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1 Fitch Risk and Performance Monitor The following commentary is part of a periodic analysis of recent Credit Default Swap market activity and results generated by Fitch's proprietary Market Implied Ratings models. All data presented below is derived from CDS prices provided by Fitch's CDS Pricing Service and Market Implied Ratings models. The contents of this page are not indicative of the opinions, commentaries, or analyses of Fitch's rating analysts, and are therefore separate and distinct from rating analyst activity, actions and opinions. Nothing in this commentary is a recommendation to buy, sell, or hold any security. Unless otherwise noted, all references to CDS pricing and CDS Market Implied Ratings are as of the date of this analysis. To receive highlights of the information on this page delivered directly to your inbox, please register here. 05 September 2008 In this week s special Risk Performance Monitor, we examine the effectiveness of using the Fitch CDS Implied Rating (CDS IR) model to anticipate agency rating actions. The following analysis observes how differences between CDS IRs and Agency Ratings (AR), expressed as notch differentials, can be used to predict future agency rating actions. The analysis finds that by observing the notch differentials, the CDS IR effectively anticipates rating actions and is therefore a valuable tool for portfolio monitoring and investment decision-making. Background - CDS Implied Ratings at a Glance As a marketplace for single-entity default risk, the Credit Default Swap market holds tremendous potential for fixed income risk and relative value assessments. In theory, a CDS spread contains information about both the absolute and relative risk levels of a given entity, as well as the market s appetite for risk. Like all market prices, however, disaggregating a spread into its probability of default, loss given default, and liquidity premium is extremely difficult, if not impossible, in practice. Compared to other, long established marketplaces, the CDS market poses several unique challenges. Chief among these is the fact that the spreads which best reflect market sentiment for a given entity are not always comparable across firms, meaning any analysis comparing spread levels across the market runs the risk of either entering basis differentials or leaving-out valuable market information. Further clouding the ability to derive insights is the fact that the CDS market is dominated by a handful of major financial institutions with massive notional positions. This concentration of market activity leads to a high degree of technical spread movement that often has little to do with an entity s sustainable spread level. Utilizing data from Fitch CDS Pricing Services, the Fitch CDS Implied Ratings model endeavors to control for these and other challenges. The resulting model controls for market noise in three ways: 1. Determines the risk of an entity relative to the rest of the market, as opposed to calculating a discreet probability of default and/or loss-given-default. 2. Analyzes the best spread for each entity on a like-for-like basis, where relative comparisons are performed only for entities with the same restructuring type and currency. 3. Assesses recent historical trading patterns of spreads rather than spot or end-of-day spread levels. Launched in 2007, the Fitch CDS Implied Ratings model produces a collective market consensus view of a single entity s credit condition, expressed on an agency rating scale from AAA to CCC. In terms of performance, we find the model is well-calibrated to agency ratings in general, as, on average, ~90% of all CDS IRs are within 2 notches of their agency rating. While there is a high-degree of consistency, we also find that the model is a good early warning signal as 52% percent of all rating actions were anticipated by the CDS IR within 3 months of the action. Lastly, we find that the CDS IR model does an excellent job of rank ordering potential defaulters, outperforming both agency ratings and other publicly available models in default prediction accuracy. For more detailed information regarding the Fitch CDS IR model and its performance, please refer to the CDS IR Model methodology document. More recently, FitchSolutions researchers have been investigating the relationships between CDS IR levels and agency rating actions, the details of which are below.

2 Notch Differential Analysis The differences between agency ratings and CDS IRs can be categorized by the number of notches apart the CDS IR is from the agency rating on a traditional ratings scale. For example, if the CDS IR for company X is A-, while the AR is BBB-, the notch differential, or, is +3 notches. On the other hand, if the CDS IR for Company Y is BBB- while the AR is A-, the is then -3 notches. The matrix below provides a visual illustration of notch differentials. Agency Rating A- 0 1 notch 2 notch BBB+ BBB A- BBB+ BBB BBB- BBB- -1 notch -2 notch -3 notch 0 1 notch -1 notch -2 notch 0-1 notch 3 notch 2 notch 1 notch 0 Using the notch categorization outlined above, we next calculate the notch differentials for each entity in the CDS IR universe. For this analysis we re interested in determining the rate of upgrades, downgrades and no changes from the first instance of the notch being observed over 1 year and 3 year time horizons. By observing the rate of agency actions from the first instance of each notch differential across all entities we can then determine the probability of upgrade, downgrade and no change for each CDS IR movement. The analysis was performed on rating actions observed between January 2001 and July Results: A Strong Direct Relationship Between Gaps and Future Rating Actions The charts below show the rate of agency actions by each notch differential category over a 1 year and 3 year horizon. The analysis demonstrates a strong direct relationship between the CDS IR level and future Agency Rating action. At the 0 notch differential level we observe nearly random agency actions, while the rate of actual agency downgrades steadily increases as the negative notch differential (CDS IR worse than AR) increases. Similarly, the rate of upgrades greatly increases as the notch differentials become more positive. These same trends are even more pronounced within the 3 year horizon.

