Chap11 12

Saunders & Cornett, Financial
Institutions Management, 4th ed.

1
A bank is a place that will lend
you money if you can prove that
you dont need it.
Bob Hope
2
Why New Approaches to Credit
Risk Measurement and
Management?

Why Now?
3
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, J&J, Pfizer, UPS. Late 70s: 58 firms. Early
90s: 22 firms.

4
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.
5
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
6
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.
7
Declining and Volatile Values of
Collateral
Worldwide deflation in real asset prices.
Ex: Japan and Switzerland
Lending based on intangibles ex. Enron.
8
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.
9
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.
10
Traditional Approaches to Credit
Risk Measurement
20 years of modeling history
11
Expert Systems The 5 Cs
Character reputation, repayment history
Capital equity contribution, leverage.
Capacity Earnings volatility.
Collateral Seniority, market value & volatility of
MV of collateral.
Cycle Economic conditions.
1990-91 recession default rates >10%, 1992-1999: <
3% p.a. Altman & Saunders (2001)
Non-monotonic relationship between interest rates &
excess returns. Stiglitz-Weiss adverse selection & risk
shifting.
12
Problems with Expert Systems
Consistency
Across borrower. Good customers are likely to be
treated more leniently. A rolling loan gathers no loss.
Across expert loan officer. Loan review committees try
to set standards, but still may vary.
Dispersion in accuracy across 43 loan officers
evaluating 60 loans: accuracy rate ranged from 27-50.
Libby (1975), Libby, Trotman & Zimmer (1987).
Subjectivity
What are the optimal weights to assign to each factor?
13
Credit Scoring Models
Linear Probability Model
Logit Model
Probit Model
Discriminant Analysis Model
97% of banks use to approve credit card
applications, 70% for small business lending, but
only 8% of small banks (<$5 billion in assets) use
for small business loans. Mester (1997).
14
Linear Discriminant Analysis
The Altman Z-Score Model
Z-score (probability of default) is a function of:
Working capital/total assets ratio (1.2)
Retained earnings/assets (1.4)
EBIT/Assets ratio (3.3)
Market Value of Equity/Book Value of Debt (0.6)
Sales/Total Assets (1.0)
Critical Value: 1.81

15
Problems with Credit Scoring
Assumes linearity.
Based on historical accounting ratios, not market
values (with exception of market to book ratio).
Not responsive to changing market conditions.
56% of the 33 banks that used credit scoring for credit
card applications failed to predict loan quality
problems. Mester (1998).
Lack of grounding in economic theory.
16
The Option Theoretic Model of
Credit Risk Measurement
Based on Merton (1974)
KMV Proprietary Model
17
The Link Between Loans and
Optionality: Merton (1974)
Figure 4.1: Payoff on pure discount bank
loan with face value=0B secured by firm
asset value.
Firm owners repay loan if asset value (upon
loan maturity) exceeds 0B (eg., 0A
2
). Bank
receives full principal + interest payment.
If asset value < 0B then default. Bank receives
assets.
18
Using Option Valuation Models
to Value Loans
Figure 4.1 loan payoff = Figure 4.2 payoff to the writer of
a put option on a stock.
Value of put option on stock = equation (4.1) =
f(S, X, r, o, t) where
S=stock price, X=exercise price, r=risk-free rate, o=equity
volatility,t=time to maturity.
Value of default option on risky loan = equation (4.2) =
f(A, B, r, o
A
, t) where
A=market value of assets, B=face value of debt, r=risk-free
rate, o
A
=asset volatility,t=time to debt maturity.
19
$ Pay of f
Assets 0 A
1
B A
2
Figure 4.1 The pay of f to a bank lender
20
$ Pay of f
Stock Price (S)
0
+
X
Figure 4.2 The pay of f to the writer of a put option on a stock.
21
Problem with Equation (4.2)
A and o
A
are not observable.
Model equity as a call option on a firm. (Figure 4.3)
Equity valuation = equation (4.3) =
E = h(A, o
A
, B, r, t)
Need another equation to solve for A and o
A
:
o
E
= g(o
A
) Equation (4.4)
Can solve for A and o
A
with equations (4.3) and (4.4) to
obtain a Distance to Default = (A-B)/ o
A

