RSM6305

Credit Risk
Introduction
• Roshan Gaonkar, PhD

“Sometimes it’s the journey that teaches you a lot about your destination”
– Drake
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RSM 6305 – Credit Risk
• Contact: [email protected]

• Tuesdays & Thursdays: 6pm – 8.30 pm/8.00pm, LL1060

• Virtual Office Hours: Friday Afternoons by Appointment

• Graduate Assistant: Kaizhi Yang ([email protected])

• Scope
‒ Introductory Course in Fixed Income and Credit
‒ How to value Fixed Income and Credit Products
‒ Evaluation of Credit Risk
‒ Evaluation of Investment Strategies
‒ Credit Risk Management Frameworks

• Textbook
‒ Credit Risk Modelling Using Excel and VBA, by Gunter Löffler & Peter Posch
‒ Quick, easy and practical step-by-step development of simple credit models

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RSM 6305 – Credit Risk

• Approach
‒ Practitioners perspective
 Credit risk and its management existed before the theories
 Develop intuition
‒ Follow the market – review market themes each class
‒ Problems and assignments motivated by real world problems
‒ US Centric
 US Markets and Central Bank Policy affect the whole world, simply due to the size of the
market (US$ 275 Bn of Canadian IG vs. US$7 Trillion of US IG)
 Canadian markets and policy lag US, due to the strong interconnectedness of the
economies
 Many Canadian financial institutions largely invest in US fixed income markets, which are
more innovative and versatile
‒ Evolving course content

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RSM 6305 – Credit Risk

• Lecture 1 – April 30 : Motivation and Introduction

• Lecture 2 – May 2 : Interest Rate Fundamentals
• Lecture 3 – May 7 : Interest Rate Curves and Derivatives
• Lecture 4 – May 9 : Fundamentals of Credit
• Lecture 5 – May 14 : Structural Models of Credit
• Lecture 6 – May 16 : Credit Scoring Models and Ratings
• Lecture 7 – May 21 : Credit Derivatives
• Lecture 8 – May 23 : Credit Portfolios and Securitization
• Lecture 9 – May 28 : Capital Treatment for Credit
• Lecture 10 – May 30 : Trading Strategies and Review
• Lecture 11 – Jun 4 : Team Presentations
• Lecture 12 – Jun 6 : Team Presentations

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RSM 6305 – Credit Risk

• Grading
‒ Class participation – 10%
‒ Fixed Income Quiz – 10%
‒ Credit Quiz – 15%
‒ Group Credit Analysis – 20%
‒ Group Research Presentation – 15%
‒ Final Exam – 30%

• Academic Integrity

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MGF 6305 and You

• Who is in the class?

‒ What are your backgrounds ?
‒ Have you worked in Finance before?

• What do you want out of the class?

‒ Get ready for an internship/job
‒ Explore new areas
‒ Just want to graduate!!

• What type of jobs and careers are you headed for?

• Anything I can do to make this course more relevant?

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 Lecture 1

Credit Markets
Motivation & Landscape
Today’s Agenda

• Financial crisis of 2008

• Key Themes in Credit Markets

‒ Monetary Policy & Economic Cycles
‒ Leverage
‒ Financial Regulation
‒ Ratings

• Asset Classes and Financial Instruments

• Financial Markets Ecosystem

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Global Financial Crisis of 2008

PBS: How the 2008 financial crisis crashed the economy and
changed the world
GFC 2008 – Why did it Happen?
• Global Financial Crisis
• Credit Crisis Economy &
• Great Recession Monetary Policy
Regulation &
Market Financial
Structure Innovation

Agency
Problems/
Leverage
Conflicts of
Interest

Speculation
 Economy and Monetary Policy
• Economy and Monetary Policy
‒ Fed response to high-tech bubble of
2000-2002 was an aggressive reduction
in interest rates
 Concerns about jobless recovery, China WTO
and Savings Glut
 T-bill rates dropped drastically between
2001 and 2004
 As a result, this recession was mild and brief,
engendering a new term, the “Great
Moderation”

