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Michael K. Ong Professor and Director, Finance Program Executive Director, Center for Financial Markets Stuart Graduate School of Business Illinois Institute of Technology 312.906.6568. ong@stuart.iit.edu. Return to Risk Limited website: www.RiskLimited.com. Managing Credit Risk

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Michael K. Ong Professor and Director, Finance Program

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Michael K. Ong

Professor and Director, Finance Program

Executive Director, Center for Financial Markets

Stuart Graduate School of Business

Illinois Institute of Technology

312.906.6568. ong@stuart.iit.edu

Return to Risk Limited website: www.RiskLimited.com

Managing Credit Risk

in Volatile Environments

Energy Credit Risk Congress 2003

The Houstonian Hotel, Houston, TX

November 12-13, 2003

Organized by Risk Limited


Source: William J. Bernstein, “Credit Risk: How Much? When?”, www.efficientfrontier.com.

Widening of Credit Spreads -

a Precursor of Something Ominous


Source: Moody’s Special Comment “Default & Recovery Rates of Corporate Bond Issuers”, February 2003.

Sharp Increase in Default Rates


5.0%

4.5%

+2 Std Dev

4.0%

3.5%

+1 Std Dev

3.0%

2.5%

Average

2.0%

1.5%

1.0%

0.5%

0.0%

1980

1981

1982

1983

1984

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

Source: David Hamilton, “Historical Corporate Rating Migration, Default, and Recovery Rates”, 2002

Default Rate for All Corporate Issuers

Reached Extreme in 2001


1) WorldCom, Inc. $23.2 Billion

2) Enron Corp. $9.9 Billion

3) NTL Communications Corp. $8.5 Billion

4) Adelphia Communications Corp. $6.9 Billion

5) Finova Capital Corp. $6.3 Billion

6) United Pan-Europe Communications $5.1 Billion

7) Pacific Gas & Electric Co. $5.0 Billion

8) XO Communications Inc. $4.9 Billion

9) Southern California Edison Co. $4.7 Billion

10) Global Crossing Holdings LTD $3.8 Billion

Total:$78.3 Billion

Source: David Hamilton, “Historical Corporate Rating Migration, Default, and Recovery Rates”, 2002

10 Largest Rated Corporate Bond Defaults


Funded BankBank Maturities

Exposure MaturingAs % of Total Debt

in 2003-2006Maturities

RatingOutlook($ Millions)2003-2006

American Electric Power BBB+Stable1,24416

AES Corp. B+Watch Negative2,48347

Allegheny Energy BBWatch Negative 1,04046

Aquila BBB-Negative 35636

Black Hills CorpBBBStable55899

Calpine CorpBBNegative5,50075

CMS EnergyBBNegative2,74069

Constellation Energy GroupA-Stable29619

Dominion ResourcesBBB+Stable64010

Duke EnergyAStable2,35027

DynegyB+Watch Negative1,90064

El Paso CorpBBB+Watch Negative92017

Edison Mission EnergyBBB-Watch Negative1,838100

EntergyBBBStable95036

MirantBBNegative3,61471

PG& E National Energy GroupB-Watch Negative2,45891

NRG EnergyD-4,28792

PPLBBBNegative24816

Public Service Enterprise GroupBBBStable83327

Teco EnergyBBBWatch Negative34059

TXUBBBNegative1,09413

Williams CompaniesB+Watch Negative2,00032

Total37,570Mean 48

Source: Standard and Poors, November 2002, as reported by James Ockendon, “Delaying the Inevitable?”, Energy Power Risk Management, May 2003

Energy Company Profiles


  • Defining credit culture

“A credit culture is made up of principles that need to be communicated. A credit culture is rooted in corporate attitudes, philosophies, traditions, and standards that require administrative underpinnings. The role of credit culture is to create a risk management climate that will foster … good banking …” Henry Muller*

  • Corporate priorities

“How much risk?” versus “How much return?”

  • Credit discipline

Proper metrics for risk and performance measurement.

* Henry Muller, “Risk Management and the Credit Culture - A Necessary Interaction”, Credit Risk Management (Robert Morris Associates) 1995.

Behavioral Reactions to Uncertainty


* Sample for illustrative purposes only.

Quantitative Tools for Managing Credit Risk

  • Loan Loss Reserves and Capital Allocation


* Sample for illustrative purposes only.

Quantitative Tools for Managing Credit Risk

  • Measures for Concentration Risk


Chicago Portfolio’s 10 Largest Expected Losses*

Expected LossCommitmentOutstanding

1) American Airlines $16,765,137$65,000,000$65,000,000

2) Enron Corp. $14,223,195$92,500,000$50,000,000

3) FMI International, LLC $14,052,022$28,000,000$19,342,252

4) Xerox Corp. $13,996,139 $95,000,000$45,000,100

5) Viasystems, Inc. $10,000,001$18,250,000$12,500,000

6) Napoleon Holdings, Inc.$9,875,325$27,500,000$25,333,333

7) Pacific Gas & Electric Co. $9,750,386$20,000,000$20,000,000

8) Revlon Consumer Products Corp.$8,491,111$15,000,000$14,923,021

9) Texas Industries, Inc. $8,477,299$25,750,000$15,000,000

10) Hamilton Beach Proctor Silex $7,768,894$17,000,000$17,000,000

* Sample for illustrative purposes only.

Quantitative Tools for Managing Credit Risk

  • Top 10 Exposures, Risk and Return Characteristics, etc.


Commitment Amount *

Banks

12%

Diversified Financial

12%

Remaining

Industries

35%

Electric Utilities

9%

Communications

Technology

3%

General Index

6%

Securities Brokers

Oil Companies-Major

3%

Chemicals

6%

4%

Food

Gas utilities

5%

5%

* Sample for illustrative purposes only.

