S&P Viewpoint

Recovery ratings focus solely on expected recovery in the event of a payment default of a specific issue and use a numerical scale that runs from '1+' to '6'. The recovery rating is not linked to, or limited by, the issuer credit rating or any other rating and provides a specific opinion about the expected recovery prospects. Standard & Poor's recovery rating analysis for non-sovereigns generally compares the nominal value expected to be received at the end of the workout period or bankruptcy to exposure at default, the latter defined as principal plus accrued and unpaid interest at the point of default.

For sovereigns, political considerations and difficulties in obtaining and enforcing judgments create the possibility of protracted workout periods. Given the potential for significant accumulation of past-due interest in some sovereign defaults, and the prevalence of maturity extensions in sovereign workouts, we express the expected recovery rate for sovereign issuers in terms of net present value (NPV). The approach for sovereigns is equivalent to discounting both the remaining scheduled payments under the original debt instrument and the recovery given default at a post-restructuring discount rate.

Standard & Poor's recovery ratings, although informed by historical data (including our proprietary LossStats™ database for the U.S.) showing average recovery experience, are based on a fundamental issuer- and instrument-specific, scenario-based recovery analysis.

Once we have extended recovery rating coverage to a given sector and debt type, generally all new debt instruments issued by speculative-grade entities will be assigned recovery ratings as part of the assignment of their issue ratings. The analysis of these two elements--the likelihood of default, already incorporated in the issuer credit rating, and the expected recovery rate--are the integral components of the issue credit rating. We will, therefore, assign the issue rating based on the issuer credit rating as adjusted, if appropriate, per the recovery rating and the guidelines shown in table 1. This process will be applied for debt across the capital structure once the roll-out is complete, i.e., secured, unsecured, and subordinated debt will be rated based on the issuer credit rating and recovery rating.

We will continue to place primary emphasis for the issue rating on the likelihood of default, and the instrument rating will be higher, lower, or equal to the issuer credit rating based on the specific issue's recovery expectations relative to the long-term average recovery rate for unsecured debt, rather than based on relative position in insolvency. We have "re-based" the issue rating around a central recovery tendency of approximately 50%. Therefore, issues with recovery rates significantly above 50% (i.e., with an expected recovery rate of 70% or above) will be rated higher than the issuer credit rating, and those significantly below 50% (expected recovery rate of 30% or below) will be rated below the issuer credit rating.

Recovery ratings will not be applied to securitizations, including corporate securitizations, or to covered bonds, all of which will continue to be rated based on asset-specific criteria.

The distinctive characteristics of particular jurisdictions' insolvency regimes have a significant effect on the amounts ultimately recovered by both secured and unsecured creditors, the time to recover such amounts, and the overall predictability of the process. In addition, for most jurisdictions outside the U.S., there is very little reliable historical default and recovery data available to verify in practice the predictability of insolvency proceedings and actual recovery rates.

To consistently incorporate this legal analysis in our recovery and issue ratings consistently, we are reviewing all significant jurisdictions to assess how insolvency proceedings in practice affect post-default recovery prospects. We have reviewed 12 systems so far and expect to analyze and classify a total of about 40 before year-end.

The general concept is to cap both the recovery and issue ratings in countries where we expect the recovery process and actual recovery rates to be negatively affected by weak insolvency regimes. Further guidance on our approach to classifying insolvency regimes and related recovery and issue rating guidelines will be included as part of the roll-out for industrial and financial service recovery ratings.

For investment-grade issuers (those rated 'BBB-' or higher), it is more difficult to predict a path to default and, therefore, to perform a scenario-based, firm- and instrument-specific recovery analysis. We believe some markets have less interest in such analysis, given the lower likelihood of default. We expect to assign recovery ratings on selected investment-grade issuers with secured debt obligations, as we have for some time on utility first-mortgage bonds. Otherwise, we would assess instrument recovery based on class-level recovery assumptions and incorporate these in the issue rating. For example, subordinated debt of investment-grade issuers will generally continue to be rated one notch lower than the issuer credit rating. Very well-secured debt could be rated higher than the issuer credit rating. For example, first-mortgage bonds of investment-grade utilities can be rated up to two notches above the issuer credit rating.

Once we have rolled out recovery ratings on unsecured and subordinated debt (expected by fourth quarter 2007), speculative-grade preferred stock and equity hybrids will be rated based on instrument-specific recovery prospects. However, we expect few rating changes based on this shift. We expect most such instruments of speculative-grade issuers to receive a recovery rating of '6' on the revised scale (0% to 10% recovery after a default), which implies being rated two notches below the issuer credit rating for purposes of reflecting ultimate recovery prospects, similar to the two-notch cut these instruments have historically received for subordination.

Currently, we also reflect heightened payment risk represented by deferral features in rating equity hybrids. Therefore, in addition to adjusting the issue rating on equity hybrids to account for ultimate recovery prospects, we would also make further adjustments to reflect deferral features. Our current convention is to rate such instruments at least one additional notch lower to account for the deferral risk. For example, a preferred stock with a recovery rating of '6' would typically be rated three notches below the issuer credit rating: two notches for negligible ultimate recovery prospects, and one notch for the deferral feature. When we have heightened concerns that the issuer may defer--whether because of the exercise of its right to defer optionally, the breaching of a mandatory deferral trigger, or the exercise of the prerogatives of a regulator--we increase the gap between the issuer credit rating and the issue rating, and we do not impose any arbitrary limit on the size of the gap. (See " Criteria: Assigning Ratings To Hybrid Capital Issues," published March 28, 2006.)

The enhancements described above do not have a significant effect on CDO analytical methodology or on CDO ratings. Under our current CDO methodology, we consider the default probability to be driven by the issuer rating for industrial, financial, and sovereign debt. The recovery expectations are asset-specific, based on the seniority and security of the asset. In an Oct. 17, 2006, article titled " CDO Spotlight: Using Standard & Poor’s Recovery Ratings in Cash Flow CDOs," we highlighted that CDO managers have an option to incorporate our recovery ratings as the source of recovery estimates for CDO purposes. We expect to release a separate commentary updating guidelines on the use of recovery ratings in cash flow CDOs.