The handbook of credit risk management originating, assessing, and managing credit exposures

The Handbook of Credit Risk Management ffirs.indd 11/14/2012 10:12:43 PM Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States With offices in North America, Europe, Australia, and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers’ professional and personal knowledge and understanding The Wiley Finance series contains books written specifically for finance and investment professionals as well as sophisticated individual investors and their financial advisors Book topics range from portfolio management to e-commerce, risk management, financial engineering, valuation and financial instrument analysis, as well as much more For a list of available titles, visit our website at www.WileyFinance.com ffirs.indd 11/14/2012 10:12:43 PM The Handbook of Credit Risk Management Originating, Assessing, and Managing Credit Exposures Sylvain Bouteillé Diane Coogan-Pushner John Wiley & Sons, Inc ffirs.indd 11/14/2012 10:12:43 PM Cover design: Leiva-Sposato Cover image: © Jason Reed/Getty Images Copyright © 2013 by Sylvain Bouteillé and Diane Coogan-Pushner All rights reserved Published by John Wiley & Sons, Inc., Hoboken, New Jersey Published simultaneously in Canada No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, (978) 750-8400, fax (978) 646-8600, or on the Web at www.copyright.com Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) 748-6011, fax (201) 748-6008, or online at http://www.wiley.com/go/permissions Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose No warranty may be created or extended by sales representatives or written sales materials The advice and strategies contained herein may not be suitable for your situation You should consult with a professional where appropriate Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages For general information on our other products and services or for technical support, please contact our Customer Care Department within the United States at (800) 762-2974, outside the United States at (317) 572-3993 or fax (317) 572-4002 Wiley publishes in a variety of print and electronic formats and by print-on-demand Some material included with standard print versions of this book may not be included in e-books or in print-ondemand If this book refers to media such as a CD or DVD that is not included in the version you purchased, you may download this material at http://booksupport.wiley.com For more information about Wiley products, visit www.wiley.com Library of Congress Cataloging-in-Publication Data: Bouteillé, Sylvain The handbook of credit risk management : originating, assessing, and managing credit exposures / Sylvain Bouteillé, Diane Coogan-Pushner p.  cm — (Wiley finance series)  Includes index ISBN 978-1-118-30020-6 (cloth); ISBN 978-1-118-42146-8 (ebk); ISBN 978-1-118-43389-8 (ebk); ISBN 978-1-118-30020-6 (ebk) 1.  Credit—Management.  2. Risk management. I.  Coogan-Pushner, Diane. II.  Title HG3751.B68 2013   332.7—dc23 2012032288 Printed in the United States of America 10 ffirs.indd 11/14/2012 10:12:43 PM To my wife, Setsuko; my sons, Pierre and Franỗois; and my parents —Sylvain Bouteillé To my Dad —Diane Coogan-Pushner ffirs.indd 11/14/2012 10:12:43 PM Contents Preface xiii Acknowledgments xxi Part One Origination Chapter Fundamentals of Credit Risk What Is Credit Risk? Types of Transactions That Create Credit Risk Who Is Exposed to Credit Risk? Why Manage Credit Risk? Chapter Governance Guidelines Setting Limits Skills Oversight Chapter Checklist for Origination Does the Transaction Fit into My Strategy? Does the Risk Fit into My Existing Portfolio? Do I Understand the Credit Risk? Does the Seller Keep an Interest in the Deal? Are the Proper Mitigants in Place? Is the Legal Documentation Satisfactory? Is the Deal Priced Adequately? Do I Have the Skills to Monitor the Exposure? Is There an Exit Strategy? 3 18 21 22 25 26 29 33 34 35 36 37 38 38 39 40 40 vii ftoc.indd 11/14/2012 9:04:08 PM viii Contents Part Two Credit Assessment Chapter Measurement of Credit Risk Exposure Default Probability The Recovery Rate The Tenor Direct versus Contingent Exposure The Expected Loss Chapter Dynamic Credit Exposure Long-Term Supply Agreements Derivative Products The Economic Value of a Contract Mark-to-Market Valuation Value at Risk (VaR) Chapter Fundamental Credit Analysis Accounting Basics A Typical Credit Report Agency Conflict, Incentives, and Merton’s View of Default Risk Chapter Alternative Estimations of Credit Quality The Evolution of an Indicator: Moody’s Analytics EDF™ Credit Default Swap Prices Bond Prices Chapter Securitization Asset Securitization Overview The Collateral The Issuer The Securities Main Families of ABS Securitization for Risk Transfer ftoc.indd 45 45 50 60 62 63 63 65 66 68 71 73 76 79 80 88 97 103 104 110 116 119 120 123 127 128 131 135 11/14/2012 9:04:08 PM Contents Credit Risk Assessment of ABS Warehousing Risk ix 137 138 Part Three Portfolio Management Chapter Credit Portfolio Management Level 1 Level 2 Level 3 Organizational Set-Up and Staffing The IACPM Chapter 10 Economic Capital and Credit Value at Risk (CVaR) Capital: Economic, Regulatory, Shareholder Defining Losses: Default versus Mark-to-Market Credit Value at Risk or CVaR Creating the Loss Distribution Active Portfolio Management and CVaR Pricing Chapter 11 Regulation Doing Business with