The use of credit scoring models and the importance of a credit culture

The Use of Credit Scoring Models
and the Importance of a Credit
Culture
Dr. Edward I. Altman
Stern School of Business
New York University


Evolution of Scoring Systems
•

Qualitative (Subjective)

•

Univariate (Accounting/Market Measures)

•

Multivariate (Accounting/Market Measures)
– Discriminant, Logit, Probit Models (Linear, Quadratic)
– Non-Linear Models (e.g.., RPA, NN)

•

Discriminant and Logit Models in Use
–
–
–
–
–

–

Consumer Models - Fair Isaacs
Z-Score (5) - Manufacturing
ZETA Score (7) - Industrials
Private Firm Models (eg. Risk Calc (Moody’s), Z” Score)
EM Score (4) - Emerging Markets, Industrial
Other - Bank Specialized Systems
2


Evolution of Scoring Systems
(continued)
•

Artificial Intelligence Systems
– Expert Systems
– Neural Networks (eg. Credit Model (S&P), CBI (Italy))

•

Option/Contingent Claims Models
– Risk of Ruin
– KMV Credit Monitor Model

•

Blended Ratio/Market Value Models
– Moody’s Risk Cal
– Bond Score (Credit Sights)

– Z-Score (Market Value Model)

3


Problems With Traditional Financial Ratio Analysis
1 Univariate Technique
1-at-a-time
2 No “Bottom Line”
3 Subjective Weightings
4 Ambiguous
5 Misleading
4


Forecasting Distress With Discriminant Analysis
Linear Form
Z = a1x1 + a2x2 + a3x3 + …… + anxn
Z = Discriminant Score (Z Score)
a1

an = Discriminant Coefficients (Weights)

x1

xn = Discriminant Variables (e.g. Ratios)

Example
x

x
x

EBIT
TA

x
x

x
x
x

x

x
x

x
x

x

x
x

x

x
x x

x
x
x x
x xx x
x x

x

x

x
x x

x x x

x

EQUITY/DEBT

5


“Z” Score Component Definitions
Variable
X1

Definition

Weighting Factor

Working Capital

1.2

Total Assets
X2

Retained Earnings

1.4

Total Assets
X3

EBIT

3.3

Total Assets
X4

Market Value of Equity

0.6

Book Value of Total Liabilities
X5

Sales

Total Assets

1.0
6


Z Score
Bankruptcy Model
Z = .012X1 + .014X2 + .033X3 + .006X4 + .999X5
e.g. 20.0%

Z = 1.2X1 + 1.4X2 + 3.3X3 + .6X4 + .999X5
e.g. 0.20

X1 = Current Assets - Current Liabilities

X4 = Market Value of Equity

Total Assets
X2 =

Retained Earnings
Total Assets

Total Liabilities
X5 =

Sales

(= # of Times

Total Assets

e.g. 2.0x)

X3 = Earnings Before Interest and Taxes
Total Assets
7


Zones of Discrimination:
Original Z - Score Model

Z > 2.99 - “Safe” Zone
1.8 < Z < 2.99 - “Grey” Zone
Z < 1.80 - “Distress” Zone

8


Average Z-Score by S&P Bond Rating
S&P 500: 1992 - 2001

Rating
AAA

1996-2001
#
Average
Firms Z Score

SD
66
6.20
3.06

1995
1994
1993
1992
Average
Average
Average
Average
Z Score SD Z Score SD Z Score SD Z Score SD
5.02
1.60
4.38
1.38
4.51
1.50
5.26
2.19

AA

194

4.73

2.36

4.30

1.91

4.05

1.83

4.03

1.89

4.23

2.09

A

519

3.74

2.29

3.61

2.26

3.47

2.01

3.61

2.18

3.92

3.26

BBB

530

2.81

1.48

2.78

1.49

2.70

1.58

2.84

1.74

2.60

1.54

BB

538

2.38

1.85

2.45

1.62

2.28

1.69

2.19

1.63

2.10

1.54

B

390

1.80

1.91

1.67

1.23

1.88

1.52

1.96

1.72

1.96

2.33

9

0.33

1.16

CCC+CC

9


Estimating Probability of Default and Probability of Loss
Given Defaults

• Credit scores on new issues to estimate
• Bond ratings equivalents on new issues and then,
• Utilize mortality rates to estimate annual and
cumulative defaults

