CR 1 – Fundamentals of Credit Risk

Credit risk is the chance of losing money because a counterparty does not honor a financial obligation, whether that obligation is a sum of money owed, a commitment to perform, or a claim that must be settled. The party carrying the obligation is called the obligor. Most obligations sit inside a contract that creates a legal liability to pay or to perform, but a contract does not have to be written down to count, because an oral agreement can also bind the parties in law. So the search for credit risk cannot stop at the documents on file; any promise another party has made to you is a candidate.

A loss can arrive through three different doors, and each one behaves differently once trouble starts.

Inability to pay

The common case is an obligor that simply does not have the money. A typical story is a company that borrows heavily to fund fast expansion and then discovers that operating cash flow is too thin to meet the repayments. Other firms see their products or services become obsolete, or watch revenue shrink until it no longer covers operating and financing costs. When a payment date arrives and the cash is not there, the firm defaults, and the lender and every other counterparty may take a loss. A growing share of these cases follows a sudden, uninsured event that wipes out a business very quickly; the COVID-19 pandemic and the California wildfires of 2020 wiped out many small and medium-sized firms.

Unwillingness to pay

Less often, the obligor can pay but refuses. The usual trigger is a commercial dispute over whether a contract is valid. The consequences for creditors can look the same at first, yet the ending is often kinder: if the dispute goes to court and the lender wins, the borrower still has the means to pay, so the amount owed is recovered and the final loss shrinks or disappears.

Nontimeliness of payment

Credit losses also come from timing alone. Money that is repaid late costs the lender or trade creditor either the interest income it could have earned or the finance charges on the working capital it had to borrow in the meantime. The principal comes back in full, but the time value of money is lost.

Political risk on top of credit risk

An obligor that is both able and willing to pay can still fail its creditors when its government intervenes. In 2002 Argentina forced banks to convert dollar-denominated deposits and debts into Argentine pesos, a measure known as pesification. Firms operating there saw their U.S. dollar bank deposits lose value, and their loans and trade credits lost even more, because the conversion rate applied to loans was harsher than the one applied to deposits.

Time is risk

Every credit exposure shares one feature: the longer the contract runs, the riskier it is, since each extra day is another day on which the obligor could become unable, unwilling or late. Whatever the transaction, three questions frame the analysis. How much could be lost, or what would it cost, if the obligor fails to pay or perform? How likely is the counterparty to default? And if it does, what remedy exists, how much can be recovered, how long will recovery take, and what will it cost to pursue?

Three words are often used as if they meant the same thing, yet each describes a different state or event, and keeping them apart makes it much easier to read a credit file.

Insolvency is a financial state

An obligor is insolvent when its liabilities are larger than its assets. Insolvency describes the shape of the balance sheet, not an action. A firm in this condition may keep paying its bills for some time, which is why people who treat insolvency and bankruptcy as synonyms are mixing up a condition with a legal event.

Default is a missed obligation

Default is the failure to meet a contractual obligation, most often by not paying. It usually, though not always, springs from either insolvency or illiquidity. Illiquidity means the obligor does not have cash on hand when a payment falls due, even if its assets on paper exceed its debts. A refusal to pay in a commercial dispute can also produce a default with neither insolvency nor illiquidity behind it.

Bankruptcy is a court process

Bankruptcy begins when a court becomes involved after a default, typically because the company files for protection. In the United States the filing is made under either Chapter 11 or Chapter 7 of federal bankruptcy law. The court examines the finances of the defaulted entity and negotiates with management, creditors and sometimes equity owners. Wherever it can, the court tries to keep the business running by selling assets or reworking financing with lenders. The process ends either in a restructuring of the business or, if no viable restructuring exists, in its dissolution.

Before credit risk can be managed, every situation in which a counterparty failure could cost money has to be found. For a long time the job was fairly easy: credit risk was managed mainly in bank lending and in trade receivables, and a handy rule was to look for cash or goods changing hands at the start of a commercial agreement, since the danger was that the cash would not come back or the goods would not be paid for. Modern banking products broke that rule. Derivatives in particular can build up very large credit exposures without anyone lending money or selling a product. Seven recurring arrangements cover most of the ground.

