Improving Counterparty Risk Analysis

The substantial recession coupled with increased default rates across a wide-variety of asset classes experienced in the recent financial crisis have highlighted the need for robust credit analysis. Chief in the minds of treasurers and risk managers are fundamental questions about counterparty risk and creditworthiness. To address these questions effectively, companies require enhanced risk management tools with transparent, innovative analytics and accurate fundamental data that allow them to quickly assess the relative credit worthiness of their various counterparties.

Challenges for Corporate Treasurers

In addition to the widespread difficulties with credit worthiness resulting from the financial crisis, two other factors make the job of corporate treasurers increasingly difficult: the interconnected global economy and the speed of transacting business in an evolving digital environment. Treasurers need to manage exposure to a large number of diverse counterparties across their lines of credit, suppliers, purchasers, distributors and investment exposures, and often need to make credit decisions under limited time frames.

Large corporations may have credit exposure to more than 100,000 counterparties that range from global blue-chip corporations to relatively small private companies. Thus, the number of exposures that any single credit analyst must monitor is growing, reducing the time available to look at each exposure at the same time as pressure increases to perform deeper analysis. For example, performing a robust peer-based analysis for a specific company from financial statements can take an analyst several days and even longer if utilising a large peer group. Contributing to the length of this task are making consistent financial line item adjustments and standardising reported financials across global reporting standards and currencies. This can be time consuming and arduous.

Investors, too, need better insight into substantial counterparty risks that may be present in their portfolios along with the ability to assess these same risks across a large universe of potential investments.

Both corporate treasurers and investors face challenges in obtaining accurate and reliable financials for each of their counterparties – particularly within the private company universe. There is clearly a need for better insight into smaller, private, and un-rated firms.

The Credit Crisis and Ongoing Vulnerability

In the rated universe tracked by Standard & Poor’s Ratings Services in 2009, there were 264 corporate defaults globally – the highest annual total since S&P began tracking the number in 1981. This amounted to US$627.7bn in associated securities. Of these defaults, 193 were in the US, 19 in Europe, 36 in the emerging markets, and 17 in the other developed regions (Australia, Canada, Japan, and New Zealand). Moreover, S&P observed increased credit degradation among non-defaulting issues as well.

One-year global corporate rating transition studies indicate that 2009 was one of the most stressful years since S&P began tracking this statistic in 1981 (see Tables 1 & 2.) The number of investment-grade entities transitioning to speculative grade in 2009 was exceeded in only three prior years since 1981. Moreover, the number of speculative-grade entities transitioning to investment grade in 2009 was the lowest percentage in the past 28 years. Defaults for both investment grade and speculative grade entities were near highs in 2009 with investment-grade defaults at 0.32%, exceeded only by 0.41% in 2008, and speculative-grade defaults at 9.23%, exceeded only by 1991’s 11.04% and 2001’s 9.61%.

Table 1: Investment Grade Ratings Transitions

Remained Investment Grade (1981-2009) Remained Investment Grade (2009) Transitioned to Speculative Grade (2009) Defaulted (2009)
92.58% 89.78% 3.34% * 0.32% **

* Exceeded only by 1985-86 and 2002.
** Exceeded only by 2008 where it was 0.41%
Source: Standard & Poor’s Global Fixed Income Research and Standard & Poor’s CreditPro as published in
“Default, Transition, and Recovery: 2009 Annual Global Corporate Default Study And Rating Transitions” of 17 March 2010.

Table 2: Speculative Grade Ratings Transitions

Remained Speculative Grade (1981-2009) Remained Speculative Grade (2009) Transitioned to Investment Grade (2009) Defaulted (2009)
81.79% 78.47% 1.36% * 9.23% **

* Lowest percentage over the last 28 years.
** Exceeded only by 1991 where it was 11.04%, and 2001 where it was 9.61%
Source: Standard & Poor’s Global Fixed Income Research and Standard & Poor’s CreditPro as published in
“Default, Transition, and Recovery: 2009 Annual Global Corporate Default Study And Rating Transitions” of 17 March 2010.

Clearly the markets endured heightened stress over this past credit cycle. If these pressures exist in the relatively transparent and sophisticated rated debt markets, the need for risk analysis in the un-rated and private sectors is likely to be even greater and more difficult to assess.

While we believe the crisis is largely behind us, the slow to moderate recovery that most economists predict will put continued pressure on firms to meet their obligations. S&P predicts unemployment rates to rise slightly over the summer but remain below October’s peak levels. Furthermore, S&P predicts an increase in US real GDP of 3.3% in 2010 and 3.1% in 2011 as compared to US GDP of -2.4% in 2009. The outlook for the US corporate speculative-grade default rate is at 3.5% for the 12 months ending March 2011 with alternative scenarios of 4.9% at the pessimistic end and 3.0% at the optimistic, according to S&P. This baseline scenario equates to 49 speculative-grade defaults compared to 160 in 2009.

Despite what appears to be a rebounding economy and more tepid default forecasts, the markets are still susceptible to major events, particularly over the next two to five years, as recent debt refinancing and extensions come due. European markets are still vulnerable to the fragile economic situations in Greece, Portugal, Italy, Ireland and Spain as well as travel disruptions due to the volcanic eruptions in Iceland. The US stock market’s recent ‘flash crash’ further illustrates the concerns of investors. S&P forecasts eurozone GDP increase of 1.2% in 2010 as compared to a 4.0% decline in 2009. Unemployment is forecasted to rise to 10.4% in the eurozone, with increases in most major European nations except for the UK this coming year. The global prolonged economic stresses do not look to abate anytime soon.

New Analytical Requirements

What do corporate treasurers need to cope with this challenging environment? First, they need better credit risk assessment tools that provide quick, yet robust, comparative analysis and screening based on innovative analytics to serve as a jumping-off point for more detailed analysis. Most market participants have fundamental credit assessment processes in place, but they are not very scalable – a formidable problem when they need to screen and monitor a large number of firms.

A core requirement for these tools is also the ability to build peer groups from fundamental financial data for comparative analysis across accounting standards and currencies. Key to doing this is having innovative analytics that distill the fundamental data into relative scores for assessing the credit worthiness of a firm vis-à-vis its peers.

Note, however, that innovative analytics are not acceptable without being transparent. The methodologies encapsulated in the analytics need to be documented and easily available. Moreover, the underlying data driving the analytics should be easily accessible. Greater transparency is certainly one of the key themes emerging from the recent financial crisis.

Second, the fundamental financial data driving new solutions needs to go beyond just rated entities. Counterparty exposure is not limited to the rated universe and neither is the analysis conducted by treasurers and risk officers. Indeed, there is a particular need for data in the private, un-rated universe. Of course, the financial data needs to be accurate and comparable across companies, sectors, regions, currencies and accounting standards. Thus, adjustments to reported financials need to be handled in a standardised, transparent way.

Finally, it is important that credit risk tools provide additional credit measures such as probability of default and other quantitatively-derived assessments of credit worthiness. These measures serve to round-out the initial analysis and, in the case of probability of default, provide data points that most market participants are already familiar with.

Treasurers need tools that allow them to quickly assess the relative credit worthiness of any company with respect to its peers whether it is rated or un-rated, public or private. This is certainly a tall order, but it is now an important part of an overall robust credit risk assessment process.


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