The Handbook of Credit Risk Management

Transcription

1 The Handbook of Credit Risk Management

2 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

3 The Handbook of Credit Risk Management Originating, Assessing, and Managing Credit Exposures Sylvain Bouteillé Diane Coogan-Pushner John Wiley & Sons, Inc.

4 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) , fax (978) , or on the Web at Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, (201) , fax (201) , or online at 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) , outside the United States at (317) or fax (317) 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 For more information about Wiley products, visit 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 (cloth); ISBN (ebk); ISBN (ebk); ISBN (ebk) 1. Credit Management. 2. Risk management. I. Coogan-Pushner, Diane. II. Title. HG3751.B dc Printed in the United States of America

5 To my wife, Setsuko; my sons, Pierre and François; and my parents Sylvain Bouteillé To my Dad Diane Coogan-Pushner

6 Contents Preface Acknowledgments xiii xxi Part One Origination Chapter 1 Fundamentals of Credit Risk 3 What Is Credit Risk? 3 Types of Transactions That Create Credit Risk 5 Who Is Exposed to Credit Risk? 9 Why Manage Credit Risk? 18 Chapter 2 Governance 21 Guidelines 22 Setting Limits 25 Skills 26 Oversight 29 Chapter 3 Checklist for Origination 33 Does the Transaction Fit into My Strategy? 34 Does the Risk Fit into My Existing Portfolio? 35 Do I Understand the Credit Risk? 36 Does the Seller Keep an Interest in the Deal? 37 Are the Proper Mitigants in Place? 38 Is the Legal Documentation Satisfactory? 38 Is the Deal Priced Adequately? 39 Do I Have the Skills to Monitor the Exposure? 40 Is There an Exit Strategy? 40 vii

7 viii Contents Part Two Credit Assessment Chapter 4 Measurement of Credit Risk 45 Exposure 45 Default Probability 50 The Recovery Rate 60 The Tenor 62 Direct versus Contingent Exposure 63 The Expected Loss 63 Chapter 5 Dynamic Credit Exposure 65 Long-Term Supply Agreements 66 Derivative Products 68 The Economic Value of a Contract 71 Mark-to-Market Valuation 73 Value at Risk (VaR) 76 Chapter 6 Fundamental Credit Analysis 79 Accounting Basics 80 A Typical Credit Report 88 Agency Conflict, Incentives, and Merton s View of Default Risk 97 Chapter 7 Alternative Estimations of Credit Quality 103 The Evolution of an Indicator: Moody s Analytics EDF 104 Credit Default Swap Prices 110 Bond Prices 116 Chapter 8 Securitization 119 Asset Securitization Overview 120 The Collateral 123 The Issuer 127 The Securities 128 Main Families of ABS 131 Securitization for Risk Transfer 135

8 Contents ix Credit Risk Assessment of ABS 137 Warehousing Risk 138 Part Three Portfolio Management Chapter 9 Credit Portfolio Management 143 Level Level Level Organizational Set-Up and Staffing 155 The IACPM 156 Chapter 10 Economic Capital and Credit Value at Risk (CVaR) 159 Capital: Economic, Regulatory, Shareholder 160 Defining Losses: Default versus Mark-to-Market 163 Credit Value at Risk or CVaR 165 Creating the Loss Distribution 171 Active Portfolio Management and CVaR 179 Pricing 181 Chapter 11 Regulation 183 Doing Business with a Regulated Entity 184 Doing Business as a Regulated Entity 189 How Regulation Matters: Key Regulation Directives 190 Chapter 12 Accounting Implications of Credit Risk 201 Loan Impairment 202 Loan-Loss Accounting 203 Regulatory Requirements for Loan-Loss Reserves 205 Impairment of Debt Securities 206 Derecognition of Assets 207 Consolidation of Variable Interest Entities (VIEs) 208 Accounting for Netting 209 Hedge Accounting 211 Credit Valuation Adjustments, Debit Valuation Adjustments and Own Credit Risk Adjustment 212 IFRS 7 213

