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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. [email protected] Return to Risk Limited website: www.RiskLimited.com. Managing Credit Risk

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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. [email protected]

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% Rates of Corporate Bond Issuers”, February 2003.

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) Rates of Corporate Bond Issuers”, February 2003.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 Bank Bank Maturities Rates of Corporate Bond Issuers”, February 2003.

Exposure Maturing As % of Total Debt

in 2003-2006 Maturities

Rating Outlook ($ Millions) 2003-2006

American Electric Power BBB+ Stable 1,244 16

AES Corp. B+ Watch Negative 2,483 47

Allegheny Energy BB Watch Negative 1,040 46

Aquila BBB- Negative 356 36

Black Hills Corp BBB Stable 558 99

Calpine Corp BB Negative 5,500 75

CMS Energy BB Negative 2,740 69

Constellation Energy Group A- Stable 296 19

Dominion Resources BBB+ Stable 640 10

Duke Energy A Stable 2,350 27

Dynegy B+ Watch Negative 1,900 64

El Paso Corp BBB+ Watch Negative 920 17

Edison Mission Energy BBB- Watch Negative 1,838 100

Entergy BBB Stable 950 36

Mirant BB Negative 3,614 71

PG& E National Energy Group B- Watch Negative 2,458 91

NRG Energy D - 4,287 92

PPL BBB Negative 248 16

Public Service Enterprise Group BBB Stable 833 27

Teco Energy BBB Watch Negative 340 59

TXU BBB Negative 1,094 13

Williams Companies B+ Watch Negative 2,000 32

Total 37,570 Mean 48

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

Energy Company Profiles


“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. Rates of Corporate Bond Issuers”, February 2003.

Quantitative Tools for Managing Credit Risk

  • Loan Loss Reserves and Capital Allocation


* Sample for illustrative purposes only. Rates of Corporate Bond Issuers”, February 2003.

Quantitative Tools for Managing Credit Risk

  • Measures for Concentration Risk


Chicago Portfolio’s 10 Largest Expected Losses Rates of Corporate Bond Issuers”, February 2003.*

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 * Rates of Corporate Bond Issuers”, February 2003.

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 * Rates of Corporate Bond Issuers”, February 2003.

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 * Rates of Corporate Bond Issuers”, February 2003.

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 * Rates of Corporate Bond Issuers”, February 2003.

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 * Rates of Corporate Bond Issuers”, February 2003.

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. Rates of Corporate Bond Issuers”, February 2003.

Quantitative Tools for Managing Credit Risk

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


* Sample for illustrative purposes only. Rates of Corporate Bond Issuers”, February 2003.

Quantitative Tools for Managing Credit Risk

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


* Sample for illustrative purposes only. Rates of Corporate Bond Issuers”, February 2003.

Quantitative Tools for Managing Credit Risk

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


* Sample for illustrative purposes only. Rates of Corporate Bond Issuers”, February 2003.

Quantitative Tools for Managing Credit Risk

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


Loss Distribution Rates of Corporate Bond Issuers”, February 2003.

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 Rates of Corporate Bond Issuers”, February 2003.

  • 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 Rates of Corporate Bond Issuers”, February 2003.

  • 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 Rates of Corporate Bond Issuers”, February 2003.

  • 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 Rates of Corporate Bond Issuers”, February 2003.

  • 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 Rates of Corporate Bond Issuers”, February 2003.

  • Communicating risk and hedging policies

  • Limits on concentration risk.

  • Use of credit derivatives.

  • List of qualified buy/sell protection names

  • Curse of concentration


Underwriting Rates of Corporate Bond Issuers”, February 2003.

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 Rates of Corporate Bond Issuers”, February 2003.

A good credit risk management process built on

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


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