a Regulated Entity Doing Business as a Regulated Entity How Regulation Matters: Key Regulation Directives Chapter 12 Accounting Implications of Credit Risk Loan Impairment Loan-Loss Accounting Regulatory Requirements for Loan-Loss Reserves Impairment of Debt Securities Derecognition of Assets Consolidation of Variable Interest Entities (VIEs) Accounting for Netting Hedge Accounting Credit Valuation Adjustments, Debit Valuation Adjustments and Own Credit Risk Adjustment IFRS 7 ftoc.indd 143 145 149 153 155 156 159 160 163 165 171 179 181 183 184 189 190 201 202 203 205 206 207 208 209 211 212 213 11/14/2012 9:04:08 PM x Contents Part Four Mitigation and Transfer Chapter 13 Mitigating Derivative Counterparty Credit Risk Measurement of Counterparty Credit Risk Mitigation of Counterparty Credit Risk through Collateralization Legal Documentation Dealers versus End-Users Bilateral Transactions versus Central Counterparty Clearing Prime Brokers Repurchase Agreements Final Words Chapter 14 Structural Mitigation Transactions with Corporates   Segmentation of the Commercial Loan Market   Senior versus Junior Debt   Secured versus Unsecured Loans   Covenants   Events of Default Transactions with Special Purpose Vehicles   Impact of Structural Mitigants on Default Probability   Impact of Structural Mitigants on Recovery Rates   Senior/Subordinated Structures   Credit Enhancement Chapter 15 Credit Insurance, Surety Bonds, and Letters of Credit Credit Insurance Surety Bonds Letters of Credit or LoCs The Providers’ Point of View Chapter 16 Credit Derivatives The Product The Settlement Process Valuation and Accounting Treatment ftoc.indd 10 217 217 218 225 226 227 229 230 232 233 234 240 249 250 255 258 263 267 267 270 274 11/14/2012 9:04:08 PM Contents Uses of CDS Credit Default Swaps for Credit and Price Discovery Credit Default Swaps and Insurance Indexes, Loan CDSs, MCDSs, and ABS CDSs Chapter 17 Collateral Debt Obligations (CDOs) What Are CDOs? Collateralized Loan Obligations or CLOs Arbitrage CLOs Balance Sheet CLOs ABS CDOs Credit Analysis of CDOs Chapter 18 Bankruptcy What Is Bankruptcy? Patterns of Bankrupt Companies Signaling Actions Examples of Bankruptcies ftoc.indd 11 xi 276 280 280 280 283 283 286 287 290 292 296 301 301 303 306 307 About the Authors 311 Index 313 11/14/2012 9:04:08 PM Bankruptcy ■■ 307 Hiring bankruptcy lawyers, investment banks, or specialized advisers to review strategic options is almost always a sign that a company is preparing itself for a default The role of these advisors is to try to find a solution outside the bankruptcy courts whenever possible They start discussions with the various stakeholders and quickly define options, such as finding a suitor to help the company stay alive If no alternative to a bankruptcy filing is found, they typically stay involved during the reorganization process Examples of Bankruptcies Eastman Kodak Kodak’s bankruptcy is a classic example of a company whose success was linked to a technology that gradually became obsolete and that was unable to reinvent itself to compete in a new environment When Kodak filed for bankruptcy protection in January 2012, few people were surprised Rumors about the filing had been circling the company for some time A few months earlier, the media reported that Kodak drew on its bank lines, which was a sign that the company was running out of cash and drawing on its lines before it was too late The management had naturally dismissed the filing rumors, but by mid‐January 2012, the bankruptcy made the headlines of the global media Kodak was no ordinary company, and there was an aspect of nostalgia in the articles written and the comments made on TV For many people, the little yellow boxes were synonymous with happy family vacations Before the advent of digital cameras, souvenirs were immortalized in pictures taken on Kodak films Kodak film was available all over the world, dominating the global market, with Fujifilm of Japan being a distant second In 1881, George Eastman created The Eastman Dry Plate Company and two years later, he moved it to Rochester, in the northern part of New York State, close to the Canadian border The company specialized in cameras and films for the general public, such as the Kodachrome series of films, introduced in 1935 In the early 1990s, Kodak employed more than 130,000 staff and made $16 billion of sales Kodak quickly understood the threat of the digital technology to their main business of films and film processing Kodak invested early in digital cameras that directly competed with film Rather than seeing competing products gradually making its film obsolete, Kodak decided to occupy the territory and not let the camera makers, primarily Japanese companies like Olympus or Canon, take away its business The move was successful, and c18.indd 307 11/14/2012 8:49:59 PM 308 Mitigation and Transfer Kodak’s digital cameras were one of the first to hit the market in the late 1990s Unfortunately, the competition quickly caught up, and Japanese and Korean competitors surpassed Kodak’s sales of digital cameras To make things worse, smartphones with high‐quality built‐in cameras reduced the demand for digital cameras altogether One of the first decisions made after the bankruptcy filing was to shut the digital‐camera unit, a move made to save precious cash Kodak’s other attempt to diversify away from film also was not successful