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1、1OutlineOutline OverviewOverview Market ConcernsMarket Concerns Credit Risk LimitsCredit Risk Limits Credit Risk ModelsCredit Risk Models Credit Risk DiversificationCredit Risk Diversification Credit Risk Management ProcessCredit Risk Management Process2Overview:Overview:Current State of the Credit
2、MarketCurrent State of the Credit Market Although Fixed Income has recently outperformed equity,the Corporate Although Fixed Income has recently outperformed equity,the Corporate Bond market has severely underperformed TreasuriesBond market has severely underperformed Treasuries The market has exper
3、ienced rising defaults,downgrades,and an The market has experienced rising defaults,downgrades,and an unprecedented number of Investment Grade credits falling into High Yield unprecedented number of Investment Grade credits falling into High Yield(a.k.a.“Fallen Angels”)(a.k.a.“Fallen Angels”)“Fallen
4、 Angels”are overwhelming the High Yield market as they number 14 of the top 25“Fallen Angels”are overwhelming the High Yield market as they number 14 of the top 25 issuers and comprise 20%of the total amount outstanding in High Yieldissuers and comprise 20%of the total amount outstanding in High Yie
5、ld Telecom/Energy have been at the core of the fundamental deterioration in Telecom/Energy have been at the core of the fundamental deterioration in credit with outsized spending to meet unrealistic demand expectations and credit with outsized spending to meet unrealistic demand expectations and agg
6、ressive expansions into energy trading in utilitiesaggressive expansions into energy trading in utilities Extreme market volatility and limited liquidity best characterizes the current Extreme market volatility and limited liquidity best characterizes the current state of the corporate bond marketst
7、ate of the corporate bond market Banks are restricting access to liquidity and the resulting illiquidity is contributing to the Banks are restricting access to liquidity and the resulting illiquidity is contributing to the credit markets volatilitycredit markets volatility Portfolio diversification
8、is difficult to achieve given that 33%of amount Portfolio diversification is difficult to achieve given that 33%of amount outstanding and 42%of new issue volume are in the the top 25 namesoutstanding and 42%of new issue volume are in the the top 25 names Survival depends on minimizing the occurrence
9、 and magnitude of Survival depends on minimizing the occurrence and magnitude of distressed creditsdistressed credits3Market ConcernsMarket Concerns What is contributing to the current credit What is contributing to the current credit volatility?volatility?Bear equity market and corporate scandalsBe
10、ar equity market and corporate scandals Credit recession(stressed credit market)Credit recession(stressed credit market)Liquidity crisisLiquidity crisis Historically low ratesHistorically low rates Economic recovery unclearEconomic recovery unclear4A Bear Market in EquityA Bear Market in Equity Vola
11、tility at historic highs since 1997Volatility at historic highs since 1997 3+years upside of technology bubble3+years upside of technology bubble 2.5 years of bubble bursting and corporate scandals2.5 years of bubble bursting and corporate scandals Volatility measure of “%days per year S&P 500 Index
12、 Volatility measure of “%days per year S&P 500 Index moved greater than+/-1%”in August 2002 was 43%moved greater than+/-1%”in August 2002 was 43%versus 22%historic average since 1925versus 22%historic average since 1925 Current downturn deepest since 1973-74 and longest Current downturn deepest sinc
13、e 1973-74 and longest since 1929-32 or 1946-49since 1929-32 or 1946-49 At its July 2002 low,the S&P 500 was 48%below its March At its July 2002 low,the S&P 500 was 48%below its March 2000 peak and the decline has endured for 29 months.2000 peak and the decline has endured for 29 months.This makes it
14、 the longest bear market since 1946/49 and This makes it the longest bear market since 1946/49 and together with the 1973/74 cycle,the steepest of the post-together with the 1973/74 cycle,the steepest of the post-WWII period.WWII period.(1)(1)(1)TheBankCreditAnalyst,August20025A Bear Market in Equit
15、yA Bear Market in Equity Valuations are still above historic Valuations are still above historic norms on almost every measure norms on almost every measure(Price/Earnings,(Price/Earnings,DividendYieldDividendYield,Price/Book,Price/Book,Price/Sales),except for Price/Sales),except for EarningsYield/B
16、ondYieldEarningsYield/BondYield(which is near fair (which is near fair value,as bond yields are at historic lows)value,as bond yields are at historic lows)Earnings remain under pressureEarnings remain under pressure Outflows from domestic equity mutual funds Outflows from domestic equity mutual fund
17、s and foreign sales of US stocks has intensified and foreign sales of US stocks has intensified since June 2002since June 2002(2)(2)(2)NedDavisResearchInc.,September20026Recent Equity and Fixed Income Returns(For Periods Ended 10/31/2002)Source:Lehman,Standard&Poors7Credit Market Under StressCredit