9 x Contents Part Four Mitigation and Transfer Chapter 13 Mitigating Derivative Counterparty Credit Risk 217 Measurement of Counterparty Credit Risk 217 Mitigation of Counterparty Credit Risk through Collateralization 218 Legal Documentation 225 Dealers versus End-Users 226 Bilateral Transactions versus Central Counterparty Clearing 227 Prime Brokers 229 Repurchase Agreements 230 Final Words 232 Chapter 14 Structural Mitigation 233 Transactions with Corporates 234 Segmentation of the Commercial Loan Market Senior versus Junior Debt Secured versus Unsecured Loans Covenants Events of Default Transactions with Special Purpose Vehicles 240 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 249 Credit Insurance 250 Surety Bonds 255 Letters of Credit or LoCs 258 The Providers Point of View 263 Chapter 16 Credit Derivatives 267 The Product 267 The Settlement Process 270 Valuation and Accounting Treatment 274

10 Contents xi Uses of CDS 276 Credit Default Swaps for Credit and Price Discovery 280 Credit Default Swaps and Insurance 280 Indexes, Loan CDSs, MCDSs, and ABS CDSs 280 Chapter 17 Collateral Debt Obligations (CDOs) 283 What Are CDOs? 283 Collateralized Loan Obligations or CLOs 286 Arbitrage CLOs 287 Balance Sheet CLOs 290 ABS CDOs 292 Credit Analysis of CDOs 296 Chapter 18 Bankruptcy 301 What Is Bankruptcy? 301 Patterns of Bankrupt Companies 303 Signaling Actions 306 Examples of Bankruptcies 307 About the Authors 311 Index 313

11 Preface The financial crisis, which struck the global economy in the late 2000s and continues today with the European sovereign debt troubles and ongoing banking fallout, reminds us of the relevance of sound credit risk management principles and processes. It serves as a powerful wake up call for executives of industrial companies and financial institutions across the globe. Even simple financial transactions performed daily can create heavy losses and jeopardize the very existence of a firm. Are the customers able to pay? What happens if the bank where money is deposited defaults? Can broker dealers that hold collateral disappear overnight? For everybody, the crisis (which we refer to as the 2007 crisis because in 2007, delinquencies on mortgages began occurring on a large scale and Standard & Poor s [S&P] downgraded thousands of asset-backed securities) and the collapse of major financial institutions offers an opportunity to take one step back and to rethink the basics of credit risk management. It is too often viewed only as the art of assessing single name counterparties and individual transactions. Credit risk management is more than that. The management of a credit risk portfolio involves four sequential steps: 1. Origination 2. Credit assessment 3. Portfolio management 4. Mitigation and transfer Each one must be individually well understood, but, also, the way they interact together must be perfectly mastered. It is only by fully comprehending the entire chain that risk professionals can properly fulfill their task of protecting the balance sheet of the firms employing them. We provide a comprehensive framework to manage credit risk, introducing one of the four essential steps in each part of the book. This book is based on our professional experience and also on our experience of teaching credit risk management to graduate students and finance professionals. Next, we provide an overview of each part. xiii

12 xiv preface Part One: Origination Part One focuses on the description of credit risk and on the credit risk taking process in any organization involved in credit products. We also provide a simple checklist to analyze new transactions. In Chapter 1 ( Fundamentals of Credit Risk ), we define credit risk and present the major families of transactions that generate credit risk for industrial companies and financial institutions. We conclude with the main reasons why properly managing a portfolio of credit exposures is essential to generate profits, produce an adequate return on equity or simply survive. In Chapter 2 ( Governance ), we present the strict rules that must be in place within all institutions taking credit risk. It all starts with clear and understandable credit policies or guidelines. Then, in order to control accumulation, we discuss the role of limits on similar exposures. We also provide a concrete framework to approve new transactions. To finish, we discuss the human factor: how a risk management unit must be staffed and where it must be located inside an organization. In Chapter 3 ( Checklist for Origination ), we introduce nine key questions that must be answered before accepting any transaction generating credit risk. It may sound trivial, but the best way to avoid credit losses is not to originate bad transactions. All professionals involved in risk taking must, therefore, ask themselves essential questions such as these: Does the transaction fit the strategy? Does it fit into the existing portfolio? Is the nature of the credit risk well understood? Is the deal priced adequately or is there an exit strategy? Part Two: Credit Assessment Part Two introduces the methods to estimate the amount of exposure generated by transactions of various natures before detailing how to analyze the creditworthiness of a company or of a structured credit product. The focus of Chapter 4 ( Measurement of Credit Risk ) is on the quantification of credit risk for individual transactions. We present the three main drivers influencing 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 counterparty. The default probability is a statistical measure that aims at forecasting the likelihood that an entity will default on its financial obligations. We introduce a two step approach to derive a default probability: the assignment of a rating followed by the use of historical data. Finally, there