It entered the printer market, but its market share was small compared to leaders like Hewlett‐Packard and Lexmark Early in 2012, Kodak was running out of options, and, burdened by high costs, filed for bankruptcy As this book goes to print, Kodak expects that the exit from some markets, the sale of its patent portfolio, and some pension‐fund restructuring will provide sufficient resources to allow it to emerge from bankruptcy as a smaller, focused enterprise MF Global MF Global (MF) was by no means a household name However, when it filed for bankruptcy protection in October 2011, it became the eighth largest bankruptcy in U.S history in terms of assets, just ahead of Chrysler (Table 18.1) The failure of MF is a good example of a financial company dependent on short‐term funding Less than one week went by between the time it was downgraded and when it defaulted Equally impressive was that it was liquidated shortly after its Chapter 11 filing because no company showed interest for any part of the business MF Global was a broker-dealer, heavily involved in some futures markets Its clients were primarily institutional investors but also traders, and end-users such as farmers who were MF Global’s customers, due to its big presence in agriculture derivatives products The problems of MF Global started when it was revealed that, in order to increase profitability, it had made massive purchases of European sovereign bonds When European economic troubles increased, the bonds lost value Because MF Global had financed them with borrowed money, it had to provide additional collateral to compensate for the loss of value Then, in mid‐October, rating agencies realized that the size of the bond holdings was too large compared to its balance sheet As a result they downgraded the company and it took less than a week before all stakeholders lost complete confidence in MF Global Clients that had deposited money with the firm took it back, and derivatives counterparties requested more collateral MF Global was unable to supply the amount of cash requested c18.indd 308 11/14/2012 8:49:59 PM 309 Bankruptcy Table 18.1  Ten Largest Public Company U.S Bankruptcy Filings since 1980 Company Bankruptcy Date Description Lehman Brothers Holdings Inc 09/15/08 Investment Bank $691,063 Washington Mutual, Inc 09/26/08 Savings and Loan Holding Co $327,913 WorldCom, Inc 07/21/02 Telecommunications $103,914 General Motors Corporation 06/01/09 Manufactures and Sells Cars $91,047 CIT Group Inc 11/01/09 Banking Holding Company $80,448 Enron Corp 12/02/01 Energy Trading, Natural Gas $65,503 Conseco, Inc 12/17/02 Financial Services Holding Co $61,392 MF Global Holdings Ltd 10/31/11 Commodities and Derivatives Broker $40,541 Chrysler LLC 04/30/09 Manufactures and Sells Cars $39,300 Thornburg Mortgage, Inc 05/01/09 Residential Mortgage Lending Company $36,521 Assets Listed in descending order by Pre‐Petition Assets (Assets in $mil) Source: BankruptcyData.com New Generation Research, Inc The company filed for bankruptcy protection a week after the first downgrade Soon thereafter, media reported that another firm had considered a takeover up until a couple of hours before the Chapter 11 filing, but the suspicion of fraud deterred the suitor As things now stand, large sums of customer funds are missing, and the suspicion is that these funds were used to meet collateral calls from counterparties, an illegal action in the United States The lessons learnt from the demise of MF Global are multiple First, financial institutions depend on borrowed money and it does not take much for investors to lose confidence, which triggers a run on the bank that quickly leads to bankruptcy In contrast to industrial companies like Kodak, the demise of a financial institution happens quickly Other examples include Lehman Brothers and Bear Stearns each of whose fates were sealed over a weekend Another lesson is the danger of fraud or alleged fraud There is not much that a credit analyst can when the company is involved c18.indd 309 11/14/2012 8:49:59 PM 310 Mitigation and Transfer in illegal transactions or presents inaccurate financial statements Without the discovery that MF Global had misappropriated customers’ funds, the company might have been taken over to the likely benefit of all creditors Its client base was attractive, and several competitors considered purchasing the firm All attempts fell apart after MF Global’s management was unable to explain the missing customer funds Final Words In this chapter we provided some context and color around bankruptcies Recall that a key variable in loss‐given‐default, MTM valuation, CVaR, and other measures of credit risk exposure, is the recovery value should an obligor default The recovery value is determined in large part by the bankruptcy proceeding How the negotiation, restructuring, or liquidation unfolds, as well as the actions of the obligor, its constituents, and the trustee immediately before, during, and post reorganization, will be key drivers of the ultimate recovery c18.indd 310 11/14/2012 8:49:59 PM About the Authors S ylvain Bouteillé is head, Key Account Management and a member of the management team of the North American division of Swiss Re Corporate Solutions He started his career in Japan at the French Embassy and as general representative for a large French construction company In 1996, he joined Swiss Re in Zurich (Switzerland) in the newly created credit risk management division He was in charge of a large portfolio of counterparties and was instrumental in developing credit guidelines and portfolio management activities In 1998, he moved to New York where, as U.S head of credit risk management, he was responsible for credit risk aspects of all insurance and capital markets transactions In 2003, he became U.S head of structured credit underwriting, where he originated and structured credit derivatives and financial guaranty reinsurance transactions Since 2008, he has been working with risk managers of Fortune 500 companies to develop traditional and nonstandard insurance solutions Sylvain has an MS in civil engineering from ENTPE (France) and an MBA from INSEAD (France) Since 2011, he teaches credit risk management to students in the MS program in risk management at Queens College, City University of New York Diane Coogan‐Pushner is a Distinguished Lecturer and Director of the Graduate Program in Risk Management at Queens College, City University of New York She received her PhD in economics from Boston University in 1992 and began her career in the financial services industry at the World Bank Diane then worked in finance and strategy at AT&T before moving to PricewaterhouseCoopers to originate and manage corporate finance and risk management engagements for financial institutions Diane spent a number of years at Swiss Re and was managing director, responsible for structured reinsurance transactions She was a portfolio manager at Philo Smith & Co., the longest running financial services equity hedge fund in the United States, and a portfolio manager for a private equity fund also dedicated to financial services Diane has served as a member of Standard & Poor’s Insurance Advisory Council and as a director of a privately held insurance company She speaks at industry and academic conferences, has published on topics of risk and investment performance, performs institutional investment management consulting, and is a chartered financial analyst The Handbook of Credit Risk Management: Originating, Assessing, and Managing Credit Exposures By Sylvain Bouteillé and Diane Coogan–Pushner Copyright © 2013 by Sylvain Bouteillé and Diane Coogan-Pushner babout.indd 311 311 11/14/2012 8:50:29 PM Index ABS (asset-backed securities): basic structure of, 129 collateral of, 124–126 credit risk assessment of, 131, 137–138 described, 120–123 families of, 131–135 issuers of, 127–128 priority of payments, 242–243 structural mitigation techniques, 243–247 tranches, 128–131 ABS CDOs: collateral, 293 collateral managers, 294 described, 284–285, 292–293 financial crisis and, 295–296 liability, 293–294 ABS CDSs, 282 Accounting guidelines: balance sheet, 82–84 cash flow statement, 85–86 CDSs, 274–276 consolidation of VIEs, 208–209 credit assets, 164–165 credit valuation, debit valuation, and own credit risk adjustments, 212–213 de-recognition of assets, 207–208 fundamental credit analysis, 80–88 hedge accounting, 211–212 IFRS 7, 213 impairment of debt securities, 206–207 knowledge of, and credit analysis, 79–80 loan impairment, 202–203 loan-loss accounting, 203–205 MTM, 74–75 netting, 209–210 overview, 80–81 P&L (income) statement, 84 requirements for loan-loss reserves, 205–206 Accounting Standards Codification (ASC) system, 201–202 Account receivables, as credit risk, 15–16 Acquisitions of exposures, 155 Active portfolio management and CVaR, 179–181 Adjusted exposure (AE), 47, 49–50 Advance payment bonds, 257 Affirmative covenants, 238 Agency conflict, 98–99 Aggregation of exposure, 145–146 Alignment of interests and regulation, 184–185 Allocation of capital in CPM, 150 Altman, Edward I., 58 Ambac, 247 Amortization, early, 246 Amortization effect, 74 Approval of guidelines, 23 Arbitrage CLOs, 286–290 ASC (Accounting Standards Codification) system, 201–202 Assessment: of ABS, 131, 137–138 of collateral, 124–126 of collateral managers, 298–299 of seller motivation, 37 Asset-backed securities See ABS Asset managers, exposure to credit risk, 12 Assets See also Collateral on balance sheets, 82 claims to, credit risk in, 5–6 consumer, 134 credit, accounting for, 164–165 credit enhancement of, 243–244 de-recognition of, 207–208 intangible, 83, 94 securitization of, 120–123 unsecured, 123 Asset securitization, 120–123 See also ABS; Collateral debt obligations The Handbook of Credit Risk Management: Originating, Assessing, and Managing Credit Exposures By Sylvain Bouteillé and Diane Coogan–Pushner Copyright © 2013 by Sylvain Bouteillé and Diane Coogan-Pushner bindex.indd 313 313 11/14/2012 10:02:55 PM 314 Assuming credit risk, 122 Auctions, credit-event, 273–274 Audits of financial statements, 81 Authorization of transactions, 26–29 Auto industry, 186–187 Auto loan securitizations, 134 Balance sheet, 81, 82–84 Balance sheet CLOs, 290–292 Bank for International Settlements, 184, 190–191, 192–193 Bankruptcy: described, 3, 301–303 of Eastman Kodak, 307–308 of large public companies, 309 of MF Global, 308–310 MTM and, 75 patterns of companies in, 303–306 signaling actions for, 306–307 Banks: creditworthiness of, 16 exposure to credit risk, 10–12 prime brokerage operations of, 230 regulators of, 205 Basel III directive, 192–193 Basis risk and CDSs, 277 Bid bonds, 256–257 Bilateral transactions, 218, 227–229, 232 Black, Stanley, 101, 105 Bond prices, 116–118 Bonds: catastrophe, 