WILLIAM MARGRABE GROUP, INC., CONSULTING, PRESENTS
Credit Risk Management Last revised: March 02, 2002
New, this month:
On this page:
Dr. Risk promises you at least a brief response to your important question, as soon as he has a free moment. A question of sufficiently general interest to make it into the 'Zine, tends to generate a more comprehensive response. All questions and answers become the property of The William Margrabe Group, Inc. 7/28/00
Managing Credit Risk on a Long Term Lease (7/28/00)
Dear Dr. Risk I am working as treasurer/risk manager and have the following problem. My company intends to buy an dedicated asset and operate it for 15 years and supply the products to our Client under a long term (15 yr) contract, wherby Client is paying for the capital costs of the investment plus the variable cost and marging for the products. This client however has a rating of BB, which is quite low. Can you provide me with ideas on products and pricing techniques to hedge the counterparty risk for this casus. Jan
Dear Jan Your specific situation depends on specifics about which Dr. Risk has no information, but here are some general comments about your sort of situation.
It sounds as though:
Hedging might conceivably be the prudent way to go to manage risk associated with the loan and the margin. At first glance, the actual loan payments and annuity are the sort of cash flows that you could replicate with the client's debt, and the promised loan payments and annuity are flows you could replicate with AAA debt. If so, then your ability to construct a hedge depends on your availability of hedge instruments.
However, bankruptcy law handles lease payments, interest payments, and principal differently, and that may complicate the replication problem beyond solution. Even under the best of circumstances, appropriate instruments may not be available, and constructing the hedge is not a trivial matter.
The equipment as security for the capital cost payments complicates the formation of the replicating portfolio. It seems clear that you will not find a perfect substitute for it in the marketplace.
Dr. Risk cannot think of any way to hedge the quantity risk from the profit margin, without simply selling it in the market.
You might be able to buy credit protection from a credit derivatives dealer. It would face precisely the same problems that you would face, but is likely to have greater expertise and market access, because it has been in the business.
You could more easily buy insurance or a guarantee from an insurance company or a credit guarantor. Pricing is simple, but obscure. You describe the coverage you want, and prospective vendors name the premium. It’s not clear which actuarial model they would use, so it’s hard to duplicate the model. They diversify away the risk, so you probably couldn’t duplicate the protection by bypassing the insurer or guarantor.
If this protection is valuable, it doesn't come cheap. At some point the cure would be worse than the disease. Consequently, many suppliers in your situation just play with fire, and many get burnt.
Please let us know if you need names of insurers, guarantors, or credit derivatives dealers. Dr. Risk
7/28/00 Predicting the Probability of Default (7/28/00)
Dear Dr. Risk Apart from KMV, what other models are being used for forecasting the probability of default. Could you please throw some light on the relative performance of these models. Do you think that the credit rating agencies are doing a good job in terms of prediction of bankruptcy risk? How would you rate the rating agencies in this regard? Amiyatosh
Dear Amiyatosh – Dr. Risk can
think of three main methods to forecast default, or
compute or estimate the probability of default:
How well do these methods perform? Dr. Risk saw Peter Crosbie's presentation on
credit risk at a conference, recently. He had graphs that indicated that methods
1 and 2, using market data, showed marked deterioration in implied probability
of default in advance of actual default. Dr. Risk doesn't have the impression
that either of those methods was the undisputed king of early warning systems,
and each has its methodological weaknesses. However, clearly, it appeared that
both methods provided leading indicators of changes in credit ratings, and that
is consistent with Dr. Risk's priors. Dr. Risk
Modeling the credit risk of credit derivatives (6/28/00)
Dear Dr. Risk How do practioners determine the amount of the exposure offset created by a long default swap, where the maturity of the default swap is less than the reference/underlying asset? I now for regulatory capital purposes there are policies set forth (eg: FSA in UK) which outline the conditions but was interested to know want how bank's actually record the offset? Peter
Dear Peter – In my experience, a default swap always matures when the underlying/reference note/bond matures. A total return swap may mature before the reference instrument matures.
You asked specifically about the impact of the default swap on exposure. A typical measure of exposure is replacement cost, or market value. I'd say it's probably still more common to look at exposure, deal by deal.
In any case, a logical way to incorporate a short-dated total return swap on a long-dated note or bond into computation of credit exposure is to computer credit exposure, both before and after you add it to the portfolio of deals with the relevant counterparty. The change in exposure is simply exposure "after", minus exposure "before".