13 Preface xv are few transactions that generate a complete loss when an entity defaults. Creditors are usually able to receive some money back. The amount is summarized by the recovery rate. The expected loss is the multiplication of the three parameters presented above. Chapter 5 ( Dynamic Credit Exposure ) is dedicated to the measurement of exposures that cannot be estimated in advance as they are dependent on financial market values. We present, with examples, two main families of transactions generating a dynamic credit exposure: long term supply/purchase agreements of physical commodities and derivatives trades involving, for instance, interest rates, foreign exchange, or commodities. We explain that the credit exposure of such transactions is the replacement cost of the counterparty and is measured with the concept of mark to market (MTM) valuation. We conclude by introducing the concept of value at risk (VaR), which provides a measurement of credit risk for a given time horizon and within a certain confidence interval. One of the key things to remember is that VaR is a convenient method, but it does not represent the worst case scenario. In the real world, actual losses can and have exceeded VaR. The cornerstone of all credit risk management processes is assessing the credit risk of counterparties. In Chapter 6 ( Fundamental Credit Analysis ), we present the most common method of analysis, which is a quantitative based review of the counterparty s financial data, and we also present a qualitative based review of the firm s operations and economic environment in which it operates. We start the analysis by covering basic principles of accounting and the salient features of a company s balance sheet, income statement, and cash flow statement. We then describe the key ratios summarizing the financial health of a company. We introduce the concept that the interests of the shareholders and of the creditors are not aligned. This is known as an agency conflict. In essence, creditors are not in a position to influence decisions impacting the fate of the money they invest in a company. This is the prerogative of management, appointed by shareholders. We conclude Chapter 6 by outlining a model building of the shareholders versus creditors relationship, developed in the 1970s by the Nobel Prize Laureate Robert Merton. Besides fundamental credit analysis, there are alternative ways for estimating the creditworthiness of a company, including its probability of default. We present the most common alternative ways in Chapter 7 ( Alternative Estimations of Credit Quality ). The most popular is based on the Merton Model presented in Chapter 6. Several companies offer commercial applications of the model like Moody s Analytics Expected Default Frequency (EDF ). We introduce the basics of the methodology behind the EDF and also its pros and cons. We explain that useful indication of credit quality can be extracted from the capital markets, notably the prices of

