a new approach to analyzing credit and bankruptcy risk...
TRANSCRIPT
A NEW APPROACH TO ANALYZING CREDIT AND BANKRUPTCY RISKCFA INSTITUTE: 64th ANNUAL CONFERENCEEDINBURGH, SCOTLAND,10 MAY 2011
Tim Gaumer, CFADirector of Fundamental Research Thomson ReutersDirector of Fundamental Research, Thomson Reuters
AGENDA
• CREDIT RISK MODEL– STRUCTURAL MODEL (MERTON APPROACH)– RATIO ANALYSIS
MINING TEXT DOCUMENTS– MINING TEXT DOCUMENTS– ESTIMATING LOSS GIVEN DEFAULT– CDS MARKET– COMBINATION RESULTS
• Q & A
Wh ki dit d l?Why are we working on a credit model?• Benefits fixed income, equity and multi-asset class investors
• A systematic approach offer the broadest global coverage• A systematic approach offer the broadest global coverage– Independent credit research firms cover only a small segment of the universe
• Investors are seeking another, more timely, independent viewpointLoss of confidence in the iss er paid model and pro iders– Loss of confidence in the issuer paid model and providers
• Uniform, systematic evaluation methodology– Avoids potential sources of bias
Allows for relative comparison across companies– Allows for relative comparison across companies– Updated daily
• A multi-factor approachEvaluates the probability of financial distress from multiple perspectives– Evaluates the probability of financial distress from multiple perspectives
• It’s forward-looking, using forecasts to drive ratio analysis
• It yields better results– A better default predictor– An enhanced equity selection tool
3
StarMine Credit Risk: Analytics built on Thomson Reuters content
C dit i k t i ti b bilit f d f ltCredit risk metrics – rating, probability of default
For trading, investment management, risk management
StarMine Credit Risk g
5 Powerful component models il bl i di id ll t th
Component ModelsCDS modelLoss Given Default
Sophisticated analytics that allow clear
available individually or together
StarMine Analytics
SmartEstimates Implied
Financial Ratios
Text Mining
Structural(Merton)
Volatility
Text processing &
Capital structure
Incorporates text estimates
Sophisticated analytics that allow clear drill-down
Thomson Reuters Source Data
I/B/E/S Thomson Reuters
Reuters News
SmartEstimates+ SmartRatios
Implied CDS Spread
Reuters
StreetEventsTranscripts
DataScope Fixed
Text processing &document scoring
Filings SECAPI
Incorporates text, estimates, and other unique, high-quality content
I/B/E/S Estimates
Thomson Reuters CDS Spreads
Reuters Fundamentals
DataScope Fixed Income & Equities
4
AGENDA
• CREDIT RISK MODEL– STRUCTURAL MODEL (MERTON APPROACH)– RATIO ANALYSIS
MINING TEXT DOCUMENTS– MINING TEXT DOCUMENTS– ESTIMATING LOSS GIVEN DEFAULT– CDS MARKET– COMBINATION RESULTS
• Q & A
Merton/Structural model:A standard approach that works well
Input Effect on default probabilityLeverage (debt/assets) Higher leverage increases D.P.Asset volatility Higher asset volatility increases D.P.Asset growth rate Higher growth rate decreases D.P.
• Uses option pricing theory to estimate market value of a firm’s assets.
s
A possible asset value path
(random walk with drift)
• Models a company’s equity as a call option on its assets.
• Probability of default equates to probability that asset value of Va
lue of Asset
Distribution ofasset value at horizon
probability that asset value of firm will fall below the default point (~liabilities). i.e., probability that the option expires worthless
Market A0
Default Point
Probabilityexpires worthless.
• We use a 1-year horizon. Time
of default
6
Our Structural Credit Risk (SCR) improves on the ( ) pMerton model with a number of innovative features
• Optimized leverage, volatility, and drift inputs.• e.g. different treatment of balance sheet liabilities for certain companies in
the financials sector.
