Tuesday, October 31, 2000 When companies argue that they shouldn't have to provide detailed risk management information to investors and analysts (because they won't understand), its time to be very afraid. In honour of Hallowe'en, here are two really scary stories. Joe Niedzielski A new accounting standard requiring companies to report on their balance sheets the fair market value of their holdings of derivatives and that they be marked to market, will provide analysts with more information on the corporate use of these financial tools than was ever available before. ... some familiar with it question whether analysts who track the future prospects of Corporate America are up to the task of unraveling how business and financial risk is hedged. American Banker Dina Dublon, Chase's Chief financial officer, said expanded disclosure could mislead investors in assessing a bank's risk. And on the other hand... Forbes.com Baruch Lev of New York University's Stern School of Business has been elaborating on these propositions for many years. A study by Christine Botosan of the University of Utah published in Accounting Review has contrasted companies that are the most forthcoming in their shareholder reports with the least forthcoming and shows huge advantages--capital costs as much as 970 basis points lower--for those delivering the most information.   Saturday, October 21, 2000 FT.com Sir Howard Davies, chairman of the Financial Services Authority,... speaking at a conference in London, said closer alignment between the level of risk and the amount of capital put aside would mean less risky banks required lower reserves. This is very significant statement. Its the first time that I have heard a regulator indicate that some banks might be allowed to reduce their regulatory capital. The Basel Committee previously seemed to be working under the assumption that no reduction is capital would be allowed. Any reduction in credit capital would be offset by (at least) an equal increase in capital for other risks. Extracts from his speech are here SalomonSmithBarney One of the most common investor mistakes is choosing an investment management firm or mutual fund based on recent top performance.   Saturday, October 14, 2000 economist.com Incentives in the junk-underwriting business only make matters worse. Risk-adjusted, this is a terrible business for banksí shareholders. A large slice of the profits goes to bank employees, who are increasingly prepared to gamble by underwriting low-quality debt which, if they prove unable to offload it, could do serious damage to their bank. In other words, the best risk management system in the world cannot achieve the discipline that occurs when employees, with the potential to take huge risks, are also significant shareholders.   Friday, October 13, 2000 Credit Magazine Swaps counterparties presumably bought or sold protection on Peru based on their assessment of its credit fundamentals. Perhaps they should also have considered the countryís ability to handle litigation. Event risk rears its ugly head in Peru. risknews.net Four industry groups - the British Bankers Association (BBA), the European Banking Federation (EBF), the International Swaps and Derivatives Association (Isda), and the Risk Management Association (RMA) - are conducting an ongoing European loss-given default study.   Tuesday, October 10, 2000 bankruptcydata.com Owens Corning and all of its U.S. operating subsidiaries and certain other U.S. subsidiaries filed for Chapter 11 protection with the U.S. Bankruptcy Court in the District of Delaware [on October 5]. The Company announced that the filing was the result of growing demands on its cash flow resulting from asbestos liability. The Company further announced that it has secured a $500 million debtor-in-possession financing commitment from Bank of America. The Company subsequently filed an emergency motion seeking a Court order blocking bank lenders led by Credit Suisse First Boston from canceling the credit of the 109 affiliates that were not included in the Chapter 11 filing or from taking funds from these affiliates' accounts. KMV's EDF (red line) provided early indications of increasing risk starting in 1997, but it became critical about a year ago. S+P (blue line)apparently didn't see it coming, until very recently, as the BBB- rating has been unchanged over the last 5 years, except for the past few months. The chart also shows the median EDF for other companies in Owens Corning's SIC code (green line). Once again, Owens Corning started to deviate from its peers about a year ago.   Thanks to Rocky Ieraci for pointing out that I had mixed up the EDF and S+P colours.   Monday, October 9, 2000 The Banker No longer able to invest in government securities for a steady high income, [Turkish] banks are being forced to turn to real banking ñ lending ñ as a way of making money. With just over 80 banks licensed in Turkey, and 8 of them now under state control, their default rate is running at about 10% Nobody ever said that lending was easy.   Thursday, October 5, 2000 OSFI As institutions move up the risk curve to enhance returns to shareholders, and as governments find it necessary to accommodate these changes, often with a view to assuring a level playing field with foreign institutions, we need to recognize that these changes are occurring at what may prove to be a late stage in the longest period of economic recovery in recorded history. Duh! Institutions are virtually forced to move up the risk curve by regulators (OSFI included) who enforce capital requirements that don't distinguish between low risk and high risk loans. It is completely disingenious for regulators to try to absolve themselves of responsibility for banks taking more risk: they are not disinterested bystanders, they are active co-conspirators. Its even worse, there are products, such as credit swaps, which can reduce a bank's exposure to risk, but OSFI only recognizes this in a very small number of cases. Andrew Willis It seems long-time client Vodafone Group kicked Goldman Sachs out of its $15-billion (U.S.) commercial paper program after the investment bank refused to offer a $450-million credit line to the wireless phone company. I never did hear whether Ford was successful in convincing its investment bankers to participate in loss-leader loans, but this is the exact same situation. I suppose Goldman looked at this very carefully and concluded that the prospects for fee income from Vodafone didn't justify the potential risks (i.e. losses) that might arise from a $450MM loan. Although the article says that Vodafone "kicked" Goldman out, in reality it was Goldman who fired Vodaphone as a customer.   