A classic book on credit risk management is updated to reflect the current economic crisis Credit Risk Management In and Out of the Financial Crisis dissects the 2007-2008 credit crisis and provides solutions for professionals looking to better manage risk through modeling and new technology.

List of Abbreviations xi Preface xv PART ONE Bubbles and Crises: The Global Financial Crisis of 2007 2009 CHAPTER 1 Setting the Stage for Financial Meltdown 3 Introduction 3 The Changing Nature of Banking 3 Reengineering Financial Institutions and Markets 17 Summary 21 Appendix 1.1: Ratings Comparisons for the Three Major Rating Agencies 23 CHAPTER 2 The Three Phases of the Credit Crisis 24 Introduction 24 Bursting of the Credit Bubble 24 Phase 1: Credit Crisis in the Mortgage Market 29 Phase 2: The Crisis Spreads Liquidity Risk 33 Phase 3: The Lehman Failure Underwriting and Political Intervention Risk 37 Summary 43 CHAPTER 3 The Crisis and Regulatory Failure 45 Introduction 45 Crisis Intervention 45 Looking Forward: Restructuring Plans 52 Summary 64 PART TWO Probability of Default Estimation CHAPTER 4 Loans as Options: The Moody s KMV Model 67 Introduction 67 The Link between Loans and Options 67 TheMoody's KMV Model 70 Testing the Accuracy of EDFTM Scores 74 Critiques of Moody's KMV EDFTM Scores 86 Summary 93 Appendix 4.1: Merton's Valuation Model 93 Appendix 4.2: Moody's KMV RiskCalcTM 95 CHAPTER 5 Reduced Form Models: Kamakura s Risk Manager 98 Introduction 98 Deriving Risk-Neutral Probabilities of Default 99 Generalizing the Discrete Model of Risky Debt Pricing 102 The Loss Intensity Process 105 Kamakura's Risk Information Services (KRIS) 108 Determinants of Bond Spreads 110 Summary 114 Appendix 5.1: Understanding a Basic Intensity Process 114 CHAPTER 6 Other Credit Risk Models 117 Introduction 117 Credit Scoring Systems 117 Mortality Rate Systems 121 Artificial Neural Networks 125 Comparison of Default Probability Estimation Models 127 Summary 131 PART THREE Estimation of Other Model Parameters CHAPTER 7 A Critical Parameter: Loss Given Default 135 Introduction 135 Academic Models of LGD 135 Disentangling LGD and PD 142 Moody's KMV's Approach to LGD Estimation 143 Kamakura's Approach to LGD Estimation 146 Summary 146 CHAPTER 8 The Credit Risk of Portfolios and Correlations 148 Introduction 148 Modern Portfolio Theory (MPT): An Overview 149 Applying MPT to Nontraded Bonds and Loans 150 Estimating Correlations across Nontraded Assets 152 Moody's KMV's Portfolio Manager 153 Kamakura and Other Reduced Form Models 161 Summary 165 PART FOUR Putting the Parameters Together CHAPTER 9 The VAR Approach: CreditMetrics and Other Models 169 Introduction 169 The Concept of Value at Risk 170 Capital Requirements 177 Technical Issues and Problems 180 The Portfolio Approach in CreditMetrics 184 Summary 195 Appendix 9.1: Calculating the Forward Zero Curve for Loan Valuation 195 Appendix 9.2: Estimating Unexpected Losses Using Extreme Value Theory 200 Appendix 9.3: The Simplified Two-Asset Subportfolio Solution to the N-Asset Portfolio Case 202 Appendix 9.4: CreditMetrics and Swap Credit Risk 202 CHAPTER 10 Stress Testing Credit Risk Models: Algorithmics Mark-to-Future 208 Introduction 208 Back-Testing Credit Risk Models 209 Using the Algorithmics Mark-to-Future Model 215 Stress Testing U.S. Banks in 2009 220 Summary 227 CHAPTER 11 RAROC Models 228 Introduction 228 What Is RAROC? 228 RAROC, ROA, and RORAC 229 Alternative Forms of RAROC 230 The RAROC Denominator and Correlations 235 RAROC and EVA 238 Summary 238 PART FIVE Credit Risk Transfer Mechanisms CHAPTER 12 Credit Derivatives 243 Introduction 243 Credit Default Swaps 244 Credit Securitizations 259 Financial Firms' Use of Credit Derivatives 269 CDS Spreads and Rating Agency Rating Systems 269 Summary 271 Appendix 12.1: Pricing the CDS Spread with Counterparty Credit Risk Exposure 272 CHAPTER 13 Capital Regulation 274 Introduction 274 The 2006 Basel II Plan 275 Summary 296 Appendix 13.1: Loan Rating Systems 297 Notes 303 Bibliography 341 Index 365

Anthony Saunders is the John M. Schiff Professor of Finance and former chair of the Department of Finance at the Stern School of Business at New York University. He holds positions on the Board of Academic Consultants of the Federal Reserve Board of Governors as well as the Council of Research Advisors for the Federal National Mortgage Association, and has been a visiting scholar at the Comptroller of the Currency and at the International Monetary Fund. Linda Allen is the Presidential Professor of Finance at the Zicklin School of Business at Baruch College, City University of New York (CUNY), and Adjunct Professor of Finance at the Stern School of Business, New York University. She has been a member of the Standard & Poor's Academic Council since its formation in 2004. Professor Allen has published extensively in top academic journals in finance and economics.