GE Capital Modeling Originate & Hold Portfolios in RiskFrontier - - PowerPoint PPT Presentation

GE Capital

Modeling “Originate & Hold” Portfolios in RiskFrontier

Stefano Santilli October 16, 2012

The views expressed are solely the author’s and not those of the General Electric Company. None of the materials presented contain any investment advice or guarantees of success and any use of the methods presented is at your own risk

Moody’s Analytics - Risk Practitioner Conference

• Mark-to-Market/Model (“MtM” based on Lattice Valuation) is the most

commonly used valuation setting in RiskFrontier

• Its use is recommended in most cases and it is typically the most appropriate

choice for modeling trading assets, securitizations, and all cases where an analysis of the market value of the assets is critical

• Modeling the Ecap of an “Originate & Hold” portfolio of loans and leases

(banking book) with Lattice Valuation or other market value-based approach, when the portfolio is not actually marked-to-market, could lead to:

• Results not compatible with the institution’s practices
• Adverse selection in the comparison of alternative origination choices
• Sub-optimal amount of Ecap in good and bad times
• The use of Mark-to-Par Spreads alleviates the issue and obtains sensible Ecap

measurement; then risk-adjusted return metrics can be calculated outside of RiskFrontier

Abstract

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GE Capital: A Diverse Portfolio with Global Footprint

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U.S.

54% 54%

Canada Europe Latin A America ca Asia P Paci cific

27% 27% 11% 11% 4% 4%

3% 3% 11% 11% 27% 27% 2% 2% 13% 13%

3% 1%

Other 6%

Geography ($0.5T assets)

Product ct Industry sect ctors

Sales Finance ce 4% 4% 7% 7% 39% 39% 30% 30% 4% 4% 5% 5% 9% Personal Loan Small and Medium Enterprises Cards Mortgage Auto JVs Other 2% 2% 17% 17% 20% 20% 3% 5% 29% 29% 3% 6% % 4% 6% 4% % 3%

Commerci cial Airlines Real Estate Business Service ces Others Energy Health Care Consumer Service ces Automotive Struct ctured inv.

Consumer Commerci cial

• Economic capital is typically defined as the amount of capital needed for the

financial institution to stay solvent. In VaR terms, it is the amount needed to cover potential losses that will be exceeded only with a certain probability (CL)

• There are at least two very different ways of interpreting “losses” and therefore

“capital”:

• Capital as the amount needed to repay lenders in case of principal losses
• n the risky assets
• Capital as replacement, held to fill the gap due to market-value losses on

the risky assets

• The first definition of capital is more appropriate for “originate and hold”

portfolios that are not marked-to-market, because it better reflects the institution’s practices and considers all losses as credit losses, thus avoiding counterintuitive results

What is Capital for?

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Issues with Using MtM for an “O&H” Portfolio: Example

Common Risk Inputs PD 4.55% LGD 35% R2 25% Maturity 3y Principal Amortizing EAD $ 1,000,000

Let’s consider the theoretical case of three potential loans* that have identical risk characteristics, but different returns:

• If we could choose which deal to originate, which one would we pick?
• Is “Deal C” the obvious choice when looking at the RiskFrontier results?

* The three deals were run in RF as part of a portfolio of ~500 loans and ~$10B of exposure

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Issues… Cont’d – MtM (Lattice) at Time of Analysis

• The MtM value at the analysis-date may accurately reflect the NPV of the

different deals

• The MtM of Deal C correctly reflects that it has a higher value than the
• thers
• For an O&H portfolio, it is interesting information, possibly useful for

pricing purposes, but does not reflect how the deals are managed (and accounting treatment). No corresponding loss or gain is recognized

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Issues… Cont’d – EL and Ecap

• EL and Ecap (in excess of EL, both RC- and TRC-based) are higher for the

deals with higher returns

• Conceptually, the EL and Ecap should be the same, since the risk drivers

are the same

• Actually, it could be argued that the Ecap should be even lower for Deal C

than for Deal A, since it receives larger payments until default

• Is “Deal C” the obvious choice when looking at the RiskFrontier results?

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Ecap (RCEL) Ecap (TRCEL)

Issues… Cont’d – RORAC

• The RORAC of the three deals is very similar; even slightly lower for the

deal with the higher return

• Deal C would not be considered better than the others, leading to

adverse selection

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RORAC (TRCEL) RORAC (RCEL)

Drawn Spread Drawn Spread

Issues… Cont’d - 2nd Example

Common Risk Inputs PD 0.39% LGD 35% R2 10% Maturity 3y Principal Amortizing EAD $ 1,000,000

Let’s consider a different set of three potential loans that are much less risky. Like before, they have identical risk characteristics, but different returns:

• If we could choose which deal to originate, which one would we pick?
• Is “Deal F” the obvious choice when looking at the RiskFrontier results?

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Issues… Cont’d - 2nd Example - Results

This type of results is not an exception, but the norm

• The higher the return:
• The higher the EL
• The higher the Ecap (both RC- and TRC-based)
• The lower the RORAC

10 Ecap (RCEL) EL RORAC (RCEL) Drawn Spread RORAC (TRCEL) Drawn Spread Ecap (TRCEL) EL

Undesired Effects of MtM for O&H Deals: Summary

While important for certain purposes (trading, securitization, capital setting for held- for-sale assets, etc.) it is not appropriate for setting capital for assets originated to be held-to-maturity and not marked-to-market. Two major issues: What can be done to solve these issues?