‒ Historic boom in housing market

resulted from seemingly stable economy
and dramatically reduced interest rates
 Low returns from traditional investments
fostered greater tolerance for risk, such as
securitized mortgages
 Easy access to credit
 Housing price speculation, sub-prime
mortgages

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Leverage
• Leverage
‒ Use of debt to enhance financial
returns
‒ $100 Asset - Borrow $90 for $10 of
equity
 What happens if value goes up 10%
 What happens if value goes down 10%

• Increased Leverage from easy

access to credit/loans
‒ Savings glut and Low mortgage
rates lead to housing speculation

‒ Cheap funding and Agency

problems at banks

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Regulation and Financial Innovation
• (De)Regulation
‒ Separation of Commercial and Investment Banks from Glass Steagall Act
repealed in 1999
• Financial Innovation and misunderstood risks
‒ Securitization
‒ Credit Default Swaps
‒ Collateralized Debt Obligations

Source: https://www.thirdway.org/report/housing-finance-part-1-the-basics-on-housing-securitization
Regulation and Financial Innovation
• Conforming mortgages were pooled almost entirely through Freddie Mac
and Fannie Mae
‒ Low-risk requiring demonstration of ability to repay loan

• New product resulting from securitization model

‒ Securitization by private firms of nonconforming “subprime” loans with higher
default risk
‒ Trend towards low- and no-documentation loans
‒ Little verification of borrower’s ability to repay

• A CDS is an insurance contract against the default of one of more borrowers

• Purchaser of the swap pays an annual premium for protection from credit risk
• Investors bought CDSs to insure safety against subprime loans
• Unlimited side bets
• Some swap issuers did not have enough capital to back their CDSs
• E.g., AIG alone sold more than $400b of CDS contracts - about $50Bn in subprime BBB
mortgages, resulting in losses of around $100Bn with around $35Bn in equity value)
Regulation and Financial Innovation
• Collateralized debt obligations
(CDOs)
‒ Designed to concentrate the credit
risk of a bundle of loans on one
class of investors, leaving the
other investors in the pool
relatively protected from that risk
‒ Prioritization of claims on loan
repayments by dividing the pool
into senior versus junior tranches
 Senior tranches – first claim on
repayments from the entire pool
 Junior tranches – paid only after the
senior tranches had received their
cut

‒ Ratings significantly
underestimated credit risk
Why Was Credit Risk Underestimated?

• Default probabilities had been estimated using historical data from

both an unrepresentative period of time and a very different
borrower pool

• Cross-regional diversification did not reduce risk as much as

anticipated

• Agency problems with rating agencies

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Market Structure

• Sources of fragility in 2007

‒ Many highly leveraged, large banks were relying primarily on short-term
loans for funding
‒ Widespread investor reliance on “credit enhancement” via CDOs

• Systemic risk is the risk of breakdown in the financial system,

particularly due to spillover effects from one market into others

https://libertystreeteconomics.newyorkfed.org/2019/06/assessing-contagion-risk-in-a-financial-network/
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The Shoe Drops
• Fall 2007
‒ Mortgage delinquencies increased on
rate resets on ARMs
‒ Housing price declines losses in
financial system which was over
levered resulting in credit shortage
and global contagion
• Crisis peaked in September 2008
‒ Fannie Mae and Freddie Mac put into
conservatorship
‒ Lehman bankruptcy, AIG bailout, and
Merrill Lynch sold to BOA
• Financial system took long time to
heal
‒ Corporate bankruptcies and job losses
‒ Consumer risk aversion
• Crisis not limited to the U.S.
‒ Greece was hardest hit

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The Aftermath

• How did it affect you/your families?