10


Marginal and Cumulative
Mortality Rate Equation
MMR(t) =

Total value of defaulting debt in year (t)
total value of the population at the start of the year (t)

MMR = Marginal Mortality Rate

One can measure the cumulative mortality rate (CMR) over a specific
time period (1,2,…, T years) by subtracting the product of the surviving
populations of each of the previous years from one (1.0), that is,

CMR(t) = 1 - Π SR(t) ,

t=1

here

CMR (t) = Cumulative Mortality Rate in (t),
SR (t) = Survival Rate in (t) , 1 - MMR (t)

11


Mortality Rate Concept
(Illustrative Calculation)
For BB Rated Issues
Security
No.

Issued
Amount

Year 1
Default

Call

SF

Year 2
Default

Call

SF

50
50
100
100
150
150
200
200
250
250

-50
---------

--100
--------

5
-----20
----

-NE
NE
100
-------

-NE

NE
----200
---

5
NE
NE
-15
-20
----

Total

1,500

50

100

25

100

200

40

Amount
Start of
Period

1,500

1,325

- 340

1
2
3
4
5
6
7
8
9
10

-

175

-

=

Year 1

Year 2

Marginal
Mortality
Rate

50/1,500 = 3.3%

100/1,325 = 7.5%

Cumulative Rate

3.3%

1 - (SR1 x SR2 ) = CMR2
1 - (96.7% x 92.5%) = 10.55%

985

NE = No longer in existence
SF = Sinking fund

12


Mortality Rates by Original Rating
All Rated Corporate Bondsa
1971-2003
1

2

3

4

Years after Issuance
5
6

7

8

9

10

AAA

Marginal
Cumulative

0.00%
0.00%

0.00%
0.00%

0.00%
0.00%

0.00%
0.00%

0.03%
0.03%

0.00%
0.03%

0.00%
0.03%

0.00%
0.03%

0.00%
0.03%

0.00%
0.03%

AA

Marginal
Cumulative

0.00%
0.00%

0.00%

0.00%

0.33%
0.33%

0.17%
0.50%

0.00%
0.50%

0.00%
0.50%

0.00%
0.50%

0.00%
0.50%

0.03%
0.53%

0.02%
0.55%

A

Marginal
Cumulative

0.01%
0.01%

0.11%
0.12%

0.02%
0.14%

0.09%
0.23%

0.05%
0.28%

0.10%
0.38%

0.06%
0.44%

0.21%
0.65%

0.11%
0.75%

0.06%
0.82%

BBB

Marginal
Cumulative

0.40%
0.40%

3.45%
3.84%

1.58%
5.38%

1.45%
6.73%

0.98%
7.64%

0.56%
8.16%

0.28%
8.98%

0.25%
9.11%

0.16%
9.25%

0.42%
9.63%

BB

Marginal
Cumulative

1.22%
1.22%

2.52%
3.77%

4.44%
7.98%

2.05% 2.55% 1.10% 1.65% 0.88% 1.72% 3.70%
9.87% 12.17% 13.14% 14.57% 15.15% 16.61% 19.69%

B

Marginal
Cumulative

3.06%
3.06%

6.92% 7.48% 8.58% 6.08% 4.18% 3.74% 2.31% 2.00% 0.88%
9.77% 16.52% 23.69% 28.32% 31.32% 33.89% 35.41% 36.70% 37.26%

CCC

Marginal
Cumulative

8.18% 15.57% 19.15% 12.18% 4.26% 10.25% 5.65% 3.15% 0.00% 4.28%
8.18% 22.48% 37.32% 44.96% 47.30% 52.70% 55.37% 56.78% 56.78% 58.63%

(a) Rated by S&P at Issuance
Based on 1,719 issues
Source: Standard & Poor's (New York) and Author's Compilation

