JEFFREY R. BOHN, PHD, leads the Financial Strategies group at Shinsei Bank in Tokyo. Previously, he led Moody’s KMV’s (MKMV’s) Global Research group and MKMV’s Credit Strategies group. After Moody’s acquired KMV, he and Roger Stein coheaded MKMV’s research and product development.

ROGER M. STEIN, PHD, is Group Managing Director of the newly formed Quantitative Research and Analytics group at Moody’s Investors Service in New York. Previously, he was head of research for Moody’s Risk Management Services. After Moody’s acquired KMV, he and Jeffrey Bohn co-headed MKMV’s research and product development.

Active Credit Portfolio Management in Practice

By Jeffrey R. Bohn Roger M. Stein

John Wiley & Sons

Copyright © 2009 Jeffrey R. Bohn and Roger M. Stein
All right reserved.
ISBN: 978-0-470-08018-4

Chapter One

The Framework: Definitions and Concepts

Commercial credit is the creation of modern times and belongs in its highest perfection only to the most enlightened and best governed nations. Credit is the vital air of the system of modern commerce. It has done more, a thousand times more, to enrich nations than all of the mines of the world. -Daniel Webster, 1934 (excerpt from speech in the U.S. Senate)

Theories of the known, which are described by different physical ideas, may be equivalent in all their predictions and are hence scientifically indistinguishable. However, they are not psychologically identical when trying to move from that base into the unknown. For different views suggest different kinds of modifications which might be made and hence are not equivalent in the hypotheses one generates from them in one’s attempt to understand what is not yet understood. -Richard Feynman, 1965

Objectives

After reading this chapter, you should understand the following:

* Definition of credit.

* Evolution of credit markets.

* The importance of a portfolio perspective of credit.

* Conceptual building blocks of credit portfolio models.

* Conceptually how credit models are used in practice.

* The impact of bank regulation on portfolio management.

* Why we advocate active credit portfolio management (ACPM).

WHAT IS CREDIT?

Credit is one of the oldest innovations in commercial practice. Historically, credit has been defined in terms of the borrowing and lending of money. Credit transactions differ from other investments in the nature of the contract they represent. Contracts where fixed payments are determined up front over a finite time horizon differentiate a credit instrument from an equity instrument. Unlike credit instruments, equity instruments tend to have no specific time horizon in their structure and reflect a claim to a share of an entity’s future profits, no matter how large these profits become. While some equity instruments pay dividends, these payments are not guaranteed, and most equity is defined by not having any predetermined fixed payments.

In contrast, traditional credit instruments facilitate transactions in which one party borrows from another with specified repayment terms over a specific horizon. These instruments include fixed-coupon bonds and floating-rate loans (the coupon payments are determined by adding a spread to an underlying benchmark rate such as the U.S. Treasury rate or LIBOR). Corporations are well-known issuers of these types of debt instruments; however, they are not the only borrowers. The past several decades have seen an explosion of consumer credit (particularly in the United States) in the form of home mortgages, credit card balances, and consumer loans. Other borrowers (also called obligors) include governments (usually termed sovereigns) and supranational organizations such as the World Bank. The credit risk of these instruments depends on the ability of the sovereign, corporation, or consumer to generate sufficient future cash flow (through operations or asset sales) to meet the interest and principal payments of the outstanding debt.

As financial engineering technology has advanced, the definition of credit has expanded to cover a wider variety of exposures through various derivative contracts whose risk and payoffs are dependent on the credit risk of some other instrument or entity. The key characteristic of these instruments is that, here again, the risk tends to lie in a predetermined payment stream over the life of the security or contract. Credit default swaps (CDS) exemplify this trend which aims to isolate the credit risk of a particular firm, the reference obligor, by linking a derivative’s value to the solvency of the reference obligor, only. These contracts require the protection buyer to pay a regular fee (or spread) to the protection seller. In the event the reference obligor defaults (per the specification of the CDS contract), the protection seller is required to make the protection buyer whole per the terms of the contract. Conceptually, the contract represents an insurance policy between the buyer (the insured) and the seller (the insurance provider). Extending the metaphor, the regular fee represents an insurance premium and the payout in the event of default represents an insurance claim under the policy. While a myriad of contract types now trade in the market, fundamentally they all represent a view on the credit risk of the underlying reference obligor.

While a CDS refers to a single name, derivative contracts on indexes of many named obligors can also be purchased as contracts on a specific basket of assets. These instruments expand the ability of credit portfolio managers to manage a large number of exposures without always resorting to hedging on a name-by-name basis or selling assets outright.

