The Handbook of Credit Risk Management Originating, Assessing, and Managing Credit Exposures

Discover an accessible and comprehensive overview of credit risk management

In the newly revised Second Edition of The Handbook of Credit Risk Management: Originating, Assessing, and Managing Credit Exposures, veteran financial risk experts Sylvain Bouteillé and Dr. Diane Coogan-Pushner deliver a holistic roadmap to credit risk management (CRM) ideal for students and the busy professional.

The authors have created an accessible and practical CRM resource consistent with a commonly implemented risk management framework. Divided into four sections—Origination, Credit Assessment, Portfolio Management, and Mitigation and Transfer—the book explains why CRM is critical to the success of large institutions and why organizational structure matters.

The Second Edition of The Handbook of Credit Risk Management also includes:

• Newly updated and enriched data, charts, and content
• Three brand new chapters on consumer finance, state and local credit risk, and sovereign risk
• New ancillary material designed to support higher education and bank credit training educators, including case studies, quizzes, and slides

Perfect for risk managers, corporate treasurers, auditors, and credit risk underwriters, this latest edition of The Handbook of Credit Risk Management will also prove to be an invaluable addition to the libraries of financial analysts, regulators, portfolio managers, and actuaries seeking a comprehensive and up-to-date guide on credit risk management.

Sylvain Bouteillé is Head of Trade Credit for the Americas at AIG, the global insurance company. Prior to AIG, Sylvain worked more than 20 years at Swiss Re, one the world’s leading providers of reinsurance and insurance. In his last role, Sylvain was a Managing Director and a Member of the Global Business Management Committee of Swiss Re Corporate Solutions. Sylvain held various leadership positions at Swiss Re including Head of Credit Risk Management NA and Head of Structured Credit Underwriting NA. Sylvain holds a MSc degree in Civil Engineering from ENTPE (France) and an MBA from INSEAD (France). He has been teaching Financial Statement Analysis and Credit Risk Management to graduate students at Queens College, City University of New York since 2011.

Diane Coogan-Pushner is a financial economist who has held the positions of Chief Risk Officer of The Navigators Group, Inc., a publicly traded commercial insurer, and Managing Director for structured reinsurance solutions at Swiss Re. During the financial crisis, Diane founded the Risk Management program for the Queens College, City University of New York, where she was Director, Associate Dean, and a full-time faculty member. Earlier in her career, Diane headed the Market Analysis and Forecasting Division  for AT&T’s consumer markets and was a portfolio manager for insurance focused funds. Diane has served on Standard & Poor’s Insurance Advisory Council and on the board of a privately held insurance company. Diane received her PhD from Boston University and began her career at the World Bank working with the financial institutions of East Africa. She is a Chartered Financial Analyst.

