New Frontiers in Managing Credit Risk

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New Frontiers in Managing Credit Risk
Christopher C. Finger PRMIA New York General
meeting
August 14, 2002
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Current topics

• Single-name risk monitoring and pricing
• Pricing and profitability based on capital
  allocation to the obligor level
• Portfolio incorporation of SME and retail
• CDO pricing, cashflow projection, aggregation

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CreditGrades for single-name credit risk

• Practical implementation of structural framework
• Get the sensitivities right.
• Beating the rating is easy.
• Want to track the market well.
• Applications
• Monitoring tool
• Input into comprehensive internal rating model
• Data sources for mark-to-market
• Consolidation of equity and credit exposures
• Trading opportunities

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Worldcom
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Worldcom
Junk status
Ebbers resigns
Downgrade
SEC inquiry
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Sometimes the equity market leads (Nextel)
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and sometimes its a voice of reason. (Motorola)
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Monitoring the marketUS CreditGrades deciles,
2002
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Granular capital allocation

• Pricing should compensate for capital usage (EL
  and UL components)
• Need for distributed reporting, timely analysis
• Monte Carlo solutions require enhancement

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Monte Carlo estimate of capital contribution
Red 1000 optimized scenarios
Blue 100,000 standard scenarios
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Monte Carlo estimate of capital contribution
2
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2,000,000 simulations
1
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Risk Contribution / Exposure
Red 1000 optimized scenarios
0
10
-1
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Blue 2,000,000 standard scenarios
-2
10
0
20
40
60
80
100
Obligor
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Incorporation of retail and SME pools
Basel definition of Retail Exposures
homogeneous portfolios comprising a large number
of small, low value loans with either a consumer
or business focus, and where the incremental risk
of any single exposure is small
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Basel discussion of retail practice

• banks commonly divide the portfolio into
  segments made up of exposures with similar risk
  characteristics
• banks then assess risk and quantify loss
  characteristics at the segment level rather than
  at the individual exposure level

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Putting it all together
Correlated market factors
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Applying the model to structured finance

• Applications
• Deal monitoring, cashflow projection
• Pricing, risk/return analysis
• Deal transparency
• Portfolio monitoring and aggregation
• Focus of modeling varies between
• Deal accuracy
• Standardization of deal description
• Speed and simulation accuracy, especially for
  issuer sensitivities

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Ultimately, goal is to aggregate exposures across
multiple CDO and bond positions.
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For more information

• www.riskmetrics.com
• www.creditgrades.com