Counterparty risk in a post Lehmans World -- January, 2010

Counterparty Risk in a Post Lehman’s World

January 28th, 2010

Fitch Solutions Representatives

Presenter

● Jonathan DiGiambattista, Managing Director, Global Head of Risk and Performance Analytics

The Panel

● Damiano Brigo, Managing Director, Quantitative Analytics

● Diana Allmendinger, Director, Research

● Catherine Downhill, Director, Integrated Data Services

● Jesse Waters, Director, Risk and Performance Platform

www.fitchsolutions.com January 28, 2010 1

Fitch Solutions is a leading provider of credit related analytics and data services● Products & Services include:

– Risk & Performance Platform for monitoring market-based credit risk signals and CDS price movements

– Integrated Data Services providing CDS & ABCDS pricing, fundamental financials, Fitch Ratings and market-based risk data

– FitchResearch.com credit research portal

● Market leading Quantitative Analytics team

● Commentaries and Publications:

– Weekly Risk and Performance Monitor providing overview of credit-related market movements of sectors and regions

– Bi-weekly Liquidity commentaries highlighting liquidity in the CDS market

– Available on www.FitchSolutions.com


Agenda

● Results of Counterparty Risk survey

● Meeting the challenges posed throughout the credit risk monitoring workflow

● Benefits, shortcomings and options for using the CDS market for risk signals

● A real-world example of counterparty risk management in a post-Lehman world

● Question and Answer


Counterparty Risk Survey 2009


Counterparty Risk Management Survey 2009

● 85 Counterparty Risk Manager interviews during October 2009

● 11 broad questions were asked re: current practices and changes since the Lehman default

● Results published in December issue of CREDIT

● Full results of the report and related articles available for download on www.FitchSolutions.com


Do you actively hedge counterparty risk? Are you set up to use central counterparties?

What other measures do you have in place to manage counterparty risk?

How many banks do you regularly deal with now? Pre-Lehman?

What measures do you have in place to monitor counterparty risk?

What factors influence your decisions not to trade with the best priced dealer?

How common are break clauses? Which dealers include their own credit risk as a discount?

Are you in favor of segregated margin accounts? How have your counterparty risk practices changed over the past year?

What is the impact of central counterparties on your business?

● Results from joint Credit/FitchSolutions survey shows most buy-side firms do not hedge counterparty risk

● Those surveyed cited hedging as too expensive– ‘manage’ counterparty risk

– Limits and collateral

– Calculating exposure

– Monitoring for ‘early warning’

● >75% of respondents are not set-up to trade on CCPs


Counterparty Risk Survey Results

Source: credit/FitchSolutions Counterparty Risk Survey

Survey shows increased efforts on monitoring CP credit quality● 63% of respondents deal with fewer counterparties today than before

Lehman defaulted

– Respondents did not see benefit of counterparty diversification due to nature of derivatives, correlation of derivatives and FI credit risks

– Fewer counterparties allows for better monitoring and enforcement of credit quality standards

● Market participants were least satisfied with counterparty credit risk monitoring and Market Liquidity


Source: credit/FitchSolutions Counterparty Risk Survey

Survey respondents cited internal workflows pose challenges for monitoring CP credit risk


66% of CRMs depend upon risk assessments from a centralized

Credit Risk function for an official risk assessment; 33% do not use a

formal credit risk assessment

Counterparty selection: >60% of CRMs deem credit risk the leading

reason to NOT trade with an ‘approved’ counterparty; 40% cited

liquidity

CRMs adjust limits and collateral requirements according to perceived likelihood of

downgrades or credit events.

5-10 ActiveCounterparties

Central Risk Assessments form ‘short-list’ of approved counterparties; also used for allocating capital

● Assessments made by credit analyst and guided by formal credit policy

– Factors include:

– Central risk assessments are ‘official’ views of entity credit risk often using rigid methodologies, particularly among BIS-II compliant firms

● Internal assessments impact P&Ls as enterprise capital requirements are based on internal-risk-weighted exposures



Financial Performance Agency Ratings

Capital Adequacy Sovereign Support

Market Signals Sovereign Risks / Ratings

Industry Standing Management Quality

Counterparty Risk Manager challenges: Avoiding adverse counterparty selection & optimize exposure to existing counterparties

● Imperative for CRMs to select counterparties on short-list with least likelihood of future downgrade or credit event within contract horizon

● CRMs take action on limits, collateral and hedging based on continuous monitoring of counterparties for risk migration relative to existing exposure



