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<title>I Want To Be A Loan</title>
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<td width="25%" valign="top" align="center"><!--webbot bot="ImageMap" rectangle="(14,297) (97,322) http://www.powermarketers.com/adrates.html" rectangle="(11,230) (95,257) http://www.powermarketers.com/pmajobs.htm" rectangle="(12,163) (96,189) http://www.powermarketers.com/main.htm##_parent" rectangle="(12,95) (96,121) http://www.powermarketers.com/power2.htm##_blank" rectangle="(11,29) (96,54) ../pmamag.htm" src="../images/magmenu.gif" alt="PMA OnLine Magazine Menu" border="0" align="center" startspan --><MAP NAME="FrontPageMap"><AREA SHAPE="RECT" COORDS="14, 297, 97, 322" HREF="http://www.powermarketers.com/adrates.html"><AREA SHAPE="RECT" COORDS="11, 230, 95, 257" HREF="http://www.powermarketers.com/pmajobs.htm"><AREA SHAPE="RECT" COORDS="12, 163, 96, 189" HREF="http://www.powermarketers.com/main.htm" TARGET="_parent"><AREA SHAPE="RECT" COORDS="12, 95, 96, 121" HREF="http://www.powermarketers.com/power2.htm" TARGET="_blank"><AREA SHAPE="RECT" COORDS="11, 29, 96, 54" HREF="../pmamag.htm"></MAP><a href="../_vti_bin/shtml.dll/articles/shimko3.htm/map"><img src="../images/magmenu.gif" alt="PMA OnLine Magazine Menu" border="0" align="center" ismap width="110" height="350" usemap="#FrontPageMap"></a><!--webbot bot="ImageMap" endspan i-checksum="29480" --><p><a href="../searchpma.htm"><img src="../images/archives.gif" alt="Archives Search" border="0" align="center" WIDTH="70" HEIGHT="40"></a></p>
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<td width="75%" valign="top"><font SIZE="5"><b><p ALIGN="left"></b></font><big><big><big><strong>I
WANT TO BE A LOAN</strong></big></big></big><i></p>
</i><p ALIGN="left"><strong><big>David C. Shimko</big><br>
P<small>RINCIPAL</small>, R<small>ISK</small> M<small>ANAGEMENT</small> A<small>DVISORY</small>
G<small>ROUP</small>, B<small>ANKERS</small> T<small>RUST</small></strong></p>
<p ALIGN="left"><big><strong>Brett Humphreys</strong></big></p>
<p ALIGN="left"><small>(<em>originally published by PMA OnLine Magazine: 08/98</em>)</small><br>
</p>
<font SIZE="2"><p align="center"></font><font size="3"><strong><em>Brett Humphreys and
David Shimko suggest a simple <br>
method to charge trading counterparties for credit risk.</em></strong></font></p>
<p> <font SIZE="2"></p>
<p></font>Some power traders trade credit risk well. They hand-pick their counterparties
to minimize the size and consequences of default, and have a good sense when to take
precautionary measures. In fact, you might say power markets characterized by uniform
bid/offer spreads, traders really trade credit risk more than market risk. They first
choose the position they want to take (often reducing market risk) and then decide with
whom they trade (taking additional credit risk).</p>
<p>Some power traders do not trade credit risk well. They take all comers at their posted
bid/offers to maximize their market share and reported P&L. Though we in risk
management might frown at this strategy, we often do little to curtail it. Measures taken
to prequalify, limit or screen low-rated counterparties reduce the problem somewhat, but
at the cost of losing profitable business. We also tend to compound the problem by giving
traders free capital by which they can justify taking increasing credit risks. </p>
<p>Credit risk has become a much more important problem since the events of June. John
Bilardello of Standard & Poor's has written "Given the inherent business risk in
energy marketing, such as the wild volatility exhibited in June and the heavy reliance on
physical and financial liquidity, Standard & Poor's believes the average quality of
the industry is commensurate with low BB credit quality." (<i>Standard & Poor's
Utilities & Perspectives</i>, July 13, 1998). Given this situation why is credit often
free? Or just lumped in with market risk? Among the excuses, we hear that credit models
are difficult to build and even more difficult to implement. Therefore, this column
proposes a simple, albeit imperfect, calculation to price counterparty credit risk and
