The hanbook credit porforlio management

Advance praise for The Handbook
of Credit Portfolio Management
“On the heels of the recent subprime mortgage crisis in the U.S.
and the resulting credit market fallout, this book represents a timely
response to groundswell concerns about the valuation models of
credit-sensitive investments. A superb exposition of practical models
for any credit risk manager!”
—Andreas A. Jobst, International Monetary Fund (IMF)
“In a context of greater uncertainty regarding the relevance of the
practices of credit risk measurement and management, this Handbook
greatly contributes to our understanding of the real place of credit
risky securities in the portfolio allocation and the risk management
processes.”
—Georges Hübner, PhD, HEC-University of Liège, Maastricht
University, and The Luxembourg School of Finance
“Handbook of Credit Portfolio Management addresses the critical
issues faced by professionals in today’s challenging investment
world. It not only reviews mainstream topics such as managing credit
portfolio risk and exposure, but also addresses the more exotic credit
risks embedded in default swaps and collateralized debt obligations.
Of particular interest is the focus on credit trading strategies covering
arbitrage, synthetic replication, and other hedge fund applications.”
—R. McFall Lamm Jr., PhD, Chief Investment Strategist, Global
Investment Management, Deutsche Bank, London
“An important compendium for all of us who spend our days thinking
about debt and issues of financial distress. This handy volume covers
the full range of issues that both academics and practitioners face on
a daily basis and will surely be a frequent reference.”
—Stephen J. Lubben, Daniel J. Moore Professor of Law, Seton Hall
University School of Law

“The discovery of credit derivatives is a milestone in the history of
the financial markets, similar to the arrival of the interest rate swap in
the early 1980s. Today credit derivatives have surpassed the bond
markets in volume, and even in volatile markets, their importance
continues to grow. Gregoriou and Hoppe are commended for bringing
together experts from various disciplines in this book. The handbook
of credit portfolio management is an indispensable tool for financial
markets practitioners.”
—Jan Job de Vries Robbé, Senior Counsel Structured Finance,
Netherlands Development Finance Company
“Risk Management is the most important challenge in banking in
times driven by market turbulences and uncertainness. Due to this
fact measuring the inherent risk and optimizing the portfolio has to
become a key competence of successful market players.”
—Wolfgang Hartmann, Member of the Board of Managing
Directors and Chief Risk Officer, Commerzbank, AG


THE HANDBOOK
OF CREDIT
PORTFOLIO
MANAGEMENT


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THE HANDBOOK

OF CREDIT
PORTFOLIO
MANAGEMENT
GREG N. GREGORIOU
CHRISTIAN HOPPE
EDITORS

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Singapore Sydney Toronto


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DOI: 10.1036/0071598340


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C O N T E N T S

FOREWORD xiii
EDITORS xvii
CONTRIBUTORS xix
PART ONE

PERFORMANCE MEASUREMENT
Chapter 1

Implementing Credit Portfolio Management 3
Thomas Ridder
Introduction 3
The Levers of Credit Portfolio Management 5
Organization of Credit Portfolio Management 9
Quantitative Methods in Credit Portfolio Management
Conclusion 17
References 18

14

Chapter 2

Credit Portfolio Management: Accounting Implications 21
Christian Burmester
Introduction 22
International Financial Reporting Standards
Conclusion 36

Acknowledgments 37

23

Chapter 3

The New Basel Capital Framework (Basel II) and Its Impact on
Investment Decisions: An Overview 39
Martin Knocinski
Introduction 40

v


vi

Contents

The Basel Accord’s General Principles 40
Selected Amendments in Basel II 43
Regulatory Treatment of Shares in a Fund according to Basel II 56
Outstanding Issues 60
Relevant Developments within Other Fields and Conclusion 62
References 64
Chapter 4

Basel II Expected Loss as a Control Parameter 67
Bernd Appasamy and Uwe Dörr
Introduction 67
Discussion: Use of EL in Risk Management 68

Summary and Outlook 77
Chapter 5

Credit Risk Capital Allocation and Performance Measurement in
Banking Institutions 79
Valerio Potì
Introduction 79
Credit Risk Capital 82
Capital Allocation, Cost of Capital, and Performance Measurement
Credit Risk Capital Measurement 87
Final Remarks and Directions for Future Research 90
Acknowledgments 91
References 92
PART TWO

EVALUATION OF CREDIT RISK
Chapter 6

Characteristics of Credit Assets and Their Relevance for
Credit Asset Management 99
Stephan Bucher and Jochen von Frowein
Introduction 99
Credit Types 101