• Employs region-specific adjustments to default rates
• Leverages StarMine Val-Mo model as an input• helps predict the upward or downward direction of future drift of the assets
7
StarMine SCR’s default prediction rate outperforms p pthe Altman Z-score, and basic Merton model
1 0
0 7
0.8
0.9
1.0ptured
in
e
0.4
0.5
0.6
0.7
Defau
lts Ca
pkiest Q
uintile
0.1
0.2
0.3
0.4
Fraction
of
Ris
0.0
0.1
All firms Financial sector firms
StarMine SCR Basic Merton Model Altman Z
8
It is also important to check the prediction accuracy of a model across all sectors
2.9
3.0
Utilities
2 6
2.7
2.8
default
ITMaterials
Industrials
Cons. Stap.
HealthcareFinancials
2.4
2.5
2.6
ual distance to d IT
EnergyCons. Discret.
2.1
2.2
2.3Actu
Telecom
2.0
2.0 2.1 2.2 2.3 2.4 2.5 2.6 2.7 2.8 2.9 3.0
Mean predicted distance to default
9
Distance-to-default explains how many standard deviations a company is from default based on how leveraged it is, the value the equity market puts on it and the variability of that valuation
EXAMPLE: LEH (1994-2008)
80
9024AABankruptcy
60
70
80
18
21A
BBB
40
5015
Stock Price
Rating
BB
20
30
9
12
StarMine SCR implied rating
B
CCC
0
10
6
9
94 95 96 96 97 98 98 99 00 00 01 02 02 03 04 04 05 06 06 07 08 08
Agency ratingStock Price
CCC
10
12/199
8/19
9
4/19
9
12/199
8/19
9
4/19
9
12/199
8/19
9
4/20
0
12/200
8/20
0
4/20
0
12/200
8/20
0
4/20
0
12/200
8/20
0
4/20
0
12/200
8/20
0
4/20
0
12/200
A SCR model can be used in several different contexts• Fixed Income:
– Measuring the riskiness of fixed income assets relative to their prices and yields
• Equity Selection:– Screening for “quality” stocks with low default risk
• Cross-asset Arbitrage:Comparing StarMine SCR defa lt probabilities ith CDS– Comparing StarMine SCR default probabilities with CDS spreads (riskiness)
11
It can also be used to improve equity portfolio performance
7Combining StarMine Val‐Mo with StarMine SCR
6
7
Val‐Mo OnlyVal‐Mo Reduced to Merton Portfolio SizeVal‐Mo Filtered by StarMine SCR
4
5
Sharpe
Ratio
2
3
Ann
ualized
0
1
1998 1999 2000 2001 2002 2003 2004 2005 2007 2008 O ll1998 1999 2000 2001 2002 2003 2004 2005 2007 2008 Overall
12
AGENDA
• CREDIT RISK MODEL– STRUCTURAL MODEL (MERTON APPROACH)– RATIO ANALYSIS
MINING TEXT DOCUMENTS– MINING TEXT DOCUMENTS– ESTIMATING LOSS GIVEN DEFAULT– CDS MARKET– COMBINATION RESULTS
• Q & A
Financial ratios for predicting firm failure can be grouped i t l t i W t f h
Profitability Coverage Growth
into several categories. We create scores for each.