137 surety, 255–258, 264–265 Breach of guidelines, 24–25 Broker dealers, regulation of, 196–197 Buffett, Warren, 13, 267 Business models, flaws in, and bankruptcy, 303–304 Calculating: default probability, 51–52 exposure, 46–50 mark to market, 73–76 Calculation agents, 222 Capital: described, 160 economic or risk, 160–161 regulatory, 161–162, 183 requirements for, 199 shareholder, 162 bindex.indd 314 Index Capital markets: bond prices and, 116–118 credit-default-swap prices and, 110–116 EDFs™ and, 104–110 Capital structure, 94, 100–101 Cash flow balance sheet CLOs, 290 Cash flow CDOs, 284 Cash-flow hedges, accounting for, 211–212 Cash flow statements, 81, 85–86 Cash reserves, 244–245 Cash settlements, 271–274 Catastrophe bonds, 137 CDO market and monoline insurance companies, 247 CDOs See Collateral debt obligations Central counterparty clearing, 227–229, 232 Chapter bankruptcy, 302 Chapter 11 bankruptcy, 302 Chinese walls, 156 Clearinghouses, 228–229, 232 CLOs See Collateralized loan obligations CMBS (commercial mortgage backed securitization), 130, 134 COGS/sales ratio, 96 Collateral: defined, 123 geographic location of, 133 quality of, 297 secured loans and, 236–237 for securitization, 123–126 types of, 126 valuation of, 48–49 Collateral debt obligations (CDOs) See also Collateralized loan obligations ABS, 292–296 credit analysis of, 296–299 described, 283–285, 299 Collateralization, mitigation of risk through: acceptable collateral, 223–224 analyzing and setting of threshold, 220–222 calculation and valuation agents, 222 described, 218–220 haircuts, 224, 225 segregation of money, 224–225 Collateralized loan obligations (CLOs): arbitrage, 286–290 balance sheet, 290–292 11/14/2012 10:02:55 PM Index described, 284, 286–287 structure and pricing, 285 Commercial bonds, 257–258 Commercial loans, 234–236 Commercial mortgage backed securitization (CMBS), 130, 134 Commodity markets and corporates, 17 Concentration of portfolios, 35 Confidence level and CVaR, 169–170 Conservatorship, 186 Consolidation of variable interest entities, 208–209 Content of guidelines, 24 Contingent claims: credit risk in, on reinsurers, 13, 14–15 Contingent credit exposure, 63 Contract bonds, 256–257 Contracts: economic value of, 71–73 legally binding, terms of, Corporates: exposure to credit risk, 15–17 transactions with, 234–240, 241 Cost in excess, 83 Cost structure, flaws in, and bankruptcy, 304–305 Counterparties See also Counterparty credit risk; Default probability central counterparty clearing, 227–229, 232 in credit risk, rating, 52–59 Counterparty credit risk: measurement of, 217–218 mitigation of, 218–225 VaR measure of, 218 Court bonds, 257–258 Covenants, 238–239 CPM See Credit portfolio management Credit agreements, 234 Credit assets, accounting for, 164–165 Credit bureaus, 125 Credit card securitization, 134 Credit committees, 28–29 Credit-default-swap prices: caveats for, 115–116 credit risk and, 110–111 bindex.indd 315 315 as early warnings, 113–114 finding, 111–112 using, 112–113 volatility in, 116, 117 Credit-default-swaps (CDSs) See also Creditdefault-swap prices; Credit derivatives ABS CDOs and, 295 for credit and price discovery, 280 described, 267–270 insurance and, 280 types of, 280–282 uses of, 276–279 Credit derivatives See also Credit-default swaps described, 267–270 settlement process, 270–274 valuation and accounting treatment, 274–276 CreditEdge™ (Moody’s), 104, 106 Credit enhancement of assets, 243–244 Credit-event auctions, 273–274 Creditex, 273 Credit insurance: coverage types, 252 credit limits, 252–253 described, 250 market participants, 250–251 political-risk insurance, 254–255 providers’ point of view on, 263–264 strengths and weaknesses of, 253–254 Credit lines/limits: in CPM, 147 setting, 25, 35 Credit-linked notes, 136–137, 267 Creditors, unequal treatment of, 186 Credit portfolio management (CPM): acquisitions or swaps of exposures, 155 active (level 3), 153–155 aggregation of exposure, 145–146 allocation of capital, 150 basic (level 1), 145–149 credit limits, 147 data requirements, 177–179 evolution of, 143–144 hedging strategy, 152 intermediate (level 2), 149–153 mitigation, 149 organizational set-up and staffing, 155–156 quantification of capital at risk, 149–150 rebalancing transactions, 152–153 11/14/2012 10:02:55 PM 316 Credit portfolio management (continued) reporting, 146 resources needed for, 144 role of, 143, 156–157 stress testing, 151 surveillance, 147–149 transfer pricing, 154 Credit reports: background of company, 89 capital structure, 94 competitor ratios, 97 in CPM, 146 debt service, 96 as deliverable of credit analysis, 79 financial statement summary, 93–94 format for, 88–89 general information sections, 89–90 liquidity and cash flow, 94–95 management, 92–93 ownership structure, 91–92 political economic, and regulatory environment, 90–91 profitability, 96–97 pro-forma financials, 97 qualitative assessment sections, 90–93 quantitative assessment sections, 93–97 rating and recommendation, 89–90 relationship and approval process, 89–90 strategy and key risk factors, 91 transaction, 89 Credit risk See also Counterparty credit risk; Exposure to credit risk; Measurement of credit risk; Transfer of risk alternative estimations of, 103–104 defined, importance of understanding of, 36–37 losses from, sources of, by entity type, sources of, by instrument, 7–8 types of transactions that create, 5–9 Credit