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Module 28: Management of Credit Risk

Module 28 Objective

Describe the tools and techniques for identifying and managing credit and counterparty risk

Sec 1 & 2: Focus on the normal view of credit risk (i.e. risk of a counterparty defaulting on its obligations)

Sec 3: Consider managing a company’s own credit worthiness (i.e. risk that the company defaults on its obligations to others)

Exam note:

  • Need to recommend strategies for dealing with market and operational risks and likely applied to credit risk too

Credit Risk Management Process

5 stages in the credit risk management process:

  1. Policy and infrastructure

  2. Credit granting

  3. Exposure monitoring, management and reporting

  4. Portfolio management

  5. Credit review

1. Policy and Infrastructure

Goal of this stage:

  1. To have documented credit policies and procedures

  2. To ensure credit risk can be effectively identified, measured, monitored, controlled and reported

This stage involves:

  1. Establishing an appropriate credit environment

  2. Adopting credit risk policies and procedures

    • Appropriate to the company’s business context

    • Address a range of topics

    • Adopted by senior management

  3. Implementing credit risk policies and procedures

    • Communicate to all relevant employees

    • Review at least annually to reflect any change in the business context

  4. Developing methodologies and models with appropriate systems

  5. Defining data standards and conventions

2. Credit Granting

Extending credit to customers or other counterparties:

  1. Credit analysis/rating of counterparties

  2. Credit approval

  3. Pricing and setting term and conditions for credit

  4. Documentation

Credit rating can be applied to the transaction or to the counterparty

Characteristics of an effective and efficient credit rating system:

  • Strike a balance between effectiveness (accurate, consistent and timely) and efficiency (low cost)

  • May be based on pure judegement or deterministic modeling (or both)

  • Should respond to changes in circumstances of the counterparty

    (e.g. ratings being review regularly)

Ratings should reflect the following factors:

  1. Borrower’s repayment history

  2. Analysis of the borrower’s ability to pay

  3. Reputation

  4. Availability and enforceability of guarantees or collateral

3. Exposure Monitoring, Management and Reporting

Purpose of this stage:

  • Prevent undue exposure to an individual counterparty

  • Ensure appropriate portfolio diversification

  • Provide early warning of possible adverse credit events

    (e.g. monitor indicators such as credit spreads and stock price volatility)

2 types of credit exposure:

  1. Current exposure:

    Amount of risk today if all credit transactions were settled and credit assets sold

  2. Potential exposure:

    Amount that may be at risk in the future

    Likely to be a function of time to maturity and volatility of the underlying instrument

Exposure may be calculated from the current exposure or using some rule of thumb (important to take consistent approach)

Exposure limits

  • Avoid concentration of risk in a single counterparties, connected counterparties and other groupings

  • Actual credit exposure should be compared to the limits

4 uses of exposure limits:

  1. Risk control:

    Prevent from engaging in overly risky business activities

  2. Allocation of risk bearing capacity:

    Limits should reflect management’s assessment of risk/return trade off

  3. Delegation of authority:

    Ensure credit decisions are made by those with the appropriate skill and delegated authority

  4. Regulatory compliance:

    Regulators maintain close scrutiny of credit risk controls

Best practice credit risk reporting

  • Relevant and timely

  • Reliable

  • Comparable

  • Material

  • Should includes

    • Trends

    • Risk-adjusted profitability

    • Large individual exposures

    • Aggregate exposures

    • Exceptions

4. Portfolio Management

Credit portfolio management function:

  • Optimize the desired risk/return trade offs by defining a target portfolio

  • Historically credit risk stayed on the company’s b/s until settlement of the transaction

  • Strategies and financial vehicles used for portfolio management includes:

    • Buying or selling assets

    • Securitizing assets

    • Hedging risks using derivatives

    • Transferring risk

Current trend is to disaggregate the business into: origination, portfolio management and servicing

  • Enables loans to be packaged into various asset-backed securities Introduces market discipline and feedback on underwriting, pricing and documentation as separate business components

  • However, a lack of controls across these dis-aggregated business components is one of the key reasons for the credit crisis

5. Credit Review

Role of credit review:

  • Review a sample of transactions and associated documentation to ensure data is correct

