Modern Credit Risk Management (eBook)

Dr. Panayiota Koulafetis has held a number of positions in the Investment Banking, Asset Management, Rating Agency and Energy Trading Sectors. At Moody’s Investors Service Ltd she led rating analysis and provided surveillance on a wide range of Structured Finance transactions across different jurisdictions: Commercial Mortgage Backed Securities (CMBS), Asset Backed Securities (ABS), Residential Mortgage Backed Securities (RMBS), Whole Business transactions/Corporate Securitisation, Small Medium Enterprises (SMEs) and Lease transactions. At the Securitization department of Nomura International plc she dealt with various transactions across different asset classes. She was also a Senior Structurer at Duke Energy, structuring mainly Energy Derivatives and dealing with complex option structures. She has also held Quantitative Research and Risk Management roles at Westdeutsche Landesbank (WestLB) Asset Management Ltd and Southern Company. Dr. Koulafetis is a regular speaker at academic and industry conferences and has published in  academic journals and practitioner periodicals. She holds a PhD in Finance from Cass Business School, City University of London, an MSc in Business Finance from Brunel University and a BSc (Hons) in Business Administration from University of Piraeus in Greece. Dr. Koulafetis works as a consultant and also lectures at the School of Economics and Finance at Queen Mary University of London and at the School of Management and Business at King’s College London.

Contents 6
List of Figures 12
List of Exhibits 13
List of Diagrams 14
List of Tables 15
Chapter 1: Introduction 16
Credit and its Role in Financial Markets 16
Sources of Credit Risk 18
Deposits 18
Accounts Receivable, Prepayment of Goods or Services, Contingent Claims 19
Loans 20
Repurchase Agreements (Repos) 21
Leases 21
Bonds 22
Derivatives 23
Credit and its Negative Impact 25
Sound Credit Risk Management 28
Credit Risk Policy and Approval Process 29
Setting Limits and Underwriting Criteria 30
Understanding and Mitigating Model Risk 31
Origination 34
Chapter 2: Quantitative Credit Risk Analysis and Management 36
Default Probability (DP) 36
Risk Neutral and Real World DPs 36
Equity Models: Merton Model, Moody’s Analytics Expected Default Frequencies (EDFs) 37
Kamakura Risk Information Services (KRIS) DP 42
Internal Methods Based on Financial Ratio Analysis: 43
Altman DP 43
Recovery Rate 45
Credit VAR and Economic Capital 48
Credit Metrics: Credit Migration Approach 48
Credit Risk Plus: Actuarial Approach 48
Credit Exposure 51
Basel I 52
Basel II and Basel 2.5 53
Basel III 54
Liquidity Coverage Ratio (LCR) 56
Net Stable Funding Ratio (NSFR) 58
Leverage Ratio (LR) 59
Capital Conservation Buffer and Countercyclical Buffer 60
Credit Risk Approaches under Basel II 61
(1) The Standardized Approach (SA) 61
(2) Internal Ratings-Based (IRB) Approach 62
Exposure at Default for Counterparty Credit Risk 63
(1) Current Exposure Method 64
(2) Standardized Method 66
(3) Internal Models Method (IMM) 68
Standardized Approach for Counterparty Credit Risk (SA-CCR) 71
Basel III—Counterparty Credit Risk (CCR) 71
Advanced CVA Risk Capital Charge-CVA VAR 73
Standardized CVA Risk Capital Charge 74
X-Value Adjustments (XVA) 76
Chapter 3: Credit Ratings: Credit Rating Agencies, Rating Process and Surveillance 77
Credit Rating Agencies—Nationally Recognized Statistical Rating Organizations 77
Introduction to Credit Ratings 79
The Rating Process 80
Moody’s Provisional Ratings—(P) 82
S& P’s Preliminary Ratings: “Prelim”
Surveillance 82
Rating Outlook 83
Rating Review 84
What Drives Credit Rating Downgrades and Upgrades 84
Rating Confirmation, Affirmation, Withdrawal and Suspension 85
Credit Ratings’ Usefulness 86
Credit Ratings’ Limitations 86
Criticism of Credit Ratings 88
Credit Rating Types 90
Moody’s Global Long-Term Issue Credit Rating Scale and Definitions 90
Moody’s Global Short-Term Issue Credit Rating Scale and Definitions 92
Linkage amongst the Moody’s Global Long-Term and Short-Term Rating Scales 92