Assumption Effect ct Problem All embedded gains/losses have been already realized at time of analysis For deals with embedded loss, EL and ECap are reduced. For deals with embedded gain, they are increased. Misleading/difficult to interpret Ecap values The definition of loss (and therefore the capital allocated) includes future unearned income If two deals have identical risk characteristics but different return, the one with higher return typically is allocated higher capital. In many cases, the risk-adjusted return is somewhat lower for the higher- return deal Potential adverse selection

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Mark-to-Par Setting in RiskFrontier

From the RiskFrontier User Manual: The terms and conditions of a loan or bond are used to calculate spread or fee information for the instrument. If this option is selected, during an analysis, this value replaces any fee

• r spread information previously provided.

Supported instrument types include: Bonds, Term Loan Bullets, Term Loan Amortizing, Revolvers, CRE Loans (Non Mortgage), and CRE with Fixed or Floating Rate. Valuation method during an analysis must be Lattice/Lattice. This option is not available for Retail instruments, CRE Mortgage Loans, or instruments with changing rate types, such as Fixed then Floating. Bond/loan options such as Prepayment, Putable, Callable, Rating Price Grid, or PD Price Grid are not currently supported.

• Mark-to-Par spreads are the calculated spreads that make the instruments

have a Lattice-based MtMt0 of Par

• All other user-inputted fees are ignored
• Achieves neutralization effect on returns by assuming that the spread

exactly compensates the lender for the risk taken (in expected value terms)

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Mark-to-Par Results: 1st Example

Common Risk Inputs PD 4.55% LGD 35% R2 25% Maturity 3y Principal Amortizing EAD $ 1,000,000

Drawn Spread Deal A 1% Deal B 4% Deal C 7% MTMt0 (Lattice) 95.6% 99.9% 104.2% EL EL Ecap - RC RCEL

EL

Ecap - TRCEL

EL

1.34% 16.22% 17.42% 1.45% 17.13% 18.50% 1.54% 17.97% 19.49% RORAC

• RC

RCEL

EL

RORAC

• TRCEL

EL

7.33% 6.88% 7.33% 6.84% 7.32% 6.81%

• Since all deals have the same risk characteristics, they all get the same

values in the risk metrics

• Since the return is assumed to be the one that compensates for the risk

characteristics, the return is the same for all deals (4.1%)

• The Rorac numbers under MtPar settings are not really useful, because

they do not reflect the actual return of the deal. Actual Rorac can be calculated outside of RiskFrontier. Given the same capital, the deals with higher return would have a higher Rorac

MtPar All 4.1% 100.0% 1.45% 16.17% 17.72% 7.73% 7.12%

Mark-to-Par spreads achieve neutralization of undesired MtM effects

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Mark-to-Par Results: 2nd Example

Drawn Spread Deal A 1% Deal B 4% Deal C 7% MTMt0 (Lattice) 100.7% 105.2% 109.7% EL EL Ecap - RC RCEL

EL

Ecap - TRCEL

EL

.117% 1.62% 1.80% .124% 1.67% 1.87% .131% 1.73% 1.93% RORAC

• RC

RCEL

EL

RORAC

• TRCEL

EL

7.18% 6.53% 7.17% 6.50% 7.16% 6.47%

• Again, all deals show the same risk output, since all deals have the same

risk characteristics

• Note: MtPar Ecap above is not directly comparable to that of the three

deals, because entire portfolio was run with MtPar settings and the deal Ecap is allocated from the total portfolio Ecap

MtPar All .54% 100.0% .120% 1.52% 1.69% 7.55% 6.86%

Return is still crucial for risk-adjusted return analysis, i.e. how to choose the right investment. Capital per se does not need to reflect the return (e.g. Basel II formula).

Common Risk Inputs PD 0.39% LGD 35% R2 10% Maturity 3y Principal Amortizing EAD $ 1,000,000

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Portfolio Ecap: MtM vs MtPar

MtM may underestimate Ecap in bad times and overestimate it in good times. MtPar corrects this phenomenon.

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t

Credit Cycl cle

For an O&H Portfolio that is not marked-to-market, the difference between MtM and Par is not recognized as gain or loss. Therefore…

Often Portfolio MtMt0 < P Par EcapMtM < < EcapMtPar

Increase in risk not fully compensated by increasing spreads Reduction in risk precedes reduction in spreads

Often Portfolio MtMt0 > > Par EcapMtM > > EcapMtPar MtMt0 declines MtMt0 increases

• Corrects unintuitive treatment of return

information in O&H portfolios that are not marked-to-market

• Deals with the same amount of money

invested and same risk characteristics attract the same capital

• The relationship between risk drivers and

capital is appropriate for all key risk drivers (e.g. PD, LGD, R2, Maturity, etc.). This would not be the case if instead we used Default-

• nly mode, because Maturity would play

no role in risk assessment

• More correctly assesses the amount of

capital for the portfolio, both in good and bad times

• Additionally, whether or not the portfolio is

O&H, Mark-to-Par spreads are useful when fee information is not available

Mark-to-Par: Conclusion

MtPar spreads are a useful way to get reasonable Ecap results for non marked-to-market O&H portfolios. More research is needed to refine the MtPar theoretical framework.

Pros Cons

• Hybrid approach, not conceptually

“pure”. Provides a practical solution to a material issue. Further research is needed.

• Risk-adjusted Return ratios need to

be calculated outside of RiskFrontier

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Contact information for Feedback

For any question or feedback, please contact Stefano at stefano.santilli@ge.com

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Appendix – Mark-to-Par Spread Formula if no Optionality

Source: Moody’s Analytics document “Overcoming Missing Fee Info Using RF”

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