Special Comment

April 2006

Contact Phone
New York
Gregory W. Bauer 1.212.553.1653
Ted Collins
Jack Dorer
John J. Kriz
Robert Riegel
Elizabeth Smith
Mark Watson
Bob Young

Assessing Corporate Governance As A Ratings Driver

For North American Financial Institutions

Summary Opinion
Moody’s implemented a series of initiatives intended to strengthen the quality of our fundamental credit analysis and
surveillance, following the large number of corporate defaults in 2001-2002. These initiatives included the hiring of
specialists and the launching of the Enhanced Analysis Initiative (EAI). As part of EAI, Moody’s has conducted system-
atic corporate governance reviews on more than 400 of the largest debt issuers in North America, including over 120
financial institutions.
As we have published our findings, we have tracked the degree to which corporate governance has been a key
driver to an issuer’s credit rating. In our recently published special comment, “Lessons Learned in Moody’s Experience in
Evaluating Corporate Governance in Major North American Issuers”(April 2006, 97401) we highlighted the overall fre-
quency of corporate governance as a ratings driver.
In that report, we pointed out that governance has been more of a ratings driver for financial institutions (FIs)
than for corporates. This trend reflects that FIs are relatively confidence-sensitive and that all of the FIs reviewed were
investment grade.
However, we have seen variation by sector within the overall FI universe. This comment describes the major fac-
tors that directed our overall categorization of companies, refining it by industry.
Our key findings include the following:
• Governance practices are heavily influenced by the ownership structures in each sector. The mutual com-
pany structure in the insurance industry, for example, presents governance issues that are different from
those associated with the family- ownership control structures so prevalent in the real estate investment
trust (REIT) sector.
• The level of regulatory burden faced by financial institutions varies significantly across sectors, and higher
levels tend to support higher quality governance.
• Board composition is characterized by the way the various industries in financial sectors have evolved in the
last decade. For example, banks typically still appoint customers and affiliated directors to their boards, even
as they grow more complex through acquisitions.
For several financial institution sectors, we have published detailed commentaries on the distinctive governance
issues we have seen (see Appendix 1).
Overview
As noted in earlier special comment, we have sought to categorize the impact of an issuer’s governance—relative to its
credit rating—in one of five ways:
• Governance is a credit strength
• Governance strengths from a creditor standpoint outweigh some weaknesses, but governance is not a rat-
ings driver at this time
• Corporate governance is neither a positive nor negative factor in our rating at this time
• Governance weaknesses from a creditor standpoint outweigh strengths, but concern on governance is not a
ratings driver at this time
• Governance is a credit challenge that could constrain future ratings improvements
• Below, we show the frequency with which we have placed issuers in these categories by sector, and com-
ment on the major factors driving our determinations.

Banking

Chart 1: Governance Categorization of Banks

0%
21%

Governance is a credit strength

42% Governance is relatively strong
Governance is neutral
Governance is relatively weak
21% Governance is a credit weakness

16%

As shows in Chart 1, for almost two-thirds of the 38 North American banks Moody’s has reviewed, governance was con-
sidered relatively strong or neutral as a ratings driver. For the remainder, governance was seen as being a relatively weak
ratings factor. For eight banks, however, governance was believed to be a potential constraint on the bank’s rating.
We have commented previously on some of the major governance features within banking.1 However, compared
with other sectors, the overarching factors that affected our views on this industry’s governance were the following:
• Strong regulatory framework provides solid foundation for governance. Banking regulators focus
heavily on controls and governance, and they set minimum requirements that go beyond those of most
other sectors. Tough enforcement powers enable regulators to seek fast—and sometimes extensive—reme-
dial action, where required.
• A number of banks have faced control failures and regulatory problems. A surprising number of banks
experienced control failures over the past few years, despite a strong regulatory framework. These failures
included a range of issues, such as weak compliance with anti-money laundering requirements, mutual fund
trading irregularities, and accounting problems.

1. See Moody’s, “Don’t Bank on Strong Governance: Observations on Corporate Governance in US Banks”, August 2005 (93743).

2 Moody’s Special Comment

 In many of those cases, regulators mandated numerous companywide changes relating to risk management and con-
trols, which we factored into our analysis as we weighed the strengths of subsequent improvements in these areas. Litiga-
tion settlements, mainly in banks’ capital markets activities, also highlighted weak governance and control structures.
• Less-than-ideal board composition due to tradition and industry consolidation. Bank boards, on
average, are larger than boards in other sectors. In Moody’s view, smaller boards are more effective. One
reason for the size of bank boards was the appointment of “constituent” or related directors, representatives
of corporate clients and, often, local real estate developers or lawyers.
This practice, albeit less common today, has limited a board’s ability to round out its director skill sets. It has also
translated into a lack of relevant industry and large public-company executive experience. The appointment of directors
who are former executives of acquired companies has also eroded the independence levels of boards in this industry.2