18、Market Under Stress Unprecedented numbers of distressed creditsUnprecedented numbers of distressed credits (“Fallen Angels”are investment grade credits that have been downgraded to high yield)(“Fallen Angels”are investment grade credits that have been downgraded to high yield)$115 billion Fallen Ang
19、els YTD through October 2002$115 billion Fallen Angels YTD through October 2002 Since 2001 default rates have exceeded 1991 highsSince 2001 default rates have exceeded 1991 highs Default rates have been rising continuously since 1999.It has been like a Default rates have been rising continuously sin
20、ce 1999.It has been like a credit recession for several years and I expect it to continue until default credit recession for several years and I expect it to continue until default rates clearly have peaked.”Edward Altman,Ph.D.NYU Stern School of rates clearly have peaked.”Edward Altman,Ph.D.NYU Ste
21、rn School of BusinessBusiness 2001 experienced the most ever Chapter 11 filings with 170 and pre-petition 2001 experienced the most ever Chapter 11 filings with 170 and pre-petition liabilities of$230 billionliabilities of$230 billion First half of 2002 had 74 filings totaling$130 billionFirst half
22、of 2002 had 74 filings totaling$130 billion Since June 1997 a series of financial crises have resulted in huge Since June 1997 a series of financial crises have resulted in huge volatility in and widening of credit spreads;this has produced volatility in and widening of credit spreads;this has produ
23、ced sustained negative excess returns in corporate issuessustained negative excess returns in corporate issues Moodys downgrade/upgrade ratio rose from 1.4 in 1998 to 4.1 Moodys downgrade/upgrade ratio rose from 1.4 in 1998 to 4.1 Moodys year-to-year defaults rose from 1.3%in 1998 to 10.53%in Moodys
24、 year-to-year defaults rose from 1.3%in 1998 to 10.53%in June 2002 and are at 9.2%for September 2002June 2002 and are at 9.2%for September 2002Source:Lehman,Moodys,EdwardAltman8Liquidity CrisisLiquidity Crisis Credit contraction in bank lending and commercial Credit contraction in bank lending and c
25、ommercial paper is causing a“liquidity crisis”,reversing trend for paper is causing a“liquidity crisis”,reversing trend for last 5 years of 20%annual expansionlast 5 years of 20%annual expansion Bank lending is currently 15%lower than last JulyBank lending is currently 15%lower than last July Non-fi
26、nancial CP has contracted 47.7%to a low of Non-financial CP has contracted 47.7%to a low of$179.5 billion in June 2002 from high of$343.3 billion$179.5 billion in June 2002 from high of$343.3 billion in December 2000in December 2000 Financial leverage(ratio of current debt to total market Financial
27、leverage(ratio of current debt to total market capitalization)of corporations increased in 2002 to capitalization)of corporations increased in 2002 to 26.6%(on$4.5 trillion),the highest level since the 1990-26.6%(on$4.5 trillion),the highest level since the 1990-91 recession91 recessionSource:Lehman
28、9Historical Lows For Historical Lows For Interest RatesInterest Rates Aggressive Fed easing with Fed Funds at 1.25%since November Aggressive Fed easing with Fed Funds at 1.25%since November 6,2002 cut of 50 bps6,2002 cut of 50 bps The resulting yield curve is the steepest since Fall 1992The resultin
29、g yield curve is the steepest since Fall 1992 Rates at 4-decade lowsRates at 4-decade lows 10-year Treasury Note yield of 3.57%on October 9th was at a 10-year Treasury Note yield of 3.57%on October 9th was at a 44-year low44-year low As of November 11,2002 the 10-year has risen 58 bps from As of Nov
30、ember 11,2002 the 10-year has risen 58 bps from this lowthis low Historically low rates led to another mortgage refinancing wave Historically low rates led to another mortgage refinancing wave which is supporting consumer spendingwhich is supporting consumer spending Expectation is for interest rate
31、s to stay low this year,rising next Expectation is for interest rates to stay low this year,rising next year as the yield curve to flatten from the short endyear as the yield curve to flatten from the short endSource:BloombergUPDATE10Uncertainty of Economic Uncertainty of Economic RecoveryRecovery B
32、lue Chip consensus GDP growth is forecast at 1.6%in Blue Chip consensus GDP growth is forecast at 1.6%in Q4-2002 and 3.3%in 2003.Q4-2002 and 3.3%in 2003.Concerns that declines in equity markets and financial Concerns that declines in equity markets and financial wealth could reduce consumer spending
33、 and economic wealth could reduce consumer spending and economic growthgrowth Continued concern:Geopolitical risk may disrupt Continued concern:Geopolitical risk may disrupt recoveryrecoverySource:BlueChipConsensusForecast11Investment Grade Corporate Investment Grade Corporate Cumulative Excess Retu