ensure that deals are being priced to reflect differential credit risks.</p>
<p>The concept, already in use at many banks, is the loan equivalent. The idea is to take
any counterparty default exposure and determine what size loan has the same default
characteristics (i.e. likelihood and severity of default). The reason for this
transformation is simple: if a counterparty has a credit rating or a credit rating can be
estimated, the cost of credit associated with a loan is simply the credit spread. If a
swap exposure has a loan equivalent, then it stands to reason that the credit costs of a
swap are the same as the credit costs of its loan equivalent. Then, if you know the credit
costs of a swap, you can determine how profitable the swap really is.</p>
<p>The steps for computing a loan equivalent and the consequent credit charge are shown in
the box. In the example, a trader evaluates a trade with counterparty A (<strong>Solid</strong>)
having an estimated $100,000 profitability and a trade with B (<strong>Shifty</strong>)
having an estimated $200,000 profitability, before credit charges.<font SIZE="2"></p>
<div align="center"><center><table border="2" width="40%">
<tr>
<td width="100%"><p align="center"></font><font size="3" color="#0080C0"><strong>COMPUTING
LOAN EQUIVALENTS AND CREDIT CHARGES</strong></font><font SIZE="2"></p>
<p>Comparing a $100,000 <strong>A-rated</strong> trade (<strong>Solid</strong>) and a
$300,000 <strong>B-rated</strong> trade (<strong>Shifty</strong>)</p>
<blockquote>
<p>Determine the potential <strong>maximum</strong> exposure of each transaction. This is
defined to be the maximum level reached by the value-at-risk calculation over the life of
a deal. Suppose this exposure level is $10,000,000 for either trade, at the 99% confidence
level. </p>
<p>Estimate the recovery rate for each counterparty. [See box below]</p>
<blockquote>
<p align="center"><strong>Solid:</strong> 50% <strong>Shifty: </strong>20%</p>
</blockquote>
<p>The loan equivalent for each potential counterparty can then be calculated. This is
simply the maximum exposure multiplied by a ratio of loss rates (1 x recovery rate). </p>
<b><p ALIGN="CENTER">Loan Equivalent Calculation</b></p>
<b>
</blockquote>
</b><div align="center"><center><table BORDER="1" CELLSPACING="2" BORDERCOLOR="#000000" CELLPADDING="7" WIDTH="451">
<tr>
<td WIDTH="20%"><i><strong>Counterparty</strong></i></td>
<td WIDTH="19%"><i><p ALIGN="CENTER"><strong>Maximum Exposure</strong></i></td>
<td WIDTH="21%"><i><p ALIGN="CENTER"><strong>Global Recovery Rate</strong></i></td>
<td WIDTH="22%"><i><p ALIGN="CENTER"><strong>Company Recovery Rate</strong></i></td>
<td WIDTH="18%"><i><p ALIGN="CENTER"><strong>Loan Equivalent</strong></i></td>
</tr>
<tr>
<td WIDTH="20%">Solid</td>
<td WIDTH="19%"><p ALIGN="CENTER">$10M</td>
<td WIDTH="21%"><p ALIGN="CENTER">42%</td>
<td WIDTH="22%"><p ALIGN="CENTER">50%</td>
<td WIDTH="18%"><p ALIGN="CENTER">$8.6 M</td>
</tr>
<tr>
<td WIDTH="20%">Shifty</td>
<td WIDTH="19%"><p ALIGN="CENTER">$10M</td>
<td WIDTH="21%"><p ALIGN="CENTER">42%</td>
<td WIDTH="22%"><p ALIGN="CENTER">20%</td>
<td WIDTH="18%"><p ALIGN="CENTER">$13.8M</td>
</tr>
</table>
</center></div><blockquote>
<p>Each loan equivalent is then viewed as a letter of credit, and the appropriate credit
charge for the trade is calculated. This is simply the loan equivalent multiplied by the
cost the potential counterparty would need to pay for a letter of credit of the same
magnitude. This cost should be equal to the spread to the risk free rate for that company:
</p>
<blockquote>
<p>The spread to the risk free rate for an A rated company�s bond is 45 bp.</p>
<p>The spread to the risk free rate for a B rated company�s bond is 173 bp.</p>
</blockquote>
<p>The appropriate credit charge for each company is therefore simply the spread to the
risk free rate multiplied by the loan equivalent size. </p>
<blockquote>
<b><p ALIGN="CENTER">Credit Charge Calculation</b></p>
</blockquote>
</blockquote>
<div align="center"><center><table BORDER="1" CELLSPACING="2" BORDERCOLOR="#000000" CELLPADDING="7" WIDTH="491">
<tr>
<td WIDTH="19%"><i><strong>Counterparty</strong></i></td>