It may make more sense to look at things in the proper portfolio setting, not deal by deal. Perhaps, consider the portfolio of all deals that should net, upon default. Also, exposure isn't the only measure of risk that one might use. Credit VaR comes to mind, although that has its drawbacks. Dr. Risk
Pricing Credit Risk (6/28/00)
Dear Dr. Risk We are looking for a good book on Pricing for Credit Risk and details of how and where to obtain it. Sarie
Dear Sarie – Dr. Risk has links to books on credit derivatives at and Also, the Jarrow-Turnbull theory book that you'll find there covers pricing of credit derivatives at a sophisticated level. Dr. Risk
Expected Loss on Retail Loans (6/28/00)
Dear Dr. Risk I am interested in learn more about the probability of default, de loss given default rate, the expected loss in credit risk, particular for retail loans. Where can i find or download information about this topics? Pablo
Dear Pablo – You could do a lot worse than looking at the resources available at . Dr. Risk needs a more specific question to provide a more specific answer. For example, Dr. Risk doesn’t know what you mean by retail loans. You could mean real estate mortgage loans, commercial credit, etc. It’s not clear whether you are interested in theory or empirical work. If it’s theory, you can pick from several possible models that encompass elements of your question, mainly reduced form models, such as Jarrow-Turnbull and Duffie-Singleton. If it’s empirical work, the main data sources are the credit rating agencies. For individual credit, you might want to see what Fair Isaac has to say. Dr. Risk
7/28/00 [more] (7/28/00)
Dear Dr. Risk I am intersted in comercial loans default and consumer credit too and i want to find some information about how can i model the probability of default of a portfolio form by consumer credit, and comercial loans. The way of how can i provisioning, working with two eyers historic information about the way of modeled loans default by internal rating categories trougth credit scoring. Where can i find information about those reduce form models you mention such as Jarrow- Turnbull and Duffie - Singleton ? Pablo
Dear Pablo – Moody's has a mid-market commercial loan model. You can probably find some information about it their web site, with a link from the Credit Risk page of www.AskDrRisk.com/CreditRisk.html. Dr. Risk is not sure what they give away.
Loan Pricing Corporation is in this business, too and has a mid-market product. See what they have at http://www.loanpricing.com.
Dr. Risk has already mentioned Fair, Isaac, which is the main source for information about credit scoring. It has a link from www.AskDrRisk.com/CreditRisk.html.
Dr. Risk can't refer you to a public source on modeling the probability of default of a portfolio of consumer and commercial loans. He's not sure what you mean. If you have a portfolio of loans, one may default and the rest may not. Does that mean the portfolio defaulted?
You can find information about the Jarrow-Turnbull model in their book, which appears on http://www.askDrRisk.com/CreditDerivatives.htm. You might look at some of Duffie's downloadable papers at http://www.few.eur.nl/few/people/houweling/bookmark.htm for a sufficient description of the Duffie-Singleton model. Dr. Risk
Where did the CreditRisk+ Technical Document go? (5/28/00)
Dear Dr. Risk I am a final year Finance/Maths student who is currently doing a research
As such, I would like to ask you a few questions: Firstly, would you know where I could get a copy of the CreditRisk+ Technical Document? It appears that it has been taken off the CSFP website.
I was also hoping to get your opinion on the current models and where you think improvements should be made and where the focus should lie. Kristin
Dear Kristin Dr. Risk checked the link from The Derivatives 'Zine to the CreditRisk+ technical document and confirmed that it was broken. Thanks for informing us. Next, Dr. Risk contacted Tom Wilde at CSFB, because he was the prime mover who innovated CreditRisk+. (GARP recently honored Tom as "Risk Manager of the Year", largely for that service to the risk management community.) Tom graciously informed us of the new location, http://www.csfb.com/creditrisk/.
Concerning Dr. Risk's opinion on current models: Dr. Risk wouldn't want to deprive you of the opportunity to dig into the models and develop your own opinions. However, at the risk of coloring those opinions, here are some questions that Dr. Risk would try to answer while modeling credit risk. The answers to these questions will help shape a useful model:
– Dr. Risk
P.S. I wasn't able to open the documents that I downloaded. My old versions worked fine. Let me know if you have a similar problem.
