What is the purpose of analysis? What is risk? What is credit risk? What is the purpose of analysis? In large part, what we do is we try to identify the risk and understand the risks. But then how do we actually analyze that risk? Our objective is in less than one. We will go through the basics of credit risks and credit risk exposures and financial products that involve credit risk. As I said, traditionally, when we think of creditors we are thinking about making a loan or buying a corporate bond. As I had mentioned, that credit risks can arise in so many different ways, not in just the conventional or traditional ways as well. Let's try to categorize that risk and define it. As we had said, one of the first things we do is credit risk management, we try to analyze that in terms of analyzing who is our counterparty? Who is that obligor? Who's the borrower. Who's the client? Who is the entity? What is that entity that actually owes us money or has an obligation to perform? Normally what we do is we do a financial analysis of that particular borrower, understand the financial condition. The details of financial analysis are out of the scope of this course. But what we'll talk about is some of the basics of what we're doing. Why is there credit analysis? What are we actually doing? We won't get into the details of analysis, but we'll talk about scoping out what should analysis do. I want to understand is a company performing, how well is the company performing, so it will increase, or I can predict with meaningfulness what that probability of default is. Now what we do is that when we do an analysis, we then summarize that analysis in terms of a credit rating and that's what we're going to cover also in lesson 1. As we have said, credit analysis involves a lender and an investor that has a relationship of some kind with a borrower, issuer, or counterparty. We're starting with I have a lender and that lender has a relationship with a borrower, issuer, counterparty, or client. It involves two parties. I have credit exposure. Then, of course, I want to make sure that I have a high probability of payback, a high probability of meeting all principal and interest payments as scheduled. Now, the relationship between the borrower and lender, of course, exists within the operating environment. The operating environment will have impact on the borrower, it will also have impact on the lender as well. When we're analyzing, and I'm speaking from the point of view of the lender or the investor, I have to analyze the borrower, but then also I have to analyze the operating environment, the credit markets, the macroeconomy, and to the extent that could have some impact on me, but it also can have impacts on the borrower as well. Credit analysis allows us to gauge, A, should I do the transaction? If I do this transaction, how should that transaction be structured? To help us understand, should I be willing to take on that credit risk, of course, we perform credit analysis. Very, very formally, credit exposure arises because of the risk of non-performance and non-payment. I have the relationship between the borrower and the lender. As I said, it can not only be the borrower, let's also say that it's going to be the counterparty, it can be the client, it can be a guarantor. If it's a guarantor, I can make a loan to the borrower, and then the borrower is guaranteed. It introduces a third party, at which point in time I need to analyze can the guarantor assure that there will be payments of principal and interests. No matter what type of exposure it is, A, what I'm going to do is that how does it arise? Initially, it's going to rise because I agreed to do a loan. It could be other ways that it could arise if it's a revolving credit facility, I don't have the exposure until there's a drawdown under the revolving credit. There we're going to say, how do we analyze that exposure? How do we measure what the exposure is? How do we monitor it from period to period? Very very easily we can think of this as I make a loan for $1 million. Then I analyze how and before I make the loan, I'm going to run an analysis to make sure that the borrower is credit-worthy. Then throughout the time of the borrowing, I'm going to try to measure that risk and then I also measure the likelihood that the borrower will perform on that. We analyze it, we measure it, and we monitor it. We also structure it at an outset. When I say structuring, that means if I make that $1 million loan, I have to determine the terms of that loan. Long-term, short-term three years, five years, one year, 10 years. I also have to understand, should I require collateral? Certain situations and we will get through this and through in the other modules is we'll understand that I will only be able to take this risk if I can manage or reduce this risk by having a resort to another source of payback. That would be say, for a collateral. Then when I make that loan, during the life of the loan, I might say, "How can I reduce it, transfer it, or eliminate it?" Can I do so? I make the loan, I put the loan in the book, I have books, I have the exposure, I have