Wednesday, October 4, 2000 Economist.com Since companies often use banks to arrange financing quickly before issuing stock or bonds, the market for syndicated loans is often revealing about embryonic trends in credit. These are worrying. Worrying indeed. Whether these nascent trends are the beginning of something big is hard to tell, though.   Friday, September 22, 2000 dismal.com There is no real evidence that bigger financial services companies are universally more efficient than smaller firms, and thus there is little justification for the premiums acquiring firms pay. So, the logical strategy if you are anyone other than a bulge-bracket player is to find someone to pay an exorbitant price for your business and walk away? Lawrence H. Meyer Why risk management matters for global financial institutions. A fairly innocuous review of risk managment issues IMHO.   17 September 2000 Basel Committee on Banking Supervision The recurrent nature of credit concentration problems, especially involving conventional credit concentrations, raises the issue of why banks allow concentrations to develop. First, in developing their business strategy, most banks face an inherent trade-off between choosing to specialise in a few key areas with the goal of achieving a market leadership position and diversifying their income streams, especially when they are engaged in some volatile market segments. This trade-off has been exacerbated by intensified competition among banks and non-banks alike for traditional banking activities, such as providing credit to investment grade corporations. Concentrations appear most frequently to arise because banks identify "hot" and rapidly growing industries and use overly optimistic assumptions about an industry's future prospects, especially asset appreciation and the potential to earn above-average fees and/or spreads. Banks seem most susceptible to overlooking the dangers in such situations when they are focused on asset growth or market share.   14 September 2000 American Banker To help investors judge the safety and soundness of particular banks, any bank that qualifies to use its own [risk rating] system [to set regulatory capital] would have to publicly disclose the methods on which the system is based.    13 September 2000 Bank for International Settlements One of the striking developments in fixed income markets in recent months has been the apparent emergence of a new link between credit and equity markets...This phenomenon seems to have stemmed from an increasingly widespread use by fixed income dealers and institutional investors of an option-based approach to estimating credit risk. You probably wouldn't see the same phenomenon in bank loan pricing. At least not yet!    7 September 2000 Predicting Delinquencies A couple of days ago the Fed released data on delinquency trends for C and I loans at the 100 largest US banks. I thought it would be interesting to compare the median North American EDF's to this data to see whether there was a relationship. There was. The chart below shows that both EDF's and delinquencies have been steadily declining since 1990, and that they both began to increase at almost exactly the same time, the middle of 1998. I remember the middle of 1998 well, and I remember being told that the changes in EDF we were observing at that time were merely the result of equity market movements, but that the credit quality of borrowers hadn't changed. Now, with the benefit of nearly 2 years hindsight, it is obvious that something more dramatic happened in 1998, and KMV's EDF was very responsive to the change. There is still the question of whether it overreacted. Even though delinquencies began to increase in 1998, they have not yet increased to the same extent as EDF's have. The current EDF median of 243 bps is about 3X its nadir of 82 bps, but the current delinquency rate (208 bps) is only 1.6X the lowest delinquency rate of 133 bps. Since the median EDF doesn't show any signs of moving back down, I would put my money on further increases in delinquencies narrowing the gap.     Catherine Paul-Chowdhury Under this ongoing pressure from the front lines, policies become less restrictive and more favourable to the client over time. First, exceptions are granted to policy, and then more exceptions. Then the front line says that the policy doesnít reflect the realities of the market (evidenced by all the exceptions the bank has been making), and needs to be changed. In other words, organizational memory of the loan loss events which gave rise to the relatively strict policies and procedures diminishes and fades. Paul-Chowdhury's working paper, "Remembering Lessons from Sector-Specific Credit Losses", provides an excellent discussion of "institutional memory" and the forces that drive organizations to repeat the same mistakes over and over. Many of the elements Paul-Chowdhury describes as contributing to the large energy and real estate losses of previous decades can be observed in lending organizations today. It's worth reading this just to put the current competitive environment in a longer term historical perspective. Of course I am biased; I was one of the people that Katy interviewed during her research. Moody's Investor Services French insolvency law is primarily focused on the preservation of employees and the debtor, with repayment of debts coming in third position Hmmm. Time to increase our LGD's for French financings.    