Why New Approaches to Credit Risk Measurement and Management

1
Why New Approaches to Credit Risk Measurement and
Management?

• Why Now?

2
Structural Increase in Bankruptcy

• Increase in probability of default
• High yield default rates 5.1 (2000), 4.3
  (1999, 1.9 (1998). Source Fitch 3/19/01
• Historical Default Rates 6.92 (3Q2001), 5.065
  (2000), 4.147 (1999), 1998 (1.603), 1997
  (1.252), 10.273 (1991), 10.14 (1990). Source
  Altman
• Increase in Loss Given Default (LGD)
• First half of 2001 defaulted telecom junk bonds
  recovered average 12 cents per 1 (0.25 in
  1999-2000)
• Only 9 AAA Firms in US Merck, Bristol-Myers,
  Squibb, GE, Exxon Mobil, Berkshire Hathaway, AIG,
  JJ, Pfizer, UPS. Late 70s 58 firms. Early 90s
  22 firms.

3
Disintermediation

• Direct Access to Credit Markets
• 20,000 US companies have access to US commercial
  paper market.
• Junk Bonds, Private Placements.
• Winners Curse Banks make loans to borrowers
  without access to credit markets.

4
More Competitive Margins

• Worsening of the risk-return tradeoff
• Interest Margins (Spreads) have declined
• Ex Secondary Loan Market Largest mutual funds
  investing in bank loans (Eaton Vance Prime Rate
  Reserves, Van Kampen Prime Rate Income, Franklin
  Floating Rate, MSDW Prime Income Trust) 5-year
  average returns 5.45 and 6/30/00-6/30/01 returns
  of only 2.67
• Average Quality of Loans have deteriorated
• The loan mutual funds have written down loan value

5
The Growth of Off-Balance Sheet Derivatives

• Total on-balance sheet assets for all US banks
  5 trillion (Dec. 2000) and for all Euro banks
  13 trillion.
• Value of non-government debt bond markets
  worldwide 12 trillion.
• Global Derivatives Markets 84 trillion.
• All derivatives have credit exposure.
• Credit Derivatives.

6
Declining and Volatile Values of Collateral

• Worldwide deflation in real asset prices.
• Ex Japan and Switzerland
• Lending based on intangibles ex. Enron.

7
Technology

• Computer Information Technology
• Models use Monte Carlo Simulations that are
  computationally intensive
• Databases
• Commercial Databases such as Loan Pricing
  Corporation
• ISDA/IIF Survey internal databases exist to
  measure credit risk on commercial, retail,
  mortgage loans. Not emerging market debt.

8
BIS Risk-Based Capital Requirements

• BIS I Introduced risk-based capital using 8
  one size fits all capital charge.
• Market Risk Amendment Allowed internal models to
  measure VAR for tradable instruments portfolio
  correlations the 1 bad day in 100 standard.
• Proposed New Capital Accord BIS II Links
  capital charges to external credit ratings or
  internal model of credit risk. To be implemented
  in 2005.

9
Appendix 1.1A Brief Overview of Key VAR Concepts

• Banks hold capital as a cushion against losses.
  What is the acceptable level of risk?
• Losses change in the assets value over a fixed
  credit horizon period (1 year) due to credit
  events.
• Figure 1.1- normal loss distribution. Figure 1.2
  skewed loss distribution. Mean of distribution
  expected losses (reserves).
• Unexpected Losses (UL) tile VAR. Losses
  exceed UL with probability .
• Definition of credit event
• Default Mode only default
• Mark-to-market all credit upgrades, downgrades
  default.

10
FIGURE 1.1
11
(No Transcript)