GE Capital Modeling “Originate & Hold” Portfolios in RiskFrontier Moody’s Analytics - Risk Practitioner Conference Stefano Santilli October 16, 2012 The views expressed are solely the author’s and not those of the General Electric Company. None of the materials presented contain any investment advice or guarantees of success and any use of the methods presented is at your own risk
Abstract Mark-to- Market/Model (“ MtM ” based on Lattice Valuation) is the most • commonly used valuation setting in RiskFrontier Its use is recommended in most cases and it is typically the most appropriate • choice for modeling trading assets, securitizations, and all cases where an analysis of the market value of the assets is critical Modeling the Ecap of an “Originate & Hold” portfolio of loans and leases • (banking book) with Lattice Valuation or other market value-based approach, when the portfolio is not actually marked-to-market, could lead to: Results not compatible with the institution’s practices Adverse selection in the comparison of alternative origination choices Sub-optimal amount of Ecap in good and bad times The use of Mark-to-Par Spreads alleviates the issue and obtains sensible Ecap • measurement; then risk-adjusted return metrics can be calculated outside of RiskFrontier 2
GE Capital: A Diverse Portfolio with Global Footprint Commerci cial Industry sect ctors Consumer Service ces 4% % Commerci cial Airlines 4% Health Care 17% 17% Geography 6% % Energy 6% ($0.5T assets) Automotive 2% 2% 3% 6% 13% 13% 3% Other 20% 20% Real Estate Asia P Paci cific 1% Latin A America ca 11% 11% 3% 29% 29% Others 3% Struct ctured inv. 5% 27% 27% Business Service ces 54% 54% U.S. Europe 27% 27% Consumer Product ct JVs Other Sales Finance ce 2% 2% 4% 4% 5% 5% Auto Personal Loan 4% 4% 4% 4% 11% 11% Canada 9% Small and Medium 3% 3% 7% 7% Enterprises Mortgage 30% 30% 39% 39% Cards 3
What is Capital for? Economic capital is typically defined as the amount of capital needed for the • financial institution to stay solvent. In VaR terms, it is the amount needed to cover potential losses that will be exceeded only with a certain probability (CL) There are at least two very different ways of interpreting “losses” and therefore • “capital”: Capital as the amount needed to repay lenders in case of principal losses on the risky assets Capital as replacement , held to fill the gap due to market-value losses on the risky assets • The first definition of capital is more appropriate for “originate and hold” portfolios that are not marked-to-market, because it better reflects the institution’s practices and considers all losses as credit losses, thus avoiding counterintuitive results 4
Issues with Using MtM for an “O&H” Portfolio: Example Let’s consider the theoretical case of three potential loans* that have identical risk characteristics, but different returns: Common Risk Inputs PD 4.55% LGD 35% R2 25% Maturity 3y Principal Amortizing EAD $ 1,000,000 If we could choose which deal to originate, which one would we pick? • • Is “Deal C” the obvious choice when looking at the RiskFrontier results? 5 * The three deals were run in RF as part of a portfolio of ~500 loans and ~$10B of exposure
Issues… Cont’d – MtM (Lattice) at Time of Analysis The MtM value at the analysis-date may accurately reflect the NPV of the • different deals The MtM of Deal C correctly reflects that it has a higher value than the • others • For an O&H portfolio, it is interesting information, possibly useful for pricing purposes, but does not reflect how the deals are managed (and accounting treatment). No corresponding loss or gain is recognized 6
Issues… Cont’d – EL and Ecap Ecap (TRC EL ) Ecap (RC EL ) EL and Ecap (in excess of EL, both RC- and TRC-based) are higher for the • deals with higher returns • Conceptually, the EL and Ecap should be the same, since the risk drivers are the same • Actually, it could be argued that the Ecap should be even lower for Deal C than for Deal A, since it receives larger payments until default Is “Deal C” the obvious choice when looking at the RiskFrontier results? • 7
Issues… Cont’d – RORAC RORAC (TRC EL ) RORAC (RC EL ) Drawn Spread Drawn Spread The RORAC of the three deals is very similar; even slightly lower for the • deal with the higher return • Deal C would not be considered better than the others, leading to adverse selection 8