How has the level of whatchamacallit been related to you-know in the past? (5/28/00)
Dear Dr. Risk what is the historic correlation pls between interest rates and credit, assuming underlying credit is investemnt grade. roger
Dear roger Dr. Risk is many things, but – alas – he's not a mindreader. Could you please provide a little context and explain why you want to know what you're asking? That way, Dr. Risk won't waste your time with detailed answers to questions that don't interest you.
Let's take your question, almost word by word.
Please help Dr. Risk help you. What are you trying to do? Why do you want this historical correlation? What model are you going to put it in? A credit derivatives pricing model? A credit risk management model? – Dr. Risk
Is the M&M theory of the cost of capital all wet? (4/28/00)
Dear Dr. Risk I own shares of Kelda Group, which owns Yorkshire Water Services. It's definitely not "New Economy", and I'm pessimistic about its long-term prospects. Recently, I heard that Moody's is probably going to downgrade its bonds from A2, so its yield spreads widened. An analyst at Moody's said, "At the moment debt is cheaper than equity for water companies ..." Kelda is thinking about securitising its revenue stream to raise money. (Aline van Duyn, "Credit reratings may hit water company bonds," Ft.com, 4/12/00) Do you agree that that's best? Roy Poseidon
Dear Roy When you make a value judgment, such as what's "best", you have to first pick a set of values. In this case, stakeholders include
Dr. Risk presumes that you would prefer to use your values, so your question is, "Do you agree that that's best for me?" or "... for original shareholders?" However, we'll have to consider the impact on other stakeholders to deduce the impact on you.
Your question raises three of the major issues in corporate finance:
Of course, Dr. Risk will look at these from your point of view, not from some ivory tower.
In any event, the buyers of the new bonds backed by the revenue stream should be indifferent to this scheme. If Kelda sells the bonds properly, these bondholders should pay a competitive price for their bonds. Good security, hence a high price.
The bankruptcy bar benefits from any plan that significantly raises the probability of Kelda's financial failure, landing it in bankruptcy court. Roughly speaking, a decrease in a corporation's equity as a percentage of assets makes bankruptcy more likely.
The Inland Revenue (the U.K.'s version of the U.S.'s IRS) is always sitting at the table, pounding the butt ends of its knife and fork against the table, demanding its piece of the pie that someone else baked. Dr. Risk doesn't know much about taxation in the U.K., hence would not care to speculate on the impact of Kelda's financing on the collections by the boys and girls at Somerset House (Inland Revenue's HQ). However, in the U.S., corporate finance decisions can significantly affect the corporate and personal tax bite out of any business operation.
You're not clear on Kelda's investment and dividend plans, hence on the destination of the funds raised. If Kelda is such an "Old Economy" investment, perhaps this is part of a scheme to disinvest and pay dividends or buy back shares. Either way, the same collateral would secure even more promises to pay, and the old bondholders would find the new bondholders in line ahead of them when it came time to seize collateral to get paid. Clearly, this would be bad for existing bondholders, neutral for the new bondholders, and good for shareholders, such as you.
Perhaps, Kelda plans to invest the funds in new plant and equipment, including prudent repairs on the old. Again, the new bondholders would be indifferent. The old bondholders would lose some collateral, but would gain a claim on new assets. Dr. Risk can't be sure of the overall impact on the shareholders and the old bondholders. The key issue is the probability distribution of asset value at the time the debt matures. If asset value exceeds debt, then the corporation will pay the bondholders in full. Otherwise, the corporation may default. A purchase of additional assets should tend to shift the probability distribution of future asset value to the right, which would be good for the bondholders. However, the investment might also affect the variability, which could be good or bad for the bondholders. Increased variability works against the bondholders, because it increases the value of the shareholders' (put) option to default. Increased variability could result from investment in a highly risky asset. Investment in an asset with negative correlation with the original assets decreases the variability of asset value. If that risky, future asset value will likely exceed (fall short of) the debt's face value, then decreased variability makes the bonds more (less) valuable, and increased variability makes the bonds less (more) valuable. – Dr. Risk
Waiter, would you recommend the Wiener ... or the Poisson? (4/28/00)
Dear Dr. Risk I am familiar with the properties of Wiener Processes, but I would like to have a good reference (either book or article) explaining the basics of Poisson Processes. I need to do some Monte Carlo modelling of Jump-Diffusion processes, and I want to make sure I get the step size right to ensure I only get one jump (at most) per period. Dr. B.