Quantitative Tools for Managing Credit Risk

  • Top 10 Exposures, Risk and Return Characteristics, etc.


Utilization *

Banks

15%

Diversified Financial

2%

Remaining Industries

37%

Electric Utilities

14%

General Index

Communications

4%

Technology

2%

Oil Companies-Major

7%

Securities Brokers

Food

1%

Chemicals

Gas utilities

6%

3%

9%

* Sample for illustrative purposes only.

Quantitative Tools for Managing Credit Risk

  • Top 10 Exposures, Risk and Return Characteristics, etc.


Projected Annual Income *

Diversified Financial

Banks

2%

6%

Electric Utilities

9%

General Index

1%

Oil Companies-Major

6%

Remaining Industries

Food

53%

5%

Gas utilities

12%

Chemicals

2%

Securities Brokers

Communications

0%

Technology

4%

* Sample for illustrative purposes only.

Quantitative Tools for Managing Credit Risk

  • Top 10 Exposures, Risk and Return Characteristics, etc.


Expected Loss *

Diversified Financial

Banks

0%

1%

Electric Utilities

18%

General Index

2%

OilCompanies-Major

1%

Food

Remaining

2%

Industries

52%

Gas utilities

9%

Chemicals

13%

Securities Brokers

Communications

0%

Technology

2%

* Sample for illustrative purposes only.

Quantitative Tools for Managing Credit Risk

  • Top 10 Exposures, Risk and Return Characteristics, etc.


Risk Capital *

Electric Utilities

Diversified Financial

7%

Banks

1%

4%

General Index

3%

Oil Companies-Major

2%

Food

1%

Remaining Industries

53%

Gas utilities

20%

Chemicals

6%

Securities Brokers

0%

Communications

Technology

3%

* Sample for illustrative purposes only.

Quantitative Tools for Managing Credit Risk

  • Top 10 Exposures, Risk and Return Characteristics, etc.


* Sample for illustrative purposes only.

Quantitative Tools for Managing Credit Risk

  • Top 10 Exposures, Risk and Return Characteristics, etc.


* Sample for illustrative purposes only.

Quantitative Tools for Managing Credit Risk

  • Top 10 Exposures, Risk and Return Characteristics, etc.


* Sample for illustrative purposes only.

Quantitative Tools for Managing Credit Risk

  • Top 10 Exposures, Risk and Return Characteristics, etc.


* Sample for illustrative purposes only.

Quantitative Tools for Managing Credit Risk

  • Top 10 Exposures, Risk and Return Characteristics, etc.


Loss Distribution

2.5%

2.0%

1.5%

Probability

1.0%

0.5%

0.0%

0.0%

1.5%

2.9%

4.4%

5.9%

7.4%

8.8%

10.3%

11.8%

13.3%

14.7%

16.2%

17.7%

19.2%

20.6%

22.1%

23.6%

25.1%

26.5%

28.0%

29.5%

30.9%

32.4%

33.9%

35.4%

36.8%

Loss/Outstanding

Quantitative Tools for Managing Credit Risk

  • Scenario analysis

Changes in exposure, risk ratings, etc.

* Sample for illustrative purposes only.


Quantitative Tools for Managing Credit Risk

  • Scenario analysis

Changes in exposure, risk ratings, etc.

Loss Distribution

2.5%

2.0%

1.5%

Probability

1.0%

0.5%

0.0%

0.0%

1.5%

2.9%

4.4%

5.9%

7.4%

8.8%

10.3%

11.8%

13.3%

14.7%

16.2%

17.7%

19.2%

20.6%

22.1%

23.6%

25.1%

26.5%

28.0%

29.5%

30.9%

32.4%

33.9%

35.4%

36.8%

Loss/Outstanding

* Sample for illustrative purposes only.


Quantitative Tools for Managing Credit Risk

  • Scenario analysis

Changes in exposure, risk ratings, etc.

Loss Distribution

2.5%

2.0%

1.5%

Probability

1.0%

0.5%

0.0%

0.0%

1.5%

2.9%

4.4%

5.9%

7.4%

8.8%

10.3%

11.8%

13.3%

14.7%

16.2%

17.7%

19.2%

20.6%

22.1%

23.6%

25.1%

26.5%

28.0%

29.5%

30.9%

32.4%

33.9%

35.4%

36.8%

Loss/Outstanding

* Sample for illustrative purposes only.


Credit Approval Process

  • Credit culture and corporate governance

  • Committee structure and accountability

  • Loan commitments (“intermediary”) versus investment banking activities

  • “How many 364-day facilities to commit? How many loan

  • commitments are at risk of being drawn in a corporation downgrade?

  • Vital role of credit ratings

  • Internal risk ratings systems versus agencies ratings.

  • Links to private equity


Loan Review Process and the Role of Workout

  • Review process

  • Monitoring frequency.

  • What drives an upgrade/downgrade?

  • Disciplined approach

  • Close involvement of relationship managers, risk managers, and

  • investment bankers

  • When does “Workout” begin?

  • Asset and collateral valuation

  • Expected loss

  • Restructuring schemes


Credit Culture Revisited

  • Communicating risk and hedging policies

  • Limits on concentration risk.

  • Use of credit derivatives.

  • List of qualified buy/sell protection names

  • Curse of concentration


Underwriting

Approval

Hold on

Balance Sheet

Monitoring and

Administration

Underwriting

Approval

Securitize

New Paradigm in Lending - “Credit Trading”

  • Traditional approach - “buy-and-hold”

Try to Get

I-Banking

Business

New paradigm in lending - “strategic credit risk management”

Credit Risk

Dispersion


Concluding Remark

A good credit risk management process built on

sound credit culture and solid principles can withstand any volatile market conditions.


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