Issues… Cont’d - 2 nd Example Let’s consider a different set of three potential loans that are much less risky. Like before, they have identical risk characteristics, but different returns: Common Risk Inputs PD 0.39% LGD 35% R2 10% Maturity 3y Principal Amortizing EAD $ 1,000,000 If we could choose which deal to originate, which one would we pick? • • Is “Deal F” the obvious choice when looking at the RiskFrontier results? 9
Issues… Cont’d - 2 nd Example - Results Ecap (TRC EL ) Ecap (RC EL ) EL EL RORAC (TRC EL ) RORAC (RC EL ) Drawn Spread Drawn Spread • The higher the return: The higher the EL The higher the Ecap (both RC- and TRC-based) The lower the RORAC 10 This type of results is not an exception, but the norm
Undesired Effects of MtM for O&H Deals: Summary While important for certain purposes (trading, securitization, capital setting for held- for-sale assets, etc.) it is not appropriate for setting capital for assets originated to be held-to-maturity and not marked-to-market. Two major issues: Assumption Effect ct Problem All embedded gains/losses For deals with embedded loss, EL Misleading/difficult to have been already realized and ECap are reduced. For deals interpret Ecap values at time of analysis with embedded gain, they are increased. The definition of loss (and If two deals have identical risk Potential adverse therefore the capital characteristics but different return, selection allocated) includes future the one with higher return typically unearned income is allocated higher capital. In many cases, the risk-adjusted return is somewhat lower for the higher- return deal What can be done to solve these issues? 11
Mark-to-Par Setting in RiskFrontier From the RiskFrontier User Manual: The terms and conditions of a loan or bond are used to calculate spread or fee information for the instrument. If this option is selected, during an analysis, this value replaces any fee or spread information previously provided. Supported instrument types include: Bonds, Term Loan Bullets, Term Loan Amortizing, Revolvers, CRE Loans (Non Mortgage), and CRE with Fixed or Floating Rate. Valuation method during an analysis must be Lattice/Lattice. This option is not available for Retail instruments, CRE Mortgage Loans, or instruments with changing rate types, such as Fixed then Floating. Bond/loan options such as Prepayment, Putable, Callable, Rating Price Grid, or PD Price Grid are not currently supported. Mark-to-Par spreads are the calculated spreads that make the instruments • have a Lattice-based MtM t0 of Par • All other user-inputted fees are ignored Achieves neutralization effect on returns by assuming that the spread • 12 exactly compensates the lender for the risk taken (in expected value terms)
Mark-to-Par Results: 1 st Example Common Risk Inputs RORAC RORAC Drawn Ecap - Ecap - MTMt0 PD 4.55% Spread - RC RC EL - TRC EL (Lattice) EL EL RC EL RC TRC EL LGD 35% EL EL EL EL Deal A 1% 7.33% 6.88% 95.6% 1.34% 16.22% 17.42% R2 25% 7.33% 6.84% Maturity 3y Deal B 4% 1.45% 17.13% 18.50% 99.9% Principal Amortizing 7.32% 6.81% Deal C 7% 1.54% 17.97% 19.49% 104.2% EAD $ 1,000,000 MtPar All 4.1% 100.0% 1.45% 16.17% 17.72% 7.73% 7.12% Since all deals have the same risk characteristics, they all get the same • values in the risk metrics • Since the return is assumed to be the one that compensates for the risk characteristics, the return is the same for all deals (4.1%) • The Rorac numbers under MtPar settings are not really useful, because they do not reflect the actual return of the deal. Actual Rorac can be calculated outside of RiskFrontier. Given the same capital, the deals with higher return would have a higher Rorac Mark-to-Par spreads achieve neutralization of undesired MtM effects 13
Mark-to-Par Results: 2 nd Example Common Risk Inputs RORAC RORAC Drawn Ecap - Ecap - MTMt0 PD 0.39% Spread - RC RC EL - TRC EL (Lattice) EL EL RC RC EL TRC EL LGD 35% EL EL EL EL Deal A 1% 7.18% 6.53% 100.7% .117% 1.62% 1.80% R2 10% Maturity 3y 7.17% 6.50% Deal B 4% .124% 1.67% 1.87% 105.2% Principal Amortizing 7.16% 6.47% Deal C 7% .131% 1.73% 1.93% 109.7% EAD $ 1,000,000 MtPar All .54% 100.0% .120% 1.52% 1.69% 7.55% 6.86% • Again, all deals show the same risk output, since all deals have the same risk characteristics • Note: MtPar Ecap above is not directly comparable to that of the three deals, because entire portfolio was run with MtPar settings and the deal Ecap is allocated from the total portfolio Ecap Return is still crucial for risk-adjusted return analysis, i.e. how to choose the right investment. Capital per se does not need to reflect the return (e.g. Basel II formula). 14
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