Profitability(e.g., Return on Capital, Profit
Margin)
Leverage(e.g., Net
Debt/Equity)
Coverage(e.g.,
EBITDA/Interest, CashFlow/Debt)
Liquidity(e.g., quick ratio,
Cash/Debt)
Growth(e.g., ROE
expansion, stability of EPS growth)
Industry-specific
SmartRatios Score&
specific Information
Country/Region
Probability of Defaulteffects
14
SmartRatios Credit RiskComponents KeyProfi tabi l i ty Scores 91‐100 (lowest risk)
Score PD
0 015% Leverage Scores 71‐90Coverage Scores 31‐70Liquidi ty Scores 11‐30Growth Scores 1‐10 (highest ri sk)
78100=lowest risk
0.015%(AA‐)
15
Incorporates both forward-looking (via SmartEstimate) and trailing ratios
SmartRatios Credit RiskComponents KeyProfi tabi l i ty Scores 91‐100 (lowest risk)
Score PD
0 015% Leverage Scores 71‐90Coverage Scores 31‐70Liquidi ty Scores 11‐30Growth Scores 1‐10 (highest ri sk)
78100=lowest risk
0.015%(AA‐)
16
Incorporates both forward-looking (via SmartEstimate) and trailing ratios
Incorporates industry-specific ratios where appropriate
SmartRatios Credit RiskComponents KeyProfi tabi l i ty Scores 91‐100 (lowest risk)
Score PD
0 015% Leverage Scores 71‐90Coverage Scores 31‐70Liquidi ty Scores 11‐30Growth Scores 1‐10 (highest ri sk)
78100=lowest risk
0.015%(AA‐)
17
Incorporates both forward-looking (via SmartEstimate) and trailing ratios
Incorporates industry-specific ratios where appropriate
Incorporates often over-looked items
Ratios based on StarMine SmartEstimates are more predictive than trailing ratios
80%
Value of SmartRatiosHit Rate: % of Failures Identified among High Risk (bottom 20%) Firms
60%
70%
80%
entif
ied
ms
40%
50%
f Fai
lure
s Id
eig
h R
isk
Firm
10%
20%
30%
Hit
Rat
e: %
of
amon
g H
i
0%
10%
FY0 FY1 SmartRatio
FY0 FY1 SmartRatio
FY0 FY1 SmartRatio
H
Earnings/Assets Debt/Equity Cash Flow/Interest
18
Industry-specific ratios: Some industries need special consideration
Ratios Banks Insurance Retail Airlines Utilities Oil & Gas All Others
Profitability Return on Capital √ √ √ √ √ √ √Profit Margin √ √ √ √ √ √ √U li d L √ √ √ √ √ √ √Unrealized Losses √ √ √ √ √ √ √Change in LIFO Reserve √ √ √ √ √ √ √Operating Leverage √Combined Ratio √Break‐even load √Passenger load √Generation Cost √
Leverage Assets/Equity √ √ √ √ √ √ √Unfunded Pension Liab √ √ √ √ √ √Net Debt/Equity √ √ √ √ √ √Tier 1 Capital Ratio √Loans/Deposits √
Coverage EBTIDA/Interest √ √ √ √ √ √Free Cash Flow/Debt √ √ √ √ √ √EBIT/Interest √ √ √ √ √ √Non‐performing Loans √Loan‐loss provision √Other Real‐Estate Owned √
Liquidity Cash/Debt √ √ √ √ √ √ √Short‐term Debt/ Total Debt √ √ √ √ √ √ √Quick Ratio √ √ √ √ √Change in Quick Ratio √ √ √ √ √Change in Reserve √Fuel Reserve √
19
Proven reserves √
Growth Normalized ROE Growth √ √ √ √ √ √ √Standard Deviation of EPS Growth √ √ √ √ √ √ √Standard Deviation of Revenue Growth √ √ √ √ √ √ √Same‐Store Sales Growth √
For global large-cap equities, both Sharpe Ratio and R t i i k t k l d dReturns increase as more risky stocks are excluded
StarMine Val‐Mo Long‐only Portfolio Filtered by SmartRatios Model PDGlobal Top 2000, Jan 1998 ‐May 2009
35%
40%
1.40
1.60
cileReturn
p , y
Annualized Sharpe
Annualized Return
20%
25%
30%
0 80
1.00
1.20
urn of Top
Dec
of Top
Decile
R
10%
15%
20%
0.40
0.60
0.80
nnua
lized
Retu
alized
Sha
rpe o
0%
5%
0.00
0.20
3 31 1 75 1 09 0 73 0 50 0 36 0 25 0 16 0 09
An
Ann
ua
21
3.31 1.75 1.09 0.73 0.50 0.36 0.25 0.16 0.09
StarMine SmartRatios Model PD Cutoff (%)
BBB+BBBBBB‐BB+BB+BBBB‐BB‐B
S R i M d l dSmartRatios Model advantages
• Forward looking via StarMine SmartEstimates
• Incorporates industry-specific ratios
• Includes often overlooked information (e.g., unrealized losses)
• More timely (updated daily)More timely (updated daily)
• Broader coverage (~35,000 companies globally), including financial sector.
