2009 Chicago Erm Farina

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    ERM Symposium

    April 2009

    Q1-Advances in Credit Risk Quantification

    Thomas M. Farina

    Michael Pykhtin

    ModeratorDan Rosen

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    Deutsche Insurance Asset Management:Credit Fundamentals & ERM

    Thomas Farina, CFA, Head of Corporate Credit Trading

    April 2009

    2

    Summary

    Fundamentals are important in current market environment and within ERM specifically

    Current credit market characterized by:

    Multiple factors have a disproportion impact on risk

    Government policy taking a major role

    Historically extreme level of volatility

    Given market backdrop, fundamental analysis and insights can assist in two ways:

    Measurement. Fundamentals can provide valuable insight in accessing market risk variables

    in their inclusion in ERM measurement

    Management . Fundamentals can provide tactical insights and assistance in the management

    of risk within an ERM framework

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    3

    ERM Overall thoughts

    1. ERM remains a vital aspect of risk measurement and management

    Facilitates the capital optimization process within Financial Institutions

    2. Difficulties within risk measurement aspects of ERM are a consequence of the unique

    market environment:

    Higher levels of volatility persist while remaining resistant to mean reversion tendencies

    Credit ratings are not telling the whole risk story

    Markets are in imbalance and signals/inputs from key market factors are conveying misleading

    conclusions

    3. Fundamental analysis provides input alternatives to the process while allowing tacticalinsights

    4

    Overview of the goal of ERM minimize required surplus

    Assets

    Liabilities

    SurplussupportingAsset Risk

    (a) overlap

    Surplussupporting

    Liability Risk

    (b) Pure Surplus

    Total

    Surplus

    Surplus exists to support risk from assets and liabilities

    Diversification provides benefits, particularly among risks with negative

    correlation

    Allows for overlap whereby no capital is needed to support

    either risk

    Frees up surplus that would otherwise be needed to support risk

    Pure Surplus is the ultimate goal of ERM and ALM, allowing

    management to:

    To take on additional risk to generate additional return

    Return surplus to shareholders and improve return on surplus

    ERM - Vital aspect of

    risk measurement and

    management

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    5

    Objectives of ERM

    Measure risk

    Risk exposure of different facets of the enterprise (primarily assets and liabilities)

    By risk category

    In aggregate

    Assess capital needs

    Surmise amount of capital that should be maintained to support the chosen level of

    risk

    Capital costs money

    Lines of business, products, or other segments that take on more risk need more

    capital and should pay for it

    Establish or modify investment behavior to minimize net risk

    For our purposes,ALM is the subset of

    ERM focused on

    specific risks to the

    balance sheet,

    primarily interest

    rates and equity

    returns

    Identify areas where risks have less than perfect positi ve correlation; these are the sources of

    diversification and correlation benefits

    ERM - Vital aspect of

    risk measurement and

    management

    6

    Where we are in Investment Grade Corporate Credit

    Source: Barclays Capital

    Corporate Index OAS

    0

    40

    80

    120

    160

    200

    240

    280

    320

    360

    400

    440

    480

    520

    560

    600

    640

    1/31/1962 12/31/196511/30/196910/31/1973 9/30/1977 8/31/1981 7/31/1985 6/30/1989 5/31/1993 4/30/1997 3/31/2001 2/28/2005 10/27/2008

    Corp.

    Spread5-1

    0-yrBonds(bps)

    0

    5

    10

    15

    20

    25

    FedFundsRate(%)

    Corp Spread (left) Fed Funds Rate (Right)

    Recession/Bank

    Failure

    Recession

    (Double-dip)

    Corporate

    Raiders

    Recession/RTC

    Monetary Shock

    Orange Cnty

    IEM

    Tight Policy to

    Squash Irrational

    Exuberance

    Subprime

    Contagion

    Fraud/Corp

    Governance

    Like most markets,

    credit risks has

    increased

    significantly and in

    some markets have

    reached historically

    peak levels

    ERM risk measurement

    difficulties: Unique

    market environment

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    7

    CreditOAS

    (bps)