the risk. Is there some tool of being able to reduce that risk as we go forward? We're starting from the beginning. Right at the beginning as I said, we need to understand who that counterparty is and that's going to involve analysis. As I had said, this is not a course in how best to do the analysis, it's trying to understand the importance of doing analysis when we have credit risk. Traditionally, we have a credit analysis presentation, whether you're talking about a group of debt investors or bond investors or a bank, we do credit analysis. That's really financial analysis along with another factor. What we're trying to do is reach a risk decision. Should we take on the risk, should we take on exposure or not? This is credit risk as opposed to say a market risk, or liquidity risk, or other types of risks. This is should I take on that obligor? Should I take on that borrower? Traditional credit analysis usually involves a certain amount of financial analysis. How strong financially, in terms of its operating earnings, its balance sheet is that obligor? Is it strong, very good, weak, or poor? That's going to help me lead to my risk decision. To the state that it is weak, I might be less inclined to do that exposure or grant that exposure or do that particular loan. But as I had said, it also involves the operating environment as well. What I will do is I'll analyze the borrower, but I also want to understand the operating environment, the macroeconomy, the sovereign risk, the country risk, the legal risk. I want to understand the context of the scenario in which I am doing this particular loan. Then I'm going to combine that with a number of other factors. I'm going to go back and look at lessons in the past. I'm going to look at history. I'm going to look at my own experiences and I'm also going to use common sense and judgment to come up with a risk assessment. We're going to come up with a risk assessment and in this course when we talk about that, we're talking about what we'd like to do in the world of credit risk management and credit analysis is come up with a rating. Now, most people are aware that a rating is something that Fitch S&P or Moody's will offer. Fitch, that's what they do, is that they provide ratings for obligors, for companies that can help us understand the risk of non-payment or the probability of default. The vast number of borrowers and obligors and counterparts don't necessarily have ratings. As institutions or banks, or lenders, or investors, sometimes we have to do our own analysis and come up with our own judgment. But we still come up with an overall assessment. The rating agencies, as I said, use an alphabet rating, AAA, AA, A, all the way down to CCC, CC, C and default. Banks may use a numerical rating, 1-10, 1-18, 1-8, 1-24. They summarize an entire financial condition with a rating. Then from that, we take the rating, BBB, BB on a 1-10 scale five, and then we translate that into a strategy. Do I want to take on this exposure? Am I willing to take a risk? Then as we had said, ultimately, what this does is helps us make a decision. Do we do the transaction? Do we do the loan? Do we buy the bond? Credit risk management helps us make credit risk decisions. This is summarized here. Part of risk management is that we do the financial analysis, we look at the deal, the transaction, the bond purchase, the loan, the loan structure, the counterparty. What are the requirements? What are the commitments? We come up with a rating and then we talk about a strategy and outlook. The risk strategy and outlook is going to be very much directly high to our analysis and rating. The strategy can be, I want to do more business with this client or obligor. I want to do more transactions or trades with this client or obligor. We can expand the relationship, we can increase the relationship, or we might want to say, "Let's keep it flat." Or if we're concerned after we have done the analysis and come up with a rating, we can actually say that we want to reduce. In some situations, we may say we want to get out, or in some situations, we don't want to onboard this client or counterparty. Analysis helps us come up with a rating and then comes up with a strategy as well. Another aspect is outlook. What we want to do is we look at history, we look at the past, but what we would like also to do is have some projection of the future. We want to be as forward-looking as possible. A lot of our understanding of financial performance is going to be based on historicals, but we want to consider what is the outlook in the industry? What is the outlook in the economy and then the operating environment as it relates to today? Then we might want to adjust our decision-making or even adjust our ratings to the extent that, yes I have accounted the history, but I want to make sure that I also have an outlook for the future as well. Then as I had said, ultimately what we are doing is we need to make a decision on a client obligor, a borrower, or a specific transaction. A transaction, deal, an investment opportunity is on the table and I want to be able to make the decision about that.
