Ch3 - Checklist for Origination, Ch4 - Measurement of Credit Risk

Question 1

Selecting good transactions is not easy, what checks and balances do you place to mitigate such losses?

Answer 1

• Does the transaction fit into my strategy/existing portfolio
• Do I understand the credit risk
• Does the seller keep an interest in the deal
• Are the proper mitigants in place
• Is the legal documentation satisfactory
• Is the deal priced adequately
• Do I have the skills to monitor the exposure
• Is there an exit strategy

Question 2

Does the transaction fit into my strategy?

Answer 2

• Elevate the decision-making process to a a senior committee (get additional points of view)
• Invest in external advice
• Document the thought and approval process
• Make sure that all relevant departments are involved

Question 3

Does the risk fit into my existing portfolio?

Answer 3

• LIMITS: on counterparties, industries, products, and countries. Whether there is capacity to take on exposure
• Concentration: if portfolio is already loaded with transaction of similar characteristics, a new on may impact concentration
• Critical mass: diversification/correlation with existing transactions
• Dry powder: keeping some capacity to deploy when they see future profitable opportunities

Question 4

Do I understand the credit risk?

Answer 4

• Even a minor change must receive proper attention as, combined with other minor changes, they create a new breed of products that have a different risk profile.
• Being careful with transactions that appear similar to existing ones

Question 5

Does the seller keep an interest in the deal?

Answer 5

• Why are they selling?
• Asymmetry of info
• Adverse selection: seller disposing of risks that he knows won’t perform well
• Mitigate this by requiring seller to retain exposure for a time

Question 6

Are the proper mitigants in place?

Answer 6

• Structural elements that help avoid or reduce a loss when a transaction deteriorates
• A mechanism to protect creditors
• Example: mortgages, where lenders can reposses a home

Question 7

Is the deal priced adequately?

Answer 7

It is essential for entities taking credit risk to be able to calculate what taking credit risk costs in order to make a profit on a risk-adjusted basis

Question 8

Do I have the skills to monitor the exposure?

Answer 8

-The main purpose of the surveillance activities is to detect, at an early stage, transactions whose performance is deviating from expectations

Question 9

Is there an exit strategy?

Answer 9

Being able to hedge or sell a credit exposure at any time

-When building a portfolio, one should think of the challenges and costs to get rid of positions if needed

Question 10

Exposure

Answer 10

“The potential maximum amount of money that could be lost in the case of default”. It is a useful gauge of absolute credit risk and of relative credit risk across transactions.

• The challenge is to arrive at values that are both economically meaningful and take practical considerations into account
• Consider: Gross Exposure, Net Exposure, and Adjusted Exposure

Question 11

Gross Exposure

Answer 11

(GE) is the worst case scenario (i.e. the absolute amount at risk)

• Represents the amount of money due by the counterparty and, therefore, the money at risk in case of bankruptcy
• Time dimension: same loan for two years is riskier than for one year

Question 12

Net Exposure

Answer 12

(NE) is GE minus the amount of collateral pledged. Four considerations:

1. Who owns the collateral in case of bankruptcy?
2. Can the collateral be valued? Haircut issues
3. Can the collateral be sold? Liquidity
4. Is the collateral correlated with the underlying exposure?

Question 13

Adjusted Exposure

Answer 13

(AE) is the NE multiplied by the expected usage given default (UGD)

• UGD captures the expected rate of utilisation of a facility in case of bankruptcy
• Creditor may have data showing that the credit facility utilisation is below the full amount most of the time, so NE can be adjusted down
• Banks consider that they are hardly ever exposed to the notional amount

Question 14

Features of “Probability of Default” (PD)

Answer 14

• Is a statistical indicator that represents the likelihood that a counterparty will default during some future time period
  1. It is never zero (very strong entities have a small chance of default)
  2. Abilities of highly rated governments to pay down their debt is in question
  3. It increases with time (financial strength of borrower deteriorates with time)
• Typically PD is calculated in a two step process: assigning a credit rating and observing historical data

Question 15

PD: Assigning a credit rating

Answer 15

Better grade = better chance to pay

• Internal rating system: only for large FIs
• Rating agencies: Moody’s, S&P’s etc (can be slow to react)
• Scoring systems: smaller companies, access financial data and conduct due diligence

Question 16

PD: Use of historical data

Answer 16

-Once the rating is assigned, as PD can be devised based on historical data for that particular rating
E.g., AA ratings typically have a 0.5% chance of default

Question 17

What are the major elements that influence recovery rates?

Answer 17

-RR is the amount of money recovered upon default, expressed as a percentage of GE. Major elements that influence RR include:
1. Total amount of assets available
2. Seniority of the position (some instruments receive share in priority)
3. Security package: e.g. lien on assets for bonds and loans
Widely used concept is the Loss Given Default (LGD) which is one minus the RR times the exposure. This reflects the net loss after recovery.

Question 18

Drivers of Expected Loss

Answer 18

= Exposure x PD x (1-RR)