22
AGENDA
• CREDIT RISK MODEL– STRUCTURAL MODEL (MERTON APPROACH)– RATIO ANALYSIS
MINING TEXT DOCUMENTS– MINING TEXT DOCUMENTS– ESTIMATING LOSS GIVEN DEFAULT– CDS MARKET– COMBINATION RESULTS
• Q & A
Text mining of company documents can predict financial failure
• Identify linguistic content that provides best discrimination between fi th t f il th th t d tfirms that fail vs. those that do not
• Apply sophisticated machine learning algorithms to these high-dimensional data to provide unique and powerful failure
di tipredictions
24
T Mi i C di Ri kText Mining Credit RiskDocuments (news, transcripts, filings)
FULL Numerical representation of documentsp , g )
“good i
ClearForest Calais
covenantgood
morning apple …doc1 0 1 1 …doc2 1 1 0 …doc3 1 0 0morning…
…potentially violating the covenants…”
potential,violat,the,covenant,
Stem words. Remove high frequency words Chop
doc3 1 0 0 …… … … … …
Bag-of-words
potential violat,…,
words. Chop into unique words and phrases Select most
valuable k-mers
tcredit f il
Officers t d
Make Date Company
Probability of Default
date1 A 0 0011Machine L i
covenant facil arrested …doc1 0 0 1 …doc2 1 0 0 …doc3 1 1 0 …
… … … … …
predictionsdate1 A 0.0011date1 B 0.0132date1 C 0.0578
… … …
Learning Algorithm
… … … … …
25
8-K filings are more numerous, and more timely (4
# of Documents per year by filing type
g , y (days vs 90 days allowed) than statements
120000
140000
160000
80000
100000
f Docum
ents
20000
40000
60000# o
0
1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006 2007 2008 2009
10K and 10Q Filings 8‐Ks Filings
SarbOxReg FD 26
Statements = 10K & 10Q
There are many sections (types) of 8-KsSection Section Title Sub SectionsSection 1 Registrant's Business and 1 Entry into a Material Definitive AgreementSection 1 Registrant s Business and
Operations1. Entry into a Material Definitive Agreement2. Termination of a Material Definitive Agreement3. Bankruptcy or Receivership
Section 2 Financial Information 1. Completion of Acquisition or Disposition of Assets2. Results of Operations and Financial Condition3. Creation of a Direct Financial Obligation or an Obligation under an Off-Balance Sheet
Arrangement of a Registrant
1. Notice of Delisting or Failure to Satisfy a Continued Listing Rule or Standard;
Arrangement of a Registrant4. Triggering Events That Accelerate or Increase a Direct Financial Obligation or an Obligation
under an Off-Balance Sheet Arrangement5. Costs Associated with Exit or Disposal Activities6. Material Impairments
Section 3 Securities and Trading Markets
1. Notice of Delisting or Failure to Satisfy a Continued Listing Rule or Standard; Transfer of Listing
Transfer of Listing g
2. Unregistered Sales of Equity Securities3. Material Modification to Rights of Security Holders
Section 4 Matters Related to Accountants and Financial Statements
1. Changes in Registrant's Certifying Accountant2. Non-Reliance on Previously Issued Financial Statements or a Related Audit Report or
Completed Interim Review
S ti 5Section 5 Corporate Governance and Management
1. Changes in Control of Registrant2. Departure of Directors or Certain Officers; Election of Directors; Appointment of Certain
Officers3. Amendments to Articles of Incorporation or Bylaws; Change in Fiscal Year4. Temporary Suspension of Trading Under Registrant's Employee Benefit Plans5. Amendment to Registrant's Code of Ethics, or Waiver of a Provision of the Code of Ethics6 Ch i Sh ll C St t6. Change in Shell Company Status
Section 6 Asset-Backed Securities 1. ABS Informational and Computational Materials2. Change of Servicer or Trustee3. Change in Credit Enhancement or Other External Support4. Failure to Make a Required Distribution5. Securities Act Updating Disclosure
Section 7 R l ti FD 1 R l ti FD Di lSection 7 Regulation FD 1. Regulation FD DisclosureSection 8 Other Events 1. Other Events (The registrant can use this Item to report events that are not specifically
