The credit crunch Implications for risk management/actuarial practice Cliff Speed February 2009 Introduction • Impact of the credit crunch on financial markets • Limitations of market based asset valuation and market derived discount rates • Impact on actuarial practice • Responses from pension and insurance regulators • Potential development of risk management going forward 2 The credit crunch • Estimates of losses range from $1.2 to $5 trillion. SOURCE: http://www.dallasloanofficer.com/files/wall%20street.jpg 3 Credit crunch – impact on spreads SOURCE: Citi 4 Credit crunch – impact on LIBOR % 3M LIBOR over UK base rate 3.00 2.50 2.00 1.50 1.00 0.50 SOURCE: Paternoster 5 Credit crunch – impact on equities FTSE100 last price FTSE 100 and Equity Volatility (VIX Index) FTSE value VIX Index VIX value 90 6500 80 6000 70 60 5500 50 5000 4500 40 30 20 4000 3500 10 0 SOURCE: Paternoster 6 Credit crunch – impact on oil SOURCE: www.thisismoney.co.uk/oil-price 7 Credit crunch – impact on currency GBPUSD currency GBP vs USD (lhs) and GBP vs EURO (rhs) GBP Vs USD 2.2 GBPEUR currency GBP Vs EUR 1.6 2.1 2 1.9 1.5 1.4 1.8 1.7 1.3 1.6 1.5 1.4 1.2 1.1 1.3 1.2 1 SOURCE: Bloomberg 8 Credit crunch – impact on banks % Movement of Bank Equity prices 120 BARC LN Equity LLOY LN Equity 100 RBS LN Equity 60 40 20 06/02/09 06/01/09 06/12/08 06/11/08 06/10/08 06/09/08 06/08/08 06/07/08 06/06/08 06/05/08 06/04/08 06/03/08 06/02/08 0 06/01/08 % 80 SOURCE: Bloomberg 9 How should assets be valued? • Traditionally assets have been valued using actuarial assumptions • Recent move towards market values • Liabilities are discounted based on expected asset returns • But what if there isn’t a market value? – mark-to-market becomes mark-to-model – …but models need inputs which often reference markets • Market dislocation impacts long term financial institutions who may have to take corrective action and so create further market stress. 10 What is an investment? • Investment is saving or deferred consumption, with risk, in the hope of gain. • Investment returns can be divided into contractual (bonds) and discretionary (equities) payments. An asset also has a resale value… …if you can find a buyer. • Equities have no contractual payments and hence their value is based primarily on their resale value. 11 Is the bad news priced into equity markets? S&P 500 S&P Value Equity markets Sensex Sensex Value 1550 22000 1450 20000 1350 18000 1250 16000 1150 14000 1050 950 12000 850 10000 750 8000 SOURCE: Paternoster 12 Is the bad news priced into equity markets? P/E ratio SOURCE: Deutsche Bank 13 How much more could markets lose? SOURCE: Deutsche Bank 14 Historical crises in today’s market S&P Value S&P 500 S&P since 2 January 08… and future levels? 1600 1400 1200 1000 800 600 1987 conditions 612 1931 conditions 513 1982 conditions 446 400 1920 conditions 304 200 02/01/08 11/04/08 20/07/08 28/10/08 05/02/09 SOURCE: Paternoster/ Deutsche Bank 15 Gilt earnings yield UKT 4.75 20 Govt % 6.5 Gilt equity yield FTSE Yield 6 5.5 5 4.5 4 3.5 3 2.5 2 SOURCE: Paternoster 16 Gilt and swap yields SOURCE: Bloomberg 17 What determines the swap rate? SOURCE: IMU special edition, Swap spreads – Why have they become negative? Andrew Smith, Deloitte, Dec 2008 18 Components of bond spreads • Government bonds and swaps include credit risk and liquidity risk • First element of a yield will be the risk free, any spread over this is compensation for other factors • Components of a corporate bond spread: – Expected default losses – Uncertainty of default timing and amount (a risk premium) – Illiquidity (another risk premium) – Residual risks (cost of portfolio management, tax affects etc). 