  • Test that systems are working

  • Enforce underwriting standards

  • Check policies and procedures are being followed

Results of the review should be communicated to management

  • Any exceptions or deficiencies should be highlighted, along with the established timeframes for their resolution

Best Practices

Basic Standard Best
Credit risk ratings Common definitions of risk and exposure measurement across the business; Very few risk ratings; Focus on individual transactions Better risk rating linking into pricing, reserve and capital requirements; Credit exposure limits by counterparty, industry, country Risk managed at individual transaction and portfolio level
Modeling Simple spreadsheet models and credit bureau reports Internal and 3rd party model consider a variety of indicators Sophisticated tools (incl. simulation models, scenario analysis and planning, advanced credit scoring, surveillance and migration models)
Credit risk function Policy, approval and monitoring More integration into loan origination; Performance measured by risk-adjusted profitability of BU Centralized active portfolio management aim to optimize portfolio risk/return; Strong credit culture

  • The level of sophistication required depends on the risk profile of the company

  • Even best practice companies can build up dangerous levels of concentration of risk

Credit Risk Management Techniques

Underwriting and due diligence:

  • Facilitate decisions as to the appropriate types of response to a particular credit risk exposure

    (i.e. avoidance, acceptance, transfer and or management)

Transfer of credit risk is often achieved by credit insurance, credit derivatives and or by the securitization of assets

1. Underwriting

Approaches to check creditworthiness

  • Credit scoring approach (Module 23)

  • Component analysis technique (Module 19)

  • 3rd party ratings (e.g. Moody’s or Experian)

2 potential outcomes of underwriting

  1. Decision

    (e.g. approve or denied)

  2. What terms should be placed on the loan

    (e.g. interest rate, requirement to provide collateral)

2. Due Diligence

Due diligence: Refers to the care a reasonable person should take before entering into any agreement or transaction with another party

  • Should be done when a company enter into a major agreement with a 3rd party

  • Degree of due diligence varies depending on the type of relationship and value of the transaction

  • Generally covers a wide range of factors (e.g. public and internal documents) including subjective information (e.g. interview with management and other stakeholders)

  • Can be expensive and time consuming

  • Process is very similar to that undertaken by credit-rating agencies when determining a rating

2 potential outcome of due diligence

  1. Avoidance of exposure to the counterparty

  2. Acting to limit exposure

    (e.g. through careful payment schedule)

Optional reading of an extensive due diligence checklist: “The Financial Risk Manual - A Systematic Guide to Identifying and Managing Financial Risk” J Holliwell

3.1 Credit Insurance

Credit insurance: One way to mitigate large exposures to particular types of credit risk

  • Particularly for incidental credit risk (not related to core business)

Benefits of credit insurance

  1. Protection against some or all bad debts

  2. Cover for some or all debtors

  3. Cover for domestic or international trade

  4. Specialist advice based on the experience of the insurer

  5. Cover for expenses incurred

  6. International cover for country risk, debt recovery services and any losses on forward foreign exchange commitments

  7. Ability to secure better terms for financing (help to offset the cost of the insurance)

Cost of the insurance will take into account: Industry sector, the country risk, the nature of the goods and services, the term of trade and the track record of existing buyers

When settling claims the insurer will ensure:

  1. Goods and services have actually been provided

  2. The debt exists

  3. That credit limits have not been exceeded

  4. Insurance premium has been paid

3.2 Credit Derivatives

2 types of instrument that can be used to manage credit risk are Credit Default Swaps (CDS) and Total Rate of Return Swaps (TRORS)

Liquidity of both the TRORS and CDS maybe better than the underlying asset

\(\hookrightarrow\) Advantage of using them as hedging tools (Instead of directly selling the underlying credit risk in the cash markets)

Both TRORS and CDS introduce counterparty risk

CDS

Use case:

  • Lenders who have reached their internal credit limit with a particular client, but wish to maintain their relationship with the client can use CDS

    e.g. CDS give Bank X the right to sell a bond, which was issued by Company Y to Bank Z for the face value of the bond should Company Y experience a pre-specified type of credit event

Types of Credit Events

  1. Bankruptcy

    (e.g. insolvency, winding-up, appointment of a receiver)

  2. Rating downgrade

  3. Repudiation

    When debt issuer simply chooses to cancel all of the o/s interest payments and the capital repayment of the debt