14 xvi preface credit default swaps and of corporate bonds. The limitations of these alternative sources are fully explained. The previous chapters focused on corporates and financial institutions but in Chapter 8 ( Securitization ) we introduce the basics of structured credit products, primarily asset backed securities, or ABS. Banks developed asset securitization in the 1970s as a way to originate mortgages without keeping them and their associated credit risk, on their balance sheet. We discuss the three building blocks of any securitization scheme: the collateral (i.e., the assets sold by the originator), the issuer of the ABS (which is an entity created for the sole purpose of making a transaction possible and is called a Special Purpose Vehicle, or SPV), and the securities sold to investors. We present the main families of ABS that are primarily supported by consumer assets like mortgages, auto loans, and credit card receivables. Part Three: Portfolio Management Part Three is primarily dedicated to the management of a portfolio of credit exposures with a focus on capital requirements. We also present how regulators all over the world impose strict conditions on financial institutions in order to limit their risk taking and maintain their capital levels, as the regulators mandate is to protect the public and maintain the financial stability of the world economy. We finish with a description of the main accounting implications associated with the major credit products. Assessing individual transactions is not enough to protect a firm s balance sheet. In Chapter 9 ( Credit Portfolio Management ), we introduce the fundamentals of credit portfolio management (CPM), which consists of analyzing the totality of the exposures owned by a firm. The main goals of CPM are to avoid accumulation on some companies or industry sectors, to prevent losses by acting when the financial situation of a counterparty deteriorates, and to estimate and minimize the amount of capital necessary to support a credit portfolio. For companies with a small portfolio, CPM can be intuitive and performed with simple methods. For institutions with a large portfolio and complex exposures, CPM requires the use of analytical models. We explain why it is crucial to adapt the sophistication of CPM activities to the real needs of an entity. As such, we present three different complexity levels that we recommend any firm adopt based on its own needs and resources. Chapter 10 ( Economic Capital and Credit Value at Risk (CVaR) ) is dedicated to the description of the analytical concepts used to evaluate the amount of capital necessary to support a credit portfolio. We introduce the

15 Preface xvii concept of a loss distribution, which associates an amount of money that can be lost with a corresponding probability. The shape of the distribution is influenced by the correlation between the assets, that is, the chance that the financial condition of distinct entities deteriorates at the same time, usually as a result of the same economic conditions. A credit loss distribution is not a normal bell shaped distribution, but, rather, it is heavily skewed. This reveals that there is a high probability of losing a small amount of money (summarized by the expected loss of the portfolio) and the low probability to lose a lot of money. To survive under the latter scenario, firms need to set aside capital. We explain that the amount of capital is determined by the concept of VaR due to credit exposure (or credit VaR, i.e., CVaR) applied to the entire portfolio. Active portfolio management aims at reducing the amount of capital by executing rebalancing transactions. Chapter 11 ( Regulation ) outlines the myriad of regulators and their respective domains as it relates to assuming or being exposed to credit risk. We present the reach of the regulators from the perspective of a credit originating business that does business with a regulated entity, since the regulation itself will materially influence the credit profile of the obligor. We also present the reach of the regulators from the perspective of the regulated entity, which are primarily financial institutions, as it relates to taking on credit risk. Regulators and their regulations are numerous, and, as this book goes to print, there are global efforts underway to harmonize both the regulatory agencies and their regulations and to remove the loopholes that exist. We attempt to give readers a sense for these new regulatory directives, including their mandates, scope, and timelines. In Chapter 12 ( Accounting Implications of Credit Risk ) we outline for readers the accounting treatment, under both U.S. GAAP and International Accounting Standards, of instruments that involve credit risk. This includes the accounting for loans, for other credit instruments such as bonds, and impairment. We outline the rules relating to de recognition and consolidation of assets, counterparty netting agreements, and the credit and debit valuation adjustments used in derivatives accounting. Although accounting should never drive risk management decisions, all risk professionals should understand the basic accounting implications associated with originating, holding, and unwinding exposures. Part Four: Mitigation and Transfer Because there is always a risk that the financial situation of a counterparty deteriorates after the conclusion of a transaction, it is common to put safeguards in the legal documentation. If properly designed, the safeguards in

