The Alta Group Round TableTampa, Florida

RISK MANAGEMENT ENVIRONMENT

“Post” Financial Crisis

Risk Management Environment

• What happened?• Effect on our businesses• Discussion---

What were the most effective steps your company took in the wake of the financial crisis

How do you see the market and risk landscape today---trend, emerging risks, opportunities

Has your company’s overall business strategy ( as distinct from just credit policy) changed as a result of the crisis?

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Global Credit Environment

• PERSPECTIVE: about every 5-6 years, there has been a significant credit event;

1970’s: REITs and Lesser Developed Countries (Brazil) 1980/90’s: Savings & Loans, LBO/MBOs, Continental Bank, Herstatt Bank,

Long Term Capital Management 2000’s: Enron, Telecom Bubble 07/08: Sub-prime/Financial Crisis

• Concerns surfaced re U.S. $12 Trillion mortgage market in early/mid 2007

Slowing of growth, then decreasing values of residential real estate in the U.S.—now down 30+% in 20 largest US markets since July, 2006 peak (S&P)

Overall Residential Mortgage Delinquency rate up sharply For sub-prime( apx $1.25-1.5T), the delinquency rate is running 25%+ Many mortgages rolled into securitized instruments—CLO, CDO’s and are

widely held----and insured by major credit insurers Losses damaged capital, caused financial firms failure Problems spread to consumer credit cards and commercial loans Leveraged loan default rate, about 2% in 2008, to peaked at 14%

+ by 4Q 09. • Tremendous disruption and damage to financial system

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Moody’s Mortgage Performance

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Crisis “Root Cause” still being debatedMacro Framework

• Housing market Housing Bubble/Foreclosures Sub-Prime

lending( underwriting, fraud, down payments/negative equity)

• Risk taking behavior Consumer/Household Borrowing Equity extraction Speculation Risk underwriting/leverage--

Corporate • Financial market factors

Innovation Ratings inaccuracy Modeling Off balance sheet financing Regulatory avoidance Sector concentration

• Macro factors Interest rates Trade Deficit

• Capital market pressures Capital looking for yield

• Regulation and Deregulation

• Commodity Price Volatility • Inaccurate economic

forecasting • Monetary expansion • Mark to Market Accounting • Interaction of the Housing

and Financial markets

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Crisis “Root Cause” Credit Risk Management Framework

Financial industry drive for growth

Supported by excess liquidity Parallel focus on E/R

measures pressuring non-revenue producing functions, like RM

Complacency Declining loss rates 2002-

2006 New tools, liquidity pools,

asset values “old rules don’t apply”

“Outsourcing” Credit Responsibility

External assessments( bank sponsor, rating agency) replaced internal decisions

Conflict between evaluating and selling risk

Many financial business now revolve around ability to securitize or syndicate

Key skill becomes marketing of risk

Retention became subordinate to marketing

Importance of internal risk assessment diminished

• Lack of experienced management in RM

Market speed and instrument complexity reduced senior management involvement in deal flow

• Policy/Strategy/Controls Reduced RM input to business

direction Shift to syndication from retention Process design focus shift to

origination/syndication

• Operational Effectiveness E/R pressures Resources shift to selling deals Speed/complexity diminished

experienced senior management involvement in deal flow---no benefit of their experience

• RESULT: BIG PROBLEMS IN MANY LENDING ORAGNIZATIONS

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Defaults/Losses/Delinquency starting to abate

• Default rates in bonds/loans moderating, but still high historically

• ELFA ageing metrics also improving

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Risk Appetite Slowly Returning---esp for larger companies

• New issuance of bonds and loans to lesser credits increasing, although substantial portion is refinancing

• Risk spreads gradually returning to “traditional” levels

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Terms and Conditions Still Tighter

• HY loan originations less likely to carry very lenient terms and conditions

• Federal reserve survey shows some easing of tightening trend by larger banks---credit availability still an issue for smaller companies

PERIOD NET PERCENT TIGHTENING

2Q 07 -3.7%

2Q08 +55.4%

2Q09 +39.6%

2Q10 -7.1%

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Comparison of Delinquency/Loss Rates

Sector Size Delinquency Delinquency Baseline-est.

