Taiwan Ratings' 2008 Corporate Default And Rating Transition Study

2009/06/25

Primary Analyst:	Andy Chang, CFA; (886) 2 8722-5815 eunice_fan@taiwanratings.com.tw
Secondary Analyst:	Susan Chu; (886) 2 8722-5813 susan_chu@taiwanratings.com.tw

Coverage

Taiwan Ratings Corp.'s annual default and ratings transition study closely examines the track record of credit ratings assigned by Taiwan Ratings since it began operations in 1998. Our comprehensive study shows that the movement of ratings has followed a broadly similar pattern to Standard & Poor's Ratings Services' global experience; however, rating movements in Taiwan have been more volatile, particularly at lower rating levels. This study primarily measures ratings migration over time and provides a quantitative measure of ratings distribution and movement.

This report covers 220 issuer credit ratings assigned by Taiwan Ratings between 1998 and 2008, inclusive. The study analyzes the movement of ratings on Taiwan-based obligors--industrials, utilities, insurance companies, financial holding companies, banks, securities firms, and other financial institutions. The study includes public and confidentially rated entities, as well as those whose ratings were withdrawn after being assigned.

Key Findings

• The credit quality of rated obligors in Taiwan showed a downward trend in 2008, due to the negative impact of the global financial crisis and economic slowdown.
• We recorded two defaults in 2008--both were distressed financial institutions under the control of Taiwan's regulator. We view such defaults as continuing to demonstrate the drastic change in domestic financial market behavior along with the trend of flight to quality.
• The positive correlation between credit ratings transition and defaults is a valid foundation for ratings in Taiwan Ratings' pool, as it is for Standard & Poor's global pool. Nonetheless, our rated pool is considerably smaller, leading to unusually higher default rates.
• The transition of ratings issued by Taiwan Ratings in 1998-2008 broadly mirrors that of Standard & Poor's global study during 1981-2008, which reveals that higher-rated issuers exhibit greater stability in ratings movement than their lower-rated counterparts. However, it should be noted that the transition within our ratings pool tends to be faster and more volatile than Standard & Poor's global ratings pool, because of the difference between national and global rating scales and the statistical limitations of a smaller sample size and shorter rating history of Taiwan Ratings.

In General The Credit Quality Of Domestic Obligors Reflects The End Of The Upgrade Cycle In 2008

The credit quality of rated obligors generally followed a downward course in 2008, particularly in the second half of the year, when locally based corporate and financial institutions more deeply felt the affect of the global economic slow down and capital market dislocation. (see table 1 and chart 1)

Ratings Remain A Good Indicator Of Default Probability

The findings of our study generally support the existence of a positive correlation between rating levels and default probability--broadly similar to the observations of Standard & Poor's global study (see "2008 Annual Global Corporate Default Study And Ratings Transitions" published on www.ratingsdirect.com on April 2, 2009). Nonetheless, the overall default experience in our pool of rated entities will continue to develop, given the smaller sample size and shorter review period compared with Standard & Poor's global experience. Our study covers ratings migration for 220 entities as of the end of 2008 during 1998-2008 compared with Standard & Poor's global rated pool of 13,162 entities during 1981-2008 and Asia pool (excluding Japan) of 667 entities during 1988-2008. In particular, the default rates during the earlier years of Taiwan Ratings' established pool (before the end of 2002) are largely limited by the small rating base. (see table 2, table 3, and table4)

As a statistically smaller and less diversified ratings pool than Standard & Poor's global ratings pool, Taiwan Ratings' issuer rating pool has several distinct anomalies including:

• No default for 'twAA' rated or higher credits;
• More volatile rating movements in 'twBBB' rated or below credits, due to the very small sample in the first few years when Taiwan Ratings began rating services (33 issuers in Jan. 1999, 60 in Jan. 2000, and 86 in Jan. 2001); and
• No 'twCCC'-rated issuer in recent years, reflecting the lack of ratings penetration at the lowest end of the ratings ladder, and unusually high representation of financials in Taiwan's rating universe, whose business model can only survive in the higher rating categories.