    Source: Barclays Capital

    Even looking at more

    constrained time

    periods which will better

    adjust for volatility, the

    move higher in risk

    remains significant

    Where we are in Investment Grade Corporate CreditERM risk measurement

    difficulties: Unique

    market environment

    8

    Continuing risk factors support further dislocations

    Banks willingness to lend sharply lower**

    Volatility (VIX Index*) remains elevated

    Sources: Federal Reserve, Conference Board, U of Mi chigan, Congressional Budget Office, Bloomberg, Capital IQ, JP Morgan, Moodys

    *The GDP Gap is the difference between real (inflation-adjusted) GDP and its estimated potential level (which corresponds to a high level of

    resource labor and capital use)

    ** Report on willingness to make consumer installment loans as reported in Feds, Senior loan Officer Opinion survey on Bank LendingPractices

    Persistent economic and

    fundamental deterioration

    Systemic risk concerns

    persist

    Continued deleveraging

    Banks

    Consumer

    Technicals continue to

    skew markets

    Weak GDP leads to expected decline in CAPEX

    Moodys Default Levels increasing

    ERM risk measurement

    difficulties: Unique

    market environment

    %

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    Degrading of credit quality

    Source: Barclays Capital

    Quality analysis of Barclays Capital credit index1973 - 2008

    ERM risk measurement

    difficulties: Unique

    market environment

    10

    Ratings are not telling the whole story

    Risk as measured by credit ratings are now showing to be more procyclical

    Potentially less reliable for the ultimate risk embedded within securities

    Risk reflected within ratings seem be more backward looking

    Questions the historic loss rates which have been very stable for a very long

    period of time

    ERM risk measurement

    difficulties: Unique

    market environment

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    11

    Many risk factors are driving the market

    Although markets are reflecting increasing levels of credit risk, there are more riskfactors present in the market which is driving assets pricing (and some of these factors

    are playing a dominant role)

    Defaults

    Downgrades

    Liquidity

    Technicals

    ERM risk measurement

    difficulties: Unique

    market environment

    12

    The downside is pr iced in

    If prices are reflecting one aspect of risk and ratings may be under representing risk, then

    does the truth lie in between?

    Source: JP Morgan

    Peak defaults were

    10% starting in 1982

    for a 10-year period

    Assuming a 35%

    recovery this equates

    to a spread of 36bps

    Current spread levels

    are reflecting a default

    rate greater than 40%

    with a 0% recovery

    2.6%

    3.5%

    3.2%

    3.0%2.9% 2.9%

    2.4%

    1.8%

    1.4%1.3%

    1.0%1.1%

    2.1%

    2.3%2.2%

    2.0%

    0.0%

    0.5%

    1.0%

    1.5%

    2.0%

    2.5%

    3.0%

    3.5%

    4.0%

    1981 1983 1985 1987 1989 1991 1993 1995

    Worst 10-year period:

    (1982 - 1991)

    10-year average:

    2.2%

    ERM risk measurement

    difficulties: Unique

    market environment

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    13

    But the market is not telling the whole story

    Source: JP Morgan

    Moves in CMBX as itrelates to cash CMBS

    CMBX moves as it relates

    to Corporate REITS

    The Basis of CDS and

    Cash

    ERM risk measurement

    difficulties: Unique

    market environment

    (300)

    (200)

    (100)

    0

    100

    1/2/2007

    3/2/2007

    5/2/2007

    7/2/2007

    9/2/2007

    11/2/2007

    1/2/2008

    3/2/2008

    5/2/2008

    7/2/2008

    9/2/2008

    11/2/2008

    1/2/2009

    3/2/2009

    (800)

    (600)

    (400)

    (200)

    0

    200

    1/2/2007

    3/2/2007

    5/2/2007

    7/2/2007

    9/2/2007

    11/2/2007

    1/2/2008

    3/2/2008

    5/2/2008

    7/2/2008

    9/2/2008

    11/2/2008

    1/2/2009

    3/2/2009

    High Grade All CDS-Bond Basis

    High Yield All CDS-Bond Basis

    bps

    bps

    14

    We understand the challenges of effective ERM

    It is very difficult to identify meaningful correlations between claim liabilities and assets

    Contractual terms (assets) compared to risk transfer (claims)

    Lack of sufficient historical data

    Highly homogenous (assets) compared to highly heterogeneous (claims)

    Optionality of liabilities is difficult to assess (Life Companies)

    Correlations tend to break down in periods of economic stress in collapse scenarios all

    correlations move to 100%

    Catastrophic conditions tend to