risk analysis See Fundamental credit analysis Credit risk management, 18–19 See also Credit portfolio management; Fundamental credit analysis; Transfer of risk Credit valuation adjustments, 212–213 Credit value at risk (CVaR): active portfolio management and, 179–181 caveats, 171 bindex.indd 316 Index confidence level, 169–170 described, 165, 182 loss distribution, 167–169, 171–179 tail, 170–171 time horizon, 165–167 Current assets, 82 Current liabilities, 83 CVaR See Credit value at risk Data vendors, 57, 58 Dealers in derivatives market, 226–227 Debit valuation adjustments, 213 Debt/EBITDA ratio, 96 Debt/equity ratio, 87 Debtor-in-possession financing, 303 Debt securities, impairment of, 206–207 Decision making, uneconomic, 189 Default: assessing value of loss upon, 172–173 defined, events of default, 239 Merton view of, 101–102 predicting, 103 priority of payments in, 234–236 Default probability (DP): calculating, 51–52 described, 50–51 impact of structural mitigants on, 239–240 joint default probability, 173–177 Moody’s Analytics Expected Default Frequency (EDF™), 104–110 rating counterparties, 52–59 for single exposures, 172 using historical data, 59–60 Default view of credit losses, 163 Defined-benefit pension funds, 305 Delegation of authority, 27–28 De-recognition of assets, 207–208 Derivative products See also Counterparty credit risk; Credit derivatives banks and, 11 corporates and, 17 credit risk in, 6, 8–9, 69 dealers versus end-users, 226–227 described, 68–69 dynamic credit exposure with, 69–71 legal documentation for transactions, 225–226 regulation of, 184, 185, 190, 195–196 11/14/2012 10:02:55 PM Index Direct credit exposure, 63 Distribution of risk See Transfer of risk Diversification of borrower pool, 125 Diversified payment rights, 135 Documentation See Credit reports; Legal documentation Dodd-Frank Wall Street Reform and Consumer Protection Act (2010), 184, 185, 191–192, 193, 194, 197 DP See Default probability Dry powder, 36 Dynamic credit exposure: in derivative products, 68–71 described, 65 in long-term supply agreements, 66–68 MTM and, 71–76 VaR and, 76–78 Early amortization of ABS, 246 Eastman Kodak, bankruptcy of, 307–308 EBIT (Earnings Before Interest and Taxes), 96–97 EBITDA (Earnings Before Interest, Taxes, Depreciation, and Amortization), 87–88, 96 Economic capital, 160–161 See also Credit value at risk EDF™ (expected default frequency), 104–110 End-users in derivatives market, 226–227 European regulatory agencies, 191, 193, 197 Events of default, 239 Excess spread, 244–245 Exit strategies, 40–41 Expected default frequency (EDF™), 104–110 Expected loss of transactions, 63–64 Exposure to credit risk See also Dynamic credit exposure corporates, 15–17 direct versus contingent, 63 by entity, 9–10 financial institutions, 10–15 hedging, 276–277 individuals, 18 measurement of, 45–50 reducing, 40–41 surveillance activities, 40 Fair Isaac Corporation (FICO), 125 Fair-value hedges, accounting for, 211 FGIC, 247 FICO score, 125 bindex.indd 317 317 Financial Accounting Standards Board, 201 Financial covenants, 238–239 Financial crisis: ABS CDOs and, 295–296 arbitrage CLOs and, 286–287 credit risk management in, 19 creditworthiness of banks in, 16 nonagency mortgage-backed securities in, 123–124 regulation and, 183 securitization activity and, 119–120, 140 stress testing and, 151 Financial guaranty, 246–247 Financial Industry Regulatory Association, 196 Financial institutions and exposure to credit risk, 10–15 Financial risk indicative ratios, 97 Financial Stability Board, 184, 190, 191, 196 Financial Stability Oversight Council, 191, 192 Financial statements: balance sheet, 82–84 cash flow, 85–86 in credit reports, 93–94 elements of, 81–82 P&L (income), 84 smell test for, 86–88 Financial structure, flaws in, and bankruptcy, 305–306 Frank, Barney, 187 FSA, 247 Fundamental credit analysis: accounting basics, 80–88 agency conflict, 97–98 capital structure, 100–101 of CDOs, 296–299 collateral assessment, 124–126 credit reports, 88–97 elements of, 79–80 of issuer of asset-backed securities, 127–128 Merton model, 101–102 misalignment of incentives, 99–100 of securities, 131 Future flow transactions, 135 G-20 and regulation of derivatives, 184, 185, 190, 196 GAAP (U.S Generally Accepted Accounting Principles), 201 See also Accounting guidelines 11/14/2012 10:02:55 PM 318 Gamesmanship, 188–189 GE (gross exposure), 47–48, 50, 76–78 Global default rates, 60, 61 Goodwill, 83, 94 Governance system: guidelines, 22–25 limits on risk, 25, 35 oversight and staffing, 29–31 principles for, 22 regulation as, 185 transaction authorization, 26–29 Governments, default probability of, 51 Gross exposure (GE), 47–48, 50, 76–78 Guidelines, 22–25 Haircuts, 224, 225 Hedge accounting, 211–212 Hedge funds, 12–13, 144 Hedging credit exposures, 276–277 Hedging strategy in CPM, 152 Hierarchy of ratings, 58–59 Historical data for probability of default, 59–60 IACPM (international Association of Credit Portfolio Managers), 156 ICISA (International Credit Insurance & Surety Association), 264 IFRS (International Financial Reporting Standards), 201, 202, 212, 213 Impairment: of debt securities, 206–207 of loans, 202–203 Incentives, misalignment of, 99–100, 187 Income statements, 81, 84 Independence of risk management unit, 29–30 Indexes, credit-default swap, 281 Individuals: exposure to credit risk, 18 risk analysis for, 125 Insider trading, 