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07.2 credit ratings and fico scores
1.
Copyright © 2018
CapitaLogic Limited This presentation file is prepared in accordance with Chapter 7 of the text book “Managing Credit Risk Under The Basel III Framework, 3rd ed” Website : https://sites.google.com/site/crmbasel E-mail : crmbasel@gmail.com Chapter 7 Credit Ratings and FICO Scores
2.
Copyright © 2018
CapitaLogic Limited 2 Declaration Copyright © 2018 CapitaLogic Limited. All rights reserved. No part of this presentation file may be reproduced, in any form or by any means, without written permission from CapitaLogic Limited. Authored by Dr. LAM Yat-fai (林日辉), Director, CapitaLogic Limited, Adjunct Professor of Finance, City University of Hong Kong, Doctor of Business Administration, CFA, CAIA, CAMS, FRM, PRM.
3.
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CapitaLogic Limited 3 Outline Credit assessments Credit ratings FICO scores Appendices
4.
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CapitaLogic Limited 4 Probability of default Expected loss EL ≈ EAD × LGD × PD × RM EAD, LGD and RM Properties of a credit product Designed by the lender PD Property of a borrower
5.
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CapitaLogic Limited 5 What is credit assessment? Is a borrower good or bad? Good – likely to survive during the lending period Bad – likely to default during the lending period What is the PD of a borrower? Lending period unified to 1 year Subject to annual credit risk review and control
6.
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CapitaLogic Limited 6 Credit assessment techniques Credit assessment External (by independent expert) Corporate credit rating Internal (by lender) RetailCorporate Retail FICO score Merton’s corporate default model Altman’s Z-score Credit scoring Credit scoring
7.
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CapitaLogic Limited 7 Outline Credit assessments Credit ratings FICO scores Appendices
8.
Copyright © 2018
CapitaLogic Limited 8 Major credit rating agencies Global credit rating agencies Moody's Investors Service http://www.moodys.com Standard & Poor's http://www.standardandpoors.com Fitch Ratings http://www.fitchratings.com Specialist credit rating agencies A.M. Best http://www.ambest.com Dagong Global Credit Rating http://en.dagongcrg.com
9.
Copyright © 2018
CapitaLogic Limited 9 Solicited rating vs unsolicited rating Solicited rating A corporation pays a service charge and provides its confidential information to a credit rating agency for the purpose of credit assessment in order to obtain a credit rating Potential conflicts of interest Business model of the 3 major global CRAs Unsolicited rating A credit rating agency takes an initiative to rate a corporation based on publicly available information Lenders pay a fee to subscribe credit ratings
10.
Copyright © 2018
CapitaLogic Limited 10 Credit rating scales Grade S&P’s, Fitch Moody’s Investment AAA Aaa AA Aa A A BBB Baa High yield BB Ba B B CCC Caa CC Ca C C
11.
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CapitaLogic Limited 11 Rating definitions (1) Rating Definition AAA A corporation rated AAA has an extremely strong capacity to meet its debt obligations. AA A corporation rated AA has a very strong capacity to meet its debt obligations. It differs from a highest rated borrower only to a small degree. A A corporation rated A has a strong capacity to meet its debt obligations but is somewhat more susceptible to the adverse effects of changes in circumstances and economic conditions than a borrower in higher rated categories.
12.
Copyright © 2018
CapitaLogic Limited 12 Rating definitions (2) Rating Definition BBB A corporation rated BBB has an adequate capacity to meet its debt obligations. However, adverse economic conditions or changing circumstances are more likely to lead to a weakened capacity of the borrower to meet its debt obligations. BB A corporation rated BB is judged to have speculative elements and subject to substantial credit risk. B A corporation rated B is more vulnerable than a borrower rated BB, but the borrower currently has the capacity to meet its debt obligations. Adverse business, financial, or economic conditions will likely impair the borrower's capacity or willingness to meet its debt obligations.
13.