Dear Dr. B. Dr. Risk has three suggestions, all on Dr. Risk's Bookshelf and through Amazon.com:
Dr. Risk hopes one of those books is what you want. Dr. Risk
Risk vs. Reward in the "Full Monte" for Credit Metrics (10/28/98)
Dear Dr. Risk i have [a] question ... concerned to risk-return-analysis Situation: If i use CreditMetrics (full mark-to-market version), the expected return of one exposure can be calculated as
[(mean value - current value)/current value] - cost of funding
Afterwards i can compare this return with the risk contribution of the exposure to the portfolio. The result is a relative ratio
My question: If i use CreditMetrics in a reduced form, that means i only consider default or non default (like CR+), i get a portfolio distribution of (potential) losses. I can analogous calculate the risk contribution for each exposure. What a measure for the expected return of each exposure should be chosen? Mike
Dear Mike In all seriousness, Dr. Risk's answer depends on his best guess of what you're really trying to accomplish, which you didn't state and which isn't obvious to Dr. Risk. Dr. Risk guesses that you want to develop a methodology for making credit decisions by a sort of marginal analysis. You want to accept the loans that have a high ratio of reward to risk, reject the loans that have a low ratio of reward to risk, and find the dividing line between the acceptable and unacceptable loans. In order to do this, you clearly need a measure of reward and a measure of risk. You've adopted the marginal contribution to credit exposure, as CreditMetrics computes it, as the measure of risk. For CreditMetrics "Full Monte" Carlo simulation of mark-to-market, you're willing to use the excess of an asset's expected rate of return over cost of funding as a measure of reward. You want to know what measure to use when you are considering only losses.
Dr. Risk could easily and truthfully answer, "The same measure of expected excess return over cost of funding will be just as valid in the 'reduced form' case as it was in the 'Full Monte' case." Unfortunately, that would be both true and misleading. The basic approach you want to take has the important and sometimes over-riding advantage of producing a decision rule, but the disadvantage of being "ad hoc" and even questionable. In academic terms, it doesn't have a firm theoretical foundation. In layman's terms, it doesn't really make sense.
I see a basic similarity between what you want to do and what Harry Markowitz did with portfolio theory you want to pick the optimal spot on the tradeoff between reward and risk. So you're off to a good start. Your choice for reward is the same as Markowitz's.
Your problems start when you pick a measure of risk (VaR) that Dr. Risk cannot imagine figuring directly into the decision maker's utility function. Markowitz chose variance as his measure of risk and Tobin justified it two ways, each sufficient by itself: (1) if the asset price distributions are normal, then variance is the natural and only measure of risk, (2) if the investor has a quadratic utility function, then you needn't go beyond variance to analyze risk. VaR as a rational measure of risk? Questionable, at best. (If you can come up with some sort of reasonable and rational argument for that, please call Dr. Risk at any hour of the day or night. This will be momentous news.)
If your measure of risk is questionable, then your results will be questionable, regardless of your measure of expected return. I would suggest going back to first principles, figuring out how your decision maker makes decisions (e.g., expectation of quadratic utility of wealth) and/or how does the world work (e.g., normal distribution of returns) and deduce your measures of reward and risk from there. Please, next time, bring Dr. Risk into the problem closer to the start, rather than at the end of seems to be a blind alley. Dr. Risk
How safe are dollar deposits in various banks around the world? (9/28/98)
Dear Dr. Risk I would like to know wich are the risk of the dollar deposits in:
A International [i.e., foreign] Banking Facilty in the US
Dear Tommaso While I'm asking some experts on this topic, please answer me this: Why do you care? Idle curiosity? Dr. Risk
Dear Dr. Risk I work for the Central Bank of my country, which have recently been upgraded in his credit rating and is seeking markets to invest. Also is a good subject to give in my class of International Banking and a good example for my students in the usage of the internet as a research tool. Tommaso
Dear Rene You closed off discussion of the thorny issue of devaluation by denominating all the accounts in dollars. Good move.
