Why New Approaches to Credit Risk Measurement and Management? Why Now?

2 Structural Increase in Bankruptcy Increase in probability of default –High yield default rates: 5.1% (2000), 4.3% (1999, 1.9% (1998). Source: Fitch 3/19/01 –Historical Default Rates: 6.92% (3Q2001), 5.065% (2000), 4.147% (1999), 1998 (1.603%), 1997 (1.252%), % (1991), 10.14% (1990). Source: Altman Increase in Loss Given Default (LGD) –First half of 2001 defaulted telecom junk bonds recovered average 12 cents per $1 ($0.25 in ) Only 9 AAA Firms in US: Merck, Bristol-Myers, Squibb, GE, Exxon Mobil, Berkshire Hathaway, AIG, J&J, Pfizer, UPS. Late 70s: 58 firms. Early 90s: 22 firms.

3 Disintermediation Direct Access to Credit Markets –20,000 US companies have access to US commercial paper market. –Junk Bonds, Private Placements. “Winner’s Curse” – Banks make loans to borrowers without access to credit markets.

4 More Competitive Margins Worsening of the risk-return tradeoff –Interest Margins (Spreads) have declined Ex: Secondary Loan Market: Largest mutual funds investing in bank loans (Eaton Vance Prime Rate Reserves, Van Kampen Prime Rate Income, Franklin Floating Rate, MSDW Prime Income Trust): 5-year average returns 5.45% and 6/30/00- 6/30/01 returns of only 2.67% –Average Quality of Loans have deteriorated The loan mutual funds have written down loan value

5 The Growth of Off-Balance Sheet Derivatives Total on-balance sheet assets for all US banks = $5 trillion (Dec. 2000) and for all Euro banks = $13 trillion. Value of non-government debt & bond markets worldwide = $12 trillion. Global Derivatives Markets > $84 trillion. All derivatives have credit exposure. Credit Derivatives.

6 Declining and Volatile Values of Collateral Worldwide deflation in real asset prices. –Ex: Japan and Switzerland –Lending based on intangibles – ex. Enron.

7 Technology Computer Information Technology –Models use Monte Carlo Simulations that are computationally intensive Databases –Commercial Databases such as Loan Pricing Corporation –ISDA/IIF Survey: internal databases exist to measure credit risk on commercial, retail, mortgage loans. Not emerging market debt.

8 BIS Risk-Based Capital Requirements BIS I: Introduced risk-based capital using 8% “one size fits all” capital charge. Market Risk Amendment: Allowed internal models to measure VAR for tradable instruments & portfolio correlations – the “1 bad day in 100” standard. Proposed New Capital Accord BIS II – Links capital charges to external credit ratings or internal model of credit risk. To be implemented in 2005.

9 Appendix 1.1 A Brief Overview of Key VAR Concepts Banks hold capital as a cushion against losses. What is the acceptable level of risk? Losses = change in the asset’s value over a fixed credit horizon period (1 year) due to credit events. Figure 1.1- normal loss distribution. Figure 1.2 – skewed loss distribution. Mean of distribution = expected losses (reserves). Unexpected Losses (UL) = %tile VAR. Losses exceed UL with probability = %. Definition of credit event: –Default Mode: only default –Mark-to-market: all credit upgrades, downgrades & default.

FIGURE 1.1

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