155–156 Insolvency, defined, Insurance See also Credit insurance credit-default swaps and, 280 political-risk, 254–255 Insurance industry: exposure to credit risk, 13–15 LoCs in, 261–262 regulation of, 194–195 bindex.indd 318 Index Insurance-Linked Securities, 137 Intangible assets, 83, 94 International Accounting Standards, 201, 202, 212 International Association of Credit Portfolio Managers (IACPM), 156 International Credit Insurance & Surety Association (ICISA), 264 International Financial Reporting Standards (IFRS), 201, 202, 212, 213 International Swaps and Derivatives Association (ISDA), 191, 225–226, 269 INTEX, 138 Investments: corporates and, 16–17 in credit, 277–278 insurance companies and, 13–14 pension funds and, 15 ISDA (International Swaps and Derivatives Association), 191, 225–226, 269 “Issuer” rating, 54 Issuers of asset-backed securities, 127–128 Joint default probability, 173–177 Junior debt, 236 Kamakura Default Probability, 110 Kealhofer, McQuown, and Vasicek (KMV) model, 102, 105–106, 107 Kealhofer, Stephen, 105 Leases, credit risk in, Legal documentation: credit agreements, 234 for credit derivatives transactions, 269 for derivatives transactions, 225–226 in securitization process, 122–123 for transactions, 38 Letters of credit (LoCs): default risk and, 234 described, 258–259 examples of, 259–262 exposure and, 63 providers’ point of view on, 265 Leverage, defined, 125 Leveraged loans, 235, 286 Liabilities on balance sheets, 83–84 LIBOR (London Interbank Offered Rate), 69 Limits on risk, setting, 25, 35 Liquidity, 144, 223 11/14/2012 10:02:55 PM 319 Index Loan CDSs, 281 Loan-loss reserves, 203–206 Loans See also Collateralized loan obligations commercial, 234–236 credit risk in, 5, 10–11 impairment of, 202–203 secured versus unsecured, 236–237 Loan seasoning, 133–134 Loan-to-value (LTV) ratio, 125, 132–133 LoCs See Letters of credit London Interbank Offered Rate (LIBOR), 69 Long credit, 277–278 Long-term assets, 82 Long-term liabilities, 83–84 Long-term supply agreements, 66–68 Loss distribution: creating, 171–179 CVaR and, 167–169 data requirements, 177–179 joint default probability, 173–177 portfolio management to tighten, 180 probability of default and, 172 value of loss upon default, 172–173 Losses, defining, 163–164 Loss given default, 62 LTV (loan-to-value) ratio, 125, 132–133 Macro hedges, accounting for, 212 Maintenance of guidelines, 23–24 Managers: asset, exposure to credit risk, 12 collateral, 294, 298–299 Mapping ratings, 59 Market capitalization, 88 Market risk management, 78 Markit, 273, 281 Mark to market (MTM): calculations for, 73–76 credit losses and, 163–164 described, 71–73 valuation of derivative contracts, 218 VaR and, 76–77 Master netting agreements, 210 MBIA, 247 MBS (mortgage backed securities), 132–134 McQuown, John, 105 Measurement of credit risk: of counterparties, 217–218 default probability, 50–60 bindex.indd 319 dimensions of, 45 direct versus contingent exposure, 63 expected loss, 63–64 exposure, 45–50 recovery rate, 60–62 tenor, 62–63 Merton model, 101–102, 104–105 MF Global, bankruptcy of, 308–310 Minimum transfer amount, 221 Mitigants, defined, 38 Mitigation See also Structural mitigation of counterparty credit risk, 218–225 in CPM, 149 Monitoring credit exposure, 40 Monoline insurance companies, 247, 250–251 Moody’s Analytics: Expected Default Frequency (EDF™), 104–110 Global Correlation Model (GCorr™), 178–179 Moody’s Investors Services: CreditEdge™, 104, 106 long-term issuer credit ratings, 56 Moral hazard, 187 Mortgage-backed securities (MBS), 132–134 Mortgages, as secured loans, 236–237 MTM See Mark to market Municipal obligation CDSs, 282 National Association of Insurance Commissioners, 194 Negative basis trade, 295–296 Negative covenants, 238 Net exposure (NE), 47, 48–49, 50 Net income, 86–87 Netting, accounting for, 209–210 Non-performance of collateral, 123–124 Nonpublic information, 155–156 Notch, defined, 240 Notes to financial statements, 81 Notional amount, 269 Obligors, defined, Off-balance-sheet obligations, 94 Offsetting, accounting for, 209–210 One-off transactions, accepting, 34–35 Operating income, 96–97 Options pricing, 101, 105 11/14/2012 10:02:55 PM 320 Origination: asset-backed securities, 124–125 checklist for, 34–41 defined, 33 drivers of, 21–22 in securitization process, 121–122 Orphans, creating, 35–36 Overcollateralization, 245, 298 Own credit risk adjustments, 213 Ownership structure, 91–92 Parameters of credit-sensitive transactions, 27 “Pass-through” security structure, 132 Pension Benefit Guaranty Corporation, 195, 302 Pension funds: CVaR and, 182 defined-benefit, costs of, 305 exposure to credit risk, 15 Performance bonds, 257 Physical settlement, 271–272 P&L (profit and loss) statement, 81, 84 Political risk and credit risk, Political-risk insurance, 254–255 Portfolios See also Credit portfolio management active management of, and CVaR, 179–181 assessing new transactions within context of, 35–36 supporting, 159–160 Prepayment: of goods and services, of mortgages, 133–134 Pricing See also Credit-default-swap prices concepts in, 181 for new transactions, 39 options, 101, 105 transfer, 39, 154 Prime brokers, 229–230 Probability of default See Default probability Profitability of companies, 86–87, 96–97 Profit and loss (P&L) statement, 81, 84 Pro-forma financials, 97 Promulgation of guidelines, 23–24 Property, plant, and equipment, 83 