Credit Risk Management In and Out of the Financial Crisis

ANTHONY SAUNDERS is the John M. Schiff Professor of Finance and former chair of the Department of Finance at the Stern School of Business at New York University. He holds positions on the Board of Academic Consultants of the Federal Reserve Board of Governors as well as the Council of Research Advisors for the Federal National Mortgage Association, and has been a visiting scholar at the Comptroller of the Currency and at the International Monetary Fund. LINDA ALLEN is the Presidential Professor of Finance at the Zicklin School of Business at Baruch College, City University of New York (CUNY), and Adjunct Professor of Finance at the Stern School of Business, New York University. She has been a member of the Standard & Poor's Academic Council since its formation in 2004. Professor Allen has published extensively in top academic journals in finance and economics.

• List of Abbreviations xiPreface xvPart One Bubbles and Crises: The Global Financial Crisis of 2007–2009Chapter 1 Setting the Stage for Financial Meltdown 3Introduction 3The Changing Nature of Banking 3Reengineering Financial Institutions and Markets 17Summary 21Appendix 1.1: Ratings Comparisons for the Three Major Rating Agencies 23Chapter 2 The Three Phases of the Credit Crisis 24Introduction 24Bursting of the Credit Bubble 24Phase 1: Credit Crisis in the Mortgage Market 29Phase 2: The Crisis Spreads—Liquidity Risk 33Phase 3: The Lehman Failure—Underwriting and Political Intervention Risk 37Summary 43Chapter 3 The Crisis and Regulatory Failure 45Introduction 45Crisis Intervention 45Looking Forward: Restructuring Plans 52Summary 64Part Two Probability of Default EstimationChapter 4 Loans as Options: The Moody’s KMV Model 67Introduction 67The Link between Loans and Options 67TheMoody’s KMV Model 70Testing the Accuracy of EDFTM Scores 74Critiques of Moody’s KMV EDFTM Scores 86Summary 93Appendix 4.1: Merton’s Valuation Model 93Appendix 4.2: Moody’s KMV RiskCalcTM 95Chapter 5 Reduced Form Models: Kamakura’s Risk Manager 98Introduction 98Deriving Risk-Neutral Probabilities of Default 99Generalizing the Discrete Model of Risky Debt Pricing 102The Loss Intensity Process 105Kamakura’s Risk Information Services (KRIS) 108Determinants of Bond Spreads 110Summary 114Appendix 5.1: Understanding a Basic Intensity Process 114Chapter 6 Other Credit Risk Models 117Introduction 117Credit Scoring Systems 117Mortality Rate Systems 121Artificial Neural Networks 125Comparison of Default Probability Estimation Models 127Summary 131Part Three Estimation of Other Model ParametersChapter 7 A Critical Parameter: Loss Given Default 135Introduction 135Academic Models of LGD 135Disentangling LGD and PD 142Moody’s KMV’s Approach to LGD Estimation 143Kamakura’s Approach to LGD Estimation 146Summary 146Chapter 8 The Credit Risk of Portfolios and Correlations 148Introduction 148Modern Portfolio Theory (MPT): An Overview 149Applying MPT to Nontraded Bonds and Loans 150Estimating Correlations across Nontraded Assets 152Moody’s KMV’s Portfolio Manager 153Kamakura and Other Reduced Form Models 161Summary 165Part Four Putting the Parameters TogetherChapter 9 The VAR Approach: CreditMetrics and Other Models 169Introduction 169The Concept of Value at Risk 170Capital Requirements 177Technical Issues and Problems 180The Portfolio Approach in CreditMetrics 184Summary 195Appendix 9.1: Calculating the Forward Zero Curve for Loan Valuation 195Appendix 9.2: Estimating Unexpected Losses Using Extreme Value Theory 200Appendix 9.3: The Simplified Two-Asset Subportfolio Solution to the N-Asset Portfolio Case 202Appendix 9.4: CreditMetrics and Swap Credit Risk 202Chapter 10 Stress Testing Credit Risk Models: Algorithmics Mark-to-Future 208Introduction 208Back-Testing Credit Risk Models 209Using the Algorithmics Mark-to-Future Model 215Stress Testing U.S. Banks in 2009 220Summary 227Chapter 11 RAROC Models 228Introduction 228What is RAROC? 228RAROC, ROA, and RORAC 229Alternative Forms of RAROC 230The RAROC Denominator and Correlations 235RAROC and EVA 238Summary 238Part Five Credit Risk Transfer MechanismsChapter 12 Credit Derivatives 243Introduction 243Credit Default Swaps 244Credit Securitizations 259Financial Firms’ Use of Credit Derivatives 269CDS Spreads and Rating Agency Rating Systems 269Summary 271Appendix 12.1: Pricing the CDS Spread withCounterparty Credit Risk Exposure 272Chapter 13 Capital Regulation 274Introduction 274The 2006 Basel II Plan 275Summary 296Appendix 13.1: Loan Rating Systems 297Notes 303Bibliography 341Index 365