called for by Form 8-K, that the registrant considers to be of importance to security holders.)Section 9 Financial Statements and
Exhibits1. Financial Statements and Exhibits 27
Some are red flags just by their mere presenceSection Section Title Sub SectionsSection 1 Registrant's Business and 1 Entry into a Material Definitive AgreementSection 1 Registrant s Business and
Operations1. Entry into a Material Definitive Agreement2. Termination of a Material Definitive Agreement3. Bankruptcy or Receivership
Section 2 Financial Information 1. Completion of Acquisition or Disposition of Assets2. Results of Operations and Financial Condition3. Creation of a Direct Financial Obligation or an Obligation under an Off-Balance Sheet
Arrangement of a Registrant
1. Notice of Delisting or Failure to Satisfy a Continued Listing Rule or Standard;
Arrangement of a Registrant4. Triggering Events That Accelerate or Increase a Direct Financial Obligation or an Obligation
under an Off-Balance Sheet Arrangement5. Costs Associated with Exit or Disposal Activities6. Material Impairments
Section 3 Securities and Trading Markets
1. Notice of Delisting or Failure to Satisfy a Continued Listing Rule or Standard; Transfer of Listing
Transfer of Listing g
2. Unregistered Sales of Equity Securities3. Material Modification to Rights of Security Holders
Section 4 Matters Related to Accountants and Financial Statements
1. Changes in Registrant's Certifying Accountant2. Non-Reliance on Previously Issued Financial Statements or a Related Audit Report or
Completed Interim Review
S ti 5Section 5 Corporate Governance and Management
1. Changes in Control of Registrant2. Departure of Directors or Certain Officers; Election of Directors; Appointment of Certain
Officers3. Amendments to Articles of Incorporation or Bylaws; Change in Fiscal Year4. Temporary Suspension of Trading Under Registrant's Employee Benefit Plans5. Amendment to Registrant's Code of Ethics, or Waiver of a Provision of the Code of Ethics6 Ch i Sh ll C St t6. Change in Shell Company Status
Section 6 Asset-Backed Securities 1. ABS Informational and Computational Materials2. Change of Servicer or Trustee3. Change in Credit Enhancement or Other External Support4. Failure to Make a Required Distribution5. Securities Act Updating Disclosure
Section 7 R l ti FD 1 R l ti FD Di lSection 7 Regulation FD 1. Regulation FD DisclosureSection 8 Other Events 1. Other Events (The registrant can use this Item to report events that are not specifically
called for by Form 8-K, that the registrant considers to be of importance to security holders.)Section 9 Financial Statements and
Exhibits1. Financial Statements and Exhibits 28
Some are red flags just by their mere presenceSection Section Title Sub SectionsSection 1 Registrant's Business and 1 Entry into a Material Definitive AgreementSection 1 Registrant s Business and
Operations1. Entry into a Material Definitive Agreement2. Termination of a Material Definitive Agreement3. Bankruptcy or Receivership
Section 2 Financial Information 1. Completion of Acquisition or Disposition of Assets2. Results of Operations and Financial Condition3. Creation of a Direct Financial Obligation or an Obligation under an Off-Balance Sheet
Arrangement of a Registrant
1. Notice of Delisting or Failure to Satisfy a Continued Listing Rule or Standard;
Arrangement of a Registrant4. Triggering Events That Accelerate or Increase a Direct Financial Obligation or an
Obligation under an Off-Balance Sheet Arrangement5. Costs Associated with Exit or Disposal Activities6. Material Impairments
Section 3 Securities and Trading Markets
1. Notice of Delisting or Failure to Satisfy a Continued Listing Rule or Standard; Transfer of Listing
Transfer of Listing g
