equivalent Fiat Auto S.p.A.

Z-Score Dec 2003 Dec 2002 Dec 2001 Dec 2000 1.07 0.84 0.87 0.92

Equivalent Rating CCC+ CCC+ CCC+ CCC+

Z''-Score 4.64 4.50 4.32 4.09

Equivalent Rating B+ B B B-

Revised Rating BB+ BB BB BB-

33

Z-Score Models and Bond Rating Equivalent Daimler-Chrysler

Z-Score Dec 2003 Dec 2002 Dec 2001 Dec 2000 1.38 1.15 1.07 1.46

Equivalent Rating BCCC+ CCC+ B-

Z''-Score 5.41 3.93 3.55 5.08

Equivalent Rating BB+ BCCC+ BB

Revised Rating BBB BBB+ BBB-

34

Z-Score Models and Bond Rating Equivalent Telefonica

Z-Score Dec 2003 Dec 2002 Dec 2001 Dec 2000 1.58 1.02 1.32 1.27

Equivalent Rating BCCC+ BCCC+

Z''-Score 4.16 3.60 3.98 3.91

Equivalent Rating B CCC+ BBBB B B+ B+

Revised Rating

35

Z-Score Models and Bond Rating Equivalent Deutsche Telecom

Z-Score Dec 2003 Dec 2002 Dec 2001 Dec 2000 0.53 0.29 0.67 1.04

Equivalent Rating CCC CCCCCC CCC+

Z''-Score 2.27 2.01 3.21 3.34

Equivalent Rating CCC CCC CCC+ CCC+ B B B B

Revised Rating

36

Z-Score Models and Bond Rating Equivalent Telecom Italia

Z-Score Dec 2003 Dec 2002 Dec 2001 Dec 2000 1.19 0.71 0.64 0.58

Equivalent Rating CCC+ CCC CCC CCC

Z''-Score 4.64 4.23 4.10 3.72

Equivalent Rating B+ B BCCC+

Revised Rating BB+ BB B+ B+

37

Z-Score Models and Bond Rating Equivalent France Telecom

Z-Score Dec 2003 Dec 2002 Dec 2001 Dec 2000 0.69 (0.19) 0.42 0.70

Equivalent Rating CCC D CCC CCC

Z''-Score 2.36 0.40 2.71 1.93

Equivalent Rating CCC CCCCCC CCCB BB B-

Revised Rating

38

Mexican Firms Z-Score Analysis

39

Mexican Corporate Issuers EM Scores and Modified Ratings (December 1994)

Company
Aeromexico Apasco CCM Cemex Cydsa DESC Empresas ICA Femsa Gemex GIDUSA (Durango) GMD Gruma Grupo Dina Hylsamex IMSA Kimberly-Clark de Mexico Liverpool Moderna Ponderosa San Luis Sidek Simec Situr Synkro TAMSA TELMEX Televisa TMM Vitro

Industry
Airlines Cement Supermarkets Cement Chemicals Conglomerate Construction Bottling Bottling Paper and Forest Products Construction Food Processing Auto Manufacturing Steel Steel Paper and Forest Products Retail Conglomerate Paper and Forest Products Autoparts Conglomerate Steel Hotel and Tourism Textile/Apparel Steel Pipes Telecommunications Cable and Media Shipping Glass

EM Score
-4.42 8.48 4.78 5.67 4.67 4.23 5.96 6.37 5.4 4.61 4.85 5.56 5.54 5.51 5.45 8.96 9.85 5.28 6.64 2.69 4.68 4.42 5.17 1.59 3.34 9.57 7.29 5.34 5.18

Bond-Rating Equivalent
D AAA BBBBBBBB BBB ABB+ B+ BB BBBBBBBBBBBBAAA AAA BB+ A CCC BBB+ BB+ CCCCCC+ AAA AA BB+ BB+

Modified Rating
D A B+ BBBB+ BB+ BB BBB+ BB+ BB BBBB+ BB+ BBBBAA A+ BB+ BB CCCB BB CCC B AABBB+ BB+ BB

Ratings M/S&P/D&P
NR/NR/NR Ba2/NR/NR NR/NR/NR Ba3/BB/BB NR/NR/NR NR/NR/NR B1/BB-/B+ NR/NR/NR Ba3/NR/NR B1/BB-/NR B3/NR/NR NR/NR/NR NR/NR/B NR/NR/NR NR/NR/NR NR/NR/NR NR/NR/NR NR/NR/NR NR/NR/NR NR/NR/NR NR/NR/CCC NR/NR/CCC NR/NR/CCC NR/NR/NR NR/NR/NR NR/NR/NR Ba2/NR/NR Ba2/BB-/NR Ba2/NR/NR