I spoke with a Wall Street professional ("Seńor Wall Street") and a source closer than I to Alan Greenspan ("Deep Vault") The key issues that came up were (a) the sanctity of property rights, (b) the banking culture , (c) capital requirements, and (d) other regulations. Obviously, an "International Banking Facility" might be a bank of the U.S., U.K., Japan, etc. (you get the picture), or Mexico, Nigeria, etc. (you get the picture). So let's divide that into
1a - A British Banking Facility in the
All other things being equal, I would say that you put 2, 3, and 4 in the right order. The British Banking Facility in the U.S. would be right up there with the U.S. bank branch in London, maybe a little ahead or behind. I'm not sophisticated enough to know for sure which is better, and maybe nobody is. The point is that U.S. and U.K. banks are – with all their imperfections – relatively reliable wonders of the modern world, and we're fortunate to have them. Hallelujah! (Senior Wall Street thinks I'm too sanguine about prospects for U.S. banks during a recession with loan defaults and praises Swiss bank accounts, backed with gold reserves.)
The Mexican Banking Facility in the U.S. would go between the U.S. bank in Hong Kong and the Mexican Bank in Mexico. Putting money in a Mexican bank has been a little like drinking Mexican water. Mexican banks in Mexico have a long record of ... uh, not being Swiss banks, and there is only so much that U.S. regulation can do to counter that. Think of U.S. regulation of a Mexican bank's U.S. branch as akin to an iodine tablet dissolving in a canteen of Mexican water. In theory, the iodine should purify the water, but would you really drink it, if you could drink New York City tap water, instead? Would you really put your money in a Mexican bank in New York, if you could put it in a New York city branch of a U.S. bank? The Hong Kong branch of CitiBank isn't quite as secure as a New York branch. However, the Communist Chinese have not yet proven that they are going to loot Hong Kong, and there is reason to hope that they may never do it: people aren't papering their walls with Hong Kong stock certificates. So, I'll give the U.S. bank in Hong Kong the benefit of some doubt.
Here are comments from the experts:
I. Seńor Wall Street is a Mexican national who works on Wall Street. He rated the credit quality, as follows:
1. (best) US bank in US
As you can see, I didn't ask him your question, precisely.
His argument is that US banks follow US practices and have US regulation. The foreign banks may have some freedom from US regulations and personnel certainly have bad habits from their hometown banking practices. Any money in Mexico is up for grabs! The US bank in Mexico has to fear some US regulation and scrutiny, which keeps it in line, and it has some protection, because the Mexican banditos don't want to anger the US without good reason. The Mexican bank in Mexico appears to have laws and rules to obey; however, the politically powerful can change them on a moment's notice, to confiscate some or all of deposits, capital, and equity.
As he explained, "In Mexico, in 1982 they nationalized banks, froze the accounts, and converted the dollar accounts into pesos at a confiscatory exchange rate. They didn't touch CitiBank, which was then mainly in the private banking business and had only accounts of prominent Mexicans. Carlos Salinas was President of Mexico. His brother, Raul, got 10% of every nationalization, hence his nickname, 'Mr. Ten Percent' ". (For a perspective on the dark side of the Mexican economy, look at http://www.cs.unb.ca/~alopez-o/politics/interoppenheimer.html.)
II: Deep Vault spoke with me on the condition that I would not identify him or her. I can assure you that what he says is not an official position of the Federal Reserve Board, any Federal Reserve Bank, or anybody in the federal government. It's one person's opinion – in my estimation a very bright person's opinion – and for all I know he wasn't taking his medication. (However, for all I know he wasn't on any medication.) According to Deep Vault, "As it turns out, the question of supervisory control of foreign banking entities is a very sensitive issue. Historically (10+ years ago), branches and agencies of foreign banks were subject to significantly fewer restrictions that US banks, e.g. branching across state lines was not prohibited. It is my understanding that US bankers were behind much of the most recent legislation regarding acceptable/unacceptable behavior by foreign bank branches and agencies.
"Let me now answer the questions addressed to Dr. Risk ... These are quite simple. I believe the questions are asking about the riskiness of deposits in particular institutions. This is a function of where the capital backing the deposits is located. If the institution is a US bank, regardless of its location, at a minimum, it is subject to US regulations (Fed, OCC, FDIC, OTS, and/or state regulators); in particular, capital requirements. Additionally, if the branch of the US bank is located outside of the US, it will be subject to local regs as well. I cannot speak to the efficacy of these regs. In some countries, they may be essentially nonexistent; in others, they may be onerous. An International Banking Facility is not a legal entity; it has to do with off-shore banking. I am not very familiar with these. Deposits in US banks have US risk, regardless of where the deposits are located. That is, the capital backing the deposits is in the US and is subject to US regulations. If the deposits are in a Mexican bank, regardless of where the deposits are (Mexico or the US), these deposits are backed by capital in Mexico. That capital is not subject to US regulatory authority. US regulatory authorities only have authority over branches and agencies located in the US.