C&I Loans $9.2 T 4.49%(4Q09)

2.5%

ELFA MLFI $518 B 4.20% (1Q10)

3.5%

Credit Cards $864B 4.5%(1Q10) 1.5-2.75%

Mortgages-Prime

$11T 6.73% (1Q10)

3%

Sub-Prime $1.25-1.5 T 25.2% (1Q10)

5-7%

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Medium/Long Term Effects

• Many Banks and Financing companies damaged• “Risk Aversion” atmosphere may persist for many quarters, if not

years• Terms/Conditions and pricing spreads now favoring the creditor• Many borrowers be squeezed out of the market—debt vs equity

risk paradigm• Increased regulation/control/taxation of Financial institutions—

limits on growth• Economic outlook less robust---recession in developed/OECD

countries slowly ending—unemployment levels high--country risk increased

• “De-leveraging”-banks, corporations and consumers• Effect of government stimulation efforts—increased taxes,

potential inflation• Increased role of Government Sector in U.S. economy• Potential pressure to “de-globalize”• Additional, non-crisis related factors to consider in risk

management for the future U.S./Western Europe ageing population—impact on labor markets,

social services, immigration policy and consumer spending “Green” impetus---impact on energy policy, government tax/spending,

regulation, new market segments Economic Competition between U.S./developed countries and China—

political spillover, commodity prices, cross border investments, China as creditor/investor nation

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Key Elements of a Strong Risk Culture

• Risk management positioned as integral part of business Fixed in corporate priorities Regular input to overall business direction Risk appetite, risk/reward balance well articulated

• Robust RM infrastructure and documentation Policies Processes

• Attitude of taking full responsibility for RM results Agency Ratings and sponsor/lead bank endorsements as inputs, not

substitute for own decision making Retaining vs selling risk

• Active participation by Senior Management in design and operation of risk management

Knowledge of deal flow Included in approval process

• Periodic senior management review of “common sense” level of risk/reward levels---Stress testing/sensitivity—macro and company specific

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Business Strategy & Objectives

Feedback

Credit Policy & Methodology

Asset Management:Accounts Receivable,

Loans/Leases and Other Exposures

Credit Assessment & Structuring

Portfolio Performance Measurements

Systems Strategy&

Audit/Business Controls

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Managing Risk –Policy/ProcessWhat has been happening at financing

organizations?

• Policy Reviewing business plans and credit policies in view

of recent events and organization’s risk appetite Deselecting segments/geographies/business lines

(eg SMB, Vendor Financing) Re-evaluating concentration issues Evaluating effectiveness of the Risk Management

function—coverage, methodologies, forecasting, protections, speed to recognize issues, reserving process/assumptions

Taking a more Enterprise Risk approach Stress testing the business

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Managing Risk –Policy/Process What has been happening at financing

organizations?

• Credit Approval Process Tightening Credit approval process Increased info/disclosure requirements on new deals Re-scoring automated models and manual

scorecards/upping the bar Decreasing Delegation Managing down lines of credit More Senior Management Reviews Reviewing all contract and collateral documentation Tighter terms and conditions Higher pricing Sensitivity to Fraud

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Managing Risk –Policy/Process What has been happening at financing

organizations?

• Receivables and Portfolio Management Increased “stress testing” Re-assessing/re-grading credit portfolios for

action and reserving Portfolio sales/exits Concentration framework/metrics Assessing/improving adequacy of AR and workout

staffs Increased frequency and intensity of customer

contacts Keeping senior management informed of all

issues

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DISCUSSION QUESTIONS

• What were the most effective steps your company took in the wake of the financial crisis

• How do you see the market and risk landscape today---trend, emerging risks, opportunities

• Has your company’s overall business strategy ( as distinct from just credit policy) changed as a result of the crisis?