40

Presentation of the firms

We have calculated the Z-score ratings of 13 major Mexican public companies from 1998 through 2002
America Movil SA de CV Apasco SA de CV Cemex SA de CV Cintra SA de CV Coca-Cola Femsa SA de CV Fomento Economico Mexicano Grupo Carso SA de CV Grupo Televisa SA Empresas ICA Sociedad Kimberly-Clark de Mexico Telefonos de Mexico SA de CV Vitro SA de CV Wal-Mart de Mexico SA de CV Industry Telecommunications Construction Material Construction Material Airlines Beverages Beverages Diversified Media Construction and Engineering Paper Telecommunications Containers and Packaging Retail
41

Z-score and Equivalent Bond Rating

Z" Score = 3.25 + 6.56 * BV of Equity Working Capital Retained Earnings EBIT + 3.26 * + 6.72 * + 1.05 * Total Assets Total Assets Total Assets BV of Liability

Z''-Score 8.15 7.60 7.30 7.00 6.85 6.65 6.40 6.25 5.85 > 8.15 8.15 7.60 7.30 7.00 6.85 6.65 6.40 6.25

Rating AAA AA+ AA AAA+ A ABBB+ BBB

Z''-Score 5.65 5.25 4.95 4.75 4.50 4.15 3.75 3.20 2.50 1.75 < 1.75 5.85 5.65 5.25 4.95 4.75 4.50 4.15 3.75 3.20 2.50 1.75

Rating BBBBB+ BB BBB+ B BCCC+ CCC CCCD

Grey zone

Safe zone

Distress zone

42

Z-score Distressed models and S&P Ratings

(As of December 31, 2002)
Z"-Score Rating

Mexico Credit Rating

(Foreign Currency LT Debt)

S&P Rating Dec 02 BBB+ BBB+ BBBBBB CCC BBBABBB+ B+

S&P Bond Rating AAA

02/07/02 03/13/00 02/10/95 07/29/92

BBBBB+ BB BB+

America Movil SA de CV Apasco SA de CV Cemex SA de CV Coca-Cola Femsa SA de CV Empresas ICA Sociedad Controladora Grupo Televisa SA Kimberly-Clark de Mexico Telefonos de Mexico SA de CV Vitro SA de CV n.a: not available

Dec 94 n.a. AAA BBBABBB AA AAA AAA BB+

Dec 02 BB AA+ B+ AAA CCC+ AA A BBB B-

AAAmerica Movil Kimberly-Clark de Mexico Telefonos de Mexico Apasco Femsa Grupo Televisa

BBB+
Cemex

BB
Vitro

BICA

D
Source: Bloomberg

B-

BB

BBB+

AA-

Z"-score Equivalent Bond Rating

43

AAA

Alfa, S.A. de C.V.

Alfa, S.A. de C.V. 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 4Q90 4Q91 4Q92 4Q93 4Q94 4Q95 4Q96 4Q97 4Q98 4Q99 4Q00 4Q01 4Q02 4Q03

44

America Movil SA de CV
(provides wireless communications services in Mexico)
Z"-Score Equivalent Rating 1

10.0

8.0

7.86

AAA 0.8 A+ BBB+ 0.6

5.73 5.19

6.0

B+ 0.4 CCC+

4.0

2.0

0.2

Dec 1998 Dec 1999 Dec 2000 Dec 2001 Dec 2002

D 0

45
Source: Bloomberg

Apasco SA de CV
(production and marketing of cement)
Z"-Score Equivalent Rating 1

10.0

9.97

9.14 8.0 7.02 6.0 7.74 7.01

AAA 0.8 A+ BBB+ 0.6 B+

4.0

0.4 CCC+

2.0

0.2

Dec 1998 Dec 1999 Dec 2000 Dec 2001 Dec 2002

D 0

46
Source: Bloomberg

Holcim Apasco, S.A. de C.V.

Holcim Apasco, S.A. de C.V. 12.0 10.0 8.0 6.0 4.0 2.0 4Q90 4Q91 4Q92 4Q93 4Q94 4Q95 4Q96 4Q97 4Q98 4Q99 4Q00 4Q01 4Q02 4Q03

47

Cemex SA de CV
(production, distribution, marketing, and sale of cement )
Z"-Score Equivalent Rating 1

10.0

8.0

AAA 0.8 A+ BBB+ 0.6

5.58 4.69 4.70

6.04 6.0 5.59 4.0

B+ 0.4 CCC+

2.0

0.2

Dec 1998 Dec 1999 Dec 2000 Dec 2001 Dec 2002

D 0

48
Source: Bloomberg

Cintra SA de CV
(AeroMxico, Mexicana, Aerocaribe, Aerolitoral,)
Z"-Score

10.0

Equivalent Rating 1

8.0

AAA 0.8 A+ BBB+ 0.6

4.63 4.52

6.0

B+ 0.4 CCC+
2.64 2.71

4.0

4.41

2.0

0.2

Dec 1998 Dec 1999 Dec 2000 Dec 2001 Dec 2002

D 0

49
Source: Bloomberg

Coca-Cola Femsa SA de CV
(production, distribution, and marketing of certain Coca-Cola trademark beverages)
Z"-Score Equivalent Rating 1

10.0

9.69

8.0 7.11 6.0 5.23 4.0 6.26

8.82

AAA 0.8 A+ BBB+ 0.6 B+ 0.4 CCC+

2.0

0.2

Dec 1998 Dec 1999 Dec 2000 Dec 2001 Dec 2002

D 0

50
Source: Bloomberg

Coca-Cola Femsa, S.A. de C.V.

Coca-Cola Femsa, S.A. de C.V. 16.0 14.0 12.0 10.0 8.0 6.0 4.0 2.0 4Q90 4Q91 4Q92 4Q93 4Q94 4Q95 4Q96 4Q97 4Q98 4Q99 4Q00 4Q01 4Q02 4Q03

51

Comercial Mexicana, S.A. de C.V.

Comercial Mexicana, S.A. de C.V. 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 4Q90 4Q91 4Q92 4Q93 4Q94 4Q95 4Q96 4Q97 4Q98 4Q99 4Q00 4Q01 4Q02 4Q03

52

Fomento Economico Mexicano SA de CV

(brews beer and bottles soft drinks)
Z"-Score Equivalent Rating 1

10.0

8.0 6.91 6.0 6.64 6.31

7.34 7.35

AAA 0.8 A+ BBB+ 0.6 B+

4.0

0.4 CCC+

2.0

0.2

Dec 1998 Dec 1999 Dec 2000 Dec 2001 Dec 2002

D 0

53
Source: Bloomberg

Grupo Bimbo, S.A. de C.V.

Grupo Bimbo, S.A. de C.V. 10.0 9.0 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 4Q90 4Q91 4Q92 4Q93 4Q94 4Q95 4Q96 4Q97 4Q98 4Q99 4Q00 4Q01 4Q02 4Q03

54

Grupo Carso SA de CV
(holding company in diverse industries (e.g. tobacco; mining, hospitality, retail, music stores,))
Z"-Score Equivalent Rating 1

10.0

8.0 6.40 6.0

AAA 0.8 A+ BBB+ 0.6 B+ 0.4 CCC+

6.37 5.81 5.58

6.01

4.0

2.0

0.2

Dec 1998 Dec 1999 Dec 2000 Dec 2001 Dec 2002

D 0

55
Source: Bloomberg

Grupo Carso, S.A. de C.V.

Grupo Carso, S.A. de C.V. 9.0 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 4Q90 4Q91 4Q92 4Q93 4Q94 4Q95 4Q96 4Q97 4Q98 4Q99 4Q00 4Q01 4Q02 4Q03

56

Grupo Continental, S.A.

Grupo Continental, S.A. 16.0 14.0 12.0 10.0 8.0 6.0 4.0 2.0 4Q90 4Q91 4Q92 4Q93 4Q94 4Q95 4Q96 4Q97 4Q98 4Q99 4Q00 4Q01 4Q02 4Q03

57

Grupo Elektra, S.A. de C.V.