The seven transaction types

Lending is the clearest case: cash leaves the lender at the outset against a promise of repayment on a schedule. A lease is the second. The lessor makes equipment or a building available to the lessee, who commits to regular future payments, and because the lessor has usually borrowed to buy the asset, it relies on those lease payments to service its own debt. Third comes the account receivable, created when a product is shipped or a service performed before payment; the seller invoices the buyer, who then has a few weeks to settle.

Prepayment for goods or services reverses the direction. The buyer pays first and expects delivery at a set time and quality, so a supplier failure can destroy the advance and also cause business interruption costs. The fifth type is a claim on an asset held by another party, a bank deposit being the standard example. Most individuals pick a bank for its services or a branch near home rather than for its financial strength. Large corporations hold far more cash, so they check a bank’s creditworthiness before using it and spread deposits across several banks to avoid concentration, because the Federal Deposit Insurance Corporation (FDIC) covers only $250,000 per account. The collapse of MF Global in 2011 reminded many investors to think hard about cash left with a broker and about the limits of Securities Investor Protection Corporation (SIPC) cover or its equivalent abroad.

The sixth type is a contingent claim, a claim that exists only if some event happens. A policyholder has no claim on an insurer when the policy is written, but acquires one the moment a covered loss occurs, and an insurer that then fails to pay inflicts a credit loss. A pension fund likewise holds a contingent claim on its sponsor if the fund’s liabilities come to exceed its assets; nobody lent or prepaid anything, yet plan participants bear credit risk if the sponsor cannot honor those liabilities. The seventh type is the derivative exposure found in interest rate swaps, foreign exchange futures and similar contracts. Both sides promise future payments whose size depends on the market value of an underlying, such as the U.S. dollar against the Japanese yen. No cash goes out at the start, but a counterparty’s distress produces the same result as a loan default: lost money. Repurchase agreements, options and short sales of shares create credit risk through the same channel.

The third column is added here to show how weak the old rule of thumb is: two of the seven types can cause a loss without any value changing hands up front.

These groupings are broad categories, and each splits further into specific instruments. Money lent, for example, may be extended as a bank loan, a consumer loan, a corporate bond, commercial paper or asset-based lending.

U.S. debt markets carried roughly $55.5 trillion of debt as of September 30, 2020, but a large part of that total carries little or no credit risk: U.S. Treasury obligations, debt of government-sponsored enterprises (GSE, or “agency” obligations) and agency-backed mortgage obligations. Once those are set aside, the instruments that do carry credit risk are dominated by the corporate sector, which issues them as corporate bonds, bank loans and commercial paper.

By instrument and by issuer

Z.1 Financial Accounts data from the Federal Reserve for that date, grouped by instrument, put corporate bonds well ahead of every other category. Bank loans and consumer credit come next at broadly similar sizes, municipal bonds follow, and open market paper is the smallest. Grouped by the type of entity that borrowed, domestic financial corporations are by far the largest source of credit exposure, ahead of domestic nonfinancial corporations, households, and state and local governments. Federal government debt and household mortgage debt are left out of this picture on purpose, because the first is usually treated as free of credit risk and most of the second is agency backed, so a case can be made that neither carries credit exposure.

Order read from Z.1 Financial Accounts charts published by the Federal Reserve (USD billions). Bank deposits fall outside the Federal Reserve measure of credit market debt.

Trade receivables and derivatives

Trade credit is another huge pool. U.S. corporations together hold over $5 trillion of trade receivables, which represents 89% of all trade receivables as of September 2020.

Derivatives dwarf everything else on a notional basis. The potential notional credit exposure from derivative transactions at June 2020 was estimated at over $600 trillion worldwide. Over-the-counter (OTC) contracts make up the great bulk of it, with OTC interest rate contracts by far the largest slice, followed at a distance by foreign exchange contracts; credit default swaps, other credit derivatives, commodity contracts and equity-linked contracts are thin slivers. The figure printed for contracts traded on exchanges is roughly $30 billion.