Figure 4.4

22
Value of
Assets (A)
Value of
Equity (E)
($)
B
L
A
1
A
2
0
Figure 4.3 Equity as a call option on a f irm.
23
B = $80m
A = $100m
t = 0 t = 1 Time (t )
Def ault Region
+o
A
o
A
Figure 4.4 Calculating the theoretical EDF
24
Mertons Theoretical PD
Assumes assets are normally distributed.
Example: Assets=$100m, Debt=$80m, o
A
=$10m
Distance to Default = (100-80)/10 = 2 std. dev.
There is a 2.5% probability that normally
distributed assets increase (fall) by more than 2
standard deviations from mean. So theoretical PD
= 2.5%.
But, asset values are not normally distributed. Fat
tails and skewed distribution (limited upside gain).
25
Mertons
Bond Valuation Model
B=$100,000, t=1 year, o=12%, r=5%,
leverage ratio (d)=90%
Substituting in Mertons option valuation
expression:
The current market value of the risky loan is
$93,866.18
The required risk premium = 1.33%
26
KMVs Empirical EDF
Utilize database of historical defaults to
calculate empirical PD (called EDF):

Fig. 4.5
Number of firms that defaulted within
a year with asset values of 2o from
Empirical EDF = B at the beginning of the year
Total population of firms with
asset values of 2o from B
at the beginning of the year
50 Defaults
Empirical EDF = Firm population of 1, 000 = 5
percent

27
5%
Empirical
EDF
Figure 4.5
def ault (DD): A hy pothetical example.
Empirical EDF and the distance to
0 Distance
to Def ault
(DD)
Proprietery
Trade-Of f
2
28
Accuracy of KMV EDFs
Comparison to External Credit Ratings
Enron (Figure 4.8)
Comdisco (Figure 4.6)
USG Corp. (Figure 4.7)
Power Curve (Figure 4.9): Deny credit to
the bottom 20% of all rankings: Type 1
error on KMV EDF = 16%; Type 1 error on
S&P/Moodys obligor-level ratings=22%;
Type 1 error on issue-specific rating=35%.

29
12/96 06/97 12/97 06/98 12/98 06/99 12/99 06/00 12/00 06/01
20
CC
CCC
B
KMV EDF Credit Measure
Source: KMV.
Agency Rating
BB
BBB
A
AA
AAA
15
10
7
5
2
1.0
.5
.20
.15
.10
.05
.02
Figure 4.6 KMV expected def ault f requency
TM
and agency rating
f or Comdisco Inc.
12/96 06/97 12/97 06/98 12/98 06/99 12/99 06/00 12/00 06/01
20
CC
CCC
B
KMV EDF Credit Measure Agency Rating
BB
BBB
A
AA
AAA
15
10
7
5
2
1.0
.5
.20
.15
.10
.05
.02
Source: KMV.
Figure 4.7 KMV expected def ault f requency
TM
and agency rating
f or USG Corp.
30
Monthly
EDF credit
measure
Agency Rating
31
100 90 80 70 60 50
Percent of Population Excluded
40 30 20 10
100
90
80
70
60
50
40
30
20
10
0
0
Figure 4.8
Source: Kealhofer (2000).
agency ratings (1990-1999) f or rated U.S. companies.
KMV EDF Credit Measure v s.
EDF Power
S&P Company Power
S&P Implied Power
Moodys Implied Power
32
Problems with KMV EDF
Not risk-neutral PD: Understates PD since includes an asset expected
return > risk-free rate.
Use CAPM to remove risk-adjusted rate of return. Derives risk-neutral
EDF (denoted QDF). Bohn (2000).
Static model assumes that leverage is unchanged. Mueller (2000) and
Collin-Dufresne and Goldstein (2001) model leverage changes.
Does not distinguish between different types of debt seniority,
collateral, covenants, convertibility. Leland (1994), Anderson,
Sundaresan and Tychon (1996) and Mella-Barral and Perraudin (1997)
consider debt renegotiations and other frictions.
Suggests that credit spreads should tend to zero as time to maturity
approaches zero. Duffie and Lando (2001) incomplete information
model. Zhou (2001) jump diffusion model.
33
Term Structure Derivation of
Credit Risk Measures
Reduced Form Models: KPMGs
Loan Analysis System and
Kamakuras Risk Manager
34
Estimating PD:
An Alternative Approach
Mertons OPM took a structural approach to
modeling default: default occurs when the
market value of assets fall below debt value
Reduced form models: Decompose risky
debt prices to estimate the stochastic default
intensity function. No structural
explanation of why default occurs.
35
A Discrete Example:
Deriving Risk-Neutral Probabilities of Default
B rated $100 face value, zero-coupon debt security
with 1 year until maturity and fixed LGD=100%.
Risk-free spot rate = 8% p.a.
Security P = 87.96 = [100(1-PD)]/1.08 Solving
(5.1), PD=5% p.a.
Alternatively, 87.96 = 100/(1+y) where y is the
risk-adjusted rate of return. Solving (5.2),
y=13.69% p.a.
(1+r) = (1-PD)(1+y) or 1.08=(1-.05)(1.1369)