Grupo Elektra, S.A. de C.V. 10.0 9.0 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 4Q90 4Q91 4Q92 4Q93 4Q94 4Q95 4Q96 4Q97 4Q98 4Q99 4Q00 4Q01 4Q02 4Q03

58

Grupo Imsa, S.A. de C.V.

Grupo Imsa, S.A. de C.V. 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 4Q90 4Q91 4Q92 4Q93 4Q94 4Q95 4Q96 4Q97 4Q98 4Q99 4Q00 4Q01 4Q02 4Q03

59

Grupo Modelo, S.A. de C.V.

Grupo Modelo, S.A. de C.V. 12.0 10.0

8.0

6.0

4.0

2.0

4Q90 4Q91 4Q92 4Q93 4Q94 4Q95 4Q96 4Q97 4Q98 4Q99 4Q00 4Q01 4Q02 4Q03

60

Grupo Mxico, S.A. de C.V.

Grupo Mxico, S.A. de C.V. 12.0 10.0

8.0

6.0

4.0

2.0

4Q90 4Q91 4Q92 4Q93 4Q94 4Q95 4Q96 4Q97 4Q98 4Q99 4Q00 4Q01 4Q02 4Q03

61

Grupo Televisa SA
(television broadcasting)
Z"-Score Equivalent Rating 1

10.0 8.77 8.0 8.58 8.48 7.53 7.66 6.0

AAA 0.8 A+ BBB+ 0.6 B+

4.0

0.4 CCC+

2.0

0.2

Dec 1998 Dec 1999 Dec 2000 Dec 2001 Dec 2002

D 0

62
Source: Bloomberg

Grupo Televisa, S.A.

Grupo Televisa, S.A. 9.0 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 4Q90 4Q91 4Q92 4Q93 4Q94 4Q95 4Q96 4Q97 4Q98 4Q99 4Q00 4Q01 4Q02 4Q03

63

Empresas ICA Sociedad Controladora SA

(construction company)
10.0

8.0

AAA 0.8 A+ BBB+ 0.6

4.52

6.0

5.17

B+
4.12 3.42 3.48

4.0

0.4 CCC+

2.0

0.2

Dec 1998 Dec 1999 Dec 2000 Dec 2001 Dec 2002

D 0

64
Source: Bloomberg

Industrias Peoles, S.A. de C.V.

Industrias Peoles, S.A. de C.V. 12.0 10.0

8.0

6.0

4.0

2.0

4Q90 4Q91 4Q92 4Q93 4Q94 4Q95 4Q96 4Q97 4Q98 4Q99 4Q00 4Q01 4Q02 4Q03

65

Kimberly-Clark de Mexico SA de CV
(manufacture and sale of consumer and industrial paper products )
Z"-Score Equivalent Rating 1

10.0 8.90 8.0 8.72 7.74 7.40 6.0 6.77

AAA 0.8 A+ BBB+ 0.6 B+

4.0

0.4 CCC+

2.0

0.2

Dec 1998 Dec 1999 Dec 2000 Dec 2001 Dec 2002

D 0

66
Source: Bloomberg

El Puerto de Liverpool, S.A. de C.V.

El Puerto de Liverpool, S.A. de C.V. 14.0 12.0 10.0 8.0 6.0 4.0 2.0 4Q90 4Q91 4Q92 4Q93 4Q94 4Q95 4Q96 4Q97 4Q98 4Q99 4Q00 4Q01 4Q02 4Q03

67

Organizacin Soriana, S.A. de C.V.

Organizacin Soriana, S.A. de C.V. 12.0 10.0

8.0

6.0

4.0

2.0

4Q90 4Q91 4Q92 4Q93 4Q94 4Q95 4Q96 4Q97 4Q98 4Q99 4Q00 4Q01 4Q02 4Q03

68

Telefonos de Mexico SA de CV
(provide telecommunications services (TELMEX))
Z"-Score Equivalent Rating 1

10.0 8.84 8.0 8.50

AAA 0.8 A+ BBB+ 0.6 B+ 0.4 CCC+

6.0

6.03

5.17 4.0 4.32

2.0

0.2

Dec 1998 Dec 1999 Dec 2000 Dec 2001 Dec 2002

D 0

69
Source: Bloomberg

Telefonos de Mxico, S.A. de C.V.