Notional value measures gross credit exposure, the most conservative way to state credit risk, because it ignores netting, collateral and the fact that a derivative’s replacement cost is normally a small fraction of its notional. So the $600 trillion headline is a ceiling on what is at stake, not an estimate of likely losses.

Every institution and every household holds credit risk, some by design and some without noticing. Holding it is not always a bad thing. Banks and hedge funds exist to earn money from originating and managing credit risk, and individuals who buy fixed income bond funds do so to collect a higher return than U.S. Treasury bonds would pay. For industrial companies and service providers the position is different: they sell without asking for payment in advance, so credit risk arrives as an unavoidable side effect of their main business.

Who holds the debt

Looking at who owns the debt securities issued by corporations and other borrowers, the Federal Reserve data put financial institutions (public and private pension funds, mutual funds, banks, insurers and others) in front. Households and nonprofits are the next largest holders, then foreign entities, while domestic nonfinancial companies and the government sector (federal, state and local) hold the least. That pattern is what one would expect, since neither governments nor nonfinancial companies exist to invest in debt or to take credit risk as a core activity.

Within the financial sector, depository institutions and mutual funds (including money market funds) hold the most, at almost $12 and $10 trillion respectively. Insurers, pension plans and finance companies each hold about half as much. With exposures of that size, it is easy to see why financial institutions keep large teams of credit risk managers.

Z.1 Financial Accounts of the Federal Reserve, September 30, 2020 (the original chart is in USD billions).

Willing and unwilling holders

A useful way to sort the players is by motive. Some take credit risk as their product: banks lend, asset managers and hedge funds invest, and insurers invest premium float. Others hold it as a by-product: corporations through receivables and supply contracts, and households through deposits, advance payments and fund choices. The willing holders build specialist teams and models; the unwilling ones often lack that expertise, which is exactly why their losses can come as a surprise. The sections that follow take each group in turn, starting with the financial institutions that carry the largest exposures.

Banks are in the business of extending credit, so they hold the largest credit portfolios and run the most sophisticated risk organizations. Their appetite has nonetheless fallen over time. Lending margins are thin and regulatory capital requirements are high, and the work regulators around the world are doing to strengthen the financial system will make banks even more reluctant to take on credit risk. Large banks have moved toward fee-earning work such as mergers-and-acquisitions advice and debt and equity issuance.

Loans and lines of credit

Loans and credit lines remain the largest source of credit risk on a bank’s books. With corporate clients, a bank often extends them to build the relationship, accepting that the loan on its own may not earn an adequate return on capital. Because these facilities could produce large losses, banks keep teams whose whole job is analyzing borrowers and reviewing loan documentation, and they increasingly hedge the exposure in the capital markets.

Loans also include asset-based lending such as repurchase agreements (repos) and securities lending. Here the bank lends cash or securities and takes collateral, for example Treasury bonds or equity. If the borrower fails to repay or to return the securities, the bank sells the collateral and its loss shrinks or vanishes. In principle the collateral covers the loan in full. The weak point is that collateral values can drop sharply in volatile markets, precisely when counterparties are most likely to default, so banks watch these exposures closely.

Derivative counterparty exposure

After loans, derivatives generate a bank’s largest credit exposure, a form known as derivative counterparty exposure. JPMorgan Chase & Co. offers a sense of scale. At the end of 2020 its derivative receivables exposure on a fair-value basis was $707 billion, led by interest rate contracts, with foreign exchange next and smaller amounts from credit derivatives, equity and commodity contracts. After netting cash and liquid securities collateral, the exposure was approximately $80 billion, against an equity base of almost $280 billion.

A worked collateral scenario

Suppose, with original numbers, a bank lends $100 million in a repo against equity collateral worth $105 million. If the equity market falls 20% and the counterparty defaults at that moment, the collateral is worth 105 × 0.80 = $84 million, leaving the bank $16 million short. The collateral that looked ample at inception fails exactly when it is needed, which is the timing problem described above.

