Arnaud de Servigny and Olivier Renault, Measuring and Managing Credit Risk

Transcription

1 P1.T4. Valuation & Risk Models Arnaud de Servigny and Olivier Renault, Measuring and Managing Credit Risk Bionic Turtle FRM Study Notes Reading 33 By David Harper, CFA FRM CIPM

2 DE SERVIGNY, CHAPTER 2: EXTERNAL AND INTERNAL RATINGS... 3 DESCRIBE EXTERNAL RATING SCALES, THE RATING PROCESS, AND THE LINK BETWEEN RATINGS AND DEFAULT

3 de Servigny, Chapter 2: External and Internal Ratings Describe external rating scales, the rating process, and the link between ratings and default. Describe the impact of time horizon, economic cycle, industry, and geography on external ratings. Review the results and explanation of the impact of ratings changes on bond and stock prices. Compare external and internal ratings approaches. Explain and compare the through the cycle and at the point approaches to score a company. Define and explain a ratings transition matrix and its elements. Describe the process for and issues with building, calibrating and back testing an internal rating system. Identify and describe the biases that may affect a rating system. Traditional Credit Analysis Classic credit analysis is an expert system that relies on the subjective judgment of trained, experienced professionals. In such an expert system, knowledge tends to warehouse among tenured professionals: The senior lender understands the institution s culture credit and the boundaries that are shaped by tradition. The senior lender is a source of rules of thumb. Banks rely on their senior lending officers to zero in on the most important issues under which the bank will make the loan. Emphasis Shifted from Balance Sheet toward Cash Flow Historically, banks made loans against the borrower s inventories and receivables collateral that could be liquidated. But more recently, banks expanded to financing fixed assets and collateral that does not have liquid markets. This shift renders collateralization less relevant to the credit process. Since debt must be repaid in cash, banks need to focus on the borrower s cash flow. Cash flow from operations (CFO) defines the company s liquidity; i.e., is it able to generate sufficient cash from internal operations to service its debt. Cash flow lending replaced secured lending as the principal activity of a commercial bank. Traditional credit analysis is associated with the three Cs : character (the borrower s willingness to repay), capacity (the borrower s ability to repay) and capital (either the borrower s capital cushion or their avenues to alternative forms of repayment). 3

4 Major Rating Agencies When the assigned reading was published, there were five agencies designated by the SEC as nationally recognized statistical rating organizations (NRSROs). Now there are at least nine NRSROs: Standard & Poor's Moody's Investors Service Fitch Ratings Kroll Bond Rating Agency A. M. Best Company Dominion Bond Rating Service, Ltd Japan Credit Rating Agency, Ltd. Egan-Jones Rating Company Morningstar, Inc. In June 2007, the SEC promulgated rules (Oversight of Credit Rating Agencies Registered as Nationally Recognized Statistical Rating Organizations) that enacted provisions of the Credit Rating Agency Reform Act. Delegated Monitoring Function Rating agencies are delegated monitors : they issue an independent credit opinion based on the application of consistent criteria. The ratings are not recommendations to buy or sell, but rather opinions. A rating is a broad indicator or broad bucket of the probability of default. Style Differences among Firms Style varies by firm: Standard & Poor s (S&P) tends to refer to the likelihood of default. S&P assigns greater weight to industry risk; i.e., the strength and stability of the industry in which the firm operates. Moody s tends to refer to expected loss. Moody s ratings place weight on business fundamentals such as demand-supply characteristics, market leadership, and cost positions. Expected loss (EL) = probability of default loss severity Duff and Phelps prioritizes the company s presentation to their rating committee. An S&P rating tends to correspond to a probability of default (PD), while a Moody s rating tends to refer to expected loss (EL) where EL = PD * LGD. 4

5 Describe external rating scales, the rating process, and the link between ratings and default. Rating scales can be short-term or long-term and they can apply to specific obligations or instruments (i.e., issue-specific credit ratings) or to an issuer s general creditworthiness (i.e., issuer credit ratings). Long and short-term instruments Issue-specific or issuer-specific Opinions into categories, not buy/sell recommendations S&P tends to reflect view on probability of default (PD) - Moody s tends to reflect view on expected loss The bond universe is broadly divided into investment grade and non-investment grade bonds. In rating long-term debt, each agency uses a system of letter grades that locate an issuer or issue on a spectrum of credit quality from the very highest (triple-a) to the very lowest (D). Investment grade = rated Baa3 or BBB- and above Speculative or non-investment grade = issues rated Ba1 or BB + and below 5