  4. Failure to pay a particular coupon

  5. Cross-default

    A cross default clause on a bond means that a credit event on another security of the issuing firm will also be considered a credit even on the referenced bond

CDS Structure

  • Payment of a fee (single or regular) by the party that is looking to hedge to the party that is selling the protection

  • Seller of the protection will make a credit default protection payment if a credit default event on the reference asset occurs within the term of the contract

  • Hedge the default risk but does not explicitly hedge the price risk

Settlement types

  1. Cash settlement:

    Amount of the protection payment = original price of the reference asset \(-\) recovery value of the reference asset

    Disadvantage:

    • Recovery process takes time, may invoke uncertain cost for the CDS owner and the ultimate recovery amount is uncertain

    • Contract needs to clearly state what is the recovery value

      If it’s the market value, it is important to specify the time

  2. Physical settlement:

    The seller pays the full notional amount and receives the defaulted security

    Disadvantage: Will be more costly than cash settlement

Other features of CDS

  • CDS contract can reference a portfolio of bonds or a whole bond index

  • Buyer of CDS may not have any insurable interest (no exposure to the reference entity)

    \(\hookrightarrow\) CDS can be used as an alternative to short-selling the reference asset

TRORS

Total rate of return swaps (total return swaps) can hedge both price and default risk

  • Total return from one asset (or group of asset) is swapped for the return on another

  • This creates a hedge for both market (price) risk and credit (default) risk of the reference assets

  • Investors who cannot short securities maybe be able to hedge a long position by paying the total rate of return in a TRORS

Use case:

  1. Increase diversification:

    Swapping one type of exposure for another without physically swapping the underlying assets

  2. Manage specific risk

    (e.g. credit risk)

Example:

  • \(A\) owns a risky bond from \(B\)

  • \(A\) pay coupons from bond to bank \(C\)

  • Bank \(C\) pays \(A\) LIBOR + 2%

  • If \(B\) doesn’t default, \(A\) pay additional payment to \(C\) = increase in the value of the bond from \(B\)

    (So \(A\) overall pays the total return received on bond from \(B\) in return for LIBOR +2%)

  • If \(B\) default, \(C\) will receive from \(A\) a net payment on default based on the face value of bond from \(B\) less recovery

3.3 Securitization

Involves pooling together a group of assets, combined with the issue of one or more tranches of asset backed securities (ABS)

  • Cashflows generated by the pool of assets are used to service the interest and capital payments on the ABS

Structure

Framework of securitization:

  1. Originator sells those assets to a special purpose vehicle (SPV)

  2. SPV raises the funds to purchase the assets by issuing debt securities such as bonds to investors (these are the ABS)

  3. The receivables transferred into the SPV meet the principal and interest liabilities on the debt securities

    • SPV may grant security over the receivables to secure its obligation to repay principal and interest

    • In which case, investor in the SPV would be entitled to claim the underlying assets in the event of default

SPV will be structured to be bankruptcy remote in the event of the failure of the borrower (i.e. it is a separately legal entity, usually a company in its own right)

  • Hence in the event of the default by the SPV, the investors has no recourse to the assets of the original owner and vice versa

Example

  1. Company X sells the secured assets that will generate the future income stream to the SPV

  2. SPV raises the required funds to purchase them by issuing (asset backed) bonds to investors

  3. Cashflow generated by the secured assets is then paid to the SPV, which in turn uses them to meet the interest and capital payments on the ABS

Benefits

  1. Converts a bundle of assets into a structured financial instrument which is then negotiable

  2. A way for a company to raise money, that is linked directly to the cashflow receipts that it anticipate receiving in the future

  3. An alternate source of finance to issuing “normal” secured or unsecured bonds

  4. A way of passing the risk in the assets to a 3rd party, removing them from the b/s and reducing capital

  5. A way of effectively selling exposure to what may be an otherwise unmarketable pool of assets

Types of Securitized Assets

Originally they are homogeneous debt obligations (residential mortgages or trade receivables) subject to relatively simple terms and conditions

  • However, scope of securitization and ABS grew rapidly prior to the credit crunch

Examples of ABS

  1. MBS residential and commercial mortgage backed securities:

    Payments are secured or collateralized on the interest and capital payments made under mortgages used to buy property

