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
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