Protection of credit exposures, 276–277 Public Company Accounting Oversight Board, 205 bindex.indd 320 Index Qualified special purpose entities (Q-SPEs), 208–209 Quantification of capital at risk, 149–150 Rating agencies, 52–57, 118, 138 Rating counterparties, 52–59 Ratings, from EDFs™ to, 109–110 Ratings arbitrage, 188–189 Rating transitions, 166 Rebalancing transactions in CPM, 152–153 Recovery rate, 60–62, 240, 241 Recovery value, 310 Reference entities (REs), 270 Regulated entities: doing business as, 189–190 doing business with, 184–189 Regulation: benefits from, 184–185 financial regulators, 197–199 key directives, 190–197 of loan-loss reserves, 205–206 objections to, 199 overview, 183–184 pitfalls from, 186–189 Regulation Fair Disclosure, 57 Regulatory arbitrage, 188 Regulatory capital, 161–162, 183 Reinsurance recoverables, 13, 14–15 Repurchase agreements (repos), 230–232 Residential mortgage-backed securities, 132–134 Reverse repos, 231 Revolving collateral, 126 Risk See Credit risk; Risk transfer; Systemic risk Risk capital, 160–161 Risk management unit, 29–31 Risk-taking activities, 21 Risk transfer See also Credit derivatives with credit insurance, 250–255, 263–264 with letters of credit, 258–262, 265 participants and products, 250 securitization for, 135–137 with surety bonds, 255–258, 264–265 techniques for, 249, 266 Sales, credit risk in, Scholes, Myron, 101, 105 Scoring systems for small companies, 57–58 Secured loans, 236–237 11/14/2012 10:02:55 PM Index Securities and Exchange Commission (SEC), 196 Securitization See also ABS; Collateral debt obligations of assets, 120–123 building blocks of, 129 collateral, 123–126 functions in process of, 121–122 history of, 119–120 issuer, 127–128 for risk transfer, 135–137 structured credit risk and, 119 tranches, 128–131 Segmentation of commercial loan market, 234, 235 Segregation of accounts, 224–225 Seizure and lack of orderly disposition, 186–187 Sellers, assessing motivations of, 37 Senior debt, 236 Servicing transactions, 122 Settlement process: cash settlement and credit-event auction, 272–274 cash versus physical settlement, 271–272 credit events, 270–271 SG&A/sales ratio, 96 Shareholder capital, 162 Shareholders’ equity, 84 Shorting credit, 278–279 Short-term assets, 82 Signaling actions of bankruptcy, 306–307 Solvency and regulation, 185 Solvency II directive, 193–194 Special purpose entities (SPEs), 208 Special purpose vehicles (SPVs): assessment of, 127–128 CDOs and, 283 consolidation of, 208 securitization and, 120, 121 transactions with, 240, 242–247 Spread, 269 Staffing of risk management unit, 29–31 Standard & Poor’s (S&P), 55, 240, 241 Static collateral, 126 Strategy, fitting transactions into, 34–35 Stress testing in CPM, 151 Structural mitigation: CDOs and, 298 described, 233–234 bindex.indd 321 321 transactions with corporates, 234–240, 241 transactions with SPVs, 240, 242–247 Structured credit, 119 See also Securitization Student loan securitization, 134 Subordination technique, 236 Supply agreements, long-term, 66–68 Surety bonds: described, 255–256 principal families of, 256–258 providers’ point of view on, 264–265 Surveillance activities, 40, 147–149 Swaps of exposures, 155 Synthetic balance sheet CLOs, 291–292 Synthetic CDOs, 284 Systemic risk, 185, 227–228 Taleb, Nassim Nicholas, 181 Tenor and default probability, 62–63 Time: CVaR and, 165–167 default probability and, 51, 62 gross exposure calculation, 48 in MTM calculation, 74 as risk, Trade finance, LoCs in, 260 Tranches, 128–131 Transactions: authorization of, 26–29 bilateral, 218, 227–229, 232 checklist for origination, 34–41 with corporates, 234–240, 241 in credit reports, 89 expected loss of, 63–64 future flow, 135 guidelines for, 22–25 repurchase agreements, 230–232 securitization process, 121–122 with special purpose vehicles, 240, 242–247 that create credit risk, 5–9 Transfer of risk See also Credit derivatives with credit insurance, 250–255, 263–264 with letters of credit, 258–262, 265 participants and products, 250 securitization for, 135–137 with surety bonds, 255–258, 264–265 techniques for, 249, 266 Transfer pricing, 39, 154 2007 crisis See Financial crisis 11/14/2012 10:02:55 PM 322 Underwriting: MBSs, 132–133 in securitization process, 122 Unsecured assets, 123 Unsecured loans, 237 Usage given default, 49–50 U.S Generally Accepted Accounting Principles (GAAP), 201 See also Accounting guidelines Vacisek, Oldrich, 105 Valuation agents, 222 Valuation of CDS, 274–276 bindex.indd 322 Index Value at risk (VaR) See also Credit value at risk criticism of, 181–182 described, 76–78 measurement of counterparty credit risk, 218 Variable interest entities (VIEs), 208–209 Warehousing risk, 138–139 Weighted-average rating factor, 297 Whole-business securitizations, 135 Z-score, 58 11/14/2012 10:02:55 PM ... in its dissolution if the business cannot be restructured The Handbook of Credit Risk Management: Originating, Assessing, and Managing Credit Exposures By Sylvain Bouteillé and Diane Coogan–Pushner... www.wiley.com Library of Congress Cataloging-in-Publication Data: Bouteillé, Sylvain The handbook of credit risk management : originating, assessing, and managing credit exposures / Sylvain Bouteillé,... the expected loss of a transaction: the exposure, the default probability, and the recovery rate The exposure is the evaluation of the amount of money that may be lost in case of default of the