The Handbook of Credit Risk Management

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 Bouteille835639_ftoc.indd 5 26-08-2021 13:48:32 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(TM) 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 Bouteille835639_ftoc.indd 6 26-08-2021 13:48:32 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 Bouteille835639_ftoc.indd 7 26-08-2021 13:48:32 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 Bouteille835639_ftoc.indd 8 26-08-2021 13:48:32 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