85


Contents

Credit Purpose 111

Conclusion 121
References 122
Chapter 7

Default Dependency Modeling: An Introduction to
Theory and Application 123
Sabine Bank and Mathias Schwarz
Introduction: Default Dependency 124
Modeling Default Dependencies 125
Measuring Credit Risk of CDOs 135
Conclusion 142
References 143
Chapter 8

A Credit Contagion Model for the Dynamics of the Rating
Transitions in a Small- and Medium-Sized Enterprises
Bank Loan Portfolio 145
Antonella Basso and Riccardo Gusso
Introduction 146
Counterparty Risk and Credit Contagion Models 147
Modeling Credit Contagion and Rating Transitions in a Portfolio of
Bank Loans 149
Simulation Analysis of Rating Transitions 152
Conclusion 160
References 160
Chapter 9

Copula-Based Credit Rating Model for Evaluating Basket
Credit Derivatives 163
Nicolas Papageorgiou, Bruno Rémillard, and Jean-Luc Gardère

Introduction 163
Literature Review 164
The Proposed Model 167
Calibration of the Parameters 170
Estimation Results 173

vii


viii

Pricing Multiname Credit Derivatives
Conclusion 179
References 180

Contents

176

Chapter 10

Mark-to-Market Valuation of Illiquid Loans 181
Claas Becker
Introduction 181
Building Liquid Generic Curves 182
Building Illiquid Generic Curves 183
The Loan Pricing Algorithm 189
Back Testing 192
Summary 193
References 193

PART THREE

MANAGING CREDIT EXPOSURE
Chapter 11

A Holistic Approach to Risk Management of Credit Portfolios 197
Christian Burmester
Introduction 197
Portfolio Management in the Context of a Bank’s Management
Risk Management of Portfolios 199
Conclusion 208
References 208

198

Chapter 12

How a Revolution in the Loan Sale Process Transformed the
Secondary Market and Portfolio Management 209
J. Kingsley Greenland II and William F. Looney
Introduction 210
Evolution of the Secondary Whole Loan Market
Buyers: Smart, Savvy, and Global 211

211


Contents

ix

Sellers: Originators of All Sizes Join In 212
How Buyers and Sellers Engage Online 214
Better Portfolio Diagnostics 218
Comparing the Two Approaches 220
Conclusion: It’s a New Day for Portfolio Managers 222
Chapter 13

What Drives the Arrangement Timetable of
Bank Loan Syndication? 223
Christophe J. Godlewski
Introduction 224
Determinants of Loan Syndication Timetable Arrangement 226
Methodology and Data 234
Results and Discussion 238
Conclusion 241
References 242
Chapter 14

Credit Default Swap and Other Credit Derivatives:
Valuation and Application 247
Ralph Karels
Introduction 247
Valuation of Credit Derivatives with Several Underlyings
Possible Application and Market Outlook 266
Conclusion 267
References 268
Chapter 15

Loan-Only Credit Default Swaps 271

Moorad Choudhry
Introduction 272
Growth of LCDS 273
Characteristics of LCDS 274
Summary 275
Reference 276

254


x

Contents

Chapter 16

Definition and Evaluation of Basket Credit Derivatives and
Single-Tranche Collateralized Debt Obligation Swaps 277
Marcus R. W. Martin, Stefan Reitz, and Carsten S. Wehn
Introduction 278
Credit Derivatives on Baskets of Reference Assets 278
Evaluation of Basket Default Swaps and CDOs 283
Quotation by a Single-Factor Model 288
Recent Developments and Models for Evaluating STCDO and
Basket Credit Derivatives 296
References 299
Chapter 17

Contingent Credit Portfolio Management: Converting Derivatives
Credit Risk into Market 301

Kai Pohl
Introduction 302
Determining the Credit Valuation Adjustment 302
Application of the CVA 307
Contingent Credit Portfolio Management 317
PART FOUR

CREDIT PORTFOLIO TRANSACTIONS
Chapter 18

Strategies of Hedge Funds and Robust Bayesian Portfolio Allocation
in Fixed-Income Markets 325
Roland Füss, Dieter G. Kaiser, and Michael Stein
Introduction 326
Fixed-Income Hedge Fund Strategies 327
A Robust Bayesian Portfolio Optimization Approach 333
Fixed-Income Portfolio Allocation Including Hedge Fund Strategies 338
Conclusion 343
References 345