Insurance

Chart 2: Governance Categorization of Insurers

7%
14%

7% Governance is a credit strength

Governance is relatively strong
Governance is neutral
43% Governance is relatively weak
Governance is a credit weakness
29%

Governance practices in the insurance sector varied significantly, as we have noted previously.3 Our evaluations of 28
North American insurers were generally positive, with almost 22 being viewed as having positive or neutral governance,
as shown in Chart 2. However, for four insurers, governance was viewed as a potential constraint on their rating.
The key factors that influenced Moody’s view on governance in the industry included these:
• Regulatory problems suggested problems with general governance. The industry has faced a broad
range of regulatory investigations in recent years. These investigations, which range across a number of
areas and have been led by a disparate group of regulators, have made it difficult for Moody’s to assess the
quality of each firm’s governance and culture. Many of the investigations focus on matters that are arguably
tangential to corporate governance, such as the use of finite reinsurance and sales practices; nevertheless,
the nature of the allegations have raised relevant questions about potential problems with individual corpo-
rate cultures, in our view.
• The ownership structure of mutually held insurance companies has been interpreted as meaning
good governance for bondholders. The presence of mutual companies among the largest U.S. insurers
distinguishes the industry from other sectors, where the public traded company model is dominant. The
lack of any shareholder constituency means that executives of these companies are under limited pressure to
pay out dividends and are under no pressure to generate market-level returns similar to those of publicly
traded companies. Mutual insurers tend to have better capital cushions and retained earnings as a result.
Moreover, independent directors can design compensation plans that discourage higher-risk growth strate-
gies. On the other hand, concerns exist about director credentials compared with those of public companies
and the relative insularity of these firms raise questions about a timely board response to any potential
threats to the business.

2. Moody’s employs a narrower definition of director independence than the major U.S. stock exchanges, which typically consider a former manager independent after
three to five years of retiring from their post. We usually deem these directors as less than fully independent.
3. See Moody’s “No Assurance of Good Governance: Observations on Corporate Governance in the U.S. Insurance Sector”, October 2005 (94705s)

Moody’s Special Comment 3

Real estate finance and Government Sponsored Entities (GSEs)

Chart 3: Governance Categorization of Real

Estate Finance Firms & GSEs
5% 11%
16%
Governance is a credit strength
21% Governance is relatively strong
Governance is neutral
Governance is relatively weak
Governance is a credit weakness

47%

Real Estate Investment Trusts (REITs)

Moody’s has highlighted previously the distinct governance features of real estate investment trusts (REITs).4 The key
factors influencing our view on governance within the 15 U.S. REITs reviewed included the following:
• A high proportion of large individual or family shareholders. The presence of these shareholders was
seen to help bondholders, due to a closer alignment of managerial and long-term shareholder interests,
which we believe to benefit bondholders. Several REITs have remained under the control of the founding
family or individuals, which highlights a strong, long-term commitment to the underlying financial health
of the REIT. This alignment of interests between management and shareholders, which is patently less
prevalent in more widely held firms, has provided stability and has enabled management to focus on long-
term growth, thus protecting the interests of debtholders.
• Higher-than-average presence of insider directors has revealed potential board challenges. The
presence of insiders (former management) or controlling family members on the board often constrained
board independence, in Moody’s view. It also created oversight challenges for independent directors and
could have dissuaded criticism of past strategies. The board’s influence on the CEO’s succession planning
was seen as being more limited, in certain cases.
• More formal, robust governance practices. A number of REITs have improved governance by rounding
out director skill-sets and structuring their board practices more efficiently. These improvements included
the addition of independent directors and directors with financial expertise, as well as the appointment of a
lead independent director. These changes have led to a higher level of board engagement on strategy and
have strengthened audit and internal controls.

Government Sponsored Entities (GSEs)

Within the real estate finance portfolio, we also reviewed the four largest Government Sponsored Entities (GSEs).
Two distinct factors influenced our views on the governance of these entities:
• Fannie Mae and Freddie Mac suffered significant accounting, control and governance failures in
recent years. The extent of the problems was broad, with subsequent, wholesale changes in management
and governance practices. The wide scope of the problems is best illustrated by the extended restatement
periods and continued management turnover. Regulatory and other investigations are ongoing.
• The cooperative structure of the FHLBank System and Farm Credit Administration has let to both
governance strengths and weaknesses. Both systems have unique structures built upon cooperative own-
ership by system borrowers. These structures provided for an additional level of oversight among the sys-
tem’s institutions and by their members, to varying degrees. The fact that the system’s banks are jointly and
severally liable for the securities issued by the system was seen as a significant benefit for bondholders.

4. See “Observations of governance in U.S. REITs—some weaknesses but getting better”, September 2005 (94031)

4 Moody’s Special Comment

 However, by design, these structures labor under the following constraints: (a) limited board independence;
(b) no integrated leadership; and, (c) limited systemwide succession planning.

