Ambit ERisk Advisory & Consulting Services

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1 Ambit ERisk Advisory & Consulting Services Fortune 500 Financial Services Company CRE Risk Rating System Improvement: The Fundamental Risk Modeling Approach Using SunGard s Ambit ERisk Advisory & Consulting Services, a Fortune 500 financial services company was able to significantly improve risk and business decisions. The Goal: During the second half of 2007, as economic conditions worsened across the United States, a Fortune 500 financial services company with over $50 billion in assets decided it was an opportune time to improve how it measured and managed risk in its commercial real estate (CRE) loan portfolio. There were two key motivations. First, even though the firm was not a regulated deposit taker, it wanted to be sure it was following industry best practices including the latest regulatory guidance on CRE risk management (please refer to page 5). Fortune 500 Bank Industry: Financial Services Environment: Centralized Location: US Assets: $50 Billion SOLUTION BENEFITS DERIVED: Helped to institute a true risk-based pricing for large CRE-linked transactions Established a robust exceptions monitoring system Supports the identification of potential problem loans in light of CRE market deteriorations Established standard way to estimate ALLL and economic capital Enhanced Customer Satisfaction Compliance with Initiatives such as SEPA The firm also needed to be sure the CRE portfolio delivered sustainable profitability to its shareholders into the future. We wanted to create a consistent and accurate measure of CRE risk that could be used to improve ratings and our Allowance for Loan & Lease Losses (ALLL), economic capital and riskadjusted pricing models, explains the senior executive in corporate credit risk who took charge of the project. Putting the firm s CRE risk measurement and ratings on a more objective and quantitative footing would mean the firm could: Structure and price each loan in line with its risks and capital costs Cherry pick the deals in the market that would make the most risk-adjusted money Forecast how the firm s CRE portfolio would perform in terms of expected losses, improving the active management of portfolio risk trends The Challenge: Turning this into reality, however, meant tackling the big methodological challenges that face many CRE lenders trying to improve their risk management:

2 Limited Default Data: Like most CRE lenders, the firm had access to only a very limited series of internal default data for CRE loans, making it impossible to build a robust statistical model of default probabilities and loss severities, of the kind now applied so widely in retail and commercial lending. We wanted to create a consistent and accurate measure of CRE risk that could be used to improve ratings and our ALLL, economic capital and risk-adjusted pricing models Balanced Analytical Model: The firm knew it must combine leading-edge quantitative analysis with more subjective lender insights, so that the final ratings captured the complex business and contractual risks typical of CRE lending. Could the firm find an approach to CRE risk rating that did not depend on historical default data and that took account of lender insights in a rigorous way? The Solution: By December 2007, a risk management team led by the senior credit executive had searched the risk management solutions market and, out of a hot list of four leading consultants, identified an innovative approach to measuring CRE risk developed by Ambit ERisk Advisory & Consulting Services, a division of SunGard. occupancy rates. The approach employed sophisticated simulation technology to forecast the effect of these drivers and their correlations on two critical CRE risk ratios 1) Loan to Value (LTV) and 2) Debt Service Coverage (DSC) - across ten thousand scenarios. The key insight behind the approach is that whether a CRE borrower defaults on a loan depends on whether these two ratios cross critical thresholds, i.e., LTV greater than 100% and DSC below 1.0. This fits with the business intuitions of the firm s credit executives if a creditor owes more than a CRE investment is worth, and at the same time the CRE investment is not producing enough revenue to service the debt, then default becomes almost inevitable. The figure below summarizes how the correlated simulation of the economic drivers of risk is used to predict the evolution of the key DSC and LTV ratios across a 12-month horizon. A big advantage is that the architecture of the model allows the key assumptions and market data to be easily updated in the light of market events such as a movement in rental rates, comments the firm s credit executive. Fig 1: Correlated Simulation for Four Key Variables Predicts DSC and LTV Values Occupancy Rate Volatility from Market data Centered around project specific input Simulated Value Ambit ERisk Advisory & Consulting Services simply showed the best understanding of the CRE sector and our firm s participation in it, Rental Rate Income says the executive in charge of the selection, and the nature of their modeling approach was a big attraction because it bypassed the requirement to have internal historical default data. The approach was based on the fundamental economic drivers of risk in a CRE Interest Rate Debt Service Property Value DSC LTV transaction including the structure of the loan and macroeconomic drivers such as the Property Price volatility of property prices, rental and

3 The number of defaults and the size of the loss in the universe of simulations indicate each deal s Probability of Default (PD) and Loss Given Default (LGD) and can therefore be used to generate separate borrower and facility ratings. It was important to us that the model could support the standard dual rating approach in the Basel II regulations, says the credit executive. The separate PD and LGD estimates would also help the firm make the optimal economic trade-off between borrower risk and strength of collateral. Rather than depending on default data, the approach required a more readily available set of information about the: Loan (e.g., balance, term, spread) Project (e.g., present occupancy rate, fixed variable expenses) Working mainly offsite, the team tailored their fundamental CRE model in line with a selected set of the most important financial variables for the firm s loan portfolio, and identified the industry-level macroeconomic indices (property prices, occupancy and rental rates) that would best represent the portfolio s particular risks. In parallel, the firm s internal project team gathered loan description data to apply to the model, drawn largely from existing records and loan approval documentation. As the fundamental model began to take shape, the Ambit ERisk Consulting team generated trial ratings and organized blind tastings to test if these early results matched the intuition of the firm s executives and showed executives how the model worked by demonstrating the effect on a known rating of altering one risk parameter (e.g., occupancy rates) at a time. Market ( i.e., relevant macroeconomic drivers such as the sector s rental income, occupancy rