Aug 10

Friday’s Movie for the 2007 FRM: Credit Risk Part 1

by David Harper, CFA, FRM, CIPM

FRM | Risk |

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We uploaded today, for customers, a 1.5 hour tutorial on credit risk. (the PowerPoint deck can be downloaded). As a review of Learning Outcomes 46.x thru 50.x, this is an introduction to credit risk. Selected key ideas in this module include:

Probability of default (PD)

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The probability of default (PD) can be inferred from the yield curve. Here, we apply principles found in forward pricing: the one-year forward rate is implied by the one-year spot rate and the two-year spot rate (specifically, it is the rate that makes us indifferent between a two-year investment and rolling over a one-year investment into the one-year forward). Once we have forward rates for both a Treasury and a corporate, the spread implies the default risk on the corporate bond.

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Sovereign risk

Sovereign risk adds an additional dimension to credit analysis: we must analyze the underlying credit quality of the borrower (typical) plus we must assess the sovereign risk of the country.

The assigned reading contains five economic variables:

  • Import ratio: total imports/total foreign exchange reserves
  • Debt service ratio: (interest + debt amortization) / export
  • Investment ratio: real investment / GNP
  • Variance of export revenue
  • Domestic money supply growth

The shortcut: for all of these except one, an increase in the ratio/metric correlates with a greater likelihood of rescheduling (i.e., the LDC is less willing or able to meet the obligation). The investment ratio has two interpretations: one says a greater ratio makes the country economically stronger to repay, the other worries it makes the country a stronger negotiator with more bargaining power.

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Securitization

We give this more attention in Part 2. But for now, notice how much of the material traces back to an originator's motive to get assets off its balance sheet. Re LO 48.7, this is the primary difference between a corporate SPE and a trust. Re 48.8, this concerns the criteria for a "true sale" (i.e., does the originator surrender control to the SPE, such that the SPE has pledge/resell/exchange rights? Note all four FAS 140 principles are really about passing control of the assets from the originator to the SPE, so the SPE has control and is separated--bankruptcy remote--from the originator). Again, Re 48.9, the anti-Enron rule, developed specifically to close a balance sheet loophole exploited by Enron.

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Counterparty Risk

Counterparty credit risk is harder to estimate than traditional loan credit risk:

  • Counterparty risk is bilateral (either party can lose). Loan exposure is unilateral
  • Value of derivatives position can be either positive or negative. Uncertainty of future credit risk exposure
  • Multiple counterparties (some exposures positive and some negative) with offsetting
  • Participants can utilize netting, collateral, early settlement provisions.
  • Difficulty in defining credit value adjustment (CVA)

External rating agencies

There are lots of scattered learning outcomes on this topic. Note the importance throughout of the economic context: economic cycles bear on probability of default, the volatility of the transition matrix (rating migrations are more volatile during recession than growth), recovery rates, and they explain largely why through-the-cycle ratings are better than point-in-time ratings.

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