Our pool of rated entities experienced a rise in defaults in 2007-2008 following the Taiwan government's action to cleanup weaker banks. Five rated issuers defaulted in 2007 and a further two defaulted in 2008. These figures included four issuers in selective default (SD) and three under regulatory supervision (twR). This is a big jump compared to the one default (placed on 'twR') observed in 2006, and has brought the total number of defaults in Taiwan's 10-year rating database to 11 (10 financial institutions and one industrial company).

The one bank with a 'SD' rating in 2008 was Chinfon Commercial Bank (rated 'twR' before 'SD'). The 'SD' rating on Chinfon reflects the bank's missing interest payments on outstanding subordinated debentures issued after July 2005. We placed our ratings on Chinfon on 'twR' in 2008 after the regulator took control of the bank. According to the law, Taiwan's Financial Restructuring Fund (FRF) will provide protection on deposit obligations as well as obligations specifically identified prior to July 2005.

The one issuer to be rated 'twR' in 2008 was Asia Trust & Investment Corp., which was placed under regulatory supervision due to the company's failure to meet regulatory capital requirements. We revised our ratings on the issuer to 'twR' from 'twB/Watch Negative/twB' following the regulator's intervention on the company's operations.

For the purpose of global consistency, financial institutions that are placed under regulatory supervision are classified as default records in this study. Placing a financial institution under regulatory supervision, or 'twR', however, does not necessarily indicate a default event but emphasizes that the regulator has the power to favor one class of obligations over others or to pay some obligations and not others.

Among the eight institutions rated 'twR' by Taiwan Ratings in 2000-2008, five had generally serviced their debt obligations as they did not have debts beyond the legal scope of the government's protection as defined by the relevant regulation (i.e. non-deposit debts issued after July 2005). The three that recorded 'SD' were The Chinese Bank, Bowa Bank, and Chinfon Commercial Bank.

Taiwan's Rating Transitions Largely Mirror Global And Regional Rating Trends

As mentioned above, our transition study shows a strong mirror to the observations by Standard & Poor's of rating movements on a global and regional scale. In particular, observations show that higher-rated issuers tend to exhibit less ratings volatility than their lower rated counterparts. For instance, the probability that a Taiwan issuer rated 'twAA' at the beginning of a year will be rated 'twAA' at the end of the year is 92.9% (see table 5), whereas the probability that an issuer rated 'twBB' at the beginning of a year will be rated 'twBB' at the end of the year is only 58.1%. The probability that a global issuer rated 'AA' will retain this rating after one year is 87.0%, whereas the probability that a global issuer rated 'BB' will retain this rating after one year is only 75.7%. The same relationship holds true among the Asia (excluding Japan) rated issuers.

Taiwan Ratings' higher-rated categories appear extremely stable, however, our lower-rated categories registered faster rating movements than those rated by Standard & Poor's, due to our smaller issuer rating pool and shorter observation period, as well as the volatility inherent in smaller or weaker financial institutions. Caution is required in interpreting the higher stability rates associated with the 'twCCC/twCC' rating category relative to the 'twB' rating category in light of the extremely small sample size. In addition, the somewhat high number of withdrawals diluted the rating stability at the 'twB' rating category (see table 6).

Global observations made by Standard & Poor's reveal that lower-rated credits generally move toward lower rating categories; however, lower-rated credits (or indeed most categories) in our pool tended to move up rather than down. This is mainly due to the large-scale rating adjustment we conducted in December 2004 to reflect important developments in the financial services industry, including the accelerating integration within financial holding company (FHC) groups, improvements in risk management across major participants, and continuing government support to maintain financial system stability. The adjustment also resulted in a lower downgrade-to-upgrade ratio for Taiwan Ratings' pool that averaged 0.3 times in 1999-2008 compared with 1.6 times for Standard & Poor's regional and global pools over the same period.

