downside risks to the macro outlook: retail credit risk implications

29
Dr. Juan M. Licari, Head of Economic & Credit Analytics – EMEA, Moody’s Analytics Originally presented at the EFMA Retail Credit Conference | June 20, 2013 | Amsterdam, The Netherlands Downside Risks to the Macro Outlook Retail Credit Risk Implications

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In this presentation, we examine how to anticipate downside risks & identify different potential scenarios, the translation of macro scenarios to retail credit portfolios, and put forth a case study which demonstrates a vintage approach to modelling risk.

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Page 1: Downside Risks to the Macro Outlook: Retail Credit Risk Implications

Dr. Juan M. Licari, Head of Economic & Credit Analytics – EMEA, Moody’s AnalyticsOriginally presented at the EFMA Retail Credit Conference | June 20, 2013 | Amsterdam, The Netherlands

Downside Risks to the Macro OutlookRetail Credit Risk Implications

Page 2: Downside Risks to the Macro Outlook: Retail Credit Risk Implications

2

Today’s Agenda

- How to anticipate downside risks & identify different potential scenariosExamples: (i) currency wars, (ii) eurozone breakdown, (iii) US fiscal situation, (iv) emerging markets hard landing, (v) oil price shock and stagflation

- Translation of macro scenarios to retail credit portfolios:Stress Testing Challenges

- UK mortgages case study:A vintage approach to modelling risk

Page 3: Downside Risks to the Macro Outlook: Retail Credit Risk Implications

3

Macro Modelling & Scenario Analysis

Page 4: Downside Risks to the Macro Outlook: Retail Credit Risk Implications

Simulation-Based Scenarios

4

Weaker Economy

Healthier Economy

Baseline:Recession

S3:Double

Dip

1-in-10

S4:Severe

Double Dip1-in-25

Alternative Economic Scenarios

S2:Mild

Double Dip

1-in-4

S1:Stronger Recovery

1-in-4

Simulation-Based

1:100 1:25 1:20 1:10 1:4 Forecast 1:4

4

S6:Stagflation

1-in-15

S5:Global

Slowdown

1-in-7

Page 5: Downside Risks to the Macro Outlook: Retail Credit Risk Implications

Current Economic Cycle

5

Expansion

In recessionAt riskRecovery

May 2013

Source: Moody’s Analytics

Page 6: Downside Risks to the Macro Outlook: Retail Credit Risk Implications

Baseline Outlook

6

12 13 14 15 16 12 13 14 15 16 12 13 14 15 16 12 13 14 15 1695

100

105

110

115

120

125

Euro zone

Real GDP, 2008Q1=100

World

U.K.

U.S.

Source: National Statistical Offices, Moody’s Analytics

Page 7: Downside Risks to the Macro Outlook: Retail Credit Risk Implications

Baseline Outlook

7

12 13 14 15 16 12 13 14 15 16 12 13 14 15 16 12 13 14 15 160

2

4

6

8

10

Rus-sia

Real GDP growth

China

Brazil

India

Source: National Statistical Offices, Moody’s Analytics

Page 8: Downside Risks to the Macro Outlook: Retail Credit Risk Implications

Quantitative Models for Scenario Analysis

-3

-2

-1

0

1

2

3

4

5

2006 2007 2008 2009 2010 (E) 2011 (F) 2012 (F) 2013 (F) 2014 (F)

8

Inflation Rate, History & Forecasts,

Euro-Zone Level

Inflation Rate Distribution, Euro-

Zone Level

Inflation Rate Distribution, Euro-

Zone Level

Page 9: Downside Risks to the Macro Outlook: Retail Credit Risk Implications

Developed Markets: GDP Growth

Euro Zone Japan Germany Spain UK US-8

-6

-4

-2

0

2

4

6BL 2013Q2 - 2014Q4 S4 (s-t-t) S6 (s-t-t)