Preface xi

PART ONE

Origination

CHAPTER 1

Fundamentals of Credit Risk 3

What is Credit Risk? 3

Types of Transactions that Create Credit Risk 5

Who is Exposed to Credit Risk? 9

Why Manage Credit Risk? 19

CHAPTER 2

Governance 21

Guidelines 22

Skills 25

Setting Limits 30

Oversight 30

Final Words 33

CHAPTER 3

Checklist for Origination 35

Does the Transaction Fit into My Strategy? 36

Does the Risk Fit into My Existing Portfolio? 37

Do I Understand the Credit Risk? 38

Does the Seller Keep an Interest in the Deal? 39

Are the Proper Mitigants in Place? 40

Is the Legal Documentation Satisfactory? 41

Is the Deal Priced Adequately? 41

Do I Have the Skills to Monitor the Exposure? 42

Is There an Exit Strategy? 43

Final Words 44

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vi Contents

PART TWO

Credit Assessment

CHAPTER 4

Measurement of Credit Risk 47

Exposure 47

Probability of Default 52

The Recovery Rate 62

The Tenor 63

Direct versus Contingent Exposure 64

The Expected Loss 65

CHAPTER 5

Dynamic Credit Exposure 67

Long-Term

Supply Agreements 68

Derivative Products 70

The Economic Value of a Contract 73

Mark-to-

Market

Valuation 75

Value at Risk (VaR) 78

CHAPTER 6

Fundamental Credit Analysis 81

Accounting Basics 83

A Typical Credit Report 91

Agency Conflict, Incentives, and Merton’s View of

Default Risk 100

Final Words 105

CHAPTER 7

Alternative Estimations of Credit Quality 107

The Evolution of an Indicator: Moody’s Analytics EDF™ 108

Credit Default Swap Prices 114

Bond Prices 120

Final Words 121

CHAPTER 8

Consumer Finance 123

What Is Consumer Finance? 126

Segmentation of Consumer Finance Products 127

Major Families of Consumer Finance Products 129

Assessment of Credit Quality 136

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Contents vii

Decisions by Lenders 139

Regulatory Environment 143

CHAPTER 9

State and Local Government Credit 145

State and Local Governments 145

Exposure Types 146

Assessing Credit Risk 151

Managing Credit Risk 157

Final Words 160

CHAPTER 10

Sovereign Credit Risk 161

Sovereign Borrowers 161

Types of Sovereign Bonds 162

Sovereign Debt Market 163

Credit Analysis 163

Mitigation 166

Default and Recovery 167

Final Words 168

CHAPTER 11

Securitization 169

Asset Securitization Overview 171

The Collateral 174

The Issuer 178

The Securities 179

Main Families of ABSs 182

Securitization for Risk Transfer 186

Credit Risk Assessment of ABS 189

Warehousing Risk 191

Final Words 192

CHAPTER 12

Collateral Loan Obligations (CLOs) 193

Overview of the Corporate Loan Market 194

What Are CLOs? 194

Arbitrage CLOs 196

Balance Sheet CLOs 200

ABS CDOs 205

Credit Analysis of CLOs 207

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viii Contents

PART THREE

Portfolio Management

CHAPTER 13

Credit Portfolio Management 213

Level 1 215

Level 2 219

Level 3 224

Organizational Setup and Staffing 226

The IACPM 227

Final Words 227

CHAPTER 14

Economic Capital and Credit Value at Risk (CVaR) 229

Capital: Economic, Regulatory, Shareholder 230

Defining Losses: Default versus Mark-to-

Market

(MTM) 232

Credit Value at Risk or CVaR 235

Creating the Loss Distribution 242

Active Portfolio Management and CVaR 249

Pricing 251

Final Words 252

CHAPTER 15

Regulation 255

Doing Business with a Regulated Entity 256

Doing Business as a Regulated Entity 262

How Regulation Matters: Key Regulation Directives 263

Final Words 271

CHAPTER 16

Accounting Implications of Credit Risk 273

Loan Impairment 274

Loan-Loss

Accounting 275

Regulatory Requirements for Loan-Loss

Reserves 277

Impairment of Debt Securities 278

Derecognition of Assets 279

Consolidation of Variable Interest Entities (VIEs) 280

Accounting for Netting 281

Hedge Accounting 282

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Contents ix

Credit Valuation Adjustments, Debit Valuation Adjustments,

and Own Credit Risk Adjustment 284

IFRS 7 285

Final Words 285

PART FOUR

Mitigation and Transfer

CHAPTER 17

Mitigating Derivative Counterparty Credit Risk 289

Measurement of Counterparty Credit Risk 289

Mitigation of Counterparty Credit Risk through

Collateralization 290

Legal Documentation 298

Dealers versus End Users 299

Bilateral Transactions Versus Central Counterparty Clearing 299

Prime Brokers 303

Repurchase Agreements 304

Final Words 306

CHAPTER 18

Structural Mitigation 307

Transactions with Corporates 308

Transactions with Special Purpose Vehicles 317

CHAPTER 19

Credit Insurance, Surety Bonds, and Letters of Credit 325

Credit Insurance 326

Surety Bonds 332

Letters of Credit or LoCs 335

The Providers’ Point of View 339

Final Words 342

CHAPTER 20

Credit Derivatives 345

The Product 345

The Settlement Process 349

Valuation and Accounting Treatment 354

Uses of CDSs 356

Credit Default Swaps for Credit and Price Discovery 360

Credit Default Swaps and Insurance 360

Indexes, Loan CDSs MCDSs, and ABS CDSs 361

CHAPTER 21

Bankruptcy 363

What Is Bankruptcy? 364

Patterns of Bankrupt Companies 365

Signaling Actions 368

Examples of Bankruptcies 369

Final Words 372

About the Authors 373

Index 375

The New copy of this book will include any supplemental materials advertised. Please check the title of the book to determine if it should include any access cards, study guides, lab manuals, CDs, etc.

The Used, Rental and eBook copies of this book are not guaranteed to include any supplemental materials. Typically, only the book itself is included. This is true even if the title states it includes any access cards, study guides, lab manuals, CDs, etc.