  2. CCABS credit card receivables:

    Based on the payments made by credit card holders to the credit card company

  3. CLO, CBO, CDO Collateralized loan, bond and debt obligations:

    Typically collateralized on existing bank loans, bonds and a mixture of both bank loans and bonds respectively

  4. Insurance securitization:

    Backed by the receivables arising from an insurance book

Almost any assets that generate a reasonably predictable income stream can in theory be used as the basis of an ABS

Tranches

Borrowing are normally made in a multi tranche format with credit ratings or credit default protection obtained for at least the major tranches

  • Tranches are repaid according to the rules laid down in the documentation

  • Actual returns will depend on the actual timing of repayments on the underlying assets, any early repayments and any default losses and recoveries

  • Expected returns on each tranche are highly sensitive to the choice of model/parameters used to project these uncertain future cashflows

By working with credit rating agencies to structure the bond tranches in the way that best meets the various risk and return requirements of the different potential investors, it may be possible to reduce the overall cost of borrowing (i.e. raise a greater price in exchange for the transfer of assets to the SPV)

Cashflows from the underlying portfolio might be used to create:

  • Bond with fixed coupon rate:

    Most senior security and its coupons are paid first

    Senior debt that might carry AAA rating

  • Bond whose coupons are paid as long as there is enough left from the senior debt:

    Mezzanine tranche, typically BB rating

  • Claim on the residual cashflows from the original portfolio after the 2 senior classes are paid:

    High yield speculative bond, equity claim

Such a tranched structure is called a collateralized debt obligation (CDO) if the underlying assets are bank loans and or bonds

  • Similar structure involving a number of different tranches of ABS can be used irrespective of the underlying securitized assets

Key benefit

  • They combine the credit risks of different instruments into a portfolio which is then divided and repackaged as several new securities with credit risk features different to the underlying instruments

  • These alternative features may be more attractive to particular investors

    \(\hookrightarrow\) Proceeds of the securitization will be higher than if the underlying instruments had been securitized as a single tranche

Credit-linked Note

CLN: A collateralized vehicle consisting of a bond with an embedded CDS

  • Can be used by the holder of corporate bonds (protection buyer) to transfer the credit risk on those bonds (reference asset) to other investors

Process:

  1. Setting up an SPV

  2. Sells the CLNs to investors

  3. Uses the proceeds to buy risk-free government bonds

  4. SPV also sells a credit default swap based on the original corporate bonds to the original bondholder

Investors receive a total return based on the CDS premium income and the yield on the risk-free bond

In return, their capital is at risk and may be required to recompensate the protection buyer in the event of a default on the reference bonds

If the CLNs are in a multi-tranche format then they provide not only a useful way of transferring credit risk but also a mean of repackaging credit risk

CLN vs CDS

  • CLN may be more attractive to investors (protection seller) who are not able to sell credit derivatives (due to internal or external constraints) but who are able to buy CLNs (if classified as bonds rather than credit derivatives)

Managing Creditworthiness

Company can manage the level of credit risk to which it exposes its own stakeholders by adjusting:

  • Capital structure

  • Mix and volume of business it writes

Entities can manage its own credit risk by raising (or distributing) capital, approach varies by entity types:

  • Investment banks:

    Work backwards from the volumes of business they expect to write and their target credit rating to determine the amount of debt capital they need to hold

  • Insurance companies:

    Follow a similar approach as investment bank but on a less tactical basis

    The raising (or distributing) of capital is more likely to result from strategic reviews (e.g. business mix)

  • Pension funds:

    Will link capital decisions (affecting contribution rates, benefit levels and the mix of capital by source) to reviews of investment strategy

    They will be made in the light of the strength of the sponsor covenant and any alternative methods of contribution to cash payments that are being used

Company with fixed capital based

  • Generally speaking, most orgs cannot change their capital base as readily as investment banks

  • 3 ways in which a business whose capital base is fixed can improve its creditworthiness:

    1. Writing less of the same business, hence conserving capital

    2. Changing the mix within each particular class of business, which may have a diversifying effect

      (e.g. improve geographic spread)

    3. Changing the mix between the various class of business, again to diversify across classes with low correlations