The Handbook of Credit Risk Management

SYLVAIN BOUTEILLÉ is Head of Trade Credit for the Americas at AIG, the global insurance company. Prior to AIG, Sylvain worked more than 20 years at Swiss Re. He holds a MSc degree in Civil Engineering from ENTPE (France) and an MBA from INSEAD (France). DIANE COOGAN-PUSHNER, PhD, has decades of experience in the financial services industry, working most recently as the Chief Risk Officer of Navigator’s Group, Inc., a publicly traded insurer. She received her doctorate from Boston University and is a CFA® charterholder.

Preface xiii

Acknowledgments xxi

About the Companion Website xxiii

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? 19

Chapter 2 Governance 21

Guidelines 22

Skills 25

Setting Limits 30

Oversight 30

Final Words 33

Chapter 3 Checklist for Origination 35

Does the Transaction Fit into My Strategy? 36

Does the Risk Fit into My Existing Portfolio? 37

Do I Understand the Credit Risk? 38

Does the Seller Keep an Interest in the Deal? 39

Are the Proper Mitigants in Place? 40

Is the Legal Documentation Satisfactory? 41

Is the Deal Priced Adequately? 41

Do I Have the Skills to Monitor the Exposure? 42

Is There an Exit Strategy? 43

Final Words 44

Part Two Credit Assessment

Chapter 4 Measurement of Credit Risk 47

Exposure 47

Probability of Default 52

The Recovery Rate 62

The Tenor 63

Direct versus Contingent Exposure 64

The Expected Loss 65

Chapter 5 Dynamic Credit Exposure 67

Long-Term Supply Agreements 68

Derivative Products 70

The Economic Value of a Contract 73

Mark-to-Market Valuation 75

Value at Risk (VaR) 78

Chapter 6 Fundamental Credit Analysis 81

Accounting Basics 83

A Typical Credit Report 91

Agency Conflict, Incentives, and Merton’s View of Default Risk 100

Final Words 105

Chapter 7 Alternative Estimations of Credit Quality 107

The Evolution of an Indicator: Moody’s Analytics EDF™ 108

Credit Default Swap Prices 114

Bond Prices 120

Final Words 121

Chapter 8 Consumer Finance 123

What Is Consumer Finance? 126

Segmentation of Consumer Finance Products 127

Major Families of Consumer Finance Products 129

Assessment of Credit Quality 136

Decisions by Lenders 139

Regulatory Environment 143

Chapter 9 State and Local Government Credit 145

State and Local Governments 145

Exposure Types 146

Assessing Credit Risk 152

Managing Credit Risk 156

Final Words 160

Chapter 10 Sovereign Credit Risk 161

Sovereign Borrowers 161

Types of Sovereign Bonds 162

Sovereign Debt Market 163

Credit Analysis 163

Mitigation 166

Default and Recovery 167

Final Words 168

Chapter 11 Securitization 169

Asset Securitization Overview 171

The Collateral 174

The Issuer 178

The Securities 179

Main Families of ABSs 182

Securitization for Risk Transfer 186

Credit Risk Assessment of ABS 189

Warehousing Risk 191

Final Words 192

Chapter 12 Collateral Loan Obligations (CLOs) 193

Overview of the Corporate Loan Market 194

What Are CLOs? 194

Arbitrage CLOs 196

Balance Sheet CLOs 200

ABS CDOs 205

Credit Analysis of CLOs 207

Part Three Portfolio Management

Chapter 13 Credit Portfolio Management 213

Level 1 215

Level 2 219

Level 3 224

Organizational Setup and Staffing 226

The IACPM 227

Final Words 227

Chapter 14 Economic Capital and Credit Value at Risk (CVaR) 229

Capital: Economic, Regulatory, Shareholder 230

Defining Losses: Default versus Mark-to-Market (MTM) 232

Credit Value at Risk or CVaR 235

Creating the Loss Distribution 242

Active Portfolio Management and CVaR 249

Pricing 251

Final Words 252

Chapter 15 Regulation 255

Doing Business with a Regulated Entity 256

Doing Business as a Regulated Entity 262

How Regulation Matters: Key Regulation Directives 263

Final Words 271

Chapter 16 Accounting Implications of Credit Risk 273

Loan Impairment 274

Loan-Loss Accounting 275

Regulatory Requirements for Loan-Loss Reserves 277

Impairment of Debt Securities 278

Derecognition of Assets 279

Consolidation of Variable Interest Entities (VIEs) 280

Accounting for Netting 281

Hedge Accounting 282

Credit Valuation Adjustments, Debit Valuation Adjustments, and Own Credit Risk Adjustment 284

IFRS 7 285

Final Words 285

Part Four Mitigation and Transfer

Chapter 17 Mitigating Derivative Counterparty Credit Risk 289

Measurement of Counterparty Credit Risk 289

Mitigation of Counterparty Credit Risk through Collateralization 290

Legal Documentation 298

Dealers versus End Users 299

Bilateral Transactions versus Central Counterparty Clearing 299

Prime Brokers 303

Repurchase Agreements 304

Final Words 306

Chapter 18 Structural Mitigation 307

Transactions with Corporates 308

Transactions with Special Purpose Vehicles 317

Chapter 19 Credit Insurance, Surety Bonds, and Letters of Credit 325

Credit Insurance 326

Surety Bonds 332

Letters of Credit or LoCs 335

The Providers’ Point of View 339

Final Words 342

Chapter 20 Credit Derivatives 345

The Product 345

The Settlement Process 349

Valuation and Accounting Treatment 354

Uses of CDSs 356

Credit Default Swaps for Credit and Price Discovery 360

Credit Default Swaps and Insurance 360

Indexes, Loan CDSs, MCDSs, and ABS CDSs 361

Chapter 21 Bankruptcy 363

What Is Bankruptcy? 364

Patterns of Bankrupt Companies 365

Signaling Actions 368

Examples of Bankruptcies 369

Final Words 372

About the Authors 373

Index 375