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A Known Unknown?

02/22/2020 01:04 PM

A Known Unknown?

Kamakura Troubled Company Index Increases by 2.02% to 14.92%

NEW YORK, February 4, 2020: The idea that the death of one butterfly could have a far-reaching effect on historical events was first introduced in a 1952 short story by Ray Bradbury, “A Sound of Thunder.”

Could the increase in short-term risk be an indicator of a shift in the credit cycle?

The Kamakura Troubled Company Index® showed a large jump in default risk last month, with a 2.02% rise to 14.92%, resulting in a drop in credit quality from the 42nd percentile to the 34th percentile. The index also displayed a fairly large jump in volatility, ranging during the month from 10.35% to 14.92%. The index reflects the percentage of 40,500 public firms that have a default probability of over 1%. An increase in the index reflects declining credit quality, while a decrease reflects improving credit quality.

At the close of January, the percentage of companies with a default probability between 1% and 5% was 11.73%, an increase of 1.64% from the prior month. The percentage with a default probability between 5% and 10% was 1.93%, an increase of 0.09%. Those with a default probability between 10% and 20% amounted to 0.96% of the total, an increase of 0.18%; and those with a default probability of over 20% amounted to 0.30%, an increase of 0.11% from the prior month. While default probabilities increased across the spectrum, the largest jump was for those in the 1%-to-5% category, indicating an increase in firms showing early signs of stress.

At 14.92%, the Troubled Company Index fell to 34th percentile of historical credit quality as measured since 1990.

Among the 10 riskiest-rated firms listed in January, six are in the U.S., two are in Spain, and one each are in Luxemburg and the U.K. The riskiest rated company in our coverage universe was Deoleo SA (BME:OLE), a Spanish company that is the world’s largest olive oil processor. During the month, it took extraordinary action to avoid bankruptcy, leaving small investors with losses which, in effect, created a selective default. It’s 1-year KDP was 51.58% up 25% for the month and has been over 30% for over a year, providing early warning. Six of the ten riskiest firms are in the energy sector. We also noticed a sharp jump among the riskiest firms’ short-term (30-day KDP) default probability. You can see these results in the charts below.

Ten Riskiest Rated Firms – 1-Year KDP

Ten Riskiest Rated Firms – 1-Month KDP

The Kamakura expected cumulative default curve for all rated companies worldwide narrowed, but the one-year expected default rate increased by 0.28% to 1.29% while the 10-year rate remained 14.23%.

Commentary
By Martin Zorn, President and Chief Operating Officer, Kamakura Corporation

Explaining market moves and credit cycle changes is easy enough in hindsight, especially after a narrative is created by financial journalists. In today’s instant-information, short-attention-span world, headlines seem to explain every move, for example, “Gold slides as potential conflict with Iran eases.”

Speaking of Iran, it seems to have disappeared from the press and the blogosphere these days as news about coronavirus takes its place. Has the Iranian risk really disappeared, or is it simply one more potential event that could disrupt the most benign credit cycle and the longest bull market in history?

We have many of these ”known-unkowns” emerging on a global basis, including the one just mentioned and the question of what happens in the U.S. post-impeachment. Now that Brexit is a done deal, what will happen next in the UK and Europe? And in addition to the health risks it causes, what will be the impact of the coronavirus epidemic on the Chinese markets and the world economy?

If it were possible for me to accurately predict unknown outcomes, I would have bought a lottery ticket and retired long ago. I do not take comfort in deterministic stress tests, nor in quantitative measures based on a limited number of risk factors, nor in normal or log-normal distribution curves—or any other models that are only accepted if they produce intuitive results. Perhaps the best preparation for risk management is to reread Roger Lowenstein’s excellent book, “When Genius Failed,” which shows that catastrophic losses can happen very quickly and are generally caused by the risks you did not model.

As risk managers, we are obliged to provide an appropriate degree of skepticism. We cannot rely on regulators to “pull the punchbowl when the party gets rolling.” Unfortunately, we cannot rely on boards, bankers, or even markets to protect against irrational risk-adjusted growth. WeWork serves as a cautionary tale of how even very smart people can confuse “tailwind” with “horsepower.” As risk managers, we want to employ the most robust simulation tools available, which means n-factor risk models, MonteCarlo simulations and understand fat-tail risks.

The last down cycle was generated by the collapse of liquidity and counterparty confidence, which went viral through the financial system. I do not know what the nature of the next cycle will be, but given the computational power available today, there is no excuse not to model as many scenarios as possible to understand their implications in advance.

