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Credit Portfolio Management John Wiley & Sons Credit Portfolio Management John Wiley & Sons Founded in 1807, John Wiley & Sons is the oldest independent publishing company in the United States. With offices in North America, Europe, Aus- tralia, and Asia, Wiley is globally committed to developing and marketing print and electronic products and services for our customers’ professional knowledge and understanding. The Wiley Finance series contains books written specifically for finance and investment professionals as well as sophisticated individual investors and their financial advisors. Book topics range from portfolio management to e-commerce, risk management, financial engineering, valuation, and fi- nancial instrument analysis, as well as much more. For a list of available titles, please visit our web site at www.Wiley Finance.com. Credit Portfolio Management CHARLES SMITHSON John Wiley & Sons, Inc. Copyright © 2003 by Charles Smithson. All rights reserved. Published by John Wiley & Sons, Inc., Hoboken, New Jersey. Published simultaneously in Canada. CreditProTM is a registered trademark of The McGraw-Hill Companies, Inc. ZETA® is the registered servicemark of Zeta Services, Inc., 615 Sherwood Parkway, Mountainside, NJ 07092. KMV® and Credit Monitor® are registered trademarks of KMV LLC. Expected Default FrequencyTM and EDFTM are trademarks of KMV LLC. Portfolio ManagerTM is a trademark of KMV LLC. RiskMetrics® is a registered service mark of J.P. Morgan Chase & Co. and is used by RiskMetrics Group, Inc., under license. CreditManager™ is a trademark owned by or licensed to RiskMetrics Group, Inc. in the United States and other countries. No part of this publication may be reproduced, stored in a retrieval system, or transmitted in any form or by any means, electronic, mechanical, photocopying, recording, scanning, or otherwise, except as permitted under Section 107 or 108 of the 1976 United States Copyright Act, without either the prior written permission of the Publisher, or authorization through payment of the appropriate per-copy fee to the Copyright Clearance Center, Inc., 222 Rosewood Drive, Danvers, MA 01923, 978-750-8400, fax 978-750-4470, or on the Web at www.copyright.com. Requests to the Publisher for permission should be addressed to the Permissions Department, John Wiley & Sons, Inc., 111 River Street, Hoboken, NJ 07030, 201-748-6011, fax 201-748-6008, e-mail: [email protected]. Limit of Liability/Disclaimer of Warranty: While the publisher and author have used their best efforts in preparing this book, they make no representations or warranties with respect to the accuracy or completeness of the contents of this book and specifically disclaim any implied warranties of merchantability or fitness for a particular purpose. No warranty may be created or extended by sales representatives or written sales materials. The advice and strategies contained herein may not be suitable for your situation. You should consult with a professional where appropriate. Neither the publisher nor author shall be liable for any loss of profit or any other commercial damages, including but not limited to special, incidental, consequential, or other damages. For general information on our other products and services, or technical support, please contact our Customer Care Department within the United States at 800-762-2974, outside the United States at 317-572-3993 or fax 317-572-4002. Wiley also publishes its books in a variety of electronic formats. Some content that appears in print may not be available in electronic books. For more information about Wiley products, visit our web site at www.wiley.com. Library of Congress Cataloging-in-Publication Data: Smithson, Charles. Credit portfolio management / Charles Smithson. p. cm. ISBN 0-471-32415-9 (CLOTH : alk. paper) 1. Bank loans—Management. 2. Bank loans—United States—Management. 3. Consumer credit—Management. 4. Portfolio management. I. Title. HG1641 .S583 2003 332.1' 753'068—dc21 2002151335 Printed in the United States of America. 10987654321 To Nathan and Matthew Preface ike its sister book, Managing Financial Risk (which deals with market Lrisk), this book evolved from a set of lecture notes. (My colleagues at Rutter Associates and I have been teaching classes on credit portfolio man- agement to bankers and regulators for almost four years now.) When lec- ture notes get mature enough that they start curling up on the edges, the instructor is faced with a choice—either throw them out or turn them into a book. I chose the latter. The good news about writing a book on credit portfolio management is that it is topical—credit risk is the area that has attracted the most atten- tion recently. The bad news is that the book will get out of date quickly. In the credit market, tools, techniques, and practices are changing rapidly and will continue to change for several years to come. We will try our best to keep the book current by providing updates on our website. Go to www.rutterassociates.com and click on the Credit Portfolio Management book icon. A number of people have contributed to this book. In particular, I