"Does all of that make sense? In short, authorities in a country only have control over capital located in that country. Foreign entities may be allowed to do business in that country, but there is no authority over the capital (its measurement, adequacy, etc.) that is located in the home country. For that reason, if you deposit money in a branch of a foreign bank located in the US, you still bear the risk that the bank may be inadequately regulated in its home country. It may go bankrupt and the US will have no control or authority over that resolution process.
"As to your additional questions ... General Information ... The specific answers to all these queries are in the Federal Reserve's Regulation K, which details the treatment of US branches of foreign banks and foreign branches of US banks. Before 1978, there was basically no federal oversight of US branches of foreign banks. Each state established its own controls. There was not coordinated oversight. The International Banking Act of 1978 established federal oversight. In 1991, the Foreign Bank Supervisory Enhancement Act was also passed. As it stands, a foreign bank must apply to the Federal Reserve. We oversee supervision in the US. The foreign bank may still be chartered as either a state or federal branch, which will affect which regulator oversees specific functions.
"Historically, the foreign bank could choose to be either insured or uninsured (that is the deposits). Since 1991, all new insured branches must be capitalized here. When a branch is established, their license will specify exactly what types of activities it can engage in. Branches can be established as either retail or wholesale ($100,000 or greater per deposit). Wholesale branches are established in large part to service high-net worth clients back in the bank's home country, i.e. to offer the safety of dollar-denominated deposits. There may also be restrictions on the source of deposits. Some branches may only accept deposits from non-US residents. Again, all of this is spelled out in great detail in Regulation K.
"Who regulates...It depends on how the foreign branch is chartered and what services they provide. It could be as many as five different regulators. There is a chart/matrix that shows which regulator is responsible for which function in which banks/branches. It is huge. I don't know know anyone who has memorized the entire thing. It's ugly.
"Deposit structure...It depends on the type of license that the branch has as I indicated above. Some branches may be restricted to a single type of deposit. Others may be able to accept numerous types. Again, Reg K.
"London and H.K...Host countries have jurisdiction. You would have to get information from them about any specific rules and regs that apply to foreign branches in their countries.
"BIS requirements apply to countries that have adopted them. In many instances though, specific requirements are left to the discretion of each country. Additionally, many countries have different definitions of capital, i.e. is preferred stock Tier 1 or Tier 2 capital. I don't want to get off on capital arbitrage, but I would imagine that certain forms of arbitrage are restricted in some countries and are all but encouraged in other countries. This is a topic for another discussion.
"Mexico is an OECD country. Interestingly, just before the crash in 1994, they were admitted to the OECD. Instantaneously, loans to government entities in Mexico had no capital requirements (per the Basle Accord) as they were deemed riskless. We all know what happened. This exemplifies one of the many problems with the Accord's statutory limits; they are arbitrary.
"Hong Kong...I don't believe it is OECD, especially now that it is back with China.
"Deposits risk in specific institutions...and you want a simple answer...It depends on credit risk and transfer risk specific to that institution.
"Recommended readings/follow-up if
you're really interested...
"In closing... Well, just imagine what the response would have been if I had truly researched the topic. Actually, I found the questions were very interesting. In fact, they were more interesting that what ever it was I was working on last week, so they got priority."
International Ratings (7/28/99)
Dear Dr. Risk How are derivative instruments rated internationally by rating agencies like S&P? What are the rating criteria and methodologies for rating these instruments? How are international corporate bond issues rated by international credit rating agencies? What are the methodologies and criteria used for rating these instruments? Roy
Dear Roy These are good questions, too good for good off-the-cuff answers. The quick answer is that to the rating agencies obviously have proprietary methodologies, but the methodologies aren't obvious to outsiders, and they differ both across rating agencies and over time for a given agency. If I look deeper into this, I'll update your answer. Meanwhile, use my links to the web sites for the rating agencies, such as Duff & Phelps, Fitch IBCA, Moody's, and S&P.