Future Downgrade

Stable Rating

No Future Credit Event Future Credit Event

Additional Capital Charge

Possible forced ‘sale’ for economic loss

Economic Loss

Economic LossStable Capital Charge

Future Upgrade Economic LossReduced Capital Charge

Reduce limitsIncrease Collateral Req’s

Aggressively reduce limitsIncrease collateral req’sHedge to eliminate exposure

Maintain limits &collateral Req’s

Increase Exposure

Meeting the challenges for monitoring counterparty credit risk


CRMs are dissatisfied with their ability to access and integrate CP credit risk signals

● CRMs have significant informational needs around current risk levelsand potential for credit risk migration

– Anticipating changes to internal risk assessments

– Full transparency into central risk methodologies and policies, and access to relevant data:

– Anticipating future credit events

– External credit risk assessments

– Early warning, benchmark and relative risk indicators

– “News flow”


Fundamental Financials Agency Ratings

Capital Adequacy Sovereign Support

Market Signals Sovereign Risks / Ratings

Industry Standing Management Quality

CDS market and derived metrics are best early warning signals available

● Cardinal and ordinal levels observed in the CDS market have most direct implications for credit risk managers

● From the CDS market we can derive:

– PDs for individual entities

– Relative risk levels by region/sector

– Historical cycle comparisons

– Sector performance

– Aggregate expectations for future default rates


But Cardinal values are difficult to rationalize


Source: FitchSolutions

Implied PD for FI’s = 9.1%(40% recovery)

0

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False signals can cloud decision-making


March 5th, 2008: Bear & Lehman have non-IG trading patterns


Source: FitchSolutions Risk & Performance Platform Source: FitchSolutions Risk & Performance Platform

Bear Stearns

Lehman

Merrill


CDS liquidity signals uncertainty

5

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Jan 07 Jun 07 Nov 07 May 08 Oct 08 Mar 09 Sep 09

Citigroup Inc. Lehman Brothers Holdings Inc. Royal Bank of Scotland Plc(Liquidity Score)

RBSpercentileRk = 72

RBSnationalization

CitigrouppercentileRk = 63

Lehmanpercentile

Rk = 8

Citigroupcapital injection

Lehman bankruptcy

RBSpercentile

Rk = 7

Citigrouppercentile

Rk = 2

Source: Fitch Solutions


CDS early warning proved valuable through the crisis

A return to uncertainty for Financials, SovereignsLiquidity for 25 Most Liquid Financials vs Sovereigns

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FS L

iqui

dity

Sco

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Financials Sovereigns

Using Fitch Solutions content to monitor Counterparty Credit Risk


A counterparty risk manager requires timely and accurate data to meet 3 key needs:


Fitch client counterparty risk monitoring practices

● Mid-sized buy-side firm transacts with financial institutions for interest rate, foreign exchange hedging, and utilizes banks for cash management

– Short-list determined by screening the Fitch international bank universe for firms with individual rating of ‘B’ or better, at least $100bn in assets and a maximum leverage ratio.

– Per internal credit policy, maximum exposure limit scales with the Fitch individual rating.

– The CRM has the ability to further limit exposure depending on perceived risk migration. To do so, the CRM monitors the following on his portfolio of counterparties :

– CDS Implied Ratings (and ‘gap’ with Agency ratings), CDS spot-spreads and CDS benchmarks

– Fitch Ratings status (outlooks, watches) and research and announcements

– Financial resultswww.fitchsolutions.com January 28, 2010 22

Counterparty Risk Management Post-Lehman

● Increased focus on counterparty selection and credit risk monitoring

● CRMs have taken on additional responsibilities for anticipating future credit events

● Information challenges persist in anticipating future movements in credit risk assessments and potential credit events

● Integration of fundamental financial data, market data, agency ratings, and fundamental research is essential for the contemporary counterparty risk manager


Fitch Solutions Research, Commentaries and Related Information

– [email protected]



● All our research and commentaries can be found on www.fitchsolutions.com and include:

– Risk and Performance Monitor

– Weekly monitor assessing geographical CDS spread movements and market indicators of credit risk

– Fitch Solutions/Credit 2009 Counterparty Risk Survey

– A write up of the survey we undertook with Credit into Counterparty Risk

– Fitch Solutions' Global CDS Liquidity Scores Commentaries

– Bi-weekly commentaries on the liquidity in the CDS market

– Quantitative Research

• Articles include: “Counterparty Risk for Credit Default Swaps”

● If you’d like to learn more about our products or research please contact the Fitch Solutions team:




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London101 Finsbury PavementLondonEC2A 1RS+44 20 7417 4222

Fitch Group Fitch Ratings Fitch Solutions Algorithmics

Fitch Solutionswww.fitchsolutions.com


Counterparty risk in a post Lehmans World -- January, 2010

Economy & Finance

Transcript of Counterparty risk in a post Lehmans World -- January, 2010