In part due to the relatively high preponderance of upgrades, the ratings in our domestic-oriented pool exhibited higher volatility than the ratings in Standard & Poor's global pool due to the smaller sample. The frequency range of annual rating changes in Taiwan was 12%-72% in 1999-2008 and averaged 34% over the same period (see table 7). This contrasts with the range of annual rating changes in Standard & Poor's global pool of 24%-34% in 1997-2008 and an average 30% over the same period (see table 8). Standard & Poor's Asia (excluding Japan) study also highlighted higher rating volatility, though this was offset to some extent by Standard & Poor's larger rating pool and longer observation period (see table 9).

Default implications of ratings transition

As the rating performance of Taiwan Ratings' scale continues to develop, including the size of the rated pool and the length of rating history, the default and rating transition is likely to closely mirror Standard & Poor's global study after its issuer pool undergoes testing through future business cycles. However, there remains a major difference in the implicit default risk between Standard & Poor's global scale and Taiwan Ratings' scale. Our scale is primarily positioned as the national scale and does not reflect sovereign risk (Taiwan is rated AA-/Negative/A-1+ by Standard & Poor's).

Based on Standard & Poor's historical observations, cumulative default rates may also be calculated for multi-year periods. Note the one-year and three-year default rate columns in table 10 are approximately equivalent to the level of the respective D (default) columns in table 11. The slight difference in results between the two tables mainly stems from slight variations in the static pools used to calculate transition to default and cumulative average default rates. Cumulative average default rates are the summary of all available static pools and are calculated using marginal default rates (conditional on survival), while the number of pools used in the average transition rate is limited by the transition's time horizon.

Appendix: Default Methodology And Definitions

This long-term corporate default and rating transition study uses the CreditPro® 7.72 database of long-term issuer credit ratings. An issuer credit rating reflects Taiwan Ratings' opinion of a company's overall capacity to pay its obligations (that is, its fundamental creditworthiness). This opinion focuses on the obligor's ability and willingness to meet its financial commitments on a timely basis, and it generally indicates the likelihood of default regarding all financial obligations of the firm. It is not necessary for a company to have rated debt in order to be assigned an issuer credit rating.

Although a company's senior secured debt (particularly debt with strong covenants) may occasionally be rated higher than the issuer credit rating on the company, specific issues are typically rated as high as or lower than the issuer rating, depending on their relative priority within the company's debt structure. For lower rated entities, the issuer credit ratings are generally two notches higher than the subordinated debt ratings; otherwise they are generally one notch higher. Therefore, though a 'twBB+' issuer credit rating is generally paired with a 'twBB-' subordinated debt rating, a 'twAA' issuer credit rating usually corresponds to a 'twAA-' subordinated rating.

Standard & Poor's ongoing enhancement of the CreditPro® database used to generate this study may lead to outcomes that differ to some degree from those reported in previous studies. However, this poses no continuity problem because each study reports statistics back to Dec. 31, 1998. Therefore, each annual default study is self-contained and effectively supersedes all previous versions.

Issuers Included In This Study

The study analyzed the rating histories of 220 companies that were rated by Taiwan Ratings as of Dec. 31, 1998, or that were first rated between that date and Dec. 31, 2008. These include industrials, utilities, insurance companies, FHCs, banks, securities firms, and other financial institutions in Taiwan with long-term credit ratings. The global data presented in this report refers to Standard & Poor's ratings histories of all 13,162 long-term rated issuers from Dec. 31, 1980 to Dec. 31, 2008. The Asia (excluding Japan) data refers to Standard & Poor's ratings histories of 667 long-term rated issuers from Dec. 31, 1992 to Dec. 31, 2008. The study includes non-confidentially and confidentially rated entities as well as those whose ratings were withdrawn after initial assignment. The analysis excludes public information (pi) ratings and ratings based on the guarantee of another company. Structured finance vehicles, public-sector issuers, and sovereign issuers are the subject of separate default and transition studies and are excluded from this study.

Subsidiaries whose debt is fully guaranteed by a parent or whose default risk is considered identical to that of their parents were excluded. The latter are companies whose obligations are not legally guaranteed by a parent but whose operating or financing activities are so inextricably entwined with those of the parent that it would be impossible to imagine the default of one and not the other. At times, however, some of these subsidiaries might not yet have been covered by a parent's guarantee, or the relationship that combines the default risk of parent and child might have come to an end, or might not have begun. Such subsidiaries were included for the period during which they carried a distinct and separate risk of default.