Asset managers pool money from individuals and institutions and invest it to meet each client’s goals for risk and return. A cautious investor focused on keeping principal safe tends to choose a money market fund, which holds mostly short-term, high-quality debt, while an investor willing to take more risk may prefer funds in equities or emerging market debt and equity. The industry is enormous: in the United States, Blackrock and Vanguard Group are examples of firms running more than $5 trillion of third-party money.

Asset managers carry credit risk for clients

Because they invest so much, asset managers face large credit exposures on their clients’ behalf, and managing that risk is central to how they earn their fees. Every investment decision weighs the creditworthiness of the corporate or sovereign issuer, since a default would drag down fund performance and could cost clients money. A portfolio manager may be drawn to bonds promising high yields; the fund’s risk managers push back because the higher yield comes with a real chance that the money is never repaid.

Hedge funds take credit risk on purpose

Hedge funds also invest large sums daily and hold matching credit exposures. Their investors accept more risk but demand higher returns, so hedge funds behave more aggressively and use riskier instruments that traditional managers often cannot access. That activity makes many transactions possible by absorbing risk others will not hold: hedge funds buy distressed loans, write protection that pays out if a borrower’s credit quality weakens, and take the riskiest slices of commercial real estate financing. When they own risky debt of a company in restructuring, they often play an active role to maximize their recovery.

What sets some hedge funds apart is that they treat a possible default as a chance to deploy capital. A bank hires credit risk managers to avoid counterparty defaults and protect shareholders; some hedge funds instead put resources into finding entities likely to default and then use short sales or written options that pay off when financial distress hits. A bank with an exposure may hedge it to recover a credit loss, while a hedge fund can profit from an obligor’s distress with no exposure to it at all. Credit default swaps (CDSs) make this easy, because they let an investor “short” credit and gain when the finances of a company or country deteriorate.

When the short goes wrong

Shorting credit or shares is risky for fundamental reasons, since a new management team may turn the business around, and for technical ones, since supply and demand in the market can create severe stress. Melvin Capital showed the second danger in January 2021. Expecting GameStop, a video game and consumer electronics retailer, to weaken, Melvin borrowed shares on a large scale, promising to return them on a set date, and sold them at market prices between $10 and $15, planning to buy them back cheaper later. Individual investors realized that short sellers would eventually have to buy large numbers of shares, so they bought first. The price climbed instead of falling, at one point reaching close to $350. Melvin closed its positions at a few hundred dollars per share, lost several billion dollars, and needed a rescue from Citadel and Point72 without which it would probably have defaulted.

Insurers meet credit risk in three places: underwriting, the investment portfolio, and reinsurance recoverables.

Underwriting

Some insurers sell protection against other firms’ credit risk, through trade credit insurance on receivables and through surety bonds. When a company they cover defaults, insurers and reinsurers can lose heavily; when the British travel agency Thomas Cook went bankrupt in 2019, insurers and reinsurers together lost hundreds of millions of dollars.

The investment portfolio

Like an asset manager, an insurer has large sums to invest. It collects premiums, invests them, and pays claims later, and many insurers lose money on underwriting (claims plus operating expenses above premiums for a block of policies) yet still report a profit thanks to the float earned before claims are paid. Warren Buffett, whose holdings include GEICO, regularly explains to Berkshire Hathaway shareholders why he values this source of investable cash. On the balance sheet, claims reserves and equity sit on the liability side against investments on the asset side; the reserves exist to pay policyholders, and only what is left after all claims belongs to shareholders. MetLife, Inc., one of the largest U.S. life insurance groups, reported $480 billion of general account assets, meaning reserves plus equity, in the fourth quarter of 2020.

Credit risk is therefore one of the central criteria in an insurer’s strategic asset allocation, and it involves a trade-off: higher expected return favors shareholders, while a low risk profile protects policyholders. That tension disappears in a mutually owned insurer, whose owners are its policyholders. Portfolios combine large holdings of safe Treasury bonds with riskier, higher-yielding debt from commercial real estate vehicles and sometimes leveraged equity stakes in hedge funds, and insurers keep dedicated credit teams even when outside managers run the money day to day.