3 Looking at the individual notch results, we can infer that once a -3 notch is established (e.g. the CDS IR is 3 notches lower than the AR), there is a 51% chance that an entity will experience a downgrade within 1 year. When we perform the same analysis within a three year window, we find that 67% of entities with a -3 notch are downgraded within 3 years. We also find that at a -2 notch differential, we see a nearly 48% chance of a firm being downgraded within one year. On the positive side, when observing a +3 notch (e.g. the CDS IR is 3 notches higher that the AR), we see that over 45% of entities receive an upgrade within one year. Again, looking at a 3 year horizon, we find that nearly 70% of the entities with a +3 notch experience an agency rating upgrade.

4 Case Studies In order to illustrate how the results of the study have played out in recent history, we examine two cases where s successfully predicted agency rating actions. In the chart above, we see that UBS had sustained a negative one notch for at least two months before being rapidly downgraded three times by the CDS IR model in November 2007, resulting in a -4 notch. As we would expect, UBS was consequently downgraded by Fitch Ratings on December 12th, Despite the rating action, the lingering -3 notch, suggested a better than 50% chance of a future downgrade. True to this prediction, and after experiencing two more CDS IR downgrades to widen the to -5 notches, UBS was downgraded by Fitch, S&P and Moody s on April 1st.

5 Hess Corporation exemplifies where positive s, reflecting perceived credit strengthening in the CDS market, accurately predicted an agency rating upgrade within one year. Hess showed a +2 notch, signaling a 43% probability of an upgrade, in September 2007, nearly 8 months before both Fitch and Moody s upgraded the entity. In this case, the CDS IR signaling quality was further improved upon as Hess Corporation s positive increased to +3 a little over a month prior to the Fitch upgrade. Implications for investors By providing the ability to better anticipate future agency rating actions, the CDS IR model can be utilized as an investment screening, portfolio monitoring and risk management tool. This is especially true of investors targeting a specific portfolio credit quality profile. While no model is perfectly accurate, when appropriately harnessed and interpreted, the signals provided by the CDS market can improve an investor s ability to anticipate events among portfolio entities. By enhancing the ability to anticipate future rating actions, portfolio managers can improve their decisions on whether to increase, decrease or maintain exposure to specific names and therefore better meet investment objectives. Companies on Alert The table below lists ten companies with CDS IRs three or more notches away from their Agency Ratings. The first five corporations are experiencing a positive three notch, implying a 45% chance of an agency rating upgrade within one year and a 69% chance within three years of the date on which the first instance of the occurred. The remaining five names, in shaded rows, are potential candidates for agency rating downgrades, showing -3 and -4 notch s.

6 Companies on Alert The table below lists ten companies with CDS IRs three or more notches away from their Agency Ratings. The first five corporations are experiencing a positive three notch, implying a 45% chance of an agency rating upgrade within one year and a 69% chance within three years of the date on which the first instance of the occurred. The remaining five names, in shaded rows, are potential candidates for agency rating downgrades, showing -3 and -4 notch s. Rohm & Haas Company A+ BBB+ 3 8/21/08 13 Oracle Corporation AA A 3 7/16/08 39 Motorola BB BBB -3 8/19/08 15 Toll Brothers, Inc. BB BBB -3 4/18/ Societe Generale A- AA- -3 7/15/08 40 IKB Deutsche Bank AG BB- BBB- -3 9/1/08 6 JP Morgan Chase BBB+ AA /27/ Source: Fitch Solutions CDS IR CDS IR Alert List AR Gap Gap since Gap duration (business days) Hasbro, Inc. A BBB 3 8/8/08 22 Loew's Corporation AA A 3 4/21/ Sony Corporation AA- A- 3 5/30/08 72

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