6 September 2000 Moody's Investors Services Going forward, with economic conditions remaining favourable, a major downturn in the credit cycle seems unlikely, and credit risk management standards are stronger than during the last major downturn in the late 1980s and early 1990s. The UK banks have also generally concentrated on their domestic market in recent years, and reduced their involvement in investment banking. This was evidenced by the relatively limited impact on UK banks of the recent emerging markets and financial markets crises. Is it just me, or is there something wrong with saying that assuming there is no cyclical downturn, then banks won't experience a cyclical downturn? Interesting how Moody's views UK banks' reduced involvement in investment banking as a good thing. American Banker Surveys show that the demand for wireless banking is small, and likely to stay that way. Right on!!    30 August 2000 Risk News To expand its client base beyond the banking sector, Moody's Risk Management Services (MRMS), the subsidiary of global credit rating agency Moody's Investors Service, is integrating its RiskCalc product with risk management software providers RiskMetrics' CreditManager product. This is a smart business combination. FT.com The pressure for consolidation in global investment banking increased on Wednesday as Credit Suisse confirmed its $11.5bn deal to buy Wall Street firm Donaldson, Lufkin Jenrette. This may not be. bankruptcydata.com PC Service Source, Inc. and its subsidiaries filed for Chapter 11 protection ... [as a] result of significant losses from its discontinued part-sales division. PC Service's EDF history....   And also.... Tokheim Corporation filed for Chapter 11 protection with the U.S. Bankruptcy Court in the District of Delaware, concurrently filing a pre-packaged Plan of Reorganization. The Company announced that its non-U.S. subsidiaries would not be affected. ....Among other things.... all outstanding shares of the Company's common stock will be cancelled and stockholders will receive warrants with a 6 year term giving them the right to acquire an aggregate of 549,451 shares of the new common stock of the reorganized Company at an exercise price of $49.50 per share. The holders of $260 million of senior and junior subordinated notes and certain other unsecured creditors will receive 4,500,000 shares of new common stock in exchange for their notes, subject to dilution for warrants to existing shareholders and management options. The Company further announced that members of the bank group will receive warrants with a 5-year term to purchase 678,334 shares of the new common stock at an exercise price of $0.01 per share.   S+P caught the increased risk a few months ago. The EDF shows it to stem back a couple of years. 'nuff said.    27 August 2000 FT.com "People should realise Japanese financial reform is far from complete," argues Sakura Shiga, a senior financial regulator who recently moved to the customs department. "The real problem is still overcapacity in the financial sector. Market discipline is needed to clean up the mess."   This man speaks the truth. Is that why he is no longer a senior financial regulator. Hmmm, I wonder... derivativesweek.com Chase is assessing the profitability of creating [a structured note] division and may decide to go ahead this fall, the official said. Chase would market the structured notes to institutional investors who want to gain exposure to asset classes or markets in which they cannot directly invest because of investment mandates or regulatory restrictions. Most of these notes would invest in a wide spectrum of option-based products, he said. The notes would be principal-guaranteed, allowing investors to hedge against market downturns, he added. This sort of thing goes on all the time, and I can't figure out for the life of me how money managers get away with it. Basically institutional investors are given money to manage, and they are given a set of rules regarding the kind of risks they are allowed to take. Immediately some smart financial engineer dreams up a way to take the risks that have been prohibited, without violating the investment rules (i.e. they figure out how to comply with the letter of the law, but not the spirit). Now if my pension fund tells a money manager that it doesn't want money invested in Central American tech stocks (if there are such things) because they are too risky, that doesn't mean that it is OK to enter into a deal with a low risk US bank (like Chase) who agrees to pass through the risk of Central American tech stocks to the pension fund. If the fund manager isn't allowed to take a risk, it shouldn't matter whether the do so directly or indirectly. And yet there is clearly a market that is big enough for Chase to set up a business unit, just to break these sorts of rules. It's scary. Do you know where your pension money is? really? morningstar.com Fidelity Investments introduced its first bank-loan fund Wednesday in the form of Fidelity Advisor Floating Rate High Income Fund. An interesting challenge to those who say that bank loans cannot be managed like a portfolio. Fidelity thinks they can.    24 August 2000 bankruptcydata.com Sunshine Mining and Refining Company and three of its subsidiaries filed for Chapter 11 protection with the United States Bankruptcy Court in the District of Delaware. The EDF history shows a familiar pattern....   