Ratings

The analytical approach taken is essentially the same as for first-secured debt, full details of which are available in the article titled "European Recovery Rating Scale Methodology: 2005 Update", published May 19, 2005 on RatingsDirect. Consideration will be given, however, to specific features of the secured subordinated instrument.

In brief, our recovery-rating methodology contemplates a plausible simulated default scenario, generally where default is defined as a payment default. We then attempt to clearly identify the components of this scenario and the effect that each component has on revenue, costs, and EBITDA. The simulated default scenario in no way assumes or pretends to know how a specific issuer will default, if ever. Rather, our goal is merely to identify a plausible default scenario that aids us in deciding whether to use an enterprise valuation approach or a discrete asset valuation approach.

Our valuation methodology considers enterprise value analysis for borrowers that we believe are likely to restructure. We consider a discrete asset valuation either when there are discrete assets to value or when we believe there is a greater likelihood that the defaulting firm would liquidate. In practice, we believe that borrowers within the widely syndicated loan market have a greater likelihood of reorganizing then liquidating. We also believe, however, that the path a given borrower follows depends largely on the simulated default scenario.

After establishing our recovery valuation approach, we then evaluate the following additional factors, which might affect the final recovery rating:

• The amount of priority debt;
• The capital structure;
• The security package;
• Intercreditor terms; and
• The legal structure, especially the applicable insolvency regimes.

To arrive at the recovery value for a second-lien facility, we generally calculate coverage by subtracting the amount of first-priority debt that is expected to be outstanding at the point of default (and any other priority debt such as the present value of capital leases) from the valuation, and then divide by the fully drawn second-lien debt. This coverage calculation yields a coverage level that corresponds to a recovery rating. In addition, the final recovery rating assignment will depend on an evaluation of the legal structure, including consideration of advanced consents, waived rights, financial covenants, and standstill limitation provisions.

As of Dec. 15, 2006, Standard & Poor's has assigned recovery ratings to 125 European corporate senior secured loans with a par value of €121.9 billion. Of these, 29 were recovery ratings assigned to commercial and industrial loans secured by second-lien loans or bonds with a par value of €7.59 billion. Our European rated second-lien loan portfolio consists of 11 publicly rated loans or bonds (37.9% of the overall European portfolio) and 19 confidentially rated debt issues (62.1% of the portfolio). In more than 75% of these structures, the second-lien debt received a bank loan rating at least one notch lower than the corporate credit rating on the borrower and at least one notch lower than the bank loan rating assigned to the associated first-lien bank debt. The average recovery rating assigned to these rated first-lien debt issues is '2.2', while the average recovery rating assigned to the associated second-lien debt issues debt is '4.2' (see table 2 and the chart).

Table 2

European Recovery Ratings Distribution
Rating	First liens as % of facilities	Second liens as % of facilities
1+ (>100% recovery)	1.1	0
1 (>100%)	29	0
2 (80%-100%)	34.4	6.3
3 (50%-80%)	24.7	25
4 (25%-50%)	8.6	6.3
5 (<25%)	2.2	62.5
Total	100	100

Of the 29 recovery ratings assigned since launch to second-lien debt, 45% of these were second-lien loans which we will look at in more detail, with the remainder bonds. A key trend in the U.S. second-lien loan market has been that many second-lien loan agreements had become far less "silent" than either we, or many market participants, originally expected. There was a substantial increase in the use of separate credit agreements and of financial covenants included in widely syndicated second-lien bank loan credit agreements. For further information see "Second-Lien Evolution Creates Higher Recovery Prospects--At First-Lien Lenders' Expense," published on RatingsDirect on Aug. 22, 2005.

Since the beginning of the year, we have been investigating to what extent second-lien structures in Europe are mirroring those of the U.S. To date, as can be seen in tables 3 and 4, the result has been inconclusive. The rated market in European second-lien loans is very limited at this point and so far there are no signs that separate loan agreements are becoming prevalent in Europe.

Table 3

U.S. Loan Documentation
	Prior to Q1 2004	Q1 2004	Q2 2004	Q3 2004	Q4 2004	Q1 2005	Q2 2005	Q32005	Q4 2005	Q1 2006	Total
First/second-lien structure	6	21	15	17	21	20	22	15	29	15	181
Single document	3	7	8	5	5	1	1	1	1	0	32
Separate credit agreements	3	14	7	12	16	19	21	14	28	15	149
Separate %	50	66.7	46.7	70.6	76.2	95.0	95.5	93.3	96.6	100

Table 4

European Loan Documentation
	2003	2004	2005	2006
First/second lien structure	1	2	3	7
Single document	1	0	1	5
Separate credit agreements	0	2	2	2
Separate (%)	0	100	67	29

There are many unresolved questions about second-lien recovery, and indeed the recovery potential for the associated first-lien lenders. There is insufficient insolvency experience to confidently anticipate how either the insolvency process or the relationship between first- and second-lien lenders may affect ultimate recoveries in Europe. While at this point there does not seem to be the same trend of non-silent seconds, we recognize that because of the complications of the various European insolvency regimes, there is more tendency for informal restructurings rather than for bankruptcy filings. As a result, holders of European second-lien loans may turn out to have a significant nuisance value. Our recovery analysis and rated portfolio will continue to monitor, review, and integrate second-lien structural evolution.

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