13


Mortality Losses by Original Rating
All Rated Corporate Bondsa
1971-2003
1

2

3

4

Years after Issuance
5
6

7

8

9

10

AAA

Marginal
Cumulative

0.00%
0.00%

0.00%
0.00%

0.00%
0.00%

0.00%
0.00%

0.00%

0.00%

0.00%
0.00%

0.00%
0.00%

0.00%
0.00%

0.00%
0.00%

0.00%
0.00%

AA

Marginal
Cumulative

0.00%
0.00%

0.00%
0.00%

0.06%
0.06%

0.06%
0.12%

0.00%
0.12%

0.00%
0.12%

0.00%
0.12%

0.00%
0.12%

0.03%
0.15%

0.02%
0.17%

A

Marginal
Cumulative

0.00%
0.00%

0.04%
0.04%

0.01%
0.05%

0.04%
0.09%

0.02%
0.11%

0.06%
0.17%

0.02%
0.19%

0.04%
0.23%

0.08%
0.31%

0.00%
0.31%

BBB

Marginal

Cumulative

0.28%
0.28%

2.54%
2.81%

1.15%
3.93%

0.94%
4.83%

0.65%
5.45%

0.37%
5.80%

0.47%
6.24%

0.15%
6.38%

0.10%
6.48%

0.29%

6.75%

BB

Marginal
Cumulative

0.73%
0.73%

1.51%
2.23%

3.24%
5.40%

1.46%
6.78%

1.40%
8.08%

0.75%
8.78%

0.99%
9.68%

0.28% 0.94% 1.18%
9.93% 10.78% 11.83%

B

Marginal
Cumulative

2.13%
2.13%

5.05% 5.60% 6.00% 4.56% 2.51% 2.74% 1.64% 1.10% 0.67%
7.07% 12.38% 17.54% 21.30% 23.38% 25.00% 26.23% 27.04% 27.53%

CCC

Marginal
Cumulative

5.48% 11.68% 15.37% 9.72% 3.20% 8.21% 4.80% 2.52% 0.00% 3.22%
5.48% 16.52% 29.35% 36.22% 38.26% 43.37% 46.05% 47.41% 47.41% 49.10%

(a) Rated by S&P at Issuance
Based on 1,535issues
Source: Standard & Poor's (New York) and Author's Compilation

14


Classification & Prediction Accuracy
Z Score (1968) Failure Model*
1969-1975

1976-1995

1997-1999

Year Prior
To Failure

Original
Sample (33)

Holdout
Sample (25)

Predictive
Sample (86)

Predictive
Sample (110)

Predictive
Sample (120)

1

94% (88%)

96% (72%)

82% (75%)

85% (78%)

94% (84%)

2

72%

80%

68%

75%

74%

3

48%

-

-

-

-

4

29%

-

-

-

-

5

36%

-

-

-

-

*Using 2.67 as cutoff score (1.81 cutoff accuracy in parenthesis)

15


Z Score Trend - LTV Corp.

Z Score

3.5
2.99 3
2.5
1.8 2
1.5
1
0.5
0
-0.5
-1
-1.5

Safe Zone
Grey Zone
Distress Zone

1980

1981

1982

1983
Year

1984

1985

1986
Bankrupt
July ‘86

16


Z Score

International Harvester (Navistar)
Z Score (1974 – 2001)
3.5
3
2.5
2
1.5
1
0.5
0
-0.5

Safe Zone

Grey Zone

Distress Zone

'74 '76 '78 '80 '82 '84 '86 '88 '90 '92 '94 '96 '98 '00
Year

17


Chrysler Corporation
Z Score (1976 – 3Q 1998*)
4
Safe Zone

3.5
Z Score

3
Operating Co.

2.5
Grey Zone

2
1.5

Consolidated Co.