Contents

Chapter 19

Characterization of the iTraxx Indexes and the Role of Credit
Index-Linked Constant Proportion Portfolio Insurances 349
Greg N. Gregoriou and Christian Hoppe
Introduction 349
The iTraxx Index Family 351

Performance Measurement 356
Credit Index-Linked Constant Proportion Portfolio Insurance 361
Conclusion 365
References 366
Chapter 20

Trading the Credit Default Swap Basis: Illustrating Positive and
Negative Basis Arbitrage Trades 369
Moorad Choudhry
Introduction 370
Relative Value and Trading the Basis 370
Factors Influencing the Basis Package 372
Trade Examples 379
Summary 394
References 394
Chapter 21

Securitization of Shipping Loans 397
Christian Kasten and Torsten Seil
Introduction 397
HSH Nordbank’s Rationale for Securitizing Shipping Loans 398
Ocean Star Transaction Structure 398
Cash Flows 401
Loss Determination 402
Ocean Star Portfolio Risk Modeling and Rating Process 402
Investors 407
Conclusion 408
References 408

xi

xii

Chapter 22

How Cheap Is “Zero” Cost Protection? 409
Panayiotis Teklos, Michael Sandigursky, Michael Hampden-Turner,
and Matt King
Introduction 410
Contract Mechanics 410
Constructing a Replicating Strategy 411
Major Risks and Sensitivity Analysis 413
Who Might Use It? 419
Conclusion 420
Chapter 23

Managing Country Risk 423
Nandita Reisinger-Chowdhury
Introduction 423
Who Needs to Worry about Sovereign Risk? 424
Why Do We Need Country Risk Management? 424
Country Risk Assessment 426
Sovereign Ratings 437
Setting Country Limits 438
Country Risk Mitigation 439
Conclusion 440
References 441
Chapter 24

Distressed Credit Assets of German Lending Banks 443
Thomas C. Knecht and Michael Blatz
Introduction 444
Conceptual Foundations of Workout Management 446
An Empirical Investigation of Workout Management 452
Conclusion 458
References 459
INDEX 461

Contents


F O R E W O R D

In times such as these, when credit markets are experiencing unprecedented volatility and a turn in the credit cycle seems imminent, credit portfolio managers across the world are exceptionally challenged. Steering
clear of large-scale credit losses is an ingenious art; a skill that is literally
dividing the banking industry to “winners” and “losers,” creating a new
ranking order of profitability and competitive position in the sector. Banks
always faced the risk of losing substantial amounts of capital due to default
risk; what is new is that some banks run colossal losses stemming from
devaluation of their secondary markets credit investments, whereas others
record vast mark-to-market (MTM) profits generated by their sizable
hedge books.
The development of alternative credit products in recent years instigated a rising number of credit exposures in various industries and
regions. The Credit Markets brought up a variety of structured solutions,
which leaves almost no gaps for end users to be able to create their own
custom made investment and hedging strategy. Most transactions are
driven by diversification and concentration motives as made transparent
by quantitative credit models. This new climate offers greater liquidity but
also introduces added complexities and risks.

Now portfolio managers (and other banking officials) have to work
even harder at firstly understanding all aspects of the credit assets, both
those originated in the primary market and those purchased or sold on the
secondary market. Secondly, portfolio managers have to be very clear
about economic, accounting and regulatory implications resulting from
their originated credit asset and when buying protection for their underlying instrument. Finally, it is vital all portfolio effects of combinations of
origination, investments and hedges in single-name assets and pool transactions are fully recognized.
The Handbook of Credit Portfolio Management will help portfolio
managers around the world to master this challenge. The book endeavors
to give honest guidance for portfolio managers actively running a wide
xiii
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xiv

Foreword

range of asset classes. Its focus on credit assets also reflects the fact that
most credit portfolio management (CPM) functions have now been established, and going forward, the main attention of CPM is transaction
driven. The book provides an extensive collection of articles drafted by
practitioners and academics engaged in this topic.
However, the handbook is not just intended for credit portfolio managers. It is also a recommended read for senior management and risk managers in financial institutions so as to master the crises the industry has
seen since July 2007. Further, and as the convergence between products
and markets continues, the handbook will be similarly appreciated by
relationship managers, hedge fund managers, and asset managers. It will
also help finance officers and regulators to understand many of the aspects
a CPM function can have, and as such The Handbook of Credit Portfolio
Management could not come at a more appropriate time.
Portfolio management had almost 15 years to develop and establish