Definition Of Default

A default event is recorded on the first occurrence of a payment default on any financial obligation, rated or unrated, other than a financial obligation subject to a bona fide commercial dispute; an exception occurs when an interest payment missed on the due date is made within the grace period. Preferred stock is not considered a financial obligation; thus, a missed preferred stock dividend is not normally equated with default. However, we consider distressed exchanges as defaults whenever the debt holders are coerced into accepting substitute instruments with lower coupons, longer maturities, or any other diminished financial terms.

Issue ratings are usually lowered to 'D' following a company's default on the corresponding obligation. In addition, 'SD' is used whenever Taiwan Ratings believes that an obligor that has selectively defaulted on a specific issue or class of obligations will continue to meet its payment obligations on other issues or classes of obligations in a timely matter. A 'twR' issuer rating indicates that an obligor is under regulatory supervision owing to its financial condition. This does not necessarily indicate a default event, but the regulator may have the power to favor one class of obligations over others or pay some obligations and not others. 'D', 'SD', and 'twR' issuer ratings are deemed defaults for purposes of this study. A default is assumed to take place on the earliest of: the date Taiwan Ratings revised the ratings to D', 'SD', or 'twR'; the date a debt payment was missed; the date a distressed exchange offer was announced; or the date the debtor filed for or was forced into bankruptcy.

Static Pool Methodology

Taiwan Ratings conducts its default studies on the basis of groupings called static pools. Static pools are formed by grouping issuers by rating category at the beginning of each year covered by the study. Each static pool is followed from that point forward. All companies included in the study are assigned to one or more static pools. When an issuer defaults, that default is assigned back to all of the static pools to which the issuer belongs.

Taiwan Ratings uses the static pool methodology to avoid certain pitfalls in estimating default rates, to ensure that default rates account for rating migration, and to allow default rates to be calculated across multi-period time horizons. Some methods for calculating default and rating transition rates might charge defaults against only the initial rating on the issuer--ignoring more recent rating changes that supply more current information. Other methods may calculate default rates using only the most recent year's default and rating data--this method may yield comparatively low default rates during periods of high rating activity, as they ignore prior years' default activity.

The pools are static in the sense that their membership remains constant over time. Each static pool can be interpreted as a buy and hold portfolio. Because errors, if any, are corrected by every new update, and because the criteria for inclusion or exclusion of companies in the default study are subject to minor revisions as time goes by, it is not possible to compare static pools across different studies. Therefore, every new update revises results back to the same starting date of Dec. 31, 1998, to avoid continuity problems.

Entities that have had ratings withdrawn--that is, revised to N.R.--are surveyed with the aim of capturing a potential default. These companies, as well as those that have defaulted, are excluded from subsequent static pools.

For instance, the 1999 static pool consists of all companies rated as of 12:01 a.m. Jan. 1, 1999. Adding those companies first rated in 1999 to the surviving members of the 1999 static pool forms the 2000 static pool. All rating changes that took place are reflected in the newly formed 2000 static pool. This same method was used to form static pools for 2001 through 2008.
Consider the following example: An issuer is originally rated 'twBB' in mid-1998 and is downgraded to 'twB' in 2000. This is followed by a rating withdrawal (N.R.) in 2002 and a default ('D') in 2005. This hypothetical company would be included in the 1999 and 2000 pools with the 'twBB' rating assigned to it at the beginning of those years; likewise, it would be included in the 2001 and 2002 pools with the 'twB' rating. It would not be part of the 1998 pool because it was not rated as of the first day of that year, and it would not be included in any pool after the last day of 2002 because the rating had been withdrawn by then. Yet each of the four pools in which this company was included (1999-2002) would record its 2005 default at the appropriate time horizon.

Ratings are withdrawn when an entity's entire debt is paid off or when the program or programs rated are terminated and the relevant debt extinguished. This may also occur as a result of mergers and acquisitions. Other ratings are withdrawn because of a lack of cooperation, particularly when a company is experiencing financial difficulties and refuses to provide all the information needed to continue our surveillance on the ratings.