Your mention of the word, "internationally", is crucial. International standards for accounting and other information are generally not as high as those in the U.S. Sometimes, the "standards" could qualify for the "Derivative Humor" page, except that the jokes are in bad taste. Dr. Risk
Dissertation Topic: Credit Risk management of commercial loan portfolio (7/14/99)
Dear Dr. Risk I am a financial economics student at the Amsterdam University. Currently I am working at a thesis about managing credit risk of commercial bank loan portfolio's and I am concentrating on the application of modern portfolio theory in managing risk and return of loan portfolio's. Although this is a very exciting subject with lots of different aspects, it is also very complex.
I have read a lot of articles and papers that deal with the issue (including the CreditMetrics and CreditRisk+ technical documents) and they all provided me with really interesting insights of how credit risk in commercial loan portfolios could be managed. Yet all authors seem to conclude that there is still a lot of work and researching that needs to be done in this field. Although this suggests that there are many opportunities for exciting research, I am somehow finding it difficult to focus on an aspect which would be value adding to the already existing literature on this subject. Maybe You could give me a few tips about what would be an interesting aspect to focus on. Chris
Dear Chris Sometimes, the world of credit risk management seems to have more in common with religion than with science. We have several "approaches" to credit risk measurement, which Anthony Saunders surveys in his new book, Credit Risk Measurement. You might think of these as analogous to the world's major religions. In this context, the BIS approach is an state religion, an "established church", such as England's Anglican Church. It's also something like voodoo, given its lack of sophistication. (In all fairness, the folks at BIS are not stupid far from it. They realize the need to enter the 20th century, and they are looking for a better way to go.)
Few scientists have tried to find testable hypothesis in the approaches, few have tried to compare the approaches, and no one has provided the evidence to reject any of the approaches. (However, Bob Geske of UCLA and MKIRisk is doing promising research about the market's ability to predict the probability of default.) A dissertation that did any of these things would be a great contribution to the literature. I don't know whether the problem is one of empty theories, missing data, or just the lack of a recent financial crisis that would allow us to separate good theory from bad.
We don't have good data. The ratings agencies, such as Fitch, Moody's, Standard & Poor's, etc. have been working in this area for years and collected a great deal of data. However, we still don't have reliable data on things we would like, such as default rates, recovery rates, or default correlations. Banks have been making loans for decades, but useful data on credit losses haven't surfaced. Perhaps a bank would let you analyze its credit data. Dr. Risk
Pricing credit risk (1/28/99)
Question: Dear Dr. Risk I am a part-time PhD student and my thesis is about interest rate swaps and credit risk in banking industry. I would be grateful if you could give me some ideas and the current issues in this area and also it would provide economic value to the banking industry. I have read in fact alot of the journal articles related to this area, but I find that I got nowhere in the notations and find that some of the articles are too hard to fully understand. Any advice for me from an experienced Dr. like you? Your prompt reply would be much appreciated. Warmest regards from Downunder Vic
Answer: Dear Vic The intersection of interest rate swaps and credit risk is a busy corner. You're dissertation should focus on a minuscule portion of the action there, and the same is true of my answer. Since you mention the tricky notation, I'll guess that you are talking about pricing credit risk for bonds and swaps. That's my focus.
The literature and industry have three ways of pricing credit risk.
1. Static replication, used to price credit default swaps and total return swaps, is the most useful way for pricing credit derivatives, but only for some products. Buying protection via a credit default swap is equivalent to shorting the related floating rate note (FRN) and buying the corresponding AAA FRN. The related FRN has the same maturity, issuer, credit rating, seniority in bankruptcy, etc. The corresponding FRN is identical, but has a AAA issuer. The payoff on this portfolio equals a payment stream equal to the excess of the FRN coupon over the AAA FRN coupon, plus a contingent payment equal to the loss on the FRN upon default. In equilibrium, the value of the credit default swap should equal the value of the replicating portfolio.
2. The structural approach to credit default looks at a credit risky bond or swap as a credit riskless bond or swap, minus an option to exchange the bond or swap for the debtor's portfolio in bankruptcy. The approach is on sound theoretical footing, practical for a firm with a trivial capital structure, but questionable for a firm with a complex capital structure. The classic Black-Scholes (1973) paper and Merton's paper on risky debt are the inspiration for this literature.
3. The reduced form approach multiplies the states of the world, beyond the usual ones with interest rate derivatives, to include states where the debtor defaults. The risk neutral probability of default and the recovery rate in default are important variables here. The approach is theoretically correct, but has a few practical problems. The recovery rates, after default, are hard to come by. Deducing the risk neutral probability of default depends on knowing the recovery rates, having a rich set of debt instruments for the debtor, and assuming that default and the level of riskless rates is independent. Jarrow and Turnbull are apparently the originators of this line of thinking. Many others have pursued this line of research.