19 How to decompose components of spreads Component Estimate From Expected loss From historic data Use Merton Model Risk premium Merton model less historic data Deduced from other components Liquidity Other Assume zero Total From market 20 Historic default rates Investment Grade defaults % % Issuer-weighted Moody's Corporate Default rates 1.8 1.6 1.4 1.2 1.0 0.8 0.6 0.4 0.2 0.0 SOURCE: Moodys 21 Merton model • Use a Merton model of the organisation to estimate the combination of spread due to expected loss and risk premum. • How does the Merton model work? – Corporate debt (D) = Risk free debt (D) – put option on firms assets Pay-off Merton model Organisation’s assets Debt level Equity pay-off Debt pay-off Organisation’s value SOURCE: Paternoster 22 Results of decomposition Basis points 280 Residual (including compensation for illiquidity) Compensation for expected loss and risk premium 260 240 220 200 180 Actual 160 140 120 100 80 60 40 20 0 97 98 99 00 01 02 03 04 05 06 07 08 SOURCE: Bank of England 23 Challenges in using the Merton model • Assumes bankruptcy costs are frictionless • Need to estimate volatility of firm’s assets (not equity) • Bankruptcy is only triggered when debt obligation falls due • Debt ratios change and have different maturity and seniority • Need to calibrate debt ratios to be consistent with historical defaults (or use observed debt ratios) • Geometric Brownian motion of assets does not permit jumps in asset values. 24 Returning to the liabilities… • We need market data to generate discount rates to value/reserve for liabilities. • We should take account of the particular features of liabilities – term – inflation linkage – illiquidity • An illiquid asset can’t be worth more than an equivalent liquid asset • Need an illiquid discount rate to value illiquid liabilities – Is there a risk-free illiquid asset? • Actuarial working party concludes “…the three components: default, liquidity and convenience are statistically confounded and no statistical analysis can separate them.” 25 Regulatory Response • Challenges exist in reserving for long-term liabilities • Insurance regulation • Pension regulation • Opposite response from regulators of same financial products. 26 Conclusion • Markets provide an objective and economically consistent approach • Models are important – but are only models • Financial contracts are always a trade off between security and cost • Credit crunch highlights the importance of illiquidity. Actuaries need to revisit current practices to take this into account • For credibility the profession needs to consider the "Tiner" test. • Regulators need a coherent and consistent approach. 27 Final Thoughts “Experience is one thing you can't get for nothing.” Oscar Wilde “Experience is simply the name we give our mistakes.” Oscar Wilde 28 References • Market Consistent Discounting, Interim report of the Market Consistent Valuation Working Party to the Finance, Investment and Enterprise Risk Management Conference. June 2008 • Liquidity Premia in Corporate Bonds, Theory, Evidence and Estimation Methods. Turnbull, Wilson & Skrk, Barrie & Hibbert, Jan. 2006 • Fair-Value Credit Spread and Liquidity Premium Estimation. D. Gott, Barrie & Hibbert, 7 June 2008 • IMU special edition, Swap spreads – Why have they become negative? Andrew Smith, Deloitte, Dec 2008 • Decomposing corporate bond spreads, L. Webber, B.o.E., Q4 2007 • 100 years of corporate bond returns revisited. Reid, Burns & Ademakinwa, Deutsche Bank, Nov 08 • Hitting Rock Bottom. Shah, Hampden-Turner & King, Citigroup, Nov 08 • www.bloomberg.com graphs and data • Moody’s Corporate Default and Recovery Rates, 1920 – 2007 • http://www.dallasloanofficer.com/files/wall%20street.jpg 29 © Paternoster 2007. Paternoster UK Ltd is authorised & regulated by the Financial Services Authority. Paternoster cannot be held responsible for the content nor the utilisation of this presentation. Should reference be made to other sources, Paternoster cannot be held responsible for the content or the nature of these sources.