A related set of securities requiring financial engineering are broadly defined as structured credit. Popular forms of structured credit (also known as securitization) include collateralized debt obligations (CDOs) and asset-backed securities (ABS). In recent times, the credit crisis has made discussion of CDOs and ABSs more common in the media. Many commentators have called for drastic measures to curtail the use of structured credit. While abuse of these instruments can increase risk in institutions and markets, structured financial products can also be used responsibly to reduce risk in the financial system. Some regional banks, for example, have successfully hedged the concentration risk in their portfolios that results from most of their loans being originated in a single geography. They do this by selling some of their portfolio risk via structured credit. Other investors have purchased this risk and integrated it into their own portfolios as diversifying investments, creating lower volatility portfolios with improved return per unit of risk profiles. All market participants benefit from this kind of trading. Of course, these instruments can be abused when combined with excessive leverage or when market participants attempt to speculate using structures they do not fully understand.

But even the simplest of financial instruments such as equity can be inappropriate for particular investors in certain situations. The same is true of structured credit. We try to be careful to distinguish the purpose from the characteristics of particular instruments.

Conceptually, the basic structure of these instruments is straightforward: A number of securities or derivative contracts called collateral are placed in a structure called a special purpose vehicle (SPV) or special purpose company (SPC), creating a corporate vehicle to direct the cash flows from the collateral. In its simplest form, the purpose of the SPV is to borrow cash, typically through debt issuance, and to use this cash to purchase the collateral: some type of credit-sensitive obligation. The collateral may be provided by a financial institution, such as a bank that issues mortgages, or purchased in the secondary market, such as the case of corporate bonds.

Why could not a financial institution just issue the bonds directly rather than through an SPV? The purpose of an SPV is typically to create bankruptcy remoteness for the issuance of the debt. This means that the ownership of collateral is legally transferred from, say, the bank that made the loans, to the SPV. The objective is to ensure that if the bank goes into default, the collateral will not be considered part of the assets of the bank. Said another way, the SPV structure ensures that the collateral will be used only for the benefit of the holders of the structured securities issued by the SPV, regardless of where it was originated.

The SPV uses the cash flow from the collateral to pay back the debt as the collateral generates payment income through, for example, amortization and interest payments. The cash flow from the collateral is paid out to holders of each class of the liability structure (called a tranche) of the SPV per a set of rules called a cash flow waterfall. The tranching of debt creates a priority of payments (or of loss positions) such that more junior tranches (i.e., those lower in the capital structure) absorb losses first, followed by the next most senior, and so on. The motivation behind these structures is the desire to change the return/risk profile of the collateral into a set of securities or tranches with different return/risk profiles, with lower tranches exposed to more risk and higher tranches enjoying greater protection from collateral losses. In many structures there are also rules that specify that all cash be directed to more senior tranches if the performance of the collateral begins to deteriorate, providing still further protection for the higher tranches. It should be obvious that the analysis of many types of structured instruments is therefore quite similar to the analysis of a portfolio of assets in any financial institution but with the added complication of waterfalls and other structural provisions.

The names of these structures, such as CDO or ABS, reflect this collateralized nature of these instruments. Each specific structure name refers to the nature of the collateral:

* CLO: Collateralized loan obligation.

* CBO: Collateralized bond obligation.

* CDO-squared: CDO of tranches issued by other CDOs.

* RMBS: Residential mortgage-backed security.

* CMBS: Commercial mortgage-backed security.

Even without the added complexity of a securitization, credit instruments can be fairly complicated on a stand-alone basis. For example, many corporate bonds incorporate an attached call option designed to give the issuer the opportunity to pay back the debt earlier, should market conditions favor doing so. The call option identifies a price at which the issuer (i.e., obligor or borrower) can purchase back the debt. In an environment of falling interest rates or improving credit quality for the borrower, this option opens the door for the borrower to take advantage of better terms as they become available. For example, a fixed-rate bond will rise in price as interest rates fall. At some point, the issuer of a callable bond will find it advantageous to purchase back the debt so they can reissue at the lower rate. The call option provides this opportunity. As another example, many bank loans are structured with triggers and other features that change the payoff of the loan conditional on various metrics related to the borrower’s performance. Such loan covenants may increase the loan’s coupon rate if the financial performance of the firm, based on a predefined metric such as a leverage ratio (e.g., total debt/total equity or total debt/total assets), deteriorates.