Life insurers also manage money for policyholders in separate accounts, which never belong to shareholders. MetLife held another $162 billion in separate account assets in 2020. Credit losses there usually do not hit shareholders directly, yet they can damage the insurer’s reputation and future business. Where the insurer has guaranteed a minimum investment return, severe credit losses may force it to draw on its own capital to keep the promise, possibly to the point of insolvency.

Reinsurance receivables and recoverables

Insurers pass part of their risk to reinsurers, a market dominated by a few large, mostly European firms such as Swiss Re (Switzerland) and Munich Re (Germany). The insurer buys a reinsurance policy and pays a premium; when a policyholder claims, the insurer passes part of the claim on, creating a reinsurance receivable due within a few weeks while the reinsurer checks it. For small, frequent losses the credit risk is mostly this short time lag, since the premiums paid roughly match the claims, and the danger is that the reinsurer vanishes in between. For catastrophes such as an earthquake or hurricane the exposure is much larger, so insurers spread risk across many reinsurers, which is hard in a concentrated industry.

For some liability policies, decades can pass between collecting premiums and settling claims. The insurer estimates those future claims, and the reinsurer’s share becomes a reinsurance recoverable, an asset contingent on the insurer eventually paying policyholders. It is larger than receivables on paid losses and is usually the biggest asset after invested assets.

Alternative capital

Reinsurance is more than 150 years old, but over the past 20 years investors have joined the market, attracted by solid returns (absent natural catastrophes) and low correlation with other asset classes. Of $600 billion of capital in reinsurance, close to $100 billion was alternative capital at the end of 2020, about one sixth (100 ÷ 600 = 16.7%). Insurers do not want these investors’ credit risk, so the capital is typically fully collateralized: investors post cash up front equal to their maximum liability, which eliminates the credit risk.

Nonfinancial corporations would rather not carry credit risk, yet they cannot avoid it, and their position is uncomfortable. Investors, rating agencies and other stakeholders tolerate few credit losses, while credit management lies outside the firm’s core skills. When a customer goes bankrupt, the list of its creditors is published and often reported in the media, and the supplier named on it can suffer bad publicity, a weaker share price and questions about the quality of its operations. Many retailers filed for bankruptcy in the late 2010s as shopping moved online; when Neiman Marcus filed in May 2020, luxury brands including Chanel, Gucci and Prada appeared among creditors owed millions of dollars of unpaid invoices.

Accounts receivable

Receivables are the largest source of corporate credit risk, because selling without advance payment amounts to lending short term to the customer. The stronger the customer, the longer and easier the terms it can demand; Walmart (United States) and Carrefour (France) are well known for extracting such terms from suppliers. Judging customers is hard. A few large clients publish timely information, but most business customers are small firms with unreliable data, and although developed economies have pushed toward compulsory publication of financial statements over the past 20 years, gaps remain.

So corporate risk managers decide on patchy information, helped by data vendors holding millions of records on financials and payment behavior, often summarized in a credit score. Dun & Bradstreet leads in the United States, Bureau Van Dijk (acquired in 2017 by Moody’s Corporation) in Europe, and Teikoku Databank in Japan. A firm deciding whether to sell can also reduce the exposure: it can buy insurance on its receivables, sell them to a factoring company that supplies both cash and credit protection, or secure foreign sales with documentary credit.

Surplus cash

The second source is cash waiting to be invested. When long-dated bond demand is strong and yields are low, large companies draw credit lines or issue bonds without an immediate need, building war chests for acquisitions. Until it is used, that cash sits in bank deposits and short-term securities, both of which carry credit risk. Companies generally stay conservative here, since bondholders gain nothing by handing cash to a company that just buys securities they could buy themselves. The 2007 crisis showed that even cash is not safe, so firms vet their banks and spread deposits, accepting that no bank is “too big to fail.”

