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New Developments in Credit Portfolio Management and Basel II:

A New Paradigm: “Underwrite & Distribute”

Michel Crouhy

PRMIAPRMIA

New York, September 26, 2005New York, September 26, 2005

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Bank Loan Portfolios

• Banks originate and hold loan exposures that are a function of

their geography and industry expertise. As a result, they hold

concentrated credit risk.

•Credit portfolios have become increasingly more concentrated in

less creditworthy obligors. This situation has made banks more

vulnerable in economic downturns (2001-2002):

– Disintermediation of banks that started in the 70s continues

today: IG firms are less likely to borrow from banks

– Regulatory rules induce banks to extend credit to lower-credit

quality obligors.

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Transformation of Credit Business

A New “Securities” Model For Credit

• Change:

• Increase balance sheet turnover

ORIGINATE & HOLD

UNDERWRITE & DISTRIBUTE

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Changes in the Approach to Credit Traditional Porfolio-BasedCredit Function

Approach

Investment strategy Originate and Hold Underwrite and Distribute

Ownership of the credit Business Unit Portfolio Managementassets or

Business Unit / Portfolio Mgmt

Risk measurement Use notional value Use risk based capital

of the loanModel only losses Model losses

due to defaultdue to default and risk migration

(MTM)

Risk Management Use a binary approval Apply risk return

process at origination decision making process

Basis for compensation Volume Risk-Adjusted Performancefor loan origination

Pricing Grid Risk Contribution

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Originate to Sell Model

Capital and Risk CommitteePolicy settingLimit settingRisk reporting

Client Coverage

Origination/ Underwriting

Syndication / Distribution

Credit Portfolio Mgt

Risk EvaluationQuantification of risk (EL, capital)Model selection / validation

Asset Sales & Trading

Monitoring & ReviewProduct

Structuring/ Securitization

Servicing

I S S U E R S & B O R R O W E R S

BANKS & INVESTORS

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Credit Portfolio Management

Credit Portfolio Group

Credit Portfolio Management

Counterparty Exposure Management

Credit Portfolio Solutions

Increases the velocity of capitalReduces concentration and event riskIncrease return on economic capitalResponsible for financials, but not a profit center_________________________________________

Hedges and trades retained Credit PortfolioHouses “public-side” Research Analysts, Portfolio Managers, Traders __________________________________________

Manages market risk of derivatives counterparty exposure _________________________________________

Provides advice to originators on structuring and credit risk mitigation

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Four Primary Portfolio Actions

1. Distribute loans through primary syndication to desired hold level

2. Reduce loan exposures by selling down, securitizing or hedging concentrated loan positions with credit default swaps

3. Focus first on high risk obligors, particularly those that are leveraged in market value terms and experience high volatility of returns

4. Simultaneously, sell or hedge low risk, low return loan assets

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Adopting Credit Asset Management Strategies

Portfolio Strategies that focus on adding credit exposures areEmerging within banks in two ways:

Credit Asset Management

• Designing cash and synthetic portfolios of credit risk purchased and

managed on a leveraged and unlevered basis with access to all credit asset

classes selecting best relative value investments with a long term

investment horizon

Credit Trading / Relative Value

• Acquiring and trading synthetic credit portfolios by selling protection on a

leveraged basis with access primarily to investment grade credit default

swaps selecting the best relative value trades with a short term trading

horizon

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Credit Asset Management StrategiesInvesting In Credit (cont’d)

Leverage 5 – 12 x Leverage 3 – 6 x

Credit Risk Credit Risk / Interest Rate Risk Credit Risk / Interest Rate Risk / Liquidity Risk / Mark-to-market

Cash Flow CDOs

“Asset Backed Securities”

Market Value CDOs

“Hedge Fund”

Loans

Combinations

High Yield Bonds

Private EquityHedge FundsEmerging MarketsOthers

CLOsBalance Sheet

CDOsGuaranteed Principal

CLOsArbitrage

CLOsLoans/HY

CBOsHY

CDOsEmerging Mkt

CFOsFund of Hedge Funds

Risk

ReturnLegal Maturity 10 – 15 years /

Expected Life 6 – 8 yearsLegal Maturity and

Expected Life 5 – 7 years

Source: RMF Investment Products Research

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Basel II

Basel II and Active Portfolio Management require the same:

• Historical data to calibrate key inputs, i.e., PDs, LGDs, EADs.

• IT infrastructure.

But, there are additional, though necessary, costs:

• Upgrading the rating systems: more granularity, two-tier rating system;

• Backtesting discipline: Keep the history of not only past ratings and

LGDs, but also of all the relevant information to reconstitute them.

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Basel II

Basel II is one step behind what is required for active credit

portfolio management:

• Credit portfolio models (internal models):

• Which rating philosophy? Point-in-Time (PIT) vs. Through-the-Cycle

(TTC)

• Capture portfolio effects

• Incorporate risk mitigation techniques and hedging strategies

• Provide opportunities for capital reduction through a better risk

assessment

• Economic capital attribution: still, regulatory arbitrage opportunities will

persist with Basel II

• Deal analyzer and pricing models

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Economic Capital EL: Expected Loss (average probability of default X loan amount at default)

UL: Unexpected Loss (1 standard deviation in value)

Capital: A loss amount determined by the probability of default of the lender

8 b.p.Expected

ValuePromised

Value

UL

Frequency

Portfolio Value

Capital

EL