36
Multiyear PD Using
Forward Rates
Using the expectations hypothesis, the yield
curves in Figure 5.1 can be decomposed:
(1+
0
y
2
)
2
= (1+
0
y
1
)(1+
1
y
1
) or 1.16
2
=1.1369(1+
1
y
1
)
1
y
1
=18.36% p.a.
(1+
0
r
2
)
2
= (1+
0
r
1
)(1+
1
r
1
) or 1.10
2
=1.08(1+
1
r
1
)
1
r
1
=12.04% p.a.
One year forward PD=5.34% p.a. from:
(1+r) = (1- PD)(1+y) 1.1204=1.1836(1 PD)
Cumulative PD = 1 [(1 - PD
1
)(1 PD
2
)] = 1 [(1-.05)(1-.0534)] =
10.07%

37
16%
14%
10%
8%
1 Yr. 2 Yr.
Time to Maturity
Spot
Yield
Zero-Coupon
Treasury Bond
A Rated Zero-
Coupon Bond
B Rated Zero-
Coupon Bond
11.5%
13.69%
Figure 5.1 Yield curv es.
38
The Loss Intensity Process
Expected Losses (EL) = PD x LGD
If LGD is not fixed at 100% then:
(1 + r) = [1 - (PDxLGD)](1 + y)
Identification problem: cannot disentangle PD
from LGD.
39
Disentangling PD from LGD
Intensity-based models specify stochastic
functional form for PD.
Jarrow & Turnbull (1995): Fixed LGD, exponentially
distributed default process.
Das & Tufano (1995): LGD proportional to bond
values.
Jarrow, Lando & Turnbull (1997): LGD proportional to
debt obligations.
Duffie & Singleton (1999): LGD and PD functions of
economic conditions
Unal, Madan & Guntay (2001): LGD a function of debt
seniority.
Jarrow (2001): LGD determined using equity prices.

40
KPMGs Loan Analysis System
Uses risk-neutral pricing grid to mark-to-market
Backward recursive iterative solution Figure 5.2.
Example: Consider a $100 2 year zero coupon loan with LGD=100%
and yield curves from Figure 5.1.
Year 1 Node (Figure 5.3):
Valuation at B rating = $84.79 =.94(100/1.1204) + .01(100/1.1204) +
.05(0)
Valuation at A rating = $88.95 = .94(100/1.1204) +.0566(100/1.1204) +
.0034(0)
Year 0 Node = $74.62 = .94(84.79/1.08) + .01(88.95/1.08)
Calculating a credit spread:
74.62 = 100/[(1.08+CS)(1.1204+CS)] to get CS=5.8% p.a.

41
0 1 2 3
Time
4
D
C
B
B+
Risk
Grade
A
Figure 5.2 The multiperiod loan migrates ov er
many periods.
42
Period 1 Period 0
Figure 5.3 Risky debt pricing.
Period 2
$100 A Rating
$100 B Rating
$85.43
$67.14
$80.28
$0 Def ault
5% 5%
0.34%
94%
94%
1%
5.66%
94%
1%
43
Noisy Risky Debt Prices
US corporate bond market is much larger than
equity market, but less transparent
Interdealer market not competitive large spreads
and infrequent trading: Saunders, Srinivasan &
Walter (2002)
Noisy prices: Hancock & Kwast (2001)
More noise in senior than subordinated issues:
Bohn (1999)
In addition to credit spreads, bond yields include:
Liquidity premium
Embedded options
Tax considerations and administrative costs of holding
risky debt

44
Mortality Rate Derivation of
Credit Risk Measures
The Insurance Approach:
Mortality Models and the CSFP
Credit Risk Plus Model
45
Mortality Analysis
Marginal Mortality Rates = (total value of
B-rated bonds defaulting in yr 1 of
issue)/(total value of B-rated bonds in yr 1
of issue).
Do for each year of issue.
Weighted Average MMR = MMR
i
=
t
MMR
t
x w where w is the size weight for
each year t.