Default Rate Calculation

Annual default rates were calculated for each static pool: first in units, and later as percentages with respect to the number of issuers in each rating category. Finally, these percentages were combined to obtain cumulative default rates for the ten years covered by the study.

Issuer-weighted Default Rates

Averages that appear in this study are calculated based on the number of issuers rather than the dollar amounts affected by defaults or rating changes. Although dollar amounts provide information about the portion of the market that is affected by defaults or rating changes, issuer-weighted averages is a more useful measure of the performance of ratings.

Many people in the investment field use statistics from this default study and CreditPro® to estimate the probability of default and the probability of rating transition. It is important to note that we do not imply a specific probability of default; however, our historical default rates are frequently used to estimate these characteristics.

Cumulative Average Default Rate Calculation

Cumulative default rates that average the experience of all static pools are derived by calculating marginal default rates, conditional on survival (survivors being non-defaulters) for each possible time horizon and for each static pool, weight averaging the conditional marginal default rates, and accumulating the average conditional marginal default rates. Conditional default rates are calculated by dividing the number of issuers in a static pool that default at a specific time horizon by the number of issuers that survived (did not default) to that point in time. Weights are based on the number of issuers in each static pool. Cumulative default rates are one minus the product of the proportion of survivors (non-defaulters).

Time Sample

This update limits the reporting of default rates to the selected time horizon; however, the data has been gathered for ten years and all calculations are based on the rating experience of that period. The maturities of most obligations are much shorter than the selected time horizon. In addition, average default statistics become less reliable at longer time horizons as the sample size becomes smaller and the cyclical nature of default rates increases its effect on averages.

Default patterns share broad similarities across all static pools, suggesting that Taiwan Ratings' rating standards have been consistent over time. Adverse business conditions tend to coincide with default upswings for all pools. Speculative-grade issuers have been hit the hardest by these upswings, but investment-grade default rates also increase in stressful periods.
Transition Analysis

Transition rates compare issuer ratings at the beginning of a time period with ratings at the end of the period. To compute one-year rating transition rates by rating category, the rating on each entity at the end of a particular year is compared with the rating at the beginning of the same year. An issuer that remained rated for more than one year is counted as many times as the number of years it was rated. For instance, an issuer continually rated from the middle of 1998 to the middle of 2003 would appear in the four consecutive one-year transition matrices from 1999 to 2002. All 1999 static pool members still rated on Dec. 31, 2008, had nine one-year transitions, while companies first rated between Jan. 1, 2008, and Dec. 31, 2008 had only one.
Each one-year transition matrix displays all rating movements between letter categories from the beginning of the year through year-end. For each rating listed in the matrix's left-most column, there are nine ratios listed in the rows, corresponding to the ratings from 'twAAA' to 'D,' plus an entry for N.R.

Practical Application Of Transition Rates

Rating transition rates are useful to investors and credit professionals for whom rating stability is important. For instance, investors restricted by law or inclination to invest in top-grade bonds would want to assess the likelihood that Taiwan Ratings' analysts will continue to assign top ratings to their investments. Conversely, investors buying high-yield bonds in hopes of profiting from a rating upgrade would be able to gauge that expectation realistically.

The credit community might also use rating transition information, in part, to determine maturity exposure limits or to measure credit risk in the context of the value-at-risk models. Rating transition matrices could also be constructed to produce stressed default rates. Such matrices are often used in the area of credit risk measurement. In addition, multiyear transition matrices are valuable tools that can be used to forecast future rating distributions and may be better suited for certain applications than are one-year transition matrices.

Comparing Transition Rates With Default Rates

Rating transition rates may be compared with the marginal and cumulative default rates described in the previous section. For example, note that the one-year default rate column of Table 2 is equivalent to column 'D' of the average one-year transition matrix found in Table 5. Cumulative average default rates are the summary of all static pools from 1998 through 2008, while the number of pools used in the average transition rate is limited by the transition's time horizon.