itself as a profit-enhancing function. Credit portfolio management often
fundamentally changed the way banks were run. One of its major achievements is the change in origination behavior due to new economic transparency introduced by modern quantitative methods and the tools helping
to assess risk-adjusted client profitability. Basel II was kicked off by leading banks developing their own risk-adjusted measures and eventually the
regulators followed suit. Building on these fundamentals it is now time to
refine and integrate areas of negligence.
The book points out the issues around asymmetric accounting introduced in 2005 by U.S. GAAP and International Financial Reporting
Standards (IFRS). Whereas the election to “fair value” the underlying
loan is economically honorable, it throws up a variety of administrational
and transactional difficulties that makes this option less attractive. Many
institutions prefer the more flexible solution and “hedge the credit hedge,”
i.e., engage in offsetting derivative transactions with the intention of
avoiding MTM volatility. As a result, CPM units enter proprietary trading
desks and hedge fund territory. The integration of counterparty risk into
CPM units is another area where the benefit can be significant due to the
netting of long and short derivative positions, but it can become a minefield if this initiative is not carefully aligned with the strategy of the bank.
The handbook evaluates some choices to be considered when fair valuing


Foreword

xv

illiquid instruments and managing credit risk from trading activities.
Further, the book also touches on points brought up in recent subprime
crises such as the insufficient rating process for structured transactions
and the inability to find appropriate marks to market for tranches of collateralized debt obligations. As such, The Handbook of Credit Portfolio
Management can be seen as a current inventory of relevant topics in the
credit arena.
Rainer Rettinger
Director

Global Corporate Banking—Portfolio Management
HSBC
London


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E D I T O R S

Greg N. Gregoriou is Professor of Finance in the School of Business and
Economics at State University of New York (Plattsburgh). He obtained his
joint PhD (Finance) from the University of Quebec at Montreal, which pools
its resources with Montreal’s three other major universities (McGill, HEC,
and Concordia). He is coeditor and editorial board member for the peerreviewed scientific Journal of Derivatives and Hedge Funds. He is also an
editorial board member for the Journal of Wealth Management, Journal of
Risk Management in Financial Institutions, and Brazilian Business Review.
He has authored over 50 articles on hedge funds, and managed futures in various U.S. and UK peer-reviewed publications, including the Journal of
Portfolio Management, Journal of Futures Markets, European Journal of
Operational Research, and Annals of Operations Research. He has published
26 books with John Wiley & Sons, Elsevier-Butterworth-Heinemann,
McGraw-Hill, Palgrave-MacMillan, and Risk Books.
Christian Hoppe works as senior specialist for securitization and credit
derivatives in credit portfolio management in the corporate banking of
Commerzbank AG Frankfurt. His main focus is on structured credit transactions to actively manage the corporate credit portfolio. Prior to this, he
was credit portfolio manager at Dresdner Kleinwort, the Investment Bank
arm of Dresdner Bank AG in Frankfurt. He started his career as a Business
and Financial Controller for Dresdner Bank in Frankfurt, responsible for the
corporate client business in Germany. He completed his economics degree
at the University of Essen-Duisburg in 2003. While writing his master’s

thesis, Christian worked in the Institutional Research Department of
Benchmark Alternative Strategies GmbH in Frankfurt. Christian is the
coauthor of several articles and books as well as the author of the German
book Derivatives Based on Alternative Investments—Construction and
Ways of Evaluation, published by Gabler.

xvii
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C O N T R I B U T O R S

Bernd Appasamy is Managing Director of d-fine GmbH. At d-fine, he is
responsible for the area of credit risk and for the expansion of d-fine’s
services in Asia and Pacific. Doctor Appasamy manages several projects
in credit risk, credit portfolio models, Basel II compliance, economic capital, commercial real estate, shipping, and aviation. Apart from quantitative and strategic advisory projects in these areas, the development and
application of pricing methods or bank operations is also of importance.
Further projects examine the development of aggregation methods for different key risk figures as well as quantifying business or reputation risk.
Sabine Bank works as a project manager in the securitization department
of KfW Bankengruppe. She is responsible for quantitative structuring and
modeling of ABS transactions, especially small- and medium-sized enterprise (SME) collateralized debt obligations (CDOs) and commercial mortgage-backed securities (CMBS). Sabine Bank joined KfW Bankengruppe
in March 2005 after graduating in economics from Rheinische FriedrichWilhelms-Universität, Bonn.
Antonella Basso is professor of Financial Mathematics and Mathematical
Finance at the University Ca’ Foscari of Venice and is currently Chairman
of the Department of Applied Mathematics. She has a degree in economics and commerce and a PhD in mathematics applied to economic problems. She was visiting fellow at the University of Warwick and its
Financial Options Research Centre, at the University of Toronto, and at the
Imperial College of London. She is also a member of the faculty of the