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The Aftermath
The Dodd-Frank Reform Act

• Dodd-Frank Wall Street Reform and Consumer Protection Act passed

in 2010
‒ Volcker Rule

• Mechanisms to mitigate systemic risk

‒ Stricter rules for bank capital, liquidity, and risk management practices
 E.g., stress tests for large banks
‒ Limit risky activities in which banks can engage
‒ Creation of the Office of Credit Ratings within the SEC to oversee the credit
rating agencies

• Moved risk taking activities outside the banking system

‒ Private Equity and Private Credit Funds
‒ Sovereign Wealth Funds and Pension Plans

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Relevance to this Course
• Macro-economic factors
‒ Where are we in the Business Cycle ?
‒ Are we in an idiosyncratic risk environment or a systemic risk environment?

• Counterparty Risk
‒ What is our dependence on the health and stability of parties we deal with
directly and indirectly?
‒ How can we minimize our exposure to our counterparties?

• Flaws in Ratings
‒ Are the ratings reflective of the true underlying credit risk?

• Flaws in Models
‒ Do the models accurately price and capture all the risks?
‒ What assumptions are in-built into the models and when do they fail?

• Stress Testing time frame

‒ Most stress tests use GFC as a scenario

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Credit Crisis – Déjà vu during Covid
• Impacted globally at same time
‒ Temporary Unemployment
‒ Business closures due to health
mandates
‒ Spending slowdown

• Massive demand to hoard cash

‒ Cashflow disruptions and defaults on
payments
‒ Commercial Paper markets froze
‒ Corporations drew down on their
revolvers

• Margin calls on levered positions

‒ Fire-sale liquidation of assets
‒ Risk-aversion amongst investors

• Do you know of businesses that Source: https://cepr.org/voxeu/columns/keeping-lights-economic-medicine-medical-

collapsed during Covid? shock
Response to Credit Crisis during Covid
• Lessons learnt and tools developed
in the aftermath of GFC were hugely
significant in managing the crisis
‒ Speed of Response
‒ Liquidity Injection and backstop to
Financial Markets
‒ Fiscal stimulus was easier politically
since no-one to blame

• Monetary Policy
‒ Forward guidance
‒ Quantitative Easing

• Market functioning
‒ Primary Dealer Credit Facility
‒ Money Market Liquidity Facility
‒ Standing Repo Facility
‒ International Swap Lines
Movement Break
Financial Markets

Equity Bond Markets

Represents ownership share Promises either a fixed
in a firm stream of income

Financial
Markets

Money Markets Derivatives

Short-term liquid low-risk Payoff depends on the value
debt securities of other financial variables

Money Markets vs. Capital Markets

Forex & Commodity Markets

Money Markets

• Made up of short-term, marketable, liquid, low-risk debt securities

‒ Think of it as cash/place to park money that isn’t invested anywhere else

• Driven by flow of cash between governments, corporations, banks,

and financial institutions, borrowing and lending for a term as short
as overnight and no longer than a year

• Money Market Funds are mutual funds that invest in money market
instruments
‒ Government funds hold short-term U.S. Treasury or agency securities
‒ Prime funds also hold other money market instruments
‒ Commercial paper has short term credit risk exposure to high quality
corporates
 Money Markets - BTMM
Treasury Bills (i.e., T-bills)
• Simplest form of borrowing wherein the
Commercial paper government raises money by selling bills to
• Short-tern unsecured debt notes, often the public
issued by large, well-known companies • 4-week and 8-week bills offered each week
and backed by a bank line of credit

SOFR
Federal funds • Repo rate for Treasury
• Funds in a bank’s reserve account at Repurchase agreements
the Federal Reserve Bank • Short-term, often over-night, sales
of securities with an agreement to
repurchase them at a slightly
higher price
• Critical to plumbing of financial
markets
Certificates of Deposit (CD)
• Bank pays interest and principal to
the depositor only at maturity Eurodollars
• Time deposit cannot be withdrawn • Dollar-denominated deposits at foreign
on demand banks or foreign branches of American
banks
Money Markets
• Because these markets are very liquid, yields across various money
market instruments are very similar during normal times