2. Unregistered Sales of Equity Securities3. Material Modification to Rights of Security Holders
Section 4 Matters Related to Accountants and Financial Statements
1. Changes in Registrant's Certifying Accountant2. Non-Reliance on Previously Issued Financial Statements or a Related Audit Report or
Completed Interim Review
S ti 5Section 5 Corporate Governance and Management
1. Changes in Control of Registrant2. Departure of Directors or Certain Officers; Election of Directors; Appointment of Certain
Officers3. Amendments to Articles of Incorporation or Bylaws; Change in Fiscal Year4. Temporary Suspension of Trading Under Registrant's Employee Benefit Plans5. Amendment to Registrant's Code of Ethics, or Waiver of a Provision of the Code of Ethics6 Ch i Sh ll C St t6. Change in Shell Company Status
Section 6 Asset-Backed Securities 1. ABS Informational and Computational Materials2. Change of Servicer or Trustee3. Change in Credit Enhancement or Other External Support4. Failure to Make a Required Distribution5. Securities Act Updating Disclosure
Section 7 R l ti FD 1 R l ti FD Di lSection 7 Regulation FD 1. Regulation FD DisclosureSection 8 Other Events 1. Other Events (The registrant can use this Item to report events that are not specifically
called for by Form 8-K, that the registrant considers to be of importance to security holders.)Section 9 Financial Statements and
Exhibits1. Financial Statements and Exhibits 29
Some are red flags just by their mere presenceSection Section Title Sub SectionsSection 1 Registrant's Business and 1 Entry into a Material Definitive AgreementSection 1 Registrant s Business and
Operations1. Entry into a Material Definitive Agreement2. Termination of a Material Definitive Agreement3. Bankruptcy or Receivership
Section 2 Financial Information 1. Completion of Acquisition or Disposition of Assets2. Results of Operations and Financial Condition3. Creation of a Direct Financial Obligation or an Obligation under an Off-Balance Sheet
Arrangement of a Registrant
1. Notice of Delisting or Failure to Satisfy a Continued Listing Rule or Standard;
Arrangement of a Registrant4. Triggering Events That Accelerate or Increase a Direct Financial Obligation or an
Obligation under an Off-Balance Sheet Arrangement5. Costs Associated with Exit or Disposal Activities6. Material Impairments
Section 3 Securities and Trading Markets
1. Notice of Delisting or Failure to Satisfy a Continued Listing Rule or Standard; Transfer of Listing
Transfer of Listing g
2. Unregistered Sales of Equity Securities3. Material Modification to Rights of Security Holders
Section 4 Matters Related to Accountants and Financial Statements
1. Changes in Registrant's Certifying Accountant2. Non-Reliance on Previously Issued Financial Statements or a Related Audit Report or
Completed Interim Review
S ti 5Section 5 Corporate Governance and Management
1. Changes in Control of Registrant2. Departure of Directors or Certain Officers; Election of Directors; Appointment of Certain
Officers3. Amendments to Articles of Incorporation or Bylaws; Change in Fiscal Year4. Temporary Suspension of Trading Under Registrant's Employee Benefit Plans5. Amendment to Registrant's Code of Ethics, or Waiver of a Provision of the Code of Ethics6 Ch i Sh ll C St t6. Change in Shell Company Status
Section 6 Asset-Backed Securities 1. ABS Informational and Computational Materials2. Change of Servicer or Trustee3. Change in Credit Enhancement or Other External Support4. Failure to Make a Required Distribution5. Securities Act Updating Disclosure
Section 7 R l ti FD 1 R l ti FD Di lSection 7 Regulation FD 1. Regulation FD DisclosureSection 8 Other Events 1. Other Events (The registrant can use this Item to report events that are not specifically
called for by Form 8-K, that the registrant considers to be of importance to security holders.)Section 9 Financial Statements and