Financial guarantors and mortgage insurers

Chart 4: Governance Categorization of Financial

Guarantors and Mortgage Insurers

0%

17% 8%

Governance is a credit strength

Governance is relatively strong
Governance is neutral
33%
Governance is relatively weak
Governance is a credit weakness

42%

Governance was not seen as a negative ratings driver for any of the financial guarantors or mortgage insurers that
Moody’s has reviewed, as shown in Chart 4. This was not surprising, given the fact the high ratings assigned to these
companies are integral to their business models. The quality of governance practices varied, nonetheless. Key factors
influencing our overall view included the following:
• The financial guarantor sector includes a diverse range of ownership and governance structures.
Ownership structures have undergone change at a number of these firms. As a consequence, there was a
marked variety in the approach to governance and the degree to which governance practices are embedded
across the firm. For the start-up firms, practices were still taking shape and will be doing so for some time.
In contrast, the long-standing public companies have had more time to develop and test their processes.
The quality of governance for those entities that were subsidiaries of public companies was strengthened by
the governance requirements placed on the parent companies. Moody’s took into account differing owner-
ship structures in evaluating governance. However, we had relatively strict expectations of governance prac-
tices, given the high ratings assigned to these firms.
• Conservative management culture has been found to benefit creditor interests, given the impor-
tance of credit ratings to strategy. The importance of financial guarantors’ financial strength to the fran-
chise and underlying value of the business was seen as aligning shareholder and creditor interests more
closely. This alignment eased some of our overriding governance concern about management acting in the
interests of shareholders, to the detriment of creditor interests. The same is true for the mortgage insurers,
albeit to a lesser extent.

Moody’s Special Comment 5

Finance and securities companies

Chart 5: Governance Categorization of Finance

Companies and Securities Firms

20%
30%

0% Governance is a credit strength

Governance is relatively strong
Governance is neutral
Governance is relatively weak
Governance is a credit weakness
30%
20%

This group of 10 companies included a range of subsectors and ownership structures. The key factors influencing our
view on the quality of governance included the following:
• For several finance companies owned by major corporates, the main issue was the degree to which
governance structures created some independence from the parent company. The governance struc-
tures for General Motors Acceptance Corp. and Ford Motor Credit Company were relatively distinct, at
least when compared to a typical subsidiary in a corporate structure. The governance “independence”
helped support our existing view that a rating differential between the ratings of these entities’ and their
parents’ ratings is warranted. In contrast, the tight integration of governance and operations between Gen-
eral Electric Capital Corp. and its parent supported our existing view that their ratings are inseparable from
a ratings perspective.
• For a couple of securities firms, succession planning was a critical concern. Moody’s has reviewed the
governance practices in all of the major securities firms, but we have not yet categorized the effect of gover-
nance on all of the firms. For two, we have done so: Morgan Stanley and Charles Schwab. In these cases,
succession planning was a critical factor influencing our view. This highlights the importance of talent
development and retention as key ratings issues in this industry.
• For many firms in this sector, executive pay plans reflected a strong focus on shareholder returns
and incentives linked closely to share price and EPS. For firms like Capital One and SLM, executive
and director compensation was focused heavily on shareholder metrics and concerns. Certain firms use
stock options aggressively and earnings per share (EPS) as their chief performance metric for long-term
compensation. We believe such shareholder-focused plans can foster a shorter-term management focus,
which can conflict with bondholder interests.

6 Moody’s Special Comment

Related Research
Rating Methodology:
Rating Methodology: U.S. and Canadian Corporate Governance Assessment, July 2003 (78666)
Special Comments: General
The Downside of Incentive Pay for Directors, April 2006 (97174)
Lessons Learned in Moody’s Experience in Evaluating Corporate Governance at Major North American Issuers,
April 2006 (97104)
Moody’s Response to Rated Companies Receiving SEC Wells Notices, October 2005 (94627)
CEO Compensation and Credit Risk, July 2005 (93592)
Takeover Defenses and Credit Risk, December 2004 (89713)
Moody’s Findings on Corporate Governance in the United States and Canada, October 2004 (89113)
Special Comments: Sector Specific
Evaluating The Rating Significance Of Regulatory Actions Against U.S. Banks, April 2006 (97230)
No Assurance of Good Governance: Observations on Corporate Governance in the U.S. Insurance Sector,
October 2004 (94705)
Observations of governance in U.S. REITs - some weaknesses but getting better, September 2005 (94031)
“Don’t Bank on Strong Governance: Observations on Corporate Governance in US Banks”, August 2005 (93743)

Moody’s Special Comment 7

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Report Number: 97279

Authors Production Associate

Constantine Nestoras Tara Cheparev
Elizabeth Smith
Mark Watson

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8 Moody’s Special Comment