Measuring Managing Credit Risk Understanding the EDF Credit

Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms 2004

2 Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms 1: THE CRITICAL ISSUE IN CREDIT 2: CALCULATING THE EDF CREDIT MEASURE 3: TESTING THE EDF CREDIT MEASURE AGENDA COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW. MOODYSKMV. COM

3 Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms SECTION 1 THE CRITICAL ISSUE IN CREDIT COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW. MOODYSKMV. COM

4 Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms The Critical Issue in Credit • The critical element in successfully managing a credit risk portfolio is that you must manage the dynamics of credit risk • Why? A handful of names whose risk has changed explains most of the risk in credit portfolios COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW. MOODYSKMV. COM

5 Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms A Handful of Names Drive Most of the Risk Managing outliers is important because a relatively small segment that disproportionately drive risk – most of the portfolio requires very little attention COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW. MOODYSKMV. COM

6 Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms Objectives in Modeling Default Risk • Measure credit risk in terms of default probabilities rather than ordinal rankings • Provide the most accurate forward-looking, causal model • Provide frequent updates and early warning of changes in credit quality COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW. MOODYSKMV. COM

7 Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms Validation Moody’s KMV EDF credit measures • Have been tested on over 29 years of data representing over 4, 000 defaults in the United States alone, as well as on smaller samples in various countries around the globe • Outperform internal and agency ratings, simple Merton models and statistical scoring models in anticipating credit events and default COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW. MOODYSKMV. COM

8 Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms EDFs Predict Future Default Rates COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW. MOODYSKMV. COM

9 Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms The EDF Credit Measure • EDF means Expected Default Frequency—the probability that a firm will default within a given time horizon • We provide EDF term structures out to 5 years • EDF Ranges from 2 to 2000 basis points COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW. MOODYSKMV. COM

10 Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms The EDF Credit Measure • A company with a current EDF credit measure of 2% has a 2% probability of defaulting within the next twelve months. If we create a portfolio of 1000 such companies, on average, 20 default over the next year, and 980 do not. • A company with a 2% EDF credit measure is 10 times more likely to default than a firm with a 0. 20% EDF credit measure. COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW. MOODYSKMV. COM

11 Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms SECTION 2 CALCULATING THE EDF CREDIT MEASURE Expected Default Frequency for firms with publicly traded equity COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW. MOODYSKMV. COM

12 Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms Drivers to the EDF Credit Measure • Leverage – Market Value of Assets vs. – Book Value of Liabilities • Risk – Volatility of Asset Value COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW. MOODYSKMV. COM

13 Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms Leverage Market Value of Assets Defaulted November 2001 Default Point (Liabilities Due) COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW. MOODYSKMV. COM

14 Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms The Market Value of Assets • The market value of the business, reflecting the equity market’s expectations of future cash flows • Not directly observable—implied from the market value of equity and the book liabilities using option pricing theory • Reflects deterioration & improvement before book assets or earnings • Market values are dynamic and forward looking; they are the source of the model’s predictive power COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW. MOODYSKMV. COM

15 Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms Calculating Market Value of Assets • Equity derives its value from the cash flows of the firm. • Equity is a call option on the firm’s assets: the right, but not the obligation, to “buy” the firm’s assets from the lender by re-paying the debt. Standard Options Terms KMV Approach (Vasicek/Kealhofer Model) Call Option Value = Market Value of Equity Strike Price = Book Liabilities Implied Underlying Asset Value Implies Market Value of Assets For more quantitative detail, please see the Moody’s KMV paper Modeling Default Risk. COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW. MOODYSKMV. COM

16 Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms Using Options Framework to Solve for Market Value of Assets Option Value We can calculate the implied option value 0 COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. When we know the Asset Value, and the Strike Price WWW. MOODYSKMV. COM Underlying Asset Value

17 Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms Using Options Framework to Solve for Market Value of Assets Equity Value (Option Value) For public firms, we can observe the “option value” and the strike price And Calculate the Implied Asset Value 0 COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. Liabilities Due WWW. MOODYSKMV. COM Underlying Asset Value

18 Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms The Default Point • A measure of the liabilities due in the event the firm is in distress • Non-cash and long-term obligations put less financial stress on the firm • Firms often increase leverage as they deteriorate • The Default Point captures the point where the typical firm defaults COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW. MOODYSKMV. COM