46
Mortality Rates - Table 11.10
Cumulative Mortality Rates (CMR) are calculated
as:
MMR
i
= 1 SR
i
where SR
i
is the survival rate defined
as 1-MMR
i
in ith year of issue.
CMR
T
= 1 (SR
1
x SR
2
xx SR
T
) over the T years of
calculation.
Standard deviation = \[MMR
i
(1-MMR
i
)/n] As the
number of bonds in the sample n increases, the standard
error falls. Can calculate the number of observations
needed to reduce error rate to say std. dev.= .001
No. of obs. = MMR
i
(1-MMR
i
)/o
2
= (.01)(.99)/(.001)
2
=
9,900
47
CSFP Credit Risk Plus
Appendix 11B
Default mode model
CreditMetrics: default probability is discrete (from
transition matrix). In CreditRisk +, default is a
continuous variable with a probability distribution.
Default probabilities are independent across loans.
Loan portfolios default probability follows a
Poisson distribution. See Fig.8.1.
Variance of PD = mean default rate.
Loss severity (LGD) is also stochastic in Credit
Risk +.

48
Def ault Rate
BBB Loan
Credit Risk Plus
CreditMetrics
Possible Path of Def ault Rate
Time Horizon
Def ault Rate
BBB Loan
Possible Path
of Def ault Rate
D
BBB
AAA
Time Horizon
Figure 8.1 Comparison of credit risk plus
and CreditMetrics.
49
Frequency
of Def aults
Distribution of
Def ault Losses
Sev erity
of Losses
Figure 8.2 The CSFP credit risk plus model.
50
Distribution of Losses
Combine default frequency and loss
severity to obtain a loss distribution.
Figure 8.3.
Loss distribution is close to normal, but
with fatter tails.
Mean default rate of loan portfolio equals
its variance. (property of Poisson distrib.)
51
Probability
Model 1
Actual
Distribution
of Losses
Losses
Figure 8.3 Distribution of losses with def ault
rate uncertainty and severity uncertainty .
52
Probability
Expected
Loss
Economic
Capital
99th
Percentile
Loss Level
Loss 0
Figure 8.4 Capital requirement under the CSFP
credit risk plus model.
53
Pros and Cons
Pro: Simplicity and low data requirements
just need mean loss rates and loss severities.
Con: Inaccuracy if distributional
assumptions are violated.
54
Divide Loan Portfolio Into
Exposure Bands
In $20,000 increments.
Group all loans that have $20,000 of
exposure (PDxLGD), $40,000 of exposure,
etc.
Say 100 loans have $20,000 of exposure.
Historical default rate for this exposure
class = 3%, distributed according to Poisson
distrib.
55
Properties of Poisson
Distribution
Prob.(n defaults in $20,000 severity band) =
(e
-m
m
n
)/n! Where: m=mean number of
defaults. So: if m=3, then prob(3defaults) =
22.4% and prob(8 defaults)=0.8%.
Table 8.2 shows the cumulative probability
of defaults for different values of n.
Fig. 8.5 shows the distribution of the default
probability for the $20,000 band.

56
.008
.05
.168
.224
Def aults
8 4 3 2 1 0
Figure 8.5 Distribution of def aults: Band 1.
57
Loss Probabilities for $20,000
Severity Band
Table 8.2 Calculation of the Probability of Default, Using the Poisson
Distribution

N Probability Cumulative
Probability

0 0.049787 0.049789
1 0.149361 0.199148
2 0.224042 0.42319
3 0.224042 0.647232
.
7 0.021604 0.988095
8 0.008102 0.996197