Commodity derivatives and forwards

For some sectors the third source is derivative trading. Food companies buy agricultural futures and utilities buy fuel futures to fix the cost of running power plants, and both sides face the risk that the other cannot make or take delivery. Exchange clearinghouses limit this with margins that move with the commodity price and a backstop if margin falls short. Many firms, though, trade forwards away from any exchange, where exposure is large on both sides: a defaulting counterparty forces the firm into the spot market, mismatching costs and revenues. So it is in agriculture, food, energy and utilities that corporate credit teams tend to be most developed.

Vendor financing and the supply chain

Makers of expensive equipment often run financing arms, such as IBM Global Financing, Caterpillar Financial Services and Ford Motor Credit Company, which serve only the parent’s customers and act like nondepository banks: they buy equipment from the parent with borrowed money and lease or rent it out, so customer defaults become their credit losses. A newer source is the supply chain. When Apple relied on a single screen supplier for some Apple Watches, it kept GT Advanced Technologies afloat with capital rather than face its liquidation. When Hanjin, the South Korean shipping company, defaulted in 2016, ports refused its ships until fees were paid, and containers reportedly holding $14 billion of goods were stranded at sea.

A pension fund sponsor, typically a corporate employer, invests on behalf of plan members much as a life insurer invests for policyholders. At September 2020, private sector and corporate sponsors held $3.5 trillion of defined benefit pension assets, U.S. state and local government plans held $9 trillion, and U.S. federal government plans held $3.8 trillion.

Much of this money sits in credit risky assets. Private funds must follow the prudent-investor rules of ERISA (the Employee Retirement Income Security Act of 1974), and public funds face similar standards, so both must actively manage credit risk even when outside managers run the portfolios. Plan members also hold the contingent claim described earlier: if the fund’s liabilities exceed its assets, they depend on the sponsor’s ability to make up the gap.

Households

Few people think of themselves as credit risk takers, yet every household is one. A family that pays a contractor in advance for a home renovation that is never finished has suffered a credit loss in the plainest sense. Individuals also take credit risk when investing, in the same way insurers and corporations do, chiefly through their choice of fund: picking a high-yield fund rather than an investment-grade bond fund buys extra yield with extra credit risk.

Bank deposits are the third channel. Regulators close banks regularly, and clients can lose money when that happens. Most countries offer some protection; in the United States the FDIC guarantees deposits up to $250,000 per account. A household with $400,000 in a single account at a failed bank (an original figure) would therefore have $150,000 unprotected, which is why spreading large balances across accounts or banks matters for individuals as much as for corporations.

Credit risk is controllable. Exposure does not fall on a company from nowhere; it grows out of transactions the firm chose to enter. When its sources are understood and can be anticipated, failing to manage it is hard to excuse.

Credit risk is also a product of human behavior. An obligor reaches a precarious position because its managers made certain decisions, and those decisions follow from the incentives they face, and from those of the shareholders they act for. Understanding what drives management and owners is therefore part of judging a counterparty’s credit profile, alongside its financial statements.

Capital and the shape of credit losses

Credit exposure is capital intensive. A credit portfolio produces many small losses that can be expected and budgeted for, but it also carries a small chance of very large losses that could be fatal. Surviving those requires a large equity base, and weak management of the portfolio can be costly enough to end in bankruptcy.

Three reasons every firm should care

Survival. Large credit losses can bankrupt a financial institution, and a nonfinancial corporation can be brought down the same way. Profitability. It sounds obvious that losing less means earning more, but that observation captures most of what drives profit, especially in low-margin businesses. Return on equity. A firm holding too much equity cannot earn an adequate return on it, and leaning on debt instead is no answer, since debt does not absorb losses and can add risk. Long-term survival needs enough equity capital combined with prudent risk management.

During the 2007 crisis some global institutions fared much better than their peers because strong credit risk management principles kept them afloat. Whatever the economic climate and whatever the type of firm, active management of the credit portfolio can raise return on equity, and the aim is simple to state: earn the most revenue possible from each unit of capital allocated to credit activities.