Best debt advisory

PORTFOLIO DIVERSIFICATION

admin — Thu, 05 Aug 2010 09:24:59 +0000

It makes no difference whether the assets are stocks and bonds held for investment purposes, financial instruments held and positions taken for trading purposes or loans. It is tempting to assume that the overall objective of credit management is to achieve the lowest level of expected credit losses for a given standard deviation or the lowest standard deviation for a given expected loss level. This fails to take account of the revenue side, however.
A simple example will suffice to illustrate how credit risk concentration may occur. Let us assume that we are a bank operating in one state that has made a large loan to a cement manufacturer which is the largest employer in the town in which it is located. To diversify the risk of being exposed to the cement industry we also have many loans to real estate companies and to retail customers such as mortgages, car loan and credit cards. If the cement manufacturer fails this may start a chain reaction:

First we have the default on the loan to the cement company. But it will also lead to many people losing their jobs. We are at the risk of these individuals who are our customers being unable to make their mortgage, car loan and credit card payments. It will also lead to credit losses and loss of business at its suppliers. If the cement manufacturer is the town’s major employer the retailers will be adversely affected. This increases the risk that they will fail. In turn this increases the risk that property

investors who have borrowed to fund the retail mall will fail. Property prices are likely to fall as will our collateral cover. The bank can foreclose on lenders that had defaulted but could face realizing significantly lower recovery rates than originally expected from selling into a falling and illiquid property market.

DECOMPOSITION AND AGGREGATION

admin — Sat, 05 Jun 2010 09:24:23 +0000

The process of decomposition and aggregation of credit risks involves more judgment than that required for market risk. As a general rule of thumb the better the relationship between the likelihood of a default occurring and the factor the lower down the decomposition tree it should be.
The following two schematic diagrams show possible decomposition and aggregation levels for a bank’s retail loan book and its corporate exposures. The first level of aggregation is that of borrower rating.
The equivalent of VAR must be estimated for each exposure at each borrower and at the lowest level. Historic correlation coefficients should be applied as we move up the tree although at the higher levels where correlations start to become weaker and less reliable it is probably better to simply make a policy decision as to whether to treat these as independent or assume perfect positive correlation.

Internal Ratings

admin — Fri, 05 Mar 2010 09:23:43 +0000

A critical starting point for a bank seeking to develop a useful historic database on credit losses is to have an internal credit rating system and allocate a rating to each exposure. Most bank rating systems have approximately 8–12 different rating grades of which 3–4 are devoted to loans now classified in some way as problem or non-performing loans. Such a rating system is necessary to price the credit risk of an exposure. When individual ratings are reviewed on a relatively frequent basis this should provide a basis to determine changes in overall asset quality. During periods when there is a general deterioration in financial conditions this should show itself as a migration of exposures from better quality to lower quality ratings. There are some broad problems with the use of internal ratings systems.
At a minimum the definitions for individual ratings should capture the following: location (city, state, country), industry classification, type of exposure, type and value of collateral, nature of any guarantees and internal credit rating of guarantor. The original definitions are critical because if definitions are subsequently changed they may make it impossible to compare present data with that from the past. The criteria for assignment to a particular band must be clear-cut. The definitions should be largely quantitative and avoid subjective assessments. The risk arising from the latter is that interpretations are likely to change over time leading to the same problems concerning comparability.
While impossible to confirm on the basis of publicly available information, anecdotal accounts suggests that the ratings of new loans granted tend to cluster around a relatively small number of the ratings available. If this were the case it would imply that banks’ differentiation between exposures from a credit risk perspective is relatively crude.
There is a natural tendency to avoid extremes and “clustering” does little to help the objective of differentiating between companies from a credit risk perspective. These classifications can become the source of much argument when they directly affect the level of expected losses, and hence pricing, and unexpected losses and hence, ultimately, allocation of capital.

PROPRIETARY DATABASES

admin — Tue, 05 Jan 2010 09:23:02 +0000

Most banks built transaction-processing systems in the past rather than the type of management information systems necessary to reach informed conclusions on credit-loss characteristics and default and loss rates. Few credit default databases went much beyond location, industrial classification and, in some instances, internal credit rating. If only the world were so simple.
All banks should maintain their own historic database for issuer failures, loan defaults and credit losses from other exposures that allowed for the data to be looked at in the following ways:

By issuer. Industrial classification, credit ratings, net debt–equity ratios, size in terms of sales and total assets, operating cashflows to debt servicing costs, breakdown of assets and liabilities by currency, breakdown of debt by term, floating–fixed, currency.
By exposure. Loan/facility/derivative etc. Size of exposure, term, floating–fixed, optionality (e.g. prepayment, repayable on demand), security (type, value), guarantees etc.
We would also want to have access to external macro-level data such as GDP growth, ca- pacity utilization rates, interest rates, inflation, current account and fiscal positions and to industry-specific data such as property and other asset prices, auto sales, housing starts and retail sales. The shopping list of requirements could go on and on.
The intellectual tools derived from mathematical group theory to analyze such information existed 30 years ago. The technology existed at the time to store much of the data collected but the computing power to analyze and use this data did not then exist. Because it could not be used at many banks it was simply overwritten or thrown away. These basic problems with data have been compounded by the adverse effects of bank acquisitions and mergers.
This is perhaps understandable. There were costs associated with storing the data and it required a leap of vision to see that in 20 or 30 years’ time that data could be used to great effect and would be extremely valuable. Newton could truthfully say “If I have seen further than others, it is by standing upon the shoulders of giants.” Today people trying to work on credit risk management problems have to make do with what mere mortals have left behind.

Exotic Interest Rate Instruments

admin — Sat, 21 Nov 2009 08:46:02 +0000

This is a relatively simple introduction to the sort of interest rate-based instruments available to both banks and corporates to enable them to manage interest rate risk. Other more exotic instruments include the following:
Swaptions. Swaptions give the holder the right but not the obligation to enter into a future defined swap agreement.
Interest rate swap futures. These are futures contracts in which the underlying instrument is the value of a specified interest rate swap contract.
Basis spread contracts. It is possible to trade futures contracts based on basis spreads,
for example on the spread between two benchmark rates such as those from an interbank market and those from government bonds.
Bond indices futures contracts. A relatively few standardized bond indices exist on which it is possible to trade futures contracts.
Caps and collars. It is possible to create a number of different positions based on combinations of call and put options.
Strips and synthetic zeroes. Investment banks can create a variety of synthetic products based on actual or notional coupon bonds. A government coupon bond can be used to create two securities. The first security entitles the holder to the coupon payments only, these securities are referred to as strips. The second makes no coupon payments but has the structure of a zero coupon bond.

Accounting Treatments Based on Intent

admin — Tue, 13 Oct 2009 08:47:33 +0000

The accounting method used affects reported earnings, book value and the value for Tier I capital as defined in the Basel Accord. Under US GAAP banks are permitted to use both the carried-at-cost and mark-to-market methods. From an economic value perspective this is clearly nonsense. The same security held in different accounts will be valued in different ways based on intent!
A bank could have holdings in an identical bond booked in three different accounts based on “intent”. If the intention is to hold the bond to maturity it is included at cost. If booked as “available- for-sale” the asset is held on the balance sheet at current market prices with unrealized gains or losses included in a reserve account within the equity account. If the bond is counted as a “trading security” the bond is marked to market with any gains or losses taken through the earnings statements. Finally, if the bank had raised finance itself by issuing its own bond with identical economic characteristics as the bond held as an asset this will be carried at cost.
The rigorous application of accounting standards results in book value numbers that are precise but have limited real meaning (although they are of consequence). Numbers that reflect economic value, by their very nature, should be approximate and based on estimates but would at least have a real significance.
Most banks have argued against compulsory mark-to-market accounting on the basis that it will result in more volatile reported earnings, book value and level of reported regulatory capital. So what? External auditors usually sign off a company’s accounts with a statement along the lines of “these financial statements give a true and fair view of the state of ABC Bank as of December 31 2006 and of the profit of ABC Bank for the year then ended”. If the economic reality is volatile then this should be reflected in financial statements and management should be prevented from trying to hide this fact through accounting obfuscation and obstruction.
The main criticism of those efforts that have been taken to make reported book value reflect economic value better is that they did not go far enough. The main area where there has been some progress in this direction has been in the treatment of traded securities. It is difficult, however, to see the sense of taking just selected parts of the interest rate-sensitive portion of a bank’s balance sheet and marking them to market, while ignoring the much larger proportion held in loans and also non-equity liabilities such as bonds that a bank has issued.