58
Economic Capital Calculations
Expected losses in the $20,000 band are $60,000
(=3x$20,000)
Consider the 99.6% VaR: The probability that
losses exceed this VaR = 0.4%. That is the
probability that 8 loans or more default in the
$20,000 band. VaR is the minimum loss in the
0.4% region = 8 x $20,000 = $160,000.
Unexpected Losses = $160,000 60,000 =
$100,000 = economic capital.
59
0
0.25
0.15
0.05
0.1
0.2
0
Amount of Loss in $
Expected
Loss
Economic
Capital
Unexpected
Loss
350,000 400,000 250,000 300,000 160,000 200,000 60,000 100,000
Figure 8.6 Loss distribution f or single loan portf olio
sev erity rate = $20,000 per $100,000 loan.
60
0
0.25
0.15
0.05
0.1
0.2
0
Amount of Loss in $
350,000 400,000 250,000 300,000 150,000 200,000 50,000 100,000
Figure 8.7 Single loan portf olio sev erity rate = $40,000
per $100,000 loan.
61
Calculating the Loss Distribution of a
Portfolio Consisting of 2 Bands:
$20,000 and $40,000 Loss Severity
Aggregate Portfolio (Loss on v = 1, Loss on v = 2)
Loss ($) in $20,000 units Probability
0 (0,0) (.0497 x .0497)
20,000 (1,0) (.1493 x .0497)
40,000 [(2, 0) (0,1)] [(.224 x .0497) + (.0497 x.1493)]
60,000 [(3, 0) (1, 1)] [(.224 x .0497) + (.1493)
2
]
80,000 [(4, 0) (2,l) (0, 2)] [(.168 x.0497) + (.224 x.1493) +
(.0497x.224)]
62
Add Another Severity Band
Assume average loss exposure of $40,000
100 loans in the $40,000 band
Assume a historic default rate of 3%
Combining the $20,000 and the $40,000
loss severity bands makes the loss
distribution more normal. Fig. 8.8.
63
0
0.120
0.060
0.020
0.040
0.080
0.100
0.000
Amount of Loss in $
350,000 400,000 250,000 300,000 150,000 200,000 50,000 100,000
Figure 8.8 Loss distribution f or two loan portf olios with
sev erity rates of $20,000 and $40,000.
64
Oversimplifications
The mean default rate was assumed
constant in each severity band. Should be a
function of macroeconomic conditions.
Ignores default correlations particularly
during business cycles.
65
Loan Portfolio Selection and
Risk Measurement
Chapter 12
66
The Paradox of Credit
Lending is not a buy and holdprocess.
To move to the efficient frontier, maximize
return for any given level of risk or
equivalently, minimize risk for any given
level of return.
This may entail the selling of loans from the
portfolio. Paradox of Credit Fig. 10.1.
67
Return
The Ef f icient
Frontier
A
B
C
Risk
0
Figure 10.1 The paradox of credit.
68
Managing the Loan Portfolio According to the
Tenets of Modern Portfolio Theory
Improve the risk-return tradeoff by:
Calculating default correlations across assets.
Trade the loans in the portfolio (as conditions
change) rather than hold the loans to maturity.
This requires the existence of a low transaction
cost, liquid loan market.
Inputs to MPT model: Expected return, Risk
(standard deviation) and correlations
69
The Optimum Risky Loan
Portfolio Fig. 10.2
Choose the point on the efficient frontier
with the highest Sharpe ratio:
The Sharpe ratio is the excess return to risk
ratio calculated as:
p
f
p
rR
o

70
Return (R
p
)
r
f
A
B
D
C
Risk (o
p
)
Figure 10.2 The optimum risky loan portf olio
71
Problems in Applying MPT to
Untraded Loan Portfolios
Mean-variance world only relevant if
security returns are normal or if investors
have quadratic utility functions.
Need 3
rd
moment (skewness) and 4
th
moment
(kurtosis) to represent loan return distributions.
Unobservable returns
No historical price data.
Unobservable correlations
72
KMVs Portfolio Manager
Returns for each loan I:
R
it
= Spread
i
+ Fees
i
(EDF
i
x LGD
i
) r
f

Loan Risks=variability around EL=EGF x
LGD = UL
LGD assumed fixed: UL
i
=
LGD variable, but independent across borrowers: UL
i
=

VOL is the standard deviation of LGD. VVOL is valuation
volatility of loan value under MTM model.
MTM model with variable, indep LGD (mean LGD): UL
i
=

) 1 ( EDF EDF
2 2
) 1 (
i i
EDFiVOL LGD EDFi EDFi +
2 2 2
) 1 ( ) 1 (
i i i
VVOL EDFi EDFiVVOL LGD EDFi EDFi + +
73
Correlations
Figure 11.2 joint PD is the shaded area.

GF
= o
GF
/o
G
o
F

GF
=

Correlations higher (lower) if isocircles are
more elliptical (circular).
If JDF
GF
= EDF
G
EDF
F
then correlation=0.

) 1 ( ) 1 (
) (
F F G G
F G GF
EDF EDF EDF EDF
EDF EDF JDF

74
Firm F
Firm G
Firm Fs
Debt Pay of f
100
100(1-LGD)
Market Value
of Assets - Firm G
Market Value
of Assets - Firm F
Face Value of Debt
Figure 11.2 Value correlation.

Chap11 12

Enviado por

Dados do documento

Título original

Direitos autorais

Formatos disponíveis

Compartilhar este documento

Compartilhar ou incorporar documento

Opções de compartilhamento

Você considera este documento útil?

Este conteúdo é inapropriado?

Direitos autorais:

Formatos disponíveis

Chap11 12

Enviado por

Direitos autorais:

Formatos disponíveis

Saunders & Cornett, Financial

Institutions Management, 4th ed.

Saunders & Cornett, Financial

Você também pode gostar