• Most money market securities are low risk (but not risk-free!) and
low return
‒ Breaking the buck
Bond Markets
• Composed of longer term borrowing or debt instruments than those
that trade in the money market
• Bond investments promise either a fixed stream of income or a
stream of income determined by a specified formula
• Capped upside

https://www.fixedincomenews.com.au/just-how-big-is-the-bond-market/
Bond Markets
• Types of Bonds
‒ Government Affiliated: Treasuries, MBS, Agencies. Municipal
‒ Private Sector: Corporate bonds (Industrials, Financials & Utilities), ABS
Bond Markets - Treasuries
• Treasury Market
‒ Largest and most liquid financial market
‒ “Risk-free”
‒ Everything evaluated with respect to return on this

• Treasury notes and treasury bonds

‒ U.S. government borrows funds in large part by selling T-notes and T-bonds
‒ Notes – maturities range up to 10 years
‒ Bonds – maturities range from 10 to 30 years

• Inflation-protected treasury bonds

‒ Many countries’ governments issue bonds linked to an index of the cost of
living in order to provide their citizens with an effective way to hedge
inflation risk
‒ In the U.S., inflation-protected T-bonds are called TIPS
Bond Markets
• Federal agency debt
‒ Agencies formed to channel credit to a particular sector that Congress
believes might not receive adequate credit through private sources
‒ E.g., FNMA (Fannie Mae), GNMA (Ginnie Mae), FHLMC (Freddie Mac)

• International bond markets

‒ International capital market centered in London
‒ Eurobond is a bond denominated in a currency other than that of the
country in which it is issued
‒ Yankee bond is a dollar-denominated bond sold in the U.S. by a non-U.S.
issuer
‒ Samurai, DimSum and Masala bonds
Bond Markets - Munis
• Municipal Bonds
‒ Bonds issued by state and local governments
 General obligation – backed by general taxing power of issuer and used to fund public
projects such as infrastructure (schools, sewage systems)
 Revenue – backed by proceeds from the project or agency they finance (typically issued
by airports, hospitals, etc.)
 Industrial development – revenue bond issued to finance commercial enterprises

‒ Tax Exempt
 At higher tax rate need much higher yields on regular bonds to match Muni return
Bond Markets - Corporates
• Corporate bonds
‒ Means by which private firms borrow money directly from the public
‒ Senior claim on the Firm
‒ Can be Secured or Unsecured
‒ Larger default risk than Treasury issued securities -> more yield for more
credit/default risk
‒ May come with options attached (Callable Bonds and Convertible Bonds)
Bond Markets – Asset backed
• Mortgage- and asset-backed
securities
‒ Ownership claim in a pool of
mortgages or an obligation that
is secured by such a pool
‒ Regular mortgage payments for
individual borrowers aggregate
in the pool and “pass-thru” to
investors
‒ Conforming vs. non-confirming
mortgages
Derivative Markets

• Derivative asset is a claim whose value is directly dependent on or is

contingent on the value of some underlying assets
‒ Stock prices, interest rates, or exchange rates, etc.
‒ Futures vs. Options
• “Side bets” on financial assets, often larger market than underlyings
‒ “Gamma Squeeze” in Meme stocks 2021
‒ Dumb Money -2023 (https://www.imdb.com/title/tt13957560/)

Source: Forbes
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Derivative Markets
• Futures contract
‒ Calls for delivery of an asset (or cash value) at a specified delivery date for an
agreed-upon price, called the futures price, to be paid at contract maturity
‒ Long position held by the trader who commits to purchasing the asset on the
delivery date
‒ Short position held by trader who commits to delivering the asset at contract
maturity