Telefonos de Mxico, S.A. de C.V. 12.0 10.0

8.0

6.0

4.0

2.0

4Q90 4Q91 4Q92 4Q93 4Q94 4Q95 4Q96 4Q97 4Q98 4Q99 4Q00 4Q01 4Q02 4Q03

70

TV Azteca, S.A. de C.V.

TV Azteca, S.A. de C.V. 8.0 7.0 6.0 5.0 4.0 3.0 2.0 1.0 4Q90 4Q91 4Q92 4Q93 4Q94 4Q95 4Q96 4Q97 4Q98 4Q99 4Q00 4Q01 4Q02 4Q03

71

Vitro SA de CV
(manufacture and marketing of glass and plastic containers)
Z"-Score Equivalent Rating 1

10.0

8.0

AAA 0.8 A+ BBB+ 0.6

4.22

6.0 5.11

5.11

B+
4.00 3.40

4.0

0.4 CCC+ 0.2

2.0

Dec 1998 Dec 1999 Dec 2000 Dec 2001 Dec 2002

D 0

72
Source: Bloomberg

Wal-Mart de Mexico SA de CV
(retail)
Z"-Score Equivalent Rating 1

10.0 9.09 9.02

8.0 7.67 6.0 7.75

7.86

AAA 0.8 A+ BBB+ 0.6 B+

4.0

0.4 CCC+

2.0

0.2

Dec 1998 Dec 1999 Dec 2000 Dec 2001 Dec 2002

D 0

73
Source: Bloomberg

KMV & HIBRYID SCORING MODELS

KMV Credit Monitor Model

Provides a quantitative assessment of the credit risk of publicly traded companies The model is theoretically rather than empirically based It is built around the markets valuation of a firms creditworthiness The model can be applied to the universe of publicly-traded companies The universe consists of thousands of companies in the U.S. By contrast, only approximately 2000 companies have publicly-traded debt that is rated by the rating agencies. Even then, bond price data is often difficult to get.

75

The Markets Valuation of Debt

The stock markets perception of the value of a firms equity are readily conveyed in a traded companys stock price The information contained in the firms stock price and balance sheet can be translated into an implied risk of default through two relationships: The relationship between the market value of a firms equity and the market value of its assets. The relationship between the volatility of a firms assets and the volatility of a firms equity.

76

KMV Credit Monitor Output

A quantitative estimate of the default probability called the expected default frequency (EDF).

EDFs are calibrated to measure the probability of a borrower defaulting within one year.

EDFs are reported in percentages ranging from 0 to 20.

77

KMV Model - Empirical Result

STEP 1 - Model Estimates Market Value and Volatility of Firms Assets

STEP 2 -

Then calculates the Distance-to-Default (# of Standard Deviations) Distance-to-Default is a Type of Asset/Liability Coverage Ratio

STEP 3 -

Distance-to-Default of a Firm is Mapped Against a Database of Empirical Frequencies of Similar Distance-to-Default Companies to Obtain Expected Default Frequency (EDF) for a Firm

78

Estimation of Market Value And Volatility of Firms Assets Asset Values are Based on Underlying Value of Firm, Independent of Firms Liabilities. Asset Volatility Calculated as the Annualized Standard Deviation of Percentage Changes in the Market Value of Assets. Equity Market Value and its Volatility, as Well as the Liability Structure, are Used as Proxies for the Assets Value and Volatility. Option Theory of Assets Used to Value Assets Since MV of Debt is Not Known. If Debt MV is Known, then A=E+D (MV). But, MV Assets are Calculated by Knowing Only the MV Equity and PV of Liabilities.
79

Estimation of Market Value And Volatility of Firms Assets

(continued)

KMV Assumes that All Short Term Debt and 50% of Long Term Liabilities Are Used to Calculate the Default Point (Was 25% of LTD). When MV Assets < Payable Liabilities then Firm Defaults. Firm Cannot Sell Off Assets or Raise Additional Capital Because All Existing Assets are Fully Encumbered.

