New Technology for Managing Credit Risk

JEAN-MARTIN AUSSANT DIRECTOR FIXED INCOME PRODUCT STRATEGY PRMIA LONDON 18 MAY 2004

Recent market environment

New market-implied techniques to manage credit risk

Introduction to the BDP (Barra Default Probability)

Practical Examples

Questions and answers (assuming I have the answers)

Discussion Outline

Practical Examples

Questions and answers

Discussion Outline

Equity declines drove re-allocations to fixed income

Simultaneously government yields decreased to all time lows

Credit default rates neared all time highs

Pension fund shortfalls (Focus on ALM)

Credit markets are increasingly complex

Universe of assets is expanding rapidly

Spread products are becoming more complicated

Limited headcount to cover expanding number of issues

Market Forces Change the Rules of Credit Investing

Currently Very Few Easy Opportunities

End of the bear credit market in 2003

Spreads have tightened to extreme levels

Lowest since 1998

Demand still high

Non-traditional investors

Source: S&P

Outperformance Is More Demanding Than Ever

Are we being correctly compensated?

Risk premium close to zero

How does a long-only investor win/outperform?

Spreads have nowhere to go

Move to

Lower-quality / higher-yielding

Find names with value still

Asset selection is key

One Default Can Negate Entire Portfolio’s Return

Credit market is strongly asymmetric

Earning the spread has become extremely difficult over the past few years

Unprecedented market conditions with record downgrades and defaults

Source: Lehman Brothers, 2002

Fundamental Analysis Alone Is Not Enough

Judgment of experienced analysts remains essential

However, judgment often impaired by questionable data

Nearly 1000 accounting re-statements in the last three years (source: SEC)

Creative accounting

What’s required is a more efficient process to monitor, screen, and select credit-risky investments

Gaining the Advantage in Credit Investing

To successfully manage credit, you need

Earlier, more accurate prediction of potential default risk

Models that allow for the real- world uncertainty of financial statements

Tools to make your credit analysis process more efficient

Practical Examples

Discussion Outline

Market-Implied Measures Provide Additional Insight

Market-implied measures from the:

Equity Market – Barra Default Probabilities (BDP)

Bond Market – Barra Implied Ratings (BIR)

Derivatives Market – Credit Default Swaps (CDS)

Coming soon…

Crossover – Empirical Credit Risk (ECR) Equity Risk Implied Spreads (ERIS)

Equity Market – BDPs Go Beyond Traditional Models

BDP advantages

Incomplete Information framework assumes fundamental data may be flawed

Use of Barra’s industry standard equity volatility forecast

Empirical study of historical leverage

Barra’s model signals significant uptrend in default risk months earlier

Bond Market – BIRs Lead Agency Ratings

Barra Implied Ratings take the bond market’s perspective on credit and match it to a best fit distribution of actual ratings

Barra Implied Ratings typically can lead agency ratings by as much as three months

Barra’s measures provide earlier warning to possible downgrade

Derivatives Market – CDS Market a Leading Indicator

Credit Default Swap (CDS) rates often provide leading indication of risk and value

CDS market is exploding: more than $4 trillion notional outstanding and most big names actively traded (source: BBA)

Cash-CDS Basis History Merrill Lynch (5 Year USD)

Practical Examples

Discussion Outline

Current Quantitative Default Models

Structural or Cause-and-Effect approach (Merton)

Default happens for a reason

Firm-specific information can be used advantageously

Reduced form approach

Default rates can be analysed statistically

Ad hoc, exogenously-given, default rate

Merton’s Structural Model of Default

Default occurs at debt maturity if the firm value is below the liabilities value

We thus need

A model of firm value process

Estimate of default point

Merton identified equity as being long a call option on the firm value

Merton identified a bond as being short a put option on the firm value

Merton’s Structural Model of Default Payoff at maturity of the bond Value of the Equity at maturity time T Value of the Bond at maturity time T i.e. default free bond + short European put on V @ K i.e. European call on V @ K

Merton’s Structural Model of Default 0 D V 0 No Default Probability of Default Default T

Reduced Form Models

Assume that default is totally unpredictable

Default comes unannounced

Based on a conditional default rate or intensity

Exogenously given

Fit well to market data including short credit spreads

Ad hoc, lack intuitive appeal

The picture:

?

Model Comparison

Based on a model definition of default

Intuitive, appealing

The default time is often (implicitly) predictable

Hard to fit to empirical data

Based on an exogenously given default rate

Ad hoc

The default time is always totally unpredictable

Easy to fit to empirical data

Structural / Cause and Effect

What we want: a hybrid model

Incorporate the best features of structural and reduced form

Avoid their pitfalls

Reduced Form

The Barra Default Probability (BDP) Model

A genuine hybrid of cause-and-effect (structural) and reduced-form models (compensator approach)

Based on a default time that is not predictable

Makes use of all publicly available liability statements and equity market data

Assumes investors have incomplete information

Calibrates easily to short credit spreads

Intuitive and appealing

Barra Default Probability Model – Intuition 0 V 0 T Distribution of possible default boundary levels Paths of Asset Value Process Expected level of default barrier Width represents ‘uncertainty’ in the default barrier level Time Asset Value

Default Barrier – Scaled Beta Distribution Mean = current debt Standard deviation, calibrated or user-configured

BDP Model – Uncertainty Can Be Varied Barra Default Probability Model Variant 1 Variant 2 Variant 3

BDP Model – A Firm Becomes Distressed 9/17/2001 9/10/2001 Credit term structure steepens and short-term spreads increase

BDP Model Subtlety – Healthy Firm 4/15/2002 4/10/2002 15% drop in equity Credit term structure steepens but short-term spreads barely move

Testing the Model – ROC Curves

Radar Operators in WWII: Plane (or flock of birds)?

Medical Diagnosis: Is this person’s Thyroid OK?

Astronomy: Is this a Planet?

Marketing Analysis: Will this household buy insurance?

Credit Risk: Will this name default ?

Non-Event Event MODEL FORECAST Event (+) Non-Event (-) True Negative False Negative False Positive True Positive REAL WORLD

ROC Curves – Merton Comparison Merton BDP Random Method

ROC Curves – First Passage Comparison First Pass BDP

ROC Curves – Moody’s Rating Comparison BDP Moody’s Rating

Practical Examples

Discussion Outline

BIR – Good Complement to Agency Ratings ZOOM ZOOM

BDP – Outlier Identification

Inspecting ‘like-credits’ in a new way can sometimes turn up opportunities or threats

USD BBB Consumer Cyclicals Average BDP = 0.20% Toys ‘R’ Us BDP = 4.97% Source: Barra Credit

BDP – Warning of Toys R Us’ Downgrade?

Bond implied ratings moved in October as well

A few days later spreads widened, and months later Toys R Us was downgraded to below investment grade (junk) Source: Barra Credit

BIR – Mandate Restrictions

Early warnings of Potential Downgrades can allow managers to exit worrying names before the flood

The Bond Market was pricing in concerns back in September when the Barra Implied Rating for Parmalat dropped to Sub-IG Source: Barra Credit

BDP – Early Warning

The equity market was also signalling concerns for Parmalat

The BDP moved well into HY levels before December Source: Barra Credit Investment Grade (approximately) . .

Capital Structure Arbitrage

Differing views from two markets on the capital structure point out interesting opportunities

FedEx’s announcement of its planned acquisition of Kinko’s triggered concern implied by the equity market but not reflected in bond spreads Source: Barra Credit

Market-Implied Measures Offer More Insight Source: Barra Credit

Research Papers and More Info