American Banker Community bankers, however, tend to look at more than just the borrower's credit score. Indeed, because of this individual attention, a community bank often will make a perfectly bankable loan to the borrower when a larger organization's computer would deny the loan. Here's my advice. Find a bank that tries to beat a good model using human judgement, and then sit back and wait for them to start reporting large losses. It won't take long.    18 August 2000 FT.com For investment banks, ...access to capital alone is not a trump card; it needs to be used wisely. It also lowers a bank's average return on equity, which is one of the measures on which its stock is valued. What does it mean for an investment bank to use it capital wisely? I suggest this can only mean that capital is deployed in small amounts to each customer and only when the the return on the capital is reasonable. To do otherwise would mean taking large credit risks that won't always be offset by high fee income. Bankruptcydata.com Showscan Entertainment filed for Chapter 11 protection with the U.S. Bankruptcy Court in the Central District of California, Los Angeles Division. Dennis Pope, President and Chief Executive Officer, stated, "While the decision to file was a difficult one, it represents the best alternative for Showscan at this time. This filing will allow us to minimize the impacts on our day-to-day operations." The Company is an international leader in production, distribution and exhibition of movie-based attractions shown in large format theatres worldwide. Here's their EDF history:  15 August 2000 The Defaulted Bonds Newsletter, published by the Bond Investors Association, is "a monthly review of individual corporate and municipal bond defaults from one of the most comprehensive databases in the US. The most recent issue notes that second quarter default volume of $9 billion has unnerved some institutional investors. Their advice? Basically: DON'T PANIC. Good advice to hitch-hikers everywhere. But they go on... To improve your odds of doing better than average, one can play the percentages and avoid bonds that will be in their second and third year from date of issuance. It is this category that historically represents the majority of the defaults for any given period For Pete's sake. Nothing about diversifying. Nothing about trying to assess the current default risk inherent in traded issues. Just keep away from 2 and 3 year old bonds. Anyone who follows this advice deserves to be burned, big time. Dominic Barton, Ragnar Helleniu, and David A. Von Asian banks with limited skill and inadequate information can substantially improve their results in just six months. Yeah, right....and pigs can fly. Bankruptcydata.com reported two bankruptcies yesterday. First: Trend-Lines, Inc. and wholly-owned subsidiary Post Tool, Inc. filed for Chapter 11 protection with the U.S. Bankruptcy Court. The specialty retailer of woodworking tools and accessories announced in June 2000 that it was planning to divest itself of its golf businesses in order to concentrate on its larger and more profitable tool business. The EDF history for this company clearly shows that it started to deteriorate 2 years ago, making the EDF a useful predictor.   On the other hand: Value America, Inc. filed for Chapter 11 protection with the U.S. Bankruptcy Court in the Western District of Virginia. The Company further announced the elimination of an additional 46 percent of its workforce. The Company stated that these most recent moves are part of an ongoing effort to focus on its electronic-services business, which involves developing online operations and infrastructure systems.   The EDF history for this company is quite short, and it didn't start to go through the roof until a few months ago. This EDF would have sent a misleading signal and this reinforces my view that it is dangerous to rely upon KMV's published EDF unless they are at least 6 months old.   13 August 2000 Yuko Kawamoto: Japan's banks are still struggling, and international benchmarks show just how far they have to climb before they become globally competitive David Keisman: Default Hurts. A lot. John Ammer and Frank Packer We examine differences in default rates by sector and obligor domicile. We find evidence that credit ratings have been imperfectly calibrated across issuer sectors in the past. Controlling for year of issue and rating, default rates appear to be higher for U.S. financial firms than for U.S. industrial firms. Sectoral differences in recovery rates do not offset the higher default rates. By contrast, we do not find significant differences in default rates between U.S. and foreign firms. Nota Bene: Ammer and Packer observe that, after controlling for annual changes in default rates, US banks were more likely to default than US corporates with the same rating. This runs counter to conventional wisdom. Discretionary Defaults I have been thinking a lot about the differences between the default experience on bonds and bank loans. I think that bank loans are inherently less risky for a variety of reasons, including: bank loans generally have tighter covenants that permit the nature of the credit exposure to be renegotiated (in favour of the bank) as the borrower's risk increases. banks tend to have multple credit relationships with a borrower and can exploit this to enhance the risk profile of all credit exposures. (e.g. the bank may use a customer's request to renew a small maturing credit facility, as an opportunity to enhance other facilities.) But perhaps more importantly, banks are in a unique position to decide for themselves whether or not they wish to experience a default. When a bond matures, the company either has the funds to repay the bond or it doesn't. Upon maturity of a bank loan, though, the bank can decide whether to extend the maturity date, or make another advance (maybe with higher pricing) to repay the original loan. These instances of forbearance by a bank are tantamount to a default, but in most cases would not show up in any bank's records as an instance of default. Banks can therefore tell themselves that their default experience is better than that of bond investors. When they do so, they are only partly right. In part they benefit from the nature of bank loans but I think that they also delude themselves by failing to acknowldge default when they agree to amended credit agreements.			Home FAQ Feedback