Exhibits1. Financial Statements and Exhibits 30
Some are red flags just by their mere presenceSection Section Title Sub SectionsSection 1 Registrant's Business and 1 Entry into a Material Definitive AgreementSection 1 Registrant s Business and
Operations1. Entry into a Material Definitive Agreement2. Termination of a Material Definitive Agreement3. Bankruptcy or Receivership
Section 2 Financial Information 1. Completion of Acquisition or Disposition of Assets2. Results of Operations and Financial Condition3. Creation of a Direct Financial Obligation or an Obligation under an Off-Balance Sheet
Arrangement of a Registrant
1. Notice of Delisting or Failure to Satisfy a Continued Listing Rule or Standard;
Arrangement of a Registrant4. Triggering Events That Accelerate or Increase a Direct Financial Obligation or an
Obligation under an Off-Balance Sheet Arrangement5. Costs Associated with Exit or Disposal Activities6. Material Impairments
Section 3 Securities and Trading Markets
1. Notice of Delisting or Failure to Satisfy a Continued Listing Rule or Standard; Transfer of Listing
Transfer of Listing g
2. Unregistered Sales of Equity Securities3. Material Modification to Rights of Security Holders
Section 4 Matters Related to Accountants and Financial Statements
1. Changes in Registrant's Certifying Accountant2. Non-Reliance on Previously Issued Financial Statements or a Related Audit Report or
Completed Interim Review
S ti 5Section 5 Corporate Governance and Management
1. Changes in Control of Registrant2. Departure of Directors or Certain Officers; Election of Directors; Appointment of
Certain Officers3. Amendments to Articles of Incorporation or Bylaws; Change in Fiscal Year4. Temporary Suspension of Trading Under Registrant's Employee Benefit Plans5. Amendment to Registrant's Code of Ethics, or Waiver of a Provision of the Code of Ethics6 Ch i Sh ll C St t6. Change in Shell Company Status
Section 6 Asset-Backed Securities 1. ABS Informational and Computational Materials2. Change of Servicer or Trustee3. Change in Credit Enhancement or Other External Support4. Failure to Make a Required Distribution5. Securities Act Updating Disclosure
Section 7 R l ti FD 1 R l ti FD Di lSection 7 Regulation FD 1. Regulation FD DisclosureSection 8 Other Events 1. Other Events (The registrant can use this Item to report events that are not specifically
called for by Form 8-K, that the registrant considers to be of importance to security holders.)Section 9 Financial Statements and
Exhibits1. Financial Statements and Exhibits 31
Extensive news coverage in Developed Europe
0 50 100 150 200 250 300 350 400
# of Securities per Month
0 50 100 150 200 250 300 350 400
NorwayFrance
GermanyUnited Kingdom
NetherlandsSpain
SwedenItaly
Switzerland
GreeceDenmarkBelgiumFinlandAustria
0 2 000 4 000 6 000 8 000 10 000 12 000 14 000 16 000 18 000
LuxembourgIcelandIreland
Portugal
0 2,000 4,000 6,000 8,000 10,000 12,000 14,000 16,000 18,000
# of Articles per Month
32
Combining signals from multiple textual sources g g pproduces a stronger credit model
1
Performance increases when using multiple sources of textual data
0.6
0.8
y Ratio
0.2
0.4
Accuracy
0
Statements News Transcripts All 3 Sources
33
*Performance may change as model is finalized
$24
Comparison of Agency Rating and TR Model Componentsfor Chesapeake Corp
AAA
Text mining can raise red flags early on8/17/2007 – Transcript
A l t I t k it ' till i
$18
$21
investment grade threshold
Agency Rating
TR Merton Model Equivalent Rating
TR Text Model Equivalent Rating
S k P i
AA
A
Analyst: I take it you're still in compliance with all of your covenants there. And have you spoken to any of your creditors about refinancing any of the credit terms?
$12
$15
ck Price
Stock Price
BBB
BB
credit terms?