34、rnsCumulative Excess ReturnsPeriodofNarrowingCorporateSpreadsASeriesofFinancialCrisesWorldcomEnronAsia CrisisRussia Collapse,LTCMTechnology Bubble Collapses12Source:LehmanCorporate Bond ValuationsCorporate Bond ValuationsAnything But Telecom and Pipelines!Anything But Telecom and Pipelines!(From Dec
35、ember 31,2001 through September 30,2002)(From December 31,2001 through September 30,2002)13Avoiding Credit Disasters and Avoiding Credit Disasters and Defaults is EssentialDefaults is EssentialSource:Lehman(2002 YTD through October 31,2002)The first ten months of 2002 saw the largest number of Falle
36、n Angels(Investment The first ten months of 2002 saw the largest number of Fallen Angels(Investment grade credits that have been downgraded to High Yield)in history(245 totaling grade credits that have been downgraded to High Yield)in history(245 totaling$115.4 Billion).$115.4 Billion).Niagara Mohaw
37、kTelecommunications,TCI Comm,ITTUS West Capital,Columbia/HCAWaste Management,Rite AidXerox,Conseco,FinovaEnron,Calpine,JCPenney,PG&E,Lucent,Mirant,S.Cal Edison,Delta Airlines,KMartWorldcom,Qwest,Tyco,Williams Co.,Georgia Pacific,USWest Comm.,AT&T Canada,Dynegy,Nortel,Gap,Goodyear14Top 50 Fallen Ange
38、ls from 1995-2002 YTDTop 50 Fallen Angels from 1995-2002 YTD WorldComs$22.8 Billion WorldComs$22.8 Billion total public debt ranks as total public debt ranks as largest fallen angellargest fallen angel Qwests$14.4 Billion is Qwests$14.4 Billion is secondsecond Tycos$8.4 Billion is thirdTycos$8.4 Bil
39、lion is third Williams$8.0 Billion is Williams$8.0 Billion is fourthfourth Enrons$6.8 Billion is sixthEnrons$6.8 Billion is sixth Georgia-Pacifics$5.7 Georgia-Pacifics$5.7 Billion is in the top 10Billion is in the top 10 May 2002 will be recalled for May 2002 will be recalled for a record$42.8 Billi
40、on of a record$42.8 Billion of fallen angel debt moving fallen angel debt moving into high yieldinto high yield July 2002 was next largest July 2002 was next largest at$22.8 Billion at$22.8 Billion Cumulative$115 Billion in Cumulative$115 Billion in principal of fallen angels in principal of fallen
41、angels in 2002 YTD is record high2002 YTD is record highSource:Lehman(2002 YTD through October 31,2002)*Index Exposure-Actual balance sheet exposure may be higher.*Credit Risk Management is Critical to PerformanceCredit Risk Management is Critical to Performance15High Yield High Yield CorporatesCorp
42、orates:Index Returns and Default Rates:Index Returns and Default Rates (From 1980 through September 30,2002)(From 1980 through September 30,2002)Source:Lehman High Yield Index 1983-2002,*-7.63%Return is YTD through September 30,2002,Credit Suisse First Boston(CSFB)Returns for 1980-1982,Moodys Defaul
43、t Rates 1983-2002,*9.2%Default Rate is for annual period from October 2001-September 2002Most years of peak default rates or following year are also years of high returns:1982,1986,1991 and 199516High Yield Spreads By Credit QualityHigh Yield Spreads By Credit Quality(From January 31,1990 Through Se
44、ptember 30,2002)(From January 31,1990 Through September 30,2002)Source:CreditSuisseFirstBoston(CSFB)Source:CreditSuisseFirstBoston(CSFB)17Paradigm Shift in Fallen Paradigm Shift in Fallen AngelsAngels Over 20%of the Lehman High Yield Index is now Over 20%of the Lehman High Yield Index is now compris
45、ed of former investment grade prised of former investment grade credits.Returns fell more rapidly than ever in 2001-2002,Returns fell more rapidly than ever in 2001-2002,so the punishment for owning a distressed credit so the punishment for owning a distressed credit was severe.was severe.Good credi
46、t defense and index-like performance Good credit defense and index-like performance made for great performancemade for great performance18Losses in Investment Grade Bonds Occur Losses in Investment Grade Bonds Occur in Months Prior to Downgradesin Months Prior to DowngradesLoss of value due to a dow
47、ngrade occurs over a few prior months.Depending on the initial credit quality losses could stretch over 2 months for AAA-AA and up to 8 months for BAAThe variability of the magnitude of the loss(i.e.,Standard deviation)is very significantAverageMonthlyUnderperformanceDuetoDowngrade8/8812/01Source:Le
48、hman19#distressed 24-month“VintageYear”issuesexcessreturnvs.UST1990 50 28.28%1991 14 40.94%.1998 29 19.33%1999 10 10.69%2000 139 8.35%Years prior 2001 250 16.56%-2001 54 -23.08%YTD Jun 2002 68 -24.21%Years since 2001 122 -23.71%All Years 372 3.35%Source:LehmanSubsequent Excess Returns(vs.UST)ofinves
49、tment-gradebondsafterdistress*Since 2001 Long Term Relative*Performance Since 2001 Long Term Relative*Performance Subsequent to Distress was Negative for Subsequent to Distress was Negative for Investment Grade BondsInvestment Grade BondsConsistentlypositiveexcessreturnssubsequenttodistressbefore200
50、1-Since2001longhorizonexcessreturnsfordistressedbondshavebeennegativebecauseofthecreditrecessionresultingfromaliquiditycrisis*RelativetoTreasuries*Lehmandefines adistressedinvestment-gradebondasRatedBaa3orhigher;Fixedcoupon;OAStoUSTreasuriesof400bpormore;andDollarprice80%ofpar.20Absolute vs.Relative