Unfortunately, I would say that approaches 2 and 3 are "not ready for prime time". One is hard pressed to come up with the required information on the debtor's portfolio to complete the structural model. One has to make assumptions about the recovery rate and often about the risk neutral probability of default. I'm not going to bet my money on either of these models at this time. However, one may not have the data need to make approach 1 work, either. Making markets in credit derivatives is not for wimps or firms with weak sales forces.
Complicated notation is a necessary evil in the world of credit derivatives, particularly for reduced form models. Some authors seem impelled to use needlessly complicated notation, but sometimes the complications are required. In either event, you just have to learn to love time and state subscripts. Best wishes. Dr. Risk
Market skepticism about agency credit quality? (11/28/98)
Question: My question has to do with the widening of the spread between 10 year treasuries and mortgage rates. For as long as I can remember it has been 80/120 bases points over the 10 yr. T/B for a 30 year mortgage. A recent article in the NY Times said the spread has widened to over 200 B/P. If using either Fannie or Freddie as the issuer of the MBS with the implied guarantee of the US government how has the market assigned what appears to be a very high risk factor to this type of investment. [Today is 10/22/98.] I notice that the last question up-date was 9/28/98 so if you e-mail back a answer it would be appreciated. Paul
Answer: I won't address your facts. I'll assume they are correct and try to explain how that could be consistent with rationality in the market. It's not clear that credit risk is the issue. I'll agree that Fannies and Freddies have little of that, although they don't have federal government guarantees, as far as I know, except for Fannie's limited "backstop authority".
The main issue here is the value of the borrower's prepayment option inherent in each loan that Fannie or Freddie buys. The more valuable that option, the more the borrower will pay for it. The borrower pays more by paying a larger coupon for a loan priced at par. The larger coupon leads to a larger yield to maturity and spread over the ten-year Treasury. Apparently, right now, that option is extremely valuable, which I don't find particularly amazing in this relatively uncertain world. See what has happened to volatilities in the Treasury bond market. I haven't looked, but would guess that they have risen.
Maybe the following illustration will be useful. If you buy
the ten-year, noncallable Treasury, trading at par, then your
coupon and yield to maturity will be a specific number, say 5%
for ten years. (I'm making this up. I don't know the real number
and don't really care. If you don't like 5%, use another number
and make the appropriate changes, elsewhere.) If you had bought
the ten-year, callable Treasury, trading at par, and its coupon
were also five percent, then three things could happen:
Similarly, the 30-year mortgage contains an embedded prepayment (American call) option. The lender demands a high coupon to pay for selling that option, and the borrower is willing to pay for the option that way. When the mortgage spread over the 10-year Treasury rises, it could be because of declining credit quality or because of increased time value for the embedded call option. Dr. Risk
Credit risk (7/28/98; revised 11/28/98)
Question: Dear Dr. Risk I research a litterature survey of the credit risk: How is credit risk measured? Stephane
Answer: Dear Stephane The short
answer is, very badly.
Links Links related to credit risk are below. Links related to other financial topics are here.
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8/28/00 The Fragile Middle Class, by Teresa A. Sullivan, Elizabeth Warren, and Jay Lawrence Westbrook. New Haven: Yale, 2000. (Reviewed in the New York Times (2000 August 24) by David Frum.
In 1996 personal bankruptcies in the U.S. surpassed one million for the first year in history. Bankruptcies are five times as frequent as they were in 1979. They increased faster during the boom years after 1994 than they did during the recession years of 1981-1982. In 1980 the bankruptcy rate in the U.S. was 130, compared to Canada's 85 and the U.K.'s 8.
Why do we see so much bankruptcy in the U.S. now, compared to the past? Why so much bankruptcy in the U.S., compared to abroad? Here are some possible reasons, in no particular order:
The U.S. has a high rates of bankruptcy and divorce. Why?
Saunders, Credit Risk Measurement (7/28/99)
Dear Dr. Risk This week I found out about a new book on credit risk measurement due to be published in June/July called "Credit Risk Measurement; New approaches to value at risk and other paradigms", by Anthony Saunders (see also the picture of the book-cover below). Maybe you heard/read about this book as well. I am very interested in your opinion, is it worth buying? Chris
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