14Q4

14Q3

14Q414Q3

14Q4 14Q4

Source: National Statistical Offices, Moody’s Analytics

9

Page 10: Downside Risks to the Macro Outlook: Retail Credit Risk Implications

Developed Markets: Inflation Rate% change on the previous year

Source: National Statistical Offices, Moody’s Analytics

Euro Zone Japan Germany Spain UK US-1.5

-1

-0.5

0

0.5

1

1.5

2

2.5

3

3.52014Q4 baseline 2014Q4 S4 2014Q4 S6

10

Page 11: Downside Risks to the Macro Outlook: Retail Credit Risk Implications

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Event-driven Scenarios

Page 12: Downside Risks to the Macro Outlook: Retail Credit Risk Implications

Event-Driven vs. Simulation-Based Scenarios

12

Weaker Economy

Healthier Economy

Baseline:Recession

S3:Double

Dip

1-in-10

S4:Severe

Double Dip1-in-25

S2:Mild

Double Dip

1-in-4

S1:Stronger Recovery

1-in-4

Simulation-Based

1:100 1:25 1:20 1:10 1:4 Forecast 1:4

12

S6:Stagflation

1-in-15

S5:Global

Slowdown

1-in-7

EmergingMarkets

Hard Landing

SovereignDefaultShock

In line withRegulatoryGuidelines

Event-Driven

Page 13: Downside Risks to the Macro Outlook: Retail Credit Risk Implications

13

Alternative Macroeconomic Scenarios

Stronger Near-Term ReboundS1

S2 Mild Second Recession

S3 Deeper Second Recession

Protracted SlumpS4

Baseline (most likely)BL

Standard

Below Trend, Long-Term GrowthS5

Oil Price ShockS6

Fed BaselineFB

Fed AdverseFA

EBA BaselineEB

EBA AdverseES

Regulatory-Driven

Fed Severely AdverseFS

Custom

Euro Zone BreakupEB

StagflationSF

Page 14: Downside Risks to the Macro Outlook: Retail Credit Risk Implications

14

GDP at Market Prices, (Bil. 2000 EUR, SA) EU Harmonised Unemployment Rate, (%, NSA)

Average Nominal House Price: Total (EUR)Interest Rate: 10-year Bond Yield, %

Event-Driven Scenario: Italy Exit - Effect on Europe

Source: Moody’s Analytics

Page 15: Downside Risks to the Macro Outlook: Retail Credit Risk Implications

GDP at Market Prices, (Bil. 2008 £, SAAR) UK Unemployment Rate, (%, SA)

Halifax Average Nominal House Price, (£, SA)Interest Rate: 10-year Bond Yield, %

Source: Moody’s Analytics

Event-Driven Scenario: Italy Exit - Effect on UK

15

Page 16: Downside Risks to the Macro Outlook: Retail Credit Risk Implications

16

Stress Testing Retail Credit Portfolios

• Key Discussion Topics:

1- Dynamic vs. Static Approach to Stress Testing, 2- Partial vs. General Equilibrium,

3- Top-down vs. Bottom-up,4- Modelling Methodologies: Stress Testing vs.

Forecasting/Scoring,

Page 17: Downside Risks to the Macro Outlook: Retail Credit Risk Implications

Historic and predicted default rates (baseline), % of balance at originationConsolidated portfolio, vintages over time

Performance of Future Loans

Forecasted Performance of Existing LoansPerformance History

17

Stress Testing: 1- Dynamic vs. Static Approach

Page 18: Downside Risks to the Macro Outlook: Retail Credit Risk Implications

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Historic and predicted default rates (severe scenario), % of balance at originationConsolidated portfolio, vintages over time

Performance of Future Loans

Forecasted Performance of Existing LoansPerformance History

Stress Testing: 1- Dynamic vs. Static Approach

Page 19: Downside Risks to the Macro Outlook: Retail Credit Risk Implications

19

Stress Testing: 2- Partial vs. General Equilibrium

Examples of collateral type for RMBS/ABS deals

» Interest rates

» Unemployment rates

» Income growth

» Profits (National Accounts)

» Share market

Small Business Loans

» Interest rates

» Unemployment rate

» Commodity/oil prices

» Price index for used cars

Auto-Equipment Loan/Lease

Illustrative

» Mortgage rate difference from origination

» Unemployment rate

» Employment growth

» Income growth

» House price growth

» Home equity

RMBS

0.00

0.10

0.20

0.30

0.40

0.50

0.60

0.70

0.80

Baseline

S3

S4

DD

0

10

20

30

40

50

60

70

80

90

100

2009

M06

2009

M11

2010

M04

2010

M09

2011

M02

2011

M07

2011

M12

2012

M05

2012

M10

2013

M03

2013

M08

2014

M01

2014

M06

2014

M11

2015

M04

2015

M09

Baseline

S3

S4

DD

PD term-structure

LGD curves

Page 20: Downside Risks to the Macro Outlook: Retail Credit Risk Implications

20

Stress Testing: 3- Top-down vs. Bottom-up

Issue: Loan level model can miss correlations and feedback effects

» Individual performance depends on other loans

» Difficult to model individuals within a system

Risk models could miss the forest for the trees– Why not model the forest, model the trees and then make

sure the tree model agrees with forest projections?