11/30/2007 - Transcript
CEO: There is a reasonable ibilit th t ill t
$6
$9 Stoc
B
CCC
possibility that we will not be able to comply with these covenants …
08/31/2008 – 10-Q
$0
$3
/ / / / / / / / /
CC
C
Based on current projections we are likely to not be in compliance with the financial covenants under the Credit required…. These matters raise
1/07 4/07 7/07 10/07 1/08 4/08 7/08 10/08 1/09
34
qsubstantial doubt about our ability to continue as a going concern
AGENDA
• CREDIT RISK MODEL– STRUCTURAL MODEL (MERTON APPROACH)– RATIO ANALYSIS
MINING TEXT DOCUMENTS– MINING TEXT DOCUMENTS– ESTIMATING LOSS GIVEN DEFAULT– CDS MARKET– COMBINATION RESULTS
• Q & A
Loss Given Default (LGD) is a common parameter inLoss Given Default (LGD) is a common parameter in risk models• Definition:
LGD = 1 – recovery rate= 1 – post-default price/redemption price
(where the post-default price refers to the price quoted one th ft th d f lt t d d ti imonth after the default event, and redemption price
normally takes value as $100)
• Usage in Modeling Credit Risk:
Expected loss = exposure * default probability * LGD
36
StarMine LGD: Incorporates high-level macro data to specific bond-level data
Macro-level: Treasury yields and spreads, VIXMacro level: Treasury yields and spreads, VIX
Industry-level: Industry Aggregate PDPD
Company-level: SmartRatiosSmartRatiosComponents
Bond-level: seniority & capital
structurestructure
StarMine Loss Given Default 37
AGENDA
• CREDIT RISK MODEL– STRUCTURAL MODEL (MERTON APPROACH)– RATIO ANALYSIS
MINING TEXT DOCUMENTS– MINING TEXT DOCUMENTS– ESTIMATING LOSS GIVEN DEFAULT– CDS MARKET– COMBINATION RESULTS
• Q & A
CDS Model: Analyze the CDS market’s view of dit i kcredit risk
• Reduced form modeling approach which uses all daily pricing data to derive a PD curvederive a PD curve
• Create CDS market-implied values, compare with StarMine forecasts.– Input: StarMine PD + StarMine LGD
Output: StarMine fair value CDS– Output: StarMine fair value CDS– Input: observed CDS price + StarMine LGD (or ISDA LGD)– Output: CDS market-implied PD
P d t t t f PD• Produce term structure of PD– Group similar companies, fit hazard rate function to their CDS, apply same
shape to like companies w/o CDS
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The CDS market is often more responsiveExample: Goldman Sachs
Comparison of StarMine CDS‐implied PD and Structural model PD
200
240
10%
12%
120
160
6%
8%
k Price
y of D
efau
lt
804%
Stock
Prob
ability
0
40
0%
2%
2/08 4/08 6/08 8/08 10/08 12/08 2/09 4/09 6/09
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/ / / / / / / / /
CDS implied PD Structural model PD Stock Price
AGENDA
• CREDIT RISK MODEL– STRUCTURAL MODEL (MERTON APPROACH)– RATIO ANALYSIS
MINING TEXT DOCUMENTS– MINING TEXT DOCUMENTS– ESTIMATING LOSS GIVEN DEFAULT– CDS MARKET– COMBINATION RESULTS
• Q & A
Incorporating information from multiple data sources adds considerable value
Power of Combining Financial Ratio, Equity Price (Merton), & Text DataHIT Rate: % Failures Predicted among High Risk (bottom 20%) Firms
95%
100%
cted
g g ( )
25% improvement
30% improvementin MISS Rate
85%
90%
of Failures Pred
icHigh Risk Firm
s
49% improvementin MISS Rate
in MISS Rate
75%
80%
HIT Rate: %
oam
ong H
70%
Text model Financial Ratio model
Merton model Financial Ratio + Merton + Text
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What did we learn about credit default prediction?• It is possible to systematically predict credit events more accurately than credit agencies Altman Z- or Ohlson O-scores (and many creditthan credit agencies, Altman Z- or Ohlson O-scores (and many credit analysts). We learned...
– Incorporating information from multiple perspectives improves upon any single source of data or type of analysisany single source of data or type of analysis
– You can often be more responsive by incorporating market intelligence embedded in CDS and stock prices
Incorporating textual analytics from several sources can flag– Incorporating textual analytics from several sources can flag problems before they show up in the numbers. And, text is underused from a quant perspective
– There is great value in using more forward-looking timely– There is great value in using more forward-looking, timely information
– Used to filter out the most risky stocks, it also adds value to equity portfoliosportfolios
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