80

KMV Strengths Can be applied to any publicly-traded company Responsive to changing conditions, (EDF updated quarterly) Based on stock market data which is timely and contains a forward looking view Strong theoretical underpinnings (versus ad-hoc models)

81

KMV Weaknesses Difficult to diagnose a theoretical EDF (what is the distribution of asset return outcomes) Problems in applying model to private companies and thinlytraded companies Results sensitive to stock market movements (does the stockmarket over-react to news?) Ad-hoc definition of anticipated liabilities (i.e.. 50% of longterm debt)

82

83

KMVS Expected Default Frequency (EDF)

Based on empirical observation of the Historical Frequency of the Number of Firms that Defaulted With Asset Values (Equity + Debt) Exceeding Face Value of Debt Service By a Certain Number of Standard (Std.) Deviations at one year prior to default. For Example: Current Market Value of Assets Expected One Year Growth in Assets Expected One Year Asset Value Standard Deviation Par Value of Debt Service in One Year Therefore: # Std. Deviations from Debt Service Expected Default Frequency (EDF)
EDF = Number of Firms that Defaulted With Asset Values 2 Std. Deviations from Debt Service Total Population of Firms With 2 Std. Deviations from Debt Service e.g.. = 50 Defaults 1,000 Population = .05 = EDF
84

= = = = = =

$ 910 10% $1,000 $ 150 $ 700 2

Comparing Z-Score and KMV-EDF Bond Rating Equivalents IBM Corporation

85

Diversification Based on Stock-Market Correlations (KMV)

Uses Contingent Claims Approach based on the level and volatility of common stock prices to assess the value of the equity and its potential distribution. Compare that distribution of equity values plus the level of debt (total assets) to the anticipated debt level in the future in order to attain the probability of default (assets < liabilities). Losses based on expected recoveries. Assess the correlation of each loans expected return based on correlations of stock prices and the unexpected losses from different combination of Loans. Observes the possible Sharpe Ratios (expected return spread / unexpected loss) on various combinations of loans with differential investments (weight) in each loan. Stipulates the official frontier portfolio.
86

BondScore (from Credit Sights) Credit Score Model

BondScore calculates credit risks on a weekly basis for all U.S. non-financial corporations with total assets in excess of $250 millions and publicly traded equity (approx. 2,200 issuers). The models output is a one year default probability estimate called Credit Risk Estimate or CRE. BondScore Credit Risk Estimates (CRE) are used in two capacities: to measure trend in credit risk migration; and to measure divergence from the rating agencies. BondScore helps to predict credit risk migration, spread movements and rating agency actions through its estimation of one year default probabilities. The BondScore model was created using 25 years of data on financial ratios, equity prices on defaults on over 2,000 issuers. A non linear logistic regression-based hybrid model, BondScore uses Altmantype financial ratios in addition to Merton-type equity inputs to predict defaults. Each of the models inputs were found to be significant predictors of default.
87

BondScore Model Inputs

EBITDA margin (EBITDA/Sales) Asset turnover (Sales/Assets) Leverage (debt including capitalized leases/equity market capitalization plus book value of debt) Size (log relative assets to all other BondScore issuers) Liquidity (Quick Ratio) Volatility of stock returns (standard deviation of error in beta equation; measures idiosyncratic volatility of issuer vs. pure volatility) Volatility of cash flow (standard deviation of EBITDA/Assets over past ten years)

88

Argenti (A Score System)

Defects In Management Weight 8 - Chief Executive is an autocrat 4 - He is also the chairman 2 - Passive Board - an autocrat assures this 2 - Unbalanced Board - too many engineers or too many finance types 1 - Poor management depth In Accountancy 3 - No budgets or budgetary controls 3 - No cash flow plans, or not updated 3 - No costing system. Cost and contribution of each product unknown 15 - Poor response to change, old fashioned product, obsolete factory, out-of-date marketing Total Defects 42 Pass 10
89

Argenti (A Score System)

Symptoms Weight 5 - Financial signs, such as Z Score 4 - Creative accounting. Chief executive is the first to see signs of failure, and in an attempt to hide it from creditors and the banks, accounts are glossed over by overvaluing stocks, using lower depreciation, etc. 3 - Non-financial signs, such as untidy offices, frozen salaries, chief executive ill, high staff turnover, low morale, rumors 1 - Terminal signs Total Symptoms Total Possible Score Total Score 0-10 0-25 10-18 18-35 >35 13 100 Pass Prognosis No Worry (High Pass) Pass Cause for Anxiety (Pass) Grey Zone - Warning Sign Company At Risk
90

25