Copyright © 2018
CapitaLogic Limited 13 Rating definitions (3) Rating Definition CCC A corporation rated CCC starts to experience financial distress and is dependent upon favorable business, financial and economic conditions to meet its debt obligations. CC A corporation rated CC is currently in financial distress. C A corporation rated C is typically in deep financial distress with very little prospect to meet its debt obligations.
14.
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CapitaLogic Limited 14 Average annual default rates Credit quality Credit rating Moody’s (%) S&P’s (%) Fitch (%) 1983 - 2016 1983 - 2016 1990 - 2016 Excellent AAA 0.00 0.00 0.13 Good AA 0.02 0.02 0.05 A 0.06 0.06 0.06 BBB 0.19 0.18 0.15 Moderate BB 0.94 0.72 0.73 B 3.56 3.76 2.12 Bad CCC to C 10.54 26.78 21.24 Example 7.2 Example 7.1
15.
Copyright © 2018
CapitaLogic Limited 15 Only 2 AAA corporations in the world Johnson & Johnson Microsoft Corporation These two corporations are richer than most countries in the world
16.
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CapitaLogic Limited 16 Basel III ECAI rating scale Rating 3-year DR (%) AAA and AA 0.10 A 0.25 BBB 1.00 BB 7.50 B 20.00
17.
Copyright © 2018
CapitaLogic Limited 17 Basel III ECAI Plus rating scale Credit quality Credit rating 3-year DR (%) PD (%) Excellent AAA 0.03 0.0100 Good AA 0.10 0.0333 A 0.25 0.0834 BBB 1.00 0.3345 Moderate BB 7.50 2.5652 B 20.00 7.1682 Bad CCC 40.00 15.6567 CC 65.00 29.5270 C 95.00 63.1597 Example 7.3
18.
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CapitaLogic Limited 18 Other credit ratings Issuer rating Financial institutions Bank Securities firm Insurance company Governments Country Super nation Municipality Issue rating Corporate bond Government bond CDO
19.
Copyright © 2018
CapitaLogic Limited 19 Annual country default rates Credit quality Credit rating Moody’s (%) S&P’s (%) Fitch (%) 1983 - 2016 1975 - 2016 1995 - 2016 Excellent AAA 0Good AA A BBB Moderate BB 0.55 0.5 0.29 B 2.76 2.6 1.30 Bad CCC to C 12.18 37.2 24.14
20.
Copyright © 2018
CapitaLogic Limited 20 10-year country default rates Credit quality Credit rating Moody’s (%) S&P’s (%) Fitch (%) Prudent PD (%)1983 - 2016 1975 - 2016 1995 - 2016 Excellent AAA 0 Good AA 1.053 0.0 0.00 0.11 A 4.004 5.8 4.00 0.60 BBB 1.628 3.6 3.85 0.39 Moderate BB 10.928 8.6 4.88 1.15 B 21.367 26.6 8.33 3.05 Bad CCC to C 50.579 79.3 25.00 14.57 1 10Prudent PD = 1 - 1 - Maximum of 10-year default rates from Moody's, S&P's, Fitch
21.
Copyright © 2018
CapitaLogic Limited 21 How reliable is credit rating? There is NO reliable credit rating A credit rating is used as long as it is NOT very unreliable The financial tsunami 2008 has demonstrated that it cannot solely rely on credit rating to conduct credit assessment
22.
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CapitaLogic Limited 22 Outline Credit assessments Credit ratings FICO scores Appendices
23.
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CapitaLogic Limited 23 Major retail credit bureaus Individual persons TransUnion Equifax Experian Small businesses Dun & Bradstreet
24.