19 Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms Default Point: An Example Market Value of Assets Total Liabilities Defaulted Default Point COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW. MOODYSKMV. COM

20 Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms Asset Volatility: A Measure of Business Risk • The uncertainty around the market value of the business • Reflects the degree of difficulty in forecasting the future cash flows • Quantifies business risk: larger firms in the same industry tend to have lower volatility • Computed by “de-levering” Equity Volatility COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW. MOODYSKMV. COM

21 Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms Asset Volatility: A Critical Driver Rising Equity Market Cap But a Dramatically Higher EDF Because of rising Asset Volatility Time COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW. MOODYSKMV. COM

22 Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms Putting It All Together Value Distribution of asset value at horizon Asset Volatility (1 Std Dev) Asset Value Distance-to-Default = 3 Standard deviations Default Point EDF Today COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. 1 Yr WWW. MOODYSKMV. COM Time

23 Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms How do we move from Distance to Default to a probability? COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW. MOODYSKMV. COM

24 Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms • We cannot use a statistics textbook. • The probability from the Normal distribution is too low. • Credit risk isn’t normal! • Statistics books don’t go beyond 3. 49—we see firms that are 4 -6 standard deviations from default subsequently defaulting. COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW. MOODYSKMV. COM

25 Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms From Distance-to-Default to EDF • Moody’s KMV uses actual default rates for companies in similar risk ranges to determine a functional relationship • Requires a large database of actual defaults COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW. MOODYSKMV. COM

26 Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms Moody’s KMV Public Company Default Database 1973– 2001 • Over 29 years of data • Over 4, 900 defaults • Over 400, 000 company-years COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW. MOODYSKMV. COM

27 Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms Scaling DD to EDF Form a “bucket of similar DD companies 1/1/1978 4. 8 1 year later, how many have defaulted? 4. 8 2 years later. . . 4. 8 4. 95 5. 0 4. 95 5. 0 5. 1 5. 2 5. 1 5. 2 • Repeat the exercise for all ranges of DD • Measure forward default observations for periods from 1 year to 5 years • Form new buckets every year through the present and repeat steps COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW. MOODYSKMV. COM

28 Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms Scaling DD to EDF Credit Measures Expected Default Frequency EDF 43 bp Distance to Default DD 4 s COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW. MOODYSKMV. COM

29 Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms Summary: Measuring EDF • Estimate asset value and asset volatility – Equity is a call option on asset value – Solve for implied asset value and volatility • Calculate Distance to Default – Contractual obligations determine Default Point – Number of standard deviations from default • Scale Distance to Default to EDF – Assign EDF using actual historical default rates COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW. MOODYSKMV. COM

30 Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms EDF Credit Measures • We have been working on developing EDF credit measures and helping lenders and investors on real credit portfolios since 1989. • We are on about the 5 th generation of the Vasicek. Kealhofer EDF model. • Experience pays off—we provide the most accurate and timely assessment of credit and default risk. COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW. MOODYSKMV. COM

31 Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms SECTION 3 TESTING THE EDF CREDIT MEASURE COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW. MOODYSKMV. COM

32 Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms EDF Credit Measure Results Can Market Information Improve Ratings? • Moody’s KMV uses equity market information to determine a firm’s probability of default: the EDF credit measure. • Here we sort the Non-Financial Single B firms on 12/31/92 by their EDF, as shown on the next slide. COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW. MOODYSKMV. COM

33 Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms 103 B-Rated Firms as of 12/31/92 14 12 10 Number of Firms 8 6 4 2 0 0. 150. 65 Low Risk 0. 671. 14 1. 152. 04 2. 162. 63 2. 693. 33 EDF Range COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW. MOODYSKMV. COM 3. 695. 32 5. 648. 49 8. 8420. 00 High Risk

34 Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms Defaults 6 Months Later 14 12 10 Number of Firms 8 6 4 2 0 0. 150. 65 Low Risk 0. 671. 14 1. 152. 04 2. 162. 63 2. 693. 33 EDF Range COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW. MOODYSKMV. COM 3. 695. 32 5. 648. 49 8. 8420. 00 High Risk

