Default rate of corporate debts and their portfolios - Book review of ‘Credit risk modeling using Excel and VBA’

I read this book since credit risk management of collateral loans is key to manage the performance of CLO tranches. In fact, it may be useful for any structured product’s credit analysis.

Individual level

There are two default prediction methods for individual debt: regression analysis and structured method. Regression analysis uses logistic regression and explanatory variables to predict default probability of a borrower. A credit score can be derived during this process to indicate borrower’s ability to repay the debt.

What side incomes may I own in the future?

Credit Cards

Credit cards are vastly used in US, and they give many benefits to card owners.

Sign-up bonus: It requires card owner to finish a total transaction amount to get this bonus. For example, the Chase Freedom credit card provide a $150 bonus if new card owner spends $500+ in first three months. The equivalent annual return is 120% (150/500 * 4). The zero annual fee makes holding this card no future cost. Similar cards include Chase freedom, Chase freedom unlimited, Discover, American Express Blue cash, etc.

What information do we need to rate a CLO investment?

CLO is a kind of securitized products which build CLO tranches based on cash flows from a leveraged loans pool. In order to analyze the performance of CLO tranches, we need to know the information of the leveraged loans in the pool. These loans’ Probability of Default (PD), Recovery Rate (RR), Default Correlations and Prepayment rates, are needed for us to have a better understanding of a CLO deal.

Here I would like to introduce a Moody’s methodology ^[1] on CLO analysis. The methodology is aimed to give a rating to CLO tranches. Since prepayment do not affect the credit rating, so no prepayment is discussed here.  

Experiences of top quants

-Book review of ‘How I became a quant’

This book tells stories of 25 famous quants, and their stories were written by quants themselves. So, you will see their different writing styles and experiences.

·      Most of them have a Doctor’s degree in STEM. It is reasonable because quants need to apply quantitative skills in solving financial problems, and advanced degrees are a proof of their strong academic problem solving skill.

·      25 quants have careers in different areas, including structured finance, portfolio management, risk management, derivatives, algorithmic trading, etc. It shows the broad application of quantitative tools in current finance industry.

·      Many of them worked for small companies focusing on a small area. The other many quants led quantitative groups within big and well known financial groups.

Why CLO may be a good investment opportunity?

Development of CLO

Collateralized loan obligation (CLO) is a form of structured products. It pools hundreds of business loans and passes cash flows to tranches of different priorities in receiving cash flow. Normally, these business loans are from below investment grade companies, which normally need to provide higher yield in their bond issuance. CLO is great at attracting all types of investors from risk averse to risk taking, to invest in corporate debts which were considered risky and not suitable for risk averse investors.

The first CLO was issued in 1987, and it provided incentives for depository banks to securitize these loans and remove these loans from their books by selling them to outside investors. The 2007-08 financial crisis is a big hit on the CLO market, although the key reason for the crisis was from subprime mortgage instead of corporate loans. Investors doubted the safety of CLOs since they have a similar structure with problematic subprime Collateralized debt obligation (CDO) and CDO². However, CLO quickly gained favor from investors, and had been the first type of secured products that recovered to the pre-crisis trading volume.