Sometimes a credit exposure does not even reflect actual cash being loaned right away. Instead of a straight term loan, a bank may extend a commitment to lend with a variety of conditions as to the terms of borrowing. We typically refer to loans where cash is actually disbursed as funded and commitments to lend as unfunded. Note, however, that a contractual commitment to lend exposes the bank to risk even if funds have not actually been transferred to the obligor. As this brief discussion highlights, credit exposures like these can be decomposed into a risk-free debt instrument and a collection of other (e.g., default, prepayment, interest rate, etc.) options. In fact, most credit instruments represent a portfolio of options.

Credit exposure also arises in the context of more traditional derivative transactions such as equity options and interest rate swaps. When such a derivative is in-the-money, the market risk (i.e., risk arising from changes in quantities driving the value of the derivative) must be separated out from the credit risk. This implicit credit risk may become significant when systemic events impact the entire market. The recent financial crisis has highlighted how the solvency of large counterparties to derivatives transactions can have widespread impact on the financial system overall. The most recent global credit crisis is not, however, the only example in modern times of increased counterparty-default risk. The latter part of 1998 also saw a substantial increase in the likelihood of counterparty default. After Russia defaulted on its domestic currency debt and LTCM (a large hedge fund) came to the brink of insolvency, many investment banks appeared to face unprecedented difficulty. In this situation, the risk of a counterparty not paying became significant. Counterparty credit risk always exists, and even if a derivative counterparty does not default, the value of an in-the-money derivative may be adversely affected by the difficulties faced by the counterparty. A firm or counterparty does not have to default in order to result in a loss of value for a particular credit-risky instrument. Counterparty credit risk has become a much more important topic as the volume of derivatives has mushroomed and market participants have become more cognizant of this risk.

The salient feature of all these different types of credit exposure is the shape of the distribution of losses. Credit exposures are typically characterized by skewed, fat-tailed return distributions. That is, the lender or originator of an exposure has a high probability of receiving its principal back plus a small profit over the life of the exposure and a low probability of losing a significant portion of the exposure. An example of a credit loss distribution can be seen in Figure 1.1.

Said another way, many borrowers have a high chance of repayment but if they do fail, they tend to fail severely. The correlation among these types of exposures tends to be quite low compared with, say, the correlation of equity exposures. However, ironically, the diversification of these exposures tends to take a larger number of names than is the case with equity or other instruments with less skewed payoffs. This low correlation coupled with the chance of losing a substantial amount on any one exposure makes these securities particularly well suited for management in the context of a large, well-diversified portfolio. If a bank’s portfolio contains only small bits of each exposure, the occasional extreme loss for any one exposure will tend not to affect the portfolio’s overall performance. Thus, diversification buys stability in the portfolio’s loss profile. Importantly, unlike the case of other instruments, even a well-diversified portfolio will typically exhibit significant skewness that cannot be diversified away. We return to this conclusion a number of times throughout this book.

EVOLUTION OF CREDIT MARKETS

While the idea of debt extends back into ancient societies, the more modern notion of credit really began in preindustrial Europe in the context of commercial payments. Credit was typically extended by way of deferred payment for goods sold or advance payment for future delivery of goods purchased (see Kohn 2001 for more details on the history of banks and credit). Over time these debts began to be treated as fungible and would be assigned to other merchants, and eventually systems of settlement evolved. Deposit banking developed in response to the need for assignment of third-party debt among strangers. Since the bank became the counterparty for multiple transactions, it could net a large number of payments without resorting to final cash settlement.

This set of circumstances enabled preindustrial banks to offer a solution to the endemic problem of liquidity risk faced by merchants, namely a short-term lack of cash preventing completion of a particular transaction. Since depositors in the bank found it convenient to leave their money with the banker so that settlement of transactions could be done without having to lug around actual coins, the bank now had a store of deposits to use as the basis of an overdraft loan. The bankers discovered that they could extend credit beyond the quantity of actual coins or gold on deposit since most depositors did not demand all of their deposits most of the time. Here we find the beginnings of leverage in financial institutions. Since the banker knew his clients well, the bank could use its knowledge of the capacity of a potential borrower (who is also likely a depositor) to repay a loan and allow this individual to periodically overdraw his account. Eventually, these short-duration, relatively small overdraft loans were supplemented and then overtaken by longer, larger commercial loans. (Again refer to Kohn 2001 for more details on the evolution of banks and credit markets.) (Continues…)

Excerpted from Active Credit Portfolio Management in Practiceby Jeffrey R. Bohn Roger M. Stein Copyright © 2009 by Jeffrey R. Bohn and Roger M. Stein. Excerpted by permission.
All rights reserved. No part of this excerpt may be reproduced or reprinted without permission in writing from the publisher.
Excerpts are provided by Dial-A-Book Inc. solely for the personal use of visitors to this web site.