<td WIDTH="19%"><i><p ALIGN="CENTER"><strong>Credit Rating</strong></i></td>
<td WIDTH="20%"><i><p ALIGN="CENTER"><strong>Credit Spread</strong></i></td>
<td WIDTH="22%"><i><p ALIGN="CENTER"><strong>Loan Equivalent</strong></i></td>
<td WIDTH="20%"><i><p ALIGN="CENTER"><strong>Credit Charge</strong></i></td>
</tr>
<tr>
<td WIDTH="19%">Solid</td>
<td WIDTH="19%"><p ALIGN="CENTER">A</td>
<td WIDTH="20%"><p ALIGN="CENTER">45 bp</td>
<td WIDTH="22%"><p ALIGN="CENTER">$8.6 M</td>
<td WIDTH="20%"><p ALIGN="CENTER">$38,700</td>
</tr>
<tr>
<td WIDTH="19%">Shifty</td>
<td WIDTH="19%"><p ALIGN="CENTER">B</td>
<td WIDTH="20%"><p ALIGN="CENTER">173 bp</td>
<td WIDTH="22%"><p ALIGN="CENTER">$13.8 M</td>
<td WIDTH="20%"><p ALIGN="CENTER">$238,740</td>
</tr>
</table>
</center></div><blockquote>
<p>The risk manager can now include this credit charge to determine which trade is really
the better trade:</p>
<blockquote>
<p>Value of <strong>Solid</strong> trade = $100,000 - 38,700 = $61,300</p>
<p>Value of <strong>Shifty</strong> trade = $200,000 - 238,700 = ($38,700)</p>
</blockquote>
</blockquote>
</td>
</tr>
</table>
</center></div><p>In this stylized and admittedly biased example, the trade which was
$100,000 more attractive on the surface is really the loser. $200,000 in initial net
present value is swamped by $238,000 in credit charges to yield a net value loss of
$38,700 for the trader.</p>
<p>Of course, since most power traders do not get charged for credit risks, they tend to
overstate the profits on their trades. This may be fine for any particular year. However,
as defaults accumulate over time, those who have not charged and created a reserve for
credit risk will realize those losses as counterparties default. </p>
<div align="center"><center><table border="2">
<tr>
<td width="100%" align="left"><p align="center"></font><font size="3" color="#0080C0"><strong>What's
the right recovery rate for a trading counterparty?</strong></font><font SIZE="2"></p>
<p>There is no simple answer. On one hand, if a pure trading counterparty defaults, it is
likely they will have no assets to distribute in bankruptcy. However, companies on average
have experienced an average bond recovery rate for all defaults from 1978 to 1995 of 42%
(See Edward Altman and Vellore Kishore, <u>Financial Analysts Journal</u>, Nov/Dec 1996)
with a broad range of differential recovery rates based on the industry. For example,
commercial banks have provided a 22% weighted average recovery rate, with investment funds
averaging 28%, so your counterparty estimated recovery rate may be much lower than 42%.
The question is, does your counterparty look more like a trader or more like an
asset-based company? An imprecise answer to this question can go a long way in estimating
expected recoveries.</td>
</tr>
</table>
</center></div></font><blockquote>
<hr width="98%" color="#FFFF00" size="1">
<p><small><strong>David Shimko</strong> is a principal in Bankers Trust's award-winning
Risk Management Advisory group, specializing in risk management consulting to the power
and energy industry. Prior to joining Bankers, he held trading floor and risk management
positions at JPMorgan. </small></p>
<p><small>A former asst. professor of finance at the University of Southern California,
Shimko has authored over 50 publications in the areas of strategic risk management and
asset valuation, including a PhD level textbook, Finance in Continuous Time: A Primer.
Shimko is a monthly columnist appearing in Risk magazine. </small></p>
<blockquote>
<p><small>David Shimko</small><br>
<small>Principal</small><br>
<small>Bankers Trust Company</small><br>
<small>130 Liberty Street, MS 2344</small><br>
<small>New York, NY 10006</small></p>
<p><small>(212) 250-4715 Tel</small> <font color="#000080">|</font> <small>(212)
250-6969 Fax</small></p>
<p><a href="mailto:[email protected]"><small>[email protected]</small></a></p>
</blockquote>
</blockquote>
<font SIZE="2" COLOR="#000000"><hr color="#FFFF00">
<p></font><font COLOR="#000000"><small>Reprinted with permission, David Shimko, Risk
Magazine Advisory group. All rights reserved. Copyright 1998.</small></font></td>
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