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Derivatives
Source: International Financing Review
Date: August 2, 2003
Author: Jean Haggerty
Increasingly active portfolio management in moves to alter the risk-return characteristics of corporate credit portfolios, and the prospect of international mark-to-market accounting changes, are fuelling interest in a credit pricing tool launched by Moody's KMV, the company said.
CreditMark differs from other credit pricing tools in that it is aimed at calculating the risk all of the paper contained in a bank's corporate credit portfolio by stripping out the value of each debt instrument's default option, said John McQuown, chairman of Moody's KMV in San Francisco. Marking-to-market is an essential prerequisite of decision-making processes aimed at improving diversification and therefore banks' risk-return ratios. Unlike equity, debt is asymmetrical and the diversity of the portfolio is what determines a portfolio's upside potential.
Traditionally, it has been difficult to apply a mark-to-market regime to corporate credit portfolios due to the variety of debt instruments available, the non-public profile of many companies and challenges related to isolating an instrument's default option from its interest rate risk.
For firms with publicly quoted equity, probabilities of default can be extracted and implied values of a default option can be ascertained. When a firm has no publicly-traded equity or when a firm's publicly traded debt does not trade, challenges arise. Bank asset managers need to make decisions based on the market value of the last issue that traded and where no trading has occurred, based on modelled market values.
As decisions about a credit portfolio's level of diversification cannot be based on an illiquid debt instrument's book value - particularly where the portfolio is perpetually turning over - the infrequent trading in individual issues of a company is a big obstacle.
"If you can't observe [the prices of debt], you must infer them. You must model them," McQuown said. To arrive at mark-to-model prices for illiquid credits, CreditMark uses debt, probabilities of default and prices available in the bond, credit default swap and loan markets as inputs. Clients can add data sources, including their own proprietary data.
In addition to rendering the lack of portfolio diversification a more visible risk, Basle II offers a platform for active diversification management.
For banks, lack of diversification, according to McQuown, is at least as big a potential problem as insufficient capital (IFR 1490).
Insight into the market value of a debt instrument's default option could also help issuers determine what they should be issuing or what form of financing they should be using, McQuown added. " In the last credit cycle, more corporate debt was issued when corporate debt was getting risky . . . Sooner or later, corporates are going to have to service their debt," he said.
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