Credit Risk ManagementRisk Management
Companies seek out more academic models to supplement less than reliable credit ratings
By Susan Kelly
Ron Borcky, global director of credit at International Paper Co. (IP), recalls his surprise back in 2001 when companies that carried investment-grade credit ratings began to "pretty much collapse." If you couldn't depend on the credit ratings agencies to spot trouble, what was the potential for hidden problems at other public companies? Borcky decided that he needed to supplement the various sources of credit data that IP already used to track its tens of thousands of customers and their ability to pay with information from CreditSights Ltd., including its BondScore, a credit risk measure that incorporates the price of a company's equity and the volatility with which it trades. "The more information I can get the better, particularly information that's plugged into the equity market," Borcky says. And that's exactly what IP is able to get from BondScore, where the risk model is based on timely market information.When companies like Enron Corp. went into unexpected tailspins a few years ago, credit risk measures that incorporated stock prices or other financial markets data proved their mettle by picking up on the problems at the companies sooner than the credit rating agencies did. Such measures, sometimes called quantitative credit measures, have been around for years, but until recently most of the companies using them were banks, brokerages and other financial institutions. Now, some sophisticated non-financial corporations are starting to see the value and are opting for market-based credit tools as part of their assessment of the creditworthiness of their customers and vendors. Currently, CreditSights is one of three companies with quantitative credit offerings targeted at corporate credit groups.
IT IS ALL IN Z-SCORE
At IP, the CreditSights information was added to a mix of inputs that includes credit scores that the company generates internally, along with data from two major bond rating agencies, Moody's Investors Service and Standard & Poor's Corp. IP also utilizes business information provider D&B Corp. The CreditSights information "helps us to have a nice balanced overview of a company's risks," Borcky says. "If we have a gap difference between the other rating agencies or our own credit opinion, we would look to see what CreditSights advises."
The notion of using equity prices as part of a formula to quantify a company's credit risk first surfaced in the late 1960s, when Edward Altman, a professor at New York University's Stern School of Business, looked at two groups of industrial companies, one made up of companies that had defaulted and the other companies that hadn't defaulted. Looking back at the period prior to the defaults, Altman analyzed the companies' financial data to identify those numbers that provided early warnings of credit problems. The Z-score he devised includes a number of financial ratios, including one that incorporates the company's stock price.
Meanwhile, economists Fischer Black, Myron Scholes and Robert Merton came up with an insight about the relationship between a company's equity and its debt. "The real simple version is, you think about the level of the firm's assets and how volatile they are," says Christopher Finger, head of credit products at RiskMetrics Group, a financial risk analytics provider. "Based on that, you get an idea of how likely it is their assets drop below a level where they can service their liabilities."
That idea became the basis of the credit risk solutions that a company called KMV began to provide in the late 1980s. Its model for calculating a company's credit risk—its expected default frequency (EDF)—takes into account the company's stock price, the volatility of its stock and its outstanding debt, or leverage. In the years since, KMV, which was acquired by Moody's in 2002, has expanded its credit analysis products, including CreditEdge and RiskCalc, to cover companies all over the world.
Hewlett-Packard Co. (HP) has been using CreditEdge, which provides daily EDFs on more than 25,000 publicly traded companies worldwide, for about two years. Chris Patafio, director of global credit operations at Hewlett-Packard, says the company started using KMV as part of its effort to automate what had been a mostly manual process in which the company's analysts examined customers' financials to assess their creditworthiness. Patafio wanted to free up those credit analysts, who typically have graduate degrees, to spend their time looking at the riskiest customers and he wanted to add "more consistency" to the credit process. CreditEdge helps provide that, Patafio says, because it looks at publicly traded companies all over the world. "So that's one model that gives us one consistent response," he says.
Moody's KMV also helps HP look at private companies, he says, with "country-specific modeling tools" that provide a credit category once HP inputs some financial data. "It's similar to a rating, but more like a statistical calculation of expected time to default," Patafio says. It has also saved the company money, he says. Patafio's not willing to provide exact numbers on savings, but says they reflect an improvement in the company's percentage of bad debt. "Nothing beats your own history [with customers], but being able to layer on top of that a vendor with years and years of data and experience with companies, that's very powerful," he says. CreditEdge also helps the company make the best use of its credit staff by relieving them of "busy work," he says.
A SPRINKLE OF MARKET REALITY