Page 21: Downside Risks to the Macro Outlook: Retail Credit Risk Implications

21

Stress Testing: 4- Modelling Methodologies

Table 1 Average probabilities (1983M1 - 2007M1)

Aaa Aa A Baa Ba B Caa-c Def Aaa 92.10% 7.52% 0.33% 0.00% 0.04% 0.00% 0.00% 0.00% Aa 0.99% 90.49% 8.07% 0.37% 0.04% 0.03% 0.00% 0.02% A 0.07% 2.76% 90.65% 5.67% 0.65% 0.15% 0.03% 0.02% Baa 0.05% 0.24% 5.51% 87.91% 4.75% 1.14% 0.23% 0.17% Ba 0.01% 0.07% 0.47% 6.35% 82.56% 8.60% 0.60% 1.33% B 0.01% 0.05% 0.18% 0.52% 5.52% 82.90% 4.74% 6.08% Caa-c 0.00% 0.02% 0.10% 1.20% 1.19% 7.12% 69.42% 20.96%

Table 2 Average probabilities (2007M6 - 2009M10)

Aaa Aa A Baa Ba B Caa-c Def Aaa 78.15% 21.71% 0.04% 0.11% 0.00% 0.00% 0.00% 0.00% Aa 0.05% 82.65% 16.03% 0.99% 0.11% 0.02% 0.07% 0.09% A 0.00% 0.88% 89.58% 8.24% 0.44% 0.30% 0.15% 0.41% Baa 0.01% 0.14% 2.20% 91.95% 4.40% 0.72% 0.20% 0.38% Ba 0.00% 0.00% 0.04% 5.10% 81.25% 10.46% 1.83% 1.32% B 0.00% 0.00% 0.07% 0.17% 3.35% 78.31% 13.55% 4.55% Caa-c 0.00% 0.00% 0.00% 0.14% 0.23% 5.74% 71.19% 22.70%

Page 22: Downside Risks to the Macro Outlook: Retail Credit Risk Implications

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Stress Testing: 4- Modelling Methodologies

Figure I: Bi-Modal Nature of Credit Transitions Bi-Modal Distribution of Baa to Ba Credit Migrations (Bar Chart) vs. a Normal, Symmetric Distribution (Green Solid Line)

01

02

03

04

0D

ensi

ty

0 .02 .04 .06 .08 .1baa_ba

First Mode: Around Normal/Good Credit

Conditions

Second Mode: Around Stressed Credit Conditions

Page 23: Downside Risks to the Macro Outlook: Retail Credit Risk Implications

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Stress Testing: 4- Modelling Methodologies0

.2.4

.6.8

1T

ran

sitio

n %

2000m1 2002m1 2004m1 2006m1 2008m1 2010m1 2012m1Month of Transition

Binary_Probit_Regression O_1_Median_Variable

0.2

.4.6

.81

Tra

nsitio

n %

2000m1 2002m1 2004m1 2006m1 2008m1 2010m1 2012m1Month of Transition

Binary_Probit_Regression O_1_Median_Variable

Binary (Probit) Model Downgrade

0.1

.2.3

.4T

rans

ition

%

2000m1 2002m1 2004m1 2006m1 2008m1 2010m1 2012m1 2014m1 2016m1Month of Transition

Actuals BaselineFSA Scenario4Custom

0.0

2.0

4.0

6.0

8T

rans

ition

%

2000m1 2002m1 2004m1 2006m1 2008m1 2010m1 2012m1 2014m1 2016m1Month of Transition

Actuals BaselineFSA Scenario4Custom

CaaC to DefaultBaa to A

Binary (Probit) Model Upgrade

Page 24: Downside Risks to the Macro Outlook: Retail Credit Risk Implications

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Case Study: UK Mortgage Market

Page 25: Downside Risks to the Macro Outlook: Retail Credit Risk Implications

Econometric model – Dynamic Panel Data Techniques

Time series performance for a given vintage and

segment

= f

Lifecycle component

» Dynamic evolution of vintages as they mature

» Nonlinear model against “age"

(1) Lifecycle component

Pool-specific quality component

» Vintage attributes (LTV, asset class/collateral type, geography,

etc.) define heterogeneity across cohorts

» Early arrears serve as proxies for underlying vintage quality

» Economic conditions at origination matter

» Econometric technique accounts for time-constant,

unobserved effect

(2) Vintage-quality component

Business cycle exposure component

» Sensitivity of performance to the evolution of

macroeconomic and credit series

(3) Business cycle exposure component

25

Page 26: Downside Risks to the Macro Outlook: Retail Credit Risk Implications

Lifecycle ComponentLifecycle Component

Modelling Approach

Consumer Credit Forecasting

Total delinquency rate (% of out. £) against months-on-book

26

Page 27: Downside Risks to the Macro Outlook: Retail Credit Risk Implications

Vintage-QualityVintage-QualityModelling Approach

Consumer Credit Forecasting

Vintage quality index (left) and Disposable Income Growth (right) against vintages

27

Page 28: Downside Risks to the Macro Outlook: Retail Credit Risk Implications

- Baseline Scenario- Stressed Scenario

Exposure to theBusiness CycleExposure to theBusiness Cycle

Modelling Approach

Consumer Credit Forecasting

Total delinquency rate (% of out. £) under different economic scenarios

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Page 29: Downside Risks to the Macro Outlook: Retail Credit Risk Implications

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