• Options
‒ Call option: Gives holder the right to purchase an asset for a specified price,
called the exercise or strike price, on or before a specified expiration date
‒ Put option: Gives holder the right to sell an asset for a specified exercise
price on or before a specified expiration date

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Derivative Markets
Futures Contract Options
• Obliged to make or take delivery • Right, but not obligation, to buy or sell
• Long (short) position must buy (sell) at the • Option is exercised only when it is
futures price profitable
• Futures contracts are entered into without • Options must be purchased (premium is
cost the price of the option itself)
• Linear Payoff • Non-Linear Payoff
Derivative Value

Derivative Value
Underlying Value Underlying Value

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Financial Markets Ecosystem

• Firms • Households • Financial Intermediaries

‒ Net demanders of capital ‒ Typically net suppliers of capital ‒ Match suppliers of capital to
‒ Raise capital now to pay for ‒ Purchase securities issued by those needing the capital
investments in plant and firms that need to raise funds ‒ Investment Banks, VCs, PE
equipment Mutual Funds, Insurance Cos,
Credit Union etc.

https://www.wallstreetprep.com/knowledge/the-ultimate-guide-to-sales-and-trading/
https://www.wallstreetprep.com/knowledge/finance-careers-overview/
Objectives of Market Participants
Capital Users Investors
Governments, Corporations, Small- Governments, Sovereign Wealth Funds
businesses (SWF), Pensions funds, Insurance companies,
• Objectives Mutual funds , hedge funds and asset
• Raise capital at the lowest cost management companies, Commercial banks,
possible Households
− Develop new projects and • Objectives
products • To buy securities of different risk-return
− To smooth-out cash flow needs profiles at a fair price
− Liquidity and Cash Needs
Financial Intermediaries − Liability-Driven Investment
Broker-Dealers, Investment Banks (Insurance, Pension Plans)
• Objectives − Investment Returns
• Maximize revenue from providing a • To obtain diversification at a low cost
matching service
− Increase volume of flow − Improve Return on Risk
− Develop relationships with • To reverse previous investment
market participants decisions at a low cost
• Profit from information edge − Active Management of Risk
Financial Markets Ecosystem – Security Lifecycle
• Primary Markets (ECM, DCM, Loan
Syndication)
‒ New issue of securities/bonds
‒ Exchange of Funds from Investors to
Issuers for Financial Claim (transfer of
cash flows across time)
‒ Funds for the Borrowers and IOU for
Lender/Investor
‒ Capital allocation into real economy

• Secondary Markets (Treasuries,

Credit, Munis - Trading desks)
‒ Trading of Previously Issued Securities
‒ No New Funds for Issuer
‒ Exchange of Claims for Money between
investors, with the help of Dealer Trading
Desks
‒ Provides exit opportunity for initial
investor and fresh investing opportunity
for new investor
‒ Capital flows between investors

https://www.overbond.com/academy/fixed-income-market/bond-life-cycle
Financial Markets Ecosystem – Sell Side IB
Financial Markets Ecosystem – Buy Side

Buy-side Firm

Asset
Public Markets Private Markets Allocation/Total
Portfolio

Equity Private Equity

Credit Private Credit

Rates Venture Capital

Derivatives Real Estate

External
Infrastructure
Managers
The Investment Process
• Portfolio
‒ A collection of investment assets

• Decisions to make in Portfolio Construction

‒ Asset Allocation: Choice among broad asset classes (e.g., stocks, bonds, real estate, etc.)
‒ Security Selection: Choice of securities within each asset class
‒ Security Analysis: Valuation of particular investments that might be included in the portfolio

• Two broad ways to construct Portfolios

‒ “Top-down” Approach
 Asset allocation followed by determination of particular securities to be held in each asset
class
 Large Asset Managers by necessity have a “Top-down” approach

‒ “Bottom-up” Approach
 Investments are made in attractively priced securities without much regard for asset allocation
 Specialist investors – Distressed, VC, HY Managers, etc.