Credit risk analysis

Is there anyone out there who have an insight or experience in Credit risk analysis can share their respective experiences on the steps that they normally carry out to evaluate credit risk of a portfolio? Thanks

Credit risk = if the chairman of the company you’re evaluating has gotten a call from Bernanke in the last 30 days

Any serious comments?

Well there are many steps you can take to evaluate the credit risk of a particular company or a portfolio of various companies. Firstly, I would do a financial analysis of the companies, using various ratios and techniques. See how much debt each company has on their balance sheet, assess the maturity profile of this debt and size in terms of equity and total capital. Analyse how cash generative the business is, and whether or not they can easily satisfy their financial obligations. Have a thorough read of the footnotes within an annual report, to analyse their costs, profits, off-balance sheet items, etc etc. Make sure you compare these ratios with values in previous years and those of other companies within the same market segment. Also, check out the major rating agencies, i.e. S&P and Moodies and have a look at how they have graded the companies and whether there has been any recent upgrades/downgrades.

Suzmis, thanks for this. From what I gather in your comments: You would do the ratio analsis in leverage, solvency and then jump into cashflow analysis (with focus on CFO).

Altman’s Z Score.

There are quite a few version on Altman’s Z Score. The one brief touched by CFIA is a bit out of date now.

Yes theKing, I would do the ratio analysis in the areas you discussed. Make sure you have a good basis of comparison, as comparing a debt-to-equity ratio for technology companies would be different to financial companies. Altman’s Z Score is another possibility, but I feel you could use a lot more ratios and not depend too much on this score. The key to credit analysis is to assess the financial stability of a firm currently and going forward. Ratios can help analyse past and current performance, but also have a read of the company’s annual report and website to see what their future strategies are and what their upcoming investments are, i.e. are they investing in good future projects. Good luck.

Suzmis, can you elaborate on how the maturity profile of the debt affects things? Is it about the duration of the liabilities vs. assets? Is it something about the costs of rolling over maturing debt? I believe you that it’s important, but I’m not quite sure how.

Well, it is important to see when the company has to pay its largest financial commitments. Lets says a company has issued a few bonds on different dates but are due to pay the principals on the same year. If the repayment year was next year and you are analysing a company which has become cash flow negative this year, this could be a sign of trouble ahead. The company will somehow have to raise funds to meet these debt obligations (e.g. could sell off part of a business), and will have to pay the principals with newly issued bonds. The maturity profile gives a great indication of when the company is likely to face an important financial decision.

Thanks suzmis, this has been very useful.

For those who have helped, thanks so much. Quick update on this interview process: Just get the call from the agent, who told me two news: The good one is that the company are creating a new position that is more quant driven as they think it suits me better which should be ready within two weeks. The new manager will explain to me face to face, once it has all the sign off. The bad one is that the other guy who they think is slightly more experience than me has the initial job that I appied for. Of course that there is no 100% guarantee that the new job will be available, but the hiring manager says he is very confident that will be the case.

congrats man

Interesting that on a CFA website everyone takes the bottom-up approach… I think that approach does not work so well if you are evaluating the risk of a portfolio of credit. When I have done risk management on credit portfolios, I’ll talk to the traders and look at all that stuff but most of it goes through me quickly because you have to find the ones that might be a problem or more likely the groups that might be a problem. Nothing works better for this stuff than nice commercial software like CreditMetrics or whatever is your particular bent. Anyway, on a portfolio your biggest risk is probably credit spread moves so the first thing to do is group stuff by rating. Mumble stuff about credit agencies being silly while you do it. The second thing you do is group things by subordination. Those groupings have a really good chance of giving you the problem children. (I personally always care about liquidity so I would ask the traders questions like “how long to sell this if you had to and how much of a beating would you take?” then make them answer with thumbscrews). Next start checking out sector exposures or bond type exposure (“got lots of auction rate securities?”). Traders tend to buy stuff that is too close together because that’s what they know and what they look at (hmmm, should I buy Delta bonds or American Airlines? both…) Right about here there are about 20 paths you can go down but the bottom up approach I think is more for the trader/PM than the risk manager. If it’s available to me, I check out CDS, asset swap spreads and asset vol and maybe get nice spreadsheets on those. I might do bottom-up stuff on unrated bonds but I would only do it with the trader who bought it. Anyway, IMHO customers like expensive software better than they like any analysis I can do. Even if it’s junk, they trust it more. I hate that, but I live with it.

coming from quantitative/market approach (maybe b/c i come from buyside?), I was surprised as well as to the number of fundamental “risk analysis” out there… i would use more of a scenario analysis, ie find the OAS and reprice the bonds/CDS for moves in this based on historical moves in the past. You could use relative moves 25%, 50% etc, or absolute moves 100bps for IG, (define this) & 300 bps move for Non IG. I don’t like using ratings, almost better to use the market, ie for OAS between 25bps-150bps take out by 100bps if between 151-300bps take out 300bps if so on… if over 1000bps then assume BK. aggregate this numbers, considering portfolio hedgies, ie credit puts, short CDX etc… and get an impact number for several scenarios… ie if spreads widen by 25% our portfolio is estimated to lose/make X%

“I don’t like using ratings” But I’ll bet you still say things like “BBB spread”. Ratings suck, but I think they still matter even though the agencies are doing their best to marginalize themselves.

JoeyDVivre Wrote: ------------------------------------------------------- > “I don’t like using ratings” > > But I’ll bet you still say things like “BBB > spread”. Ratings suck, but I think they still > matter even though the agencies are doing their > best to marginalize themselves. rarely…only b/c most securities we deal with are non-rated. it’s crap, the market is making MER CDS 250 and it’s still ‘A’ rating? CDX IG is trading 130. WAMU is BBB-?

Of course I agree with that…

joey, that post up there was good. thx. suzmis, for the bottom up approach, how do you deal with revolving credit - key issues to focus on while doing the analysis?