The Kamakura Troubled Company Index® measures the percentage of 40,575 public firms in 76 countries that have an annualized one- month default risk of over one percent. The average index value since January 1990 is 14.33%. Since November, 2015, the Kamakura index has used the annualized one-month default probability produced by the KRIS version 6.0 Jarrow-Chava reduced form default probability model, a formula that bases default predictions on a sophisticated combination of financial ratios, stock price history, and macro-economic factors.

The KRIS version 6.0 models were developed using a data base of more than 2.2 million observations and more than 2,600 corporate failures. A complete technical guide, including full model test results and parameters, is provided to subscribers. The KRIS service also includes a wide array of other default probability models that can be seamlessly loaded into Kamakura’s state-of-the-art enterprise risk management software engine, the Kamakura Risk Manager. Available models include the non-public-firm default model, the commercial real estate model, the U.S. bank model, and the sovereign model. Related data includes credit default swap trading volume by reference name, market implied credit spreads, and prices on all traded corporate bonds traded in the U.S. market. Macro factor parameter subscriptions include Heath, Jarrow, and Morton term structure models for government securities in the U.S., Germany, the UK, Canada, Spain, Sweden, Australia, Japan, Thailand, and Singapore. All parameters are derived in a no-arbitrage manner consistent with seminal papers by Heath, Jarrow, and Morton, as well as Amin and Jarrow. A KRIS Macro Factor Scenario Service subscription includes both risk-neutral and “real world” empirical scenarios for interest rates and macro factors.

The version 6.0 model was estimated over the period from 1990 to May 2014 and includes the insights of the entirety of the recent credit crisis. The 76 countries currently covered by the index are: Argentina, Australia, Austria, Bahrain, Bangladesh, Belgium, Belize, Botswana, Brazil, Bulgaria, Canada, Chile, China, Colombia, Croatia, Cyprus, Czech Republic, Denmark, Egypt, Estonia, Finland, France, Germany, Ghana, Greece, Hungary, Hong Kong, Iceland, India, Indonesia, Ireland, Israel, Italy, Japan, Jordan, Kenya, Kuwait, Luxembourg, Malaysia, Malta, Mauritius, Mexico, Nigeria, the Netherlands, New Zealand, Norway, Oman, Pakistan, Peru, the Philippines, Poland, Portugal, Qatar, Romania, Russia, Saudi Arabia, Serbia, Singapore, Slovakia, Slovenia, South Africa, South Korea, Spain, Sri Lanka, Sweden, Switzerland, Tanzania, Taiwan, Thailand, Turkey, the United Arab Emirates, Uganda, the UK, the U.S., Vietnam and Zimbabwe.

To follow the troubled company index and other risk commentary by Kamakura on a daily basis, please follow:

Kamakura CEO Dr. Donald van Deventer (www.twitter.com/dvandeventer)

Founded in 1990, Honolulu-based Kamakura Corporation is a leading provider of risk management information, processing, and software. Kamakura was recognized as a category leader in the Chartis Report,Technology Solutions for Credit Risk 2.0 2018. Kamakura was named to the World Finance 100 by the editor and readers of World Finance magazine in 2017, 2016 and 2012. In 2010, Kamakura was the only vendor to win two Credit Magazine innovation awards. Kamakura Risk Manager, first sold commercially in 1993 and now in version 10.0.3, is the first enterprise risk management system for users focused on credit risk, asset and liability management, market risk, stress testing, liquidity risk, counterparty credit risk, and capital allocation from a single software solution. The KRIS public firm default service was launched in 2002. The KRIS sovereign default service the world’s first, was launched in 2008, and the KRIS non-public firm default service was offered beginning in 2011. Kamakura added its U.S. Bank default probability service in 2014.

Kamakura has served more than 330 clients with assets ranging in size from $1.5 billion to$3.0 trillion. Its risk management products are currently used in 47 countries, including the United States, Canada, Germany, the Netherlands, France, Austria, Switzerland, the United Kingdom, Russia, Ukraine, South Africa, Australia, China, Hong Kong, India, Indonesia, Japan, Korea, Malaysia, Singapore, Sri Lanka, Taiwan, Thailand, Vietnam, and many other countries in Asia, Europe and the Middle East.

To follow risk commentary by Kamakura on a daily basis, please follow:
Kamakura CEO Dr. Donald van Deventer (www.twitter.com/dvandeventer)
Kamakura President Martin Zorn (www.twitter.com/riskmgrhi) and