want to acknowledge my colleagues at Rutter Associates—Paul Song and Mattia Filiaci. Without them, this book would never have been completed. This book benefited greatly from my involvement with the newly formed International Association of Credit Portfolio Managers (IACPM). I learned a lot from conversations with the founding board members of that organization: Stuart Brannan (Bank of Montreal); John Coffey (JP Morgan Chase); Gene Guill (Deutsche Bank); Hetty Harlan (Bank of America); Loretta Hennessey (CIBC); Charles Hyle (Barclays Capital); Paige Kurtz (Bank One); Ed Kyritz (UBS); Robin Lenna (at Citibank at the time, now at FleetBoston Financial); and Allan Yarish (at Royal Bank of Canada at the time, now at Société Genérale). For their contributions to and support for the 2002 Survey of Credit Portfolio Management Practices, I want to thank Stuart Brannan (IACPM and Bank of Montreal), David Mengle (ISDA), and Mark Zmiewski (RMA). Colleagues who contributed knowledge and material to this book include: vii viii PREFACE Michel Araten, JP Morgan Chase Marcia Banks, Bank One Brooks Brady, Stuart Braman, Michael Dreher, Craig Friedman, Gail Hessol, David Keisman, Steven Miller, Corinne Neale, Standard & Poor’s Risk Solutions Susan Eansor and Michael Lavin, Loan Pricing Corporation Chris Finger, RiskMetrics Group Robert Haldeman, Zeta Services David Kelson and Mark McCambley, Fitch Risk Management Susan Lewis, Credit Sights Robert Rudy, Moody’s–KMV Rich Tannenbaum, SavvySoft A special thank-you is due to Beverly Foster, the editor of the RMA Journal, who convinced me to write a series of articles for her journal. That series formed the first draft of many of the chapters in this book and was the nudge that overcame my inertia about putting pen to paper. Finally, as always, my biggest debt is to my wife, Cindy. CHARLES SMITHSON Rutter Associates New York, New York November 2002 Contents CHAPTER 1 The Revolution in Credit—Capital Is the Key 1 The Credit Function Is Changing 1 Capital Is the Key 6 Economic Capital 8 Regulatory Capital 11 APPENDIX TO CHAPTER 1: A Credit Portfolio Model Inside the IRB Risk Weights 21 Note 23 PART ONE The Credit Portfolio Management Process 25 CHAPTER 2 Modern Portfolio Theory and Elements of the Portfolio 27 Modeling Process Modern Portfolio Theory 27 Challenges in Applying Modern Portfolio Theory to Portfolios of Credit Assets 34 Elements of the Credit Portfolio Modeling Process 38 Note 40 CHAPTER 3 Data Requirements and Sources for Credit Portfolio Management 41 Probabilities of Default 41 Recovery and Utilization in the Event of Default 92 Correlation of Defaults 102 Notes 107 ix x CONTENTS CHAPTER 4 Credit Portfolio Models 109 Structural Models 110 Explicit Factor Models 133 Actuarial Models 141 Analytical Comparison of the Credit Portfolio Models 148 Empirical Comparison of the Credit Portfolio Models 153 What Models Are Financial Institutions Using? 161 Notes 161 APPENDIX TO CHAPTER 4: Technical Discussion of Moody’s– KMV Portfolio Manager Mattia Filiaci 162 Default Correlation 162 Facility Valuation 163 Generating the Portfolio Value Distribution 174 Outputs 176 Notes 178 PART TWO Tools to Manage a Portfolio of Credit Assets 181 CHAPTER 5 Loan Sales and Trading 183 Primary Syndication Market 183 Secondary Loan Market 191 Note 192 CHAPTER 6 Credit Derivatives with Gregory Hayt 193 Taxonomy of Credit Derivatives 193 The Credit Derivatives Market 201 Using Credit Derivatives to Manage a Portfolio of Credit Assets 203 Pricing Credit Derivatives 209 Notes 224 CHAPTER 7 Securitization 225 Elements of a CDO 225 “Traditional” and “Synthetic” CDO Structures 229 Applications of CDOs 233 Contents xi To What Extent and Why Are Financial Institutions Using Securitizations? 236 Regulatory Treatment 237 Note 240 PART THREE Capital Attribution and Allocation 241 CHAPTER 8 Capital Attribution and Allocation 243 Measuring Total Economic Capital 243 Attributing Capital to Business Units 247 Attributing Capital to Transactions 252 Performance Measures—The Necessary Precondition to Capital Allocation 258 Optimizing the Allocation of Capital 267 Notes 269 APPENDIX TO CHAPTER 8: Quantifying Operational Risk 270 Process Approaches 274 Factor Approaches 274 Actuarial Approaches 275 Notes 276 APPENDIX Statistics for Credit Portfolio Management Mattia Filiaci 277 Basic Statistics 278 Applications of Basic Statistics 306 Important Probability Distributions 314 Notes 324 References 327 Index 333 CHAPTER 1 The Revolution in Credit— Capital Is the Key THE CREDIT FUNCTION IS CHANGING The credit function is undergoing critical review at all financial institutions, and many institutions are in the process of changing the way in which the portfolio of credit assets is managed. Visible evidence of the change is found in the rapid growth in secondary loan trading, credit derivatives, and loan securitization (and we discuss these in Chapters 5, 6, and 7). Less ob- vious—but far more important—is the fact that banks are abandoning the traditional transaction-by-transaction “originate-and-hold” approach, in favor of the “portfolio approach” of an investor.
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