The Handbook of Credit Risk Management

Sylvain Bouteille is Head Key Account Management and a member of the management team of the North American division of Swiss Re Corporate Solutions. In 1996, he joined Swiss Re in Zurich, Switzerland, in the newly created credit risk management division. In 1998, Bouteille moved to New York where, as U.S. Head of Credit Risk Management, he was responsible for credit risk aspects of all insurance and capital markets transactions. In 2003, he became U.S. Head of Structured Credit Underwriting, where he originated and structured credit derivatives and financial guaranty reinsurance transactions. Since 2008, Bouteille has been working with risk managers of Fortune 500 companies to develop traditional and non-standard insurance solutions. Bouteille holds an MS in civil engineering from ENTPE (France) and an MBA from INSEAD (France). Diane Coogan-Pushner is Distinguished Lecturer and Director of the Graduate Program in Risk Management at Queens College, City University of New York. She began her career in financial services at the World Bank and held increasingly senior positions in finance and strategy at AT&T and PricewaterhouseCoopers. Coogan-Pushner moved to Swiss Re, and as Managing Director, originated and structured reinsurance transactions and other risk transfer solutions for insurance clients. Other credits include roles as a portfolio manager for a hedge fund and for a private equity fund both dedicated to financial services. She has served as a director for an insurer and as a member of S&P's Insurance Ratings Advisory Council, and consults to financial institutions in their asset management strategy. She received her PhD in economics from Boston University in 1992 and is a CFA charterholder.

Preface xiii Acknowledgments xxi Part One Origination Chapter 1 Fundamentals of Credit Risk 3 What Is Credit Risk? 3 Types of Transactions That Create Credit Risk 5 Who Is Exposed to Credit Risk? 9 Why Manage Credit Risk? 18 Chapter 2 Governance 21 Guidelines 22 Setting Limits 25 Skills 26 Oversight 29 Chapter 3 Checklist for Origination 33 Does the Transaction Fit into My Strategy? 34 Does the Risk Fit into My Existing Portfolio? 35 Do I Understand the Credit Risk? 36 Does the Seller Keep an Interest in the Deal? 37 Are the Proper Mitigants in Place? 38 Is the Legal Documentation Satisfactory? 38 Is the Deal Priced Adequately? 39 Do I Have the Skills to Monitor the Exposure? 40 Is There an Exit Strategy? 40 Part Two Credit Assessment Chapter 4 Measurement of Credit Risk 45 Exposure 45 Default Probability 50 The Recovery Rate 60 The Tenor 62 Direct versus Contingent Exposure 63 The Expected Loss 63 Chapter 5 Dynamic Credit Exposure 65 Long-Term Supply Agreements 66 Derivative Products 68 The Economic Value of a Contract 71 Mark-to-Market Valuation 73 Value at Risk (VaR) 76 Chapter 6 Fundamental Credit Analysis 79 Accounting Basics 80 A Typical Credit Report 88 Agency Conflict, Incentives, and Merton s View of Default Risk 97 Chapter 7 Alternative Estimations of Credit Quality 103 The Evolution of an Indicator: Moody s Analytics EDF 104 Credit Default Swap Prices 110 Bond Prices 116 Chapter 8 Securitization 119 Asset Securitization Overview 120 The Collateral 123 The Issuer 127 The Securities 128 Main Families of ABS 131 Securitization for Risk Transfer 135 Credit Risk Assessment of ABS 137 Warehousing Risk 138 Part Three Portfolio Management Chapter 9 Credit Portfolio Management 143 Level 1 145 Level 2 149 Level 3 153 Organizational Set-Up and Staffing 155 The IACPM 156 Chapter 10 Economic Capital and Credit Value at Risk (CVaR) 159 Capital: Economic, Regulatory, Shareholder 160 Defining Losses: Default versus Mark-to-Market 163 Credit Value at Risk or CVaR 165 Creating the Loss Distribution 171 Active Portfolio Management and CVaR 179 Pricing 181 Chapter 11 Regulation 183 Doing Business with a Regulated Entity 184 Doing Business as a Regulated Entity 189 How Regulation Matters: Key Regulation Directives 190 Chapter 12 Accounting Implications of Credit Risk 201 Loan Impairment 202 Loan-Loss Accounting 203 Regulatory Requirements for Loan-Loss Reserves 205 Impairment of Debt Securities 206 Derecognition of Assets 207 Consolidation of Variable Interest Entities (VIEs) 208 Accounting for Netting 209 Hedge Accounting 211 Credit Valuation Adjustments, Debit Valuation Adjustments and Own Credit Risk Adjustment 212 IFRS 7 213 Part Four Mitigation and Transfer Chapter 13 Mitigating Derivative Counterparty Credit Risk 217 Measurement of Counterparty Credit Risk 217 Mitigation of Counterparty Credit Risk through Collateralization 218 Legal Documentation 225 Dealers versus End-Users 226 Bilateral Transactions versus Central Counterparty Clearing 227 Prime Brokers 229 Repurchase Agreements 230 Final Words 232 Chapter 14 Structural Mitigation 233 Transactions with Corporates 234 Segmentation of the Commercial Loan Market Senior versus Junior Debt Secured versus Unsecured Loans Covenants Events of Default Transactions with Special Purpose Vehicles 240 Impact of Structural Mitigants on Default Probability Impact of Structural Mitigants on Recovery Rates Senior/Subordinated Structures Credit Enhancement Chapter 15 Credit Insurance, Surety Bonds, and Letters of Credit 249 Credit Insurance 250 Surety Bonds 255 Letters of Credit or LoCs 258 The Providers Point of View 263 Chapter 16 Credit Derivatives 267 The Product 267 The Settlement Process 270 Valuation and Accounting Treatment 274 Uses of CDS 276 Credit Default Swaps for Credit and Price Discovery 280 Credit Default Swaps and Insurance 280 Indexes, Loan CDSs, MCDSs, and ABS CDSs 280 Chapter 17 Collateral Debt Obligations (CDOs) 283 What Are CDOs? 283 Collateralized Loan Obligations or CLOs 286 Arbitrage CLOs 287 Balance Sheet CLOs 290 ABS CDOs 292 Credit Analysis of CDOs 296 Chapter 18 Bankruptcy 301 What Is Bankruptcy? 301 Patterns of Bankrupt Companies 303 Signaling Actions 306 Examples of Bankruptcies 307 About the Authors 311 Index 313