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.

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