1. Corporate Credit Scoring Models

2. 2 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 (Moody’s), Z” Score) –EM Score (4) - Emerging Markets, Industrial –Other - Bank Specialized Systems

3. 3 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 –Moody’s Risk Cal –Bond Score (Credit Sights) –Z-Score (Market Value Model)

4. 4 Key Industrial Financial Ratios (U.S. Industrial Long-term Debt)

5. Source: Moodys

7. 7 Forecasting Distress With Discriminant Analysis Linear Form Z = a 1 x 1 + a 2 x 2 + a 3 x 3 + …… + a n x n Z = Discriminant Score (Z Score) a 1 a n = Discriminant Coefficients (Weights) x 1 x n = Discriminant Variables (e.g. Ratios) Example x x x x x x x x x x x x xxx x x x x x x x x x x x x x x x x x x x x x xx x EBIT TA EQUITY/DEBT

10. Altman 1968

11. Confusion Matrix Group1 – bankrupt, Group2 – non-distressed

12. Confusion matrix

14. How do we approximate the Discriminant Model?

16. 16 Z Score Bankruptcy Model Z =.012X 1 +.014X 2 +.033X 3 +.006X 4 +.999X 5 e.g. 20.0% Z = 1.2X 1 + 1.4X 2 + 3.3X 3 +.6X 4 +.999X 5 e.g. 0.20 X 1 = Current Assets - Current Liabilities X 4 = Market Value of Equity Total Assets Total Liabilities X 2 = Retained Earnings X 5 = Sales( = # of Times Total Assets Total Assets e.g. 2.0x) X 3 = Earnings Before Interest and Taxes Total Assets

17. 17 Zones of Discrimination: Original Z - Score Model Z > 2.99 - “Safe” Zone 1.8 < Z < 2.99 - “Grey” Zone Z < 1.80 - “Distress” Zone

18. 18 Average Z-Score by S&P Bond Rating S&P 500: 1992 - 2005 Source: Compustat Database

19. 19 All Rated Corporate Bonds* 1971-2008 Mortality Rates by Original Rating *Rated by S&P at Issuance Based on 2,137 issues Source: Standard & Poor's (New York) and Altman’s Compilation

20. 20 All Rated Corporate Bonds* 1971-2008 Mortality Losses by Original Rating *Rated by S&P at Issuance Based on 1,805 issues Source: Standard & Poor's (New York) and Altman’s Compilation

21. 21 Classification & Prediction Accuracy Z Score (1968) Failure Model* 1969-19751976-1995 1997-1999 Year Prior OriginalHoldout Predictive Predictive Predictive To Failure Sample (33)Sample (25) Sample (86) Sample (110) Sample (120) 1 94% (88%) 96% (72%) 82% (75%) 85% (78%) 94% (84%) 2 72% 80% 68% 75% 74% 3 48% - - - - 4 29% - - - - 5 36% - - - - *Using 2.67 as cutoff score (1.81 cutoff accuracy in parenthesis)

22. 22 Z Model Applied to GM Shows a Decreasing Trend in the Bond Rating Equivalents from 2004 - 2008

23. 23 Z Model Applied to Ford Shows a Decreasing Trend in Z score from 2004 - 2008

24. 24 Z” Model Applied to GM Shows a Decreasing Trend in the Bond Rating Equivalents from 2004 - 2008

25. 25 Z” Model Applied to Ford Shows an Increasing Trend in the Bond Rating Equivalents from 2004 - 2008

26. 26 Z’ Score Private Firm Model Z’ =.717X 1 +.847X 2 + 3.107X 3 +.420X 4 +.998X 5 X 1 = Current Assets - Current Liabilities Total Assets X 2 = Retained Earnings Total Assets X 3 = Earnings Before Interest and Taxes Total Assets X 4 = Book Value of EquityZ’ > 2.90 - “Safe” Zone Total Liabilities 1.23 < Z’ < 2.90 - “Grey” Zone X 5 = SalesZ’ < 1.23 - “Distress” Zone Total Assets

27. 27 Z’’ Score Model for Manufacturers, Non-Manufacturer Industrials, & Emerging Market Credits Z’’ = 6.56X 1 + 3.26X 2 + 6.72X 3 + 1.05X 4 X 1 = Current Assets - Current Liabilities Total Assets X 2 = Retained Earnings Total Assets X 3 = Earnings Before Interest and Taxes Total Assets X 4 = Book Value of EquityZ’’ > 2.60 - “Safe” Zone Total Liabilities 1.1 < Z’’ < 2.60 - “Grey” Zone Z ” < 1.1 - “Distress” Zone

28. 28 EDF Equivalent Rating CC CCC B BB BBB A AA AAA Enron Credit Risk Measures Source: A. Saunders and L. Allen, Credit Risk Measurement; J. Wiley, 2002

29. 29 Comparing Z-Score and KMV-EDF Bond Rating Equivalents IBM Corporation