1
0.5
Gov’t Loan Guarantee

0
'76

'78

'80

'82

'84

'86

'88

'90

'92

'94

'96

'98

Year
*Third quarter figures for 1998 are annualized
18


Z Score

IBM Corporation
Z Score (1980 – 2001)

6
5.5
5
4.5
4
3.5
3
2.5
2
1.5
1
0.5
0

Operating Co.
Safe Zone
July 1993:
Downgrade AA- to A

Consolidated Co.
Grey Zone

BBB
BB
B

1/93: Downgrade
AAA to AA-

1980 1982 1984 1986 1988 1990 1992 1994 1996 1998 2000

Year
19


Enron Credit Risk Measures
EDF

Equivalent
Rating
CC
CCC

B
BB

BBB

A
AA
AAA

Source: A. Saunders and L. Allen, Credit Risk Measurement; J. Wiley, 2002

20


Worldcom Credit Risk Measures
Z" SCORES AND EDF'S FOR WORLDCOM

(Q4'1999 - Q1'2002)
0.01
AAA

7.00

S&P Rating

A-

BBB
BBB

6.00

AA

BEQ*

Z" Scores

5.00

0.10

BB

BB-

B+

B+

EDF

BB
1.00

CCC+

B

3.00

EDF Score

Z" Score

BBB
4.00

CCC2.00

CC

10.00
CCC
D

1.00

0.00
Q4'99
Q1'00
Quarter- Year

D
Q2'00

Q3'00

Q4'00

Z" UnAdj

Q1'01

Q2'01

Z" Adj:3.85B

Q3'01

Q4'01

Q1'02

Z" Adj:7.2B&50B

Q2'02

100.00
Q3'02

EDF

*BEQ = Z" Score Bond Equivalent Rating

Sources: Compilation by the author (E. Altman, NYU Stern), the KMV
(Moody's) Website and Standard & Poor's Corporation.

21


Key Industrial Financial Ratios U.S.
Industrial Long-term Debt
Three Year (1998-2000) Medians
EBIT interest coverage (x)
EBITDA interest coverage (x)
Funds from operations/total debt (%)
Free operating cash flow/total debt (%)
Pretax return on capital (%)
Operating income/sales (%)
Long-term debt/capital (%)
Total debt/capitalization (%)
Companies

AAA
21.4
26.5

128.8
84.2
34.9
27.0
13.3
22.9
8

AA
10.1
12.9
55.4
25.5
21.7
22.1
28.2
37.7
29

A BBB
6.1 3.7
9.1 5.8
43.2 30.8
15.0 8.5
19.4 13.6
18.6 15.4
33.9 42.5
42.5 48.2
136 218

BB
2.1
3.4
18.8
2.6
11.6
15.9
57.2
62.6
273

B CCC
0.8 0.1
1.8 1.3
7.8 1.6
-3.2 -12.9
6.6 1.0
11.9 11.9
69.7 68.8
74.8 87.7
281
22

Standard & Poor's, Corporate Ratings Criteria, Ratings and ratios.
22


Xerox Credit Quality: Z Score Analysis 1998-2000
4.00
3.50

3.46

Z-Score

3.00
2.38

2.50
2.00

1.35

1.50
1.00
0.50
12/98

Bond Rating Equivalents:
12/98 A
12/99 BB
06/00 B

12/99

Actual Rating (S&P / Moody’s):
12/98 A / A2
12/99 A / A2
07/00 A- / A3
12/00 BBB- / Ba1

5/02 BB / B1

6/00

23


Z’ Score
Private Firm Model
Z’ = .717X1 + .847X2 + 3.107X3 + .420X4 + .998X5
X1 = Current Assets - Current Liabilities
Total Assets
X2 =

Retained Earnings
Total Assets

X3 = Earnings Before Interest and Taxes
Total Assets
X4 =

Book Value of Equity
Total Liabilities

X5 =

Sales

Z’ > 2.90 - “Safe” Zone
1.23 < Z’ < 2.90 - “Grey” Zone

Z’ < 1.23 - “Distress” Zone

Total Assets
24


Z’’ Score Model for Manufacturers, Non-Manufacturer
Industrials, & Emerging Market Credits
Z’’ = 6.56X1 + 3.26X2 + 6.72X3 + 1.05X4
X1 = Current Assets - Current Liabilities
Total Assets
X2 =

Retained Earnings
Total Assets

X3 = Earnings Before Interest and Taxes
Total Assets
X4 =

Book Value of Equity
Total Liabilities

Z’’ > 2.60 - “Safe” Zone
1.1 < Z’’ < 2.60 - “Grey” Zone
Z ” < 1.1 - “Distress” Zone
25