16 xviii preface place can reduce the risk of default or improve the amount recovered after a default. We will describe the most common safeguards at the beginning of Part Four. We will then introduce techniques available to risk managers to either transfer the credit risk they hold to a third party, or to neutralize it with an offsetting position, both tactics known as hedging. For derivative transactions, in order to reduce the losses in case of the default of one s counterparty, financial institutions utilize standard principles that we describe in Chapter 13 ( Mitigating Derivative Counterparty Credit Risk ). The implementation of these principles provides confidence to market participants and promotes large scale trading or liquidity. One standard principle to limit credit exposure is to have counterparties post collateral, that is, transfer cash or easily sellable assets whenever their trading losses, measured by the mark to market value of all the transactions, exceed a pre agreed threshold. By setting very low thresholds, the uncollateralized exposure and, therefore, the potential loss are always low. We explain the key principles of a robust collateral posting mechanism. After the recent crisis, regulators vowed to impose even stronger rules for derivatives markets participants. We explain how bilateral trades between financial institutions are gradually being replaced by the involvement of central counterparties or clearinghouses. Chapter 14 ( Structural Mitigation ) is dedicated to techniques and conditions imposed on a counterparty during the lifetime of a transaction. Their objectives are either to maintain the creditworthiness of the counterparty after the inception of a transaction, or to trigger immediate repayments in case of deterioration. We start by outlining the standard techniques used in bank loans. Conditions imposed to borrowers are called covenants and we present the two main types, negative and affirmative. They do not improve the recovery expectations but prevent or delay defaults. We also describe the differences between secured and unsecured loans. In the second part we focus on the various techniques used to strengthen securitization schemes. In Chapter 15 ( Credit Insurance, Surety Bonds, and Letters of Credit ), we introduce three traditional methods used to transfer the credit risk that an entity faces to a third party. Credit insurance applies exclusively to trade receivables, that is, invoices sent to customers after a sale. It is offered by insurance companies and indemnifies the policyholder if a client does not pay. Insurance companies also offer surety bonds. Their role is to provide a payment if a counterparty fails to perform a contractual, legal, or tax obligation. We present the main two applications of surety: contract bonds in the construction industry and commercial bonds in many industrial sectors. We conclude by introducing letters of credit offered by banks to support transactions entered into by their clients. If a counterparty does not

17 Preface xix perform on its obligations, the letter of credit is drawn, that is, the issuing bank pays on behalf of its client thereby reducing the losses. Credit derivatives are another technique employed to reduce a credit exposure and are explained in detail in Chapter 16 ( Credit Derivatives ). We first present the concept of the product before explaining how a firm purchasing a credit derivative is protected in case of default of a third party entity. We then present the various uses of credit derivatives. First, a credit derivative provides a simple way to hedge a credit exposure. This was the original purpose of these instruments. Second, it can be a relatively simple way to gain credit exposure to an entity, without having to fund an investment and without having to assume interest rate exposure. Third, it can be used to speculate on the demise of an entity. We terminate by providing an overview of the limitations of credit derivatives as a hedging instrument and by presenting products based on credit derivatives exchanged in the market-place. Collateralized debt obligations or CDOs have sometimes been blamed for the role they played in the 2007 crisis. In Chapter 17 ( Collateral Debt Obligations ), we introduce the basic concept of CDOs, explaining that they are a form a securitization already detailed in Chapter 8. We distinguish between the CDOs backed by bank loans and called collateralized loan obligations or CLOs and ABS CDOs, which are backed by asset backed securities. We focus on CLOs because they are still an active product used by banks to protect loans they have on their balance sheet or to finance loans they originate. We provide a framework to analyze CLOs for entities investing in them. In contrast, ABS CDOs have totally disappeared today. Chapter 18 ( Bankruptcy ) is dedicated to financial distress and bankruptcy. We start by defining bankruptcy and its legal context. We provide patterns of companies that have defaulted, which serve as early warning for credit analysts. In order to be concrete, we present the cases of two U.S. companies that defaulted recently: Eastman Kodak and MF Global Holdings.

18 Acknowledgments We would like to acknowledge the following individuals who kindly reviewed parts of this book or provided invaluable advice: Eva Chan, Stephen Kruft, Linda Lamel, Kristen Mayhew, Dietmar Petroll, Joe Puglisi, George Pushner, Steve Malin, Thomas Raspanti, and Mario Verna. Special thanks are due to Yutong Zhao who provided capable research assistance. We also thank the professionals at Wiley who guided the writing of this book from start to finish: Tiffany Charbonnier, Bill Falloon, Meg Freeborn, and Steve Kyritz. Of course, all mistakes are ours. The opinions expressed in this book are those of Mr. Bouteillé and of Ms. Coogan Pushner, and they do not reflect in any way those of the institutions to which they are or have been affiliated. xxi

19 The Handbook of Credit Risk Management