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CapitaLogic Limited 24 Where comes personal credit data? Banks’ contribution Public records Negative data Overdue records, bankruptcy records and court orders Positive data No. of mortgages and no. of credit cards
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CapitaLogic Limited 25 Composition of FICO score Payment history (35%) The historical records of default, bankruptcy, lawsuit, court order and delayed payment will reduce the FICO score The more recent, frequent and severe the negative payment history is, the lower the FICO score will be Credit utilization (30%) A large ratio of outstanding debt amount to total credit limit will reduce the FICO score Credit history (15%) Credit history is represented by the age of the oldest loan account and the average age of all loan accounts A longer credit history will increase the FICO score Credit experience (10%) Credit experience means the history of using different types of credit products A more diversified credit experience will increase the FICO score Recent enquiry (10%) The recent enquiries from a large number of loan applications will decrease the FICO score
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CapitaLogic Limited 26 FICO scores Group From To Annual default rate (%) Super prime 740 850 0.4 Prime 680 739 2.8 Alt-A 620 679 7.5 Subprime 550 619 17.0 Deep subprime 350 549 33.8
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CapitaLogic Limited 27 Outline Credit assessment Credit rating FICO score Appendices
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CapitaLogic Limited 28
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CapitaLogic Limited 29 Rating migration One year migration rate from rating X to rating Y No. of corproations rated X 1 year ago and Y 1 year later No. of corproations rated X 1 year ago
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CapitaLogic Limited 30 Rating migration matrix From /To (%) AAA AA A BBB BB B CCC to C Default No rating AAA 87.05 9.03 0.53 0.05 0.08 0.03 0.05 0.00 3.17 AA 0.52 86.82 8.00 0.51 0.05 0.07 0.02 0.02 3.99 A 0.03 1.77 87.79 5.33 0.32 0.13 0.02 0.06 4.55 BBB 0.01 0.10 3.51 85.56 3.79 0.51 0.12 0.18 6.23 BB 0.01 0.03 0.12 4.97 76.98 6.92 0.61 0.72 9.63 B 0.00 0.03 0.09 0.19 5.15 74.26 4.46 3.76 12.06 CCC to C 0.00 0.00 0.13 0.19 0.63 12.91 43.97 26.78 15.39
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CapitaLogic Limited 31 Aggregated rating migration matrix From /To (%) AAA AA A BBB BB B CCC to C Default No rating AAA 87.05 96.08 96.61 96.66 96.74 96.77 96.82 96.82 100 AA 0.52 87.34 95.34 95.85 95.90 95.97 95.99 96.01 100 A 0.03 1.80 89.59 94.92 95.24 95.37 95.39 95.45 100 BBB 0.01 0.11 3.62 89.18 92.97 93.48 93.60 93.78 100 BB 0.01 0.04 0.16 5.13 82.11 89.03 89.64 90.36 100 B 0.00 0.03 0.12 0.31 5.46 79.72 84.18 87.94 100 CCC to C 0.00 0.00 0.13 0.32 0.95 13.86 57.83 84.61 100 Example 7.4
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CapitaLogic Limited 32 Interpolation Linear interpolation 2 points define a straight line Cubic interpolation 4 balanced points define a balanced curve 0 1 2 3 0 1 2 3 y = a + a x y = a + a x + a x + a x
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CapitaLogic Limited 33 ECAI Plus rating scale with rating modifiers Group Rating 3-year DR (%) PD (%) Excellent AAA 0.0300 0.0100 Good AA+ 0.0678 0.0226 AA 0.1000 0.0333 AA- 0.1341 0.0447 A+ 0.1803 0.0601 A 0.2500 0.0834 A- 0.3692 0.1232 Moderate BBB+ 0.5844 0.1952 BBB 1.0000 0.3345 BBB- 2.0598 0.6914 BB+ 4.1162 1.3913 BB 7.5000 2.5652 BB- 11.0869 3.8413 Poor CCC 40.00 15.6567 CC 65.00 29.5270 C 95.00 63.1597 Example 7.5
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CapitaLogic Limited 34 PD vs FICO in the prime range Middle Probit PD (%) 735 -2.1290 1.6628 730 -2.0854 1.8517 725 -2.0418 2.0585 720 -1.9982 2.2847 715 -1.9546 2.5314 710 -1.9110 2.8000 705 -1.8704 3.0711 700 -1.8301 3.3616 695 -1.7901 3.6722 690 -1.7502 4.0038 685 -1.7107 4.3571 680 -1.6713 4.7329 Example 7.6