Moody’s Rated Obligations and Issuers on the Global Long-Term and Short-Term Rating Scales 94
Moody’s National Scale Long-Term Ratings 95
Moody’s National Scale Short-Term Ratings 96
Moody’s Credit Estimate 97
Moody’s Originator Assessments 98
Moody’s Servicer Quality (SQ) Assessments 98
Standard & Poor’s Long-Term Issue Credit Rating Scale and Definitions
Standard & Poor’s Short-Term Issue Credit Rating Scale and Definitions
Standard & Poor’s Special-Purpose Ratings
Standard & Poor’s National and Regional Scale Credit Ratings
Standard & Poor’s Long-Term National and Regional Scale Credit Ratings
Standard & Poor’s Short-Term National and Regional Scale Credit Ratings
Standard & Poor’s Credit Estimate and Credit Assessment
Foreign Currency Ratings and Local Currency Ratings 106
Country Ceilings for Bonds, Bank Deposits and Other Foreign Currency Obligations 106
Country Ceiling for Bonds, Bank Deposits and Other Local Currency Obligations 106
Rating Migration 107
Chapter 4: Credit Risk Assessment of Sovereigns, Banks and Corporates 110
Credit Risk Assessment of Sovereigns 110
Economic Position 110
Institutional Position 111
Fiscal Position 112
Monetary Position 113
Event Risk 113
Moody’s Approach for Sovereigns Ratings 115
Moody’s Sovereign Rating Factors 117
Standard & Poor’s Approach for Sovereign Ratings
Standard & Poor’s Key Sovereign Rating Indicators
Foreign and Local Currency Ratings 118
Sovereign Risk and Credit Default Swap (CDS) Spreads 120
Credit Risk Assessment of Banks 122
Factors Affecting the Independent Financial Strength of Banks 123
Franchise Value, Business Strategy and Management Team 123
Risk Profile and Management 124
Financial Fundamentals 126
Macro-economic, Operating and Regulatory Environment 126
Moody’s Approach for Bank Ratings 127
The Banking and Sovereign Linkage 132
Credit Risk Assessment of Corporates 133
Standard & Poor’s Key Ratios
Moody’s Approach for Rating Companies in the Global Packaging Industry 137
Corporate Risk, Company Value, Bond Spreads and CDS 143
Chapter 5: Credit Risk Assessment of Structured Finance Securities 150
Securitization 150
True Sale Securitization 151
Securitization: Key Steps 151
Securitization Asset Requirements 152
Securitization Motivation 152
Credit Enhancement 153
Waterfall 153
Repayment Structures 154
Liquidity Facility 154
Hedging 154
Servicing 155
Paying Agent 155
SPV Insolvency Remoteness 155
Main Securitization Transaction Document 156
Synthetic Transactions 156
Securitization Major Sectors 159
Credit Risk Assessment of Commercial Mortgage Backed Securities (CMBS) 159
Credit Risk Assessment of Residential Mortgage Backed Securities (RMBS) 163
Credit Risk Assessment of Asset Backed Securities (ABS) 168
Credit Risk Assessment of Asset Backed Commercial Paper (ABCP) 171
Credit Risk Assessment of Collateralized Loan Obligations (CLOs) 174
Chapter 6: Qualitative Credit Risk Analysis and Management 178
Legal Credit Risk Analysis and Management 178
Securitization Documents 179
Offering Circular 179
Securitization Primary and Secondary Key Documents 189
Review of the Offering Circular (OC) 189
The Role of the Trustee 193
Cash Commingling Risk 194
Set-Off Risk 197
True Sale Challenge 199
Chapter 7: Credit Risk Transfer and Mitigation 200
Credit Risk Transfer and Mitigation 200
Letter of Credit (LOC) and Guarantees 200
Netting 201
International Swaps and Derivatives Association (ISDA) Master Agreement, Schedule and Credit Support Annex (CSA) 202
Centralized Counterparty Clearing and Margin Collateral 203
Collateralization and Over-collateralization 206
Covenants and Event of Default 207
Syndication 208
Excess Spread and Reserve Fund 208
Early Termination and Amortization 208
Subordination 209
Credit Derivatives 209
Total Return Swap (TRS) 210
Credit Default Swap (CDS) 213
Credit Linked Note (CLN) 218
Securitization 219
Chapter 8: Regulation 220
Regulation 220
Basel Committee 221
European Union (EU) Capital Requirements Regulation and Directive (CRR-CRD) IV 223
The Dodd–Frank Wall Street Reform and Consumer Protection Act 225
References 229
Index 231