35 Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms Defaults 1 Year Later 14 12 10 Number of Firms 8 6 4 2 0 0. 150. 65 Low Risk 0. 671. 14 1. 152. 04 2. 162. 63 2. 693. 33 EDF Range COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW. MOODYSKMV. COM 3. 695. 32 5. 648. 49 8. 8420. 00 High Risk

36 Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms Defaults 2 Years Later 14 12 10 Number of Firms 8 6 4 2 0 0. 150. 65 Low Risk 0. 671. 14 1. 152. 04 2. 162. 63 2. 693. 33 EDF Range COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW. MOODYSKMV. COM 3. 695. 32 5. 648. 49 8. 8420. 00 High Risk

37 Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms Defaults 3 Years Later 14 12 10 Number of Firms 8 6 4 2 0 0. 150. 65 Low Risk 0. 671. 14 1. 152. 04 2. 162. 63 2. 693. 33 EDF Range COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW. MOODYSKMV. COM 3. 695. 32 5. 648. 49 8. 8420. 00 High Risk

38 Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms Defaults 4 Years Later 14 12 10 Number of Firms 8 6 4 2 0 0. 150. 65 Low Risk 0. 671. 14 1. 152. 04 2. 162. 63 2. 693. 33 EDF Range COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW. MOODYSKMV. COM 3. 695. 32 5. 648. 49 8. 8420. 00 High Risk

39 Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms Defaults 4 Years Later 14 Number of Firms 12 • 103 Non-Financials Rated Single B as of December 1992 • 14 Defaults in 4 Years • 13 defaults from the above-median EDF companies 10 • Non-Defaulting firms had 2. 26% EDF • Defaulting firms had 13. 89% EDF 8 6 Equally rated firms are not the same risk Market data can add precision to traditional analysis and accounting-based evaluations 4 2 0 0. 150. 65 Low Risk 0. 671. 14 1. 152. 04 2. 162. 63 2. 693. 33 EDF Range COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW. MOODYSKMV. COM 3. 695. 32 5. 648. 49 8. 8420. 00 High Risk

40 Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms EDF Predictive Power Random Chance COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW. MOODYSKMV. COM

41 Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms EDF Provides Early Warning Weakest Quartile EDF all firms Median EDF of firms that subsequently default Benchmark: Median EDF for period for all firms 1 to 60 Months Prior to Default COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW. MOODYSKMV. COM

42 Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms EDF Provides Early Warning Weakest Quartile EDF, firms that subsequently default Weakest Quartile EDF all firms Median EDF of firms that subsequently default Best Quartile EDF, firms that subsequently default Benchmark: Median EDF for period for all firms 1 to 60 Months Prior to Default COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW. MOODYSKMV. COM

43 Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms EDF Provides Early Warning Weakest Quartile EDF, firms that subsequently default Median EDF of firms that subsequently default Weakest Quartile EDF all firms Best Quartile EDF, firms that subsequently default Benchmark: Median EDF for period for all firms 1 to 60 Months Prior to Default COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW. MOODYSKMV. COM

44 Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms EDF Predictive Power Validated Defaults in Firms with $300 mm or more in sales COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW. MOODYSKMV. COM

Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms 45 Upgrade/Downgrade Study 90% 85% Non-investment Downgrades 80% Non-investment grade Upgrades 75% Investment grade Upgrades 70% 65% Investment grade Downgrades 60% 55% 50% -12 -9 -6 -3 Months before upgrade/downgrade -1 The test was fairly conservative – to signal a ratings change, a firm had to have an EDF™ credit measure that indicated a full notch or more difference at the point X months ahead of the rating change. This means the EDF had to be 2 or more times the EDF of its grade. COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW. MOODYSKMV. COM

46 Measuring & Managing Credit Risk: Understanding the EDF™ Credit Measure for Public Firms To Learn More Please contact your Moody’s KMV client representative or visit us online at www. moodyskmv. com. Contact Moody’s KMV via e-mail at info@mkmv. com or call us at: NORTH AND SOUTH AMERICA, CALL: +1 (866) 321 -MKMV (6568) or +1 (415) 296 -9669 EUROPE, THE MIDDLE EAST, AFRICA, CALL: +44 (20) 7778 -7400 ASIA PACIFIC, CALL: +81 (3) 3218 -1160 COPYRIGHT © 2004 MOODY’S KMV COMPANY. ALL RIGHTS RESERVED. WWW. MOODYSKMV. COM