Consorzio MIB—School of Management of Trieste, in the finance area.
Her main areas of expertise include financial mathematics, mathematical
finance, and operations research. In particular, her research activities concern mainly the following subjects: models for the credit risk for portfolios
of bank loans, theory of financial options (option pricing bounds, exotic
options, computational methods for option pricing, lattice models, Monte
xix
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xx

Contributors

Carlo simulation, American-style options, discrete monitoring, and optimal
exercise boundary), stochastic dominance and financial applications, evaluation criteria for the performance of mutual funds, and efficiency evaluation of decision-making units with data envelopment analysis.
Claas Becker works as a director for the Loan Exposure Management
Group of Deutsche Bank AG in Frankfurt. He is responsible for the development and implementation of loan pricing methodology. Claas studied mathematics and physics at the University of Bochum and has a PhD in
mathematics. Following a postdoctoral position at the Institute of Applied
Mathematics in Bonn, he started his professional career in the Risk
Controlling department of Commerzbank. Since 1998, he has been working
for Deutsche Bank AG in the areas of credit risk modeling, loan pricing, and
securitization.
Michael Blatz is a partner and head of the Corporate Performance
Competence Centers of Roland Berger Strategy Consultants, Berlin. He is
responsible for the industrywide development and implementation of
restructuring concepts as well as for corporate finance transactions. Mr. Blatz
holds a degree in engineering from the Technical University of Magdeburg
and joined Roland Berger Strategy Consultants in 1990.
Stephan Bucher is a Client Relationship Manager at Dresdner Kleinwort,
the Investment Bank arm of Dresdner Bank AG. He covers financial institutions on the Indian subcontinent. Prior to this, he was working in Global

Markets business units of Dresdner Bank in Frankfurt, London, and Dubai.
He then joined the Risk Management department where he held the position of a Senior Credit Analyst for Banks and Financial Institutions.
Stephan graduated with a degree in economics at the Frankfurt School of
Finance and Management.
Christian Burmester, PhD has been General Manager of the London
Branch of Landesbank Berlin AG since 2004. The branch is an integral part
of the capital markets business of the group, specializing in proprietary trading with and investment in structured products. Prior to this, he was based
in Berlin, holding the position of Managing Director of Group Risk Control
and Exposure Management for over four years. He was responsible for the


Contributors

xxi

successful design and implementation of a global credit risk reporting
system covering the group’s retail, property finance, and capital markets
business. He also developed the internal Basel II compliant rating methodology. His banking career started in 1995 in the asset liability management
and later in the risk control division. His PhD focused on risk issues and
Monte Carlo simulation in agricultural economics.
Moorad Choudhry is Group Head of Treasury at Europe Arab Bank plc
in London, and Visiting Professor at the Department of Economics,
London Metropolitan University. He is author of Structured Credit
Products: Credit Derivatives and Synthetic Securitisation (John Wiley
2004) and Bank Asset and Liability Management (John Wiley 2007).
Moorad led the structuring team at KBC Financial Products that arranged
Picaros Funding plc, the world’s first synthetic ABCP conduit and winner
of the Euromoney “Structured Finance Deal of the Year” award for 2005.
Uwe Dörr, PhD is Manager at d-fine GmbH. He currently works in the
area of credit risk and manages several projects ranging from modeling of

credit risk parameters to full Basel II implementation for international
clients. He works on modeling the residual value risk of lease contracts.
In former projects he was engaged in interest rate and energy risk.
Roland Füss is lecturer at the department of Empirical Research and
Econometrics and assistant professor at the department of Finance and
Banking at the University of Freiburg, Germany. He holds an MBA from
the University of Applied Science in Lörrach and MEc and PhD degrees
in Economics from the University of Freiburg. His research interests are
in the field of applied econometrics, alternative investments as well as
international and real estate finance. Roland Füss has authored numerous
articles in finance journals as well as book chapters and a coeditor of a
book on commodity investments published Wiley (2008).
Jean-Luc Gardère has a Master in Financial Engineering from HEC
Montreal in 2005 where he worked on copulas in the pricing of credit
derivatives. He is currently working at CIBC World Markets as a marketer
in their Derivatives Sales & Trading Department.