In this presentation Gopalkrishna Rajagopal talks about what a financial company is, with examples of who they are and what they do. And goes through the key sectors and the business model they have in place at the Williams Capital Group.

1. Eland Capital Division of
The Williams Capital Group, L.P.
September 19, 2011
Credit Scoring for Financial Institutions
Gopalkrishna Rajagopal
Eland Capital, a division of
THE WILLIAMS CAPITAL GROUP, L.P.

2. Eland Capital Division of
The Williams Capital Group, L.P.
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Disclaimer
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3. Eland Capital Division of
The Williams Capital Group, L.P.
Table of Contents
1. Sector Description & Dynamics
2. Scoring Methodology for Issuer Credit
3. Identification of Key Drivers of Default
4. Testing of Model
5. Conclusions
2

4. Eland Capital Division of
The Williams Capital Group, L.P.
Sector Description & Dynamics
SECTION 1
3

5. Eland Capital Division of
The Williams Capital Group, L.P.
What is a Financial Company ?
 We define Financial Companies to be those engaged in asset liability
management:
• Examples:
• A Regional Bank Manages Assets in the form of short term
deposits from retail investors and makes loans to commercial
enterprises.
• A broker dealer executes client transaction either as principal or
as agent on behalf of a client.
 Example of companies that are not financial companies include:
• Visa: Functions as a servicing organization. Does not perform Asset
Liability Management.
4

6. Eland Capital Division of
The Williams Capital Group, L.P.
Key Sectors & Business Model
 Banks
• Vanilla Lending Business Model: Receive short term deposits and
lend money/ make longer dated loans. Warehouse/manage risk unless
securitized.
 Broker Dealers/Private Equity/Investment Management Firms
• Receive deposits and make Investments in a variety of
securities/investments with risk profiles ranging from vanilla to
extremely complex. Entity can act as principal or agent. The
assets/liabilities can be liquid/short dated or very illiquid/long dated.
 REITS
• Short Term liabilities are used to fund highly illiquid and long term
assets. Property REITS involve an equity stake, and Mortgage REITS
involve mortgage investments by the REIT.
 Insurance Companies
• Receive cash from clients and make investments in very long
dated products with market/actuarial risks.
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7. Eland Capital Division of
The Williams Capital Group, L.P.
Definition of Default
 It can be usually defined as
• Failure to pay principal/interest
• Bankruptcy Filing
• Covenant Violation
• Distressed Debt Restructuring where such information is available
 Default is sometimes difficult to define because of restructurings that are
motivated by impending default.
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Positive Resolution
Missed Payment
Grace Period
Negative Resolution
Bankruptcy Filing

8. Eland Capital Division of
The Williams Capital Group, L.P.
Historical Default Data
 Data from FDIC website for failed banks assisted by FDIC.
 409 failed banks (public and private firms) in the last decade
 Defaults are cyclic as expected. Peaks in the business cycle have almost
no defaults. Troughs in the business cycle have more defaults.
 Failures dominated by the credit events of 2008-2009.
 Any credit model/scoring framework for banks would rely heavily on this
period in 2008-2011 to enrich the dataset
7
0
20
40
60
80
100
120
140
160
180
2000 2001 20022003 2004 20052006 2007 2008 20092010 2011
FDIC Failed Banks
Count

9. Eland Capital Division of
The Williams Capital Group, L.P.
Scoring Methodology for Issuer Credit
SECTION 2
8

10. Eland Capital Division of
The Williams Capital Group, L.P.
An Economic Model for Default: The Structural or Merton Model
 Merton Model Assumptions
• Applicable to Public Firms with debt
• Firm is solvent if Assets are greater than Liability
• Equity is a Call option on Assets of firm
• If Assets go below liability, we have default
• Probability that Assets go below Liability over a horizon period =
Probability of Default
• Asset follows a log-normal process.
• Asset price is determined by inverting Black Scholes Formula
9
Liability
Asset
Probability
of default
Asset Price
Liability
Asset Price
Distribution
Horizon of
Interest
Time

11. Eland Capital Division of
The Williams Capital Group, L.P.
An Economic Model for Default: The Structural or Merton Model
 Strict Merton Model does not connect Default Probability to Default Data
 Hence we abstract a parameter called Distance to default
 Distance to Default (Leverage to Risk Ratio)-
 Empirical Default Probability measured from Empirical Default
Distribution
The smaller the DD, the closer the firm is to Default
 Empirical Default Probability = f (DD) where f: non linear function
10
T
T
F
A
AE
DD
A
A
A
2
ln
ln
2

12. Eland Capital Division of
The Williams Capital Group, L.P.
An Economic Model for Default: The Structural or Merton Model for
Financial Institutions - Discussion Points
 Probability of Default: Good measure that can be used to compare firms
of different sizes
 Liabilities (Corporate debt etc) contribute to financing cash flows in non-
financial sectors but are part of the operational cash flows in the financial
sector.
• What are the liabilities ? Only Face value is obtained from Filings. For
1 year horizons does short term debt play a bigger role due to roll-over
risk ?
• Do we include deposits as liabilities ? FDIC insurance exists upto
$250,000 USD. How do we account for that ?
• Asset Liability mixes can change very rapidly in financials firms. Do
Equity prices transmit those changes to DD ?
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13. Eland Capital Division of
The Williams Capital Group, L.P.
Identification of Key Drivers of Default
SECTION 3
12

14. Eland Capital Division of
The Williams Capital Group, L.P.
Identification of Drivers of Default
 General Drivers of Default: Leverage (Distance to Default, Debt to
Equity), Liquidity Ratios (Quick Ratio, Current Ratio)
Sector Specific Drivers of Default
• Banks:
Asset Quality:
• Non Performing Loans to Loan Loss Reserve,
• Texas Ratio (Non Performing Loan + Real Estate
Owned divided by Book Value of equity + Loan Loss
Reserve)
• Tier 1 Capital divided by Risk Weighted assets
Earnings quality:
• Financing Cash Flow to Net Income
Profitability
• Net Interest Margin
13

15. Eland Capital Division of
The Williams Capital Group, L.P.
Drivers of Default
 Synovus:
• Deteriorating Loan Porfolio in 2008 resulted in NPL/LLR reaching level of
over 2 at the height of the credit crisis
• Equity Markets punished Synovus resulting in more than 90% of equity
being wiped out.
• Approximate DD reduces dramatically being driven by the high leverage of
the firm during the height of the crisis
14
0.00
1.00
2.00
3.00
4.00
5.00
6.00
7.00
01-12-2006
01-05-2007
01-10-2007
01-03-2008
01-08-2008
01-01-2009
01-06-2009
01-11-2009
01-04-2010
01-09-2010
01-02-2011
NPL/LLR
DD (approx)
Normalized Equity

16. Eland Capital Division of
The Williams Capital Group, L.P.
Examples of Drivers of Default
Broker Dealers
Asset Quality:
• Tier 1 Capital divided by Risk Weighted assets
• In general firms with better credit have higher Tier 1 Capital
to Risk Weighted Assets. WAMU showed a far lower tier1 to
capital ratio than the other firms in its last days.
15
0
2
4
6
8
10
12
14
16
18
01-09-2006
01-01-2007
01-05-2007
01-09-2007
01-01-2008
01-05-2008
01-09-2008
01-01-2009
01-05-2009
01-09-2009
01-01-2010
01-05-2010
01-09-2010
01-01-2011
01-05-2011
WAMU
C
JPM
GS

17. Eland Capital Division of
The Williams Capital Group, L.P.
Off Balance Sheet Liabilities
 FAS 140 covered QSPEs (Vanilla Securitizations)
 FIN 46 R from 2003 arose as a response to Enron and resulted in
coverage of VIEs (including CP backed VIEs).
 FAS 166/167 arose in response to the credit crisis and replaced the
formulaic approach to determining if consolidation was warranted with a
more judgment based approach. Unconsolidated VIE assets as of 31-Dec
2010 are shown below:
 Judgment should be exercised to decide if the off balance sheet items
are
• a legal liability of the bank
• The extent of Govt. support that is forthcoming for the off balance
sheet liabilities
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18. Eland Capital Division of
The Williams Capital Group, L.P.
Scoring Model: Putting it all together
 Empirical Default Probability = f(DD, Leverage, Asset Quality, Liquidity,
Earnings Quality ratios). Called an Enhanced Merton Model.
 Toy Example: Empirical Default Probability versus DD. Higher DD implies
lower Default Probability
17
-1.8
-1.6
-1.4
-1.2
-1
-0.8
-0.6
-0.4
-0.2
0
-0.5 0 0.5 1 1.5 2 2.5 3
DD
ln(p)

19. Eland Capital Division of
The Williams Capital Group, L.P.
Tests For Scoring Model
SECTION 4
18

20. Eland Capital Division of
The Williams Capital Group, L.P.
0
10
20
30
40
50
60
70
80
90
100
0 10 20 30 40 50 60 70 80 90 100
%DefaultedFirms
% Total Firms
AccuracyRatioTest
Scoring Model: Testing
 Accuracy Ratio Test: Designed for Default Probability type models
•More convex the Cumulative Accuracy Profile is, the better the model
19
Cumulative
Accuracy
profile
Better Model

21. Eland Capital Division of
The Williams Capital Group, L.P.
Scoring Model: Testing
 Ex Ante/Ex Post Test
•Plot of Ex Ante versus Ex-Post Default Probability should lie on a 45
degree line
• Successful test indicates absence of bias
20
0.00%
2.00%
4.00%
6.00%
8.00%
10.00%
12.00%
14.00%
-1.00% 4.00% 9.00% 14.00%
ExAnteDef.Prob
Ex Post Def. Prob
45 degree test

22. Eland Capital Division of
The Williams Capital Group, L.P.
Conclusions
SECTION 6
21

23. Eland Capital Division of
The Williams Capital Group, L.P.
Conclusions
 An outline for a Scoring Frameworks for Financials Institutions is
provided
 Sector Dynamics that drive issuer credit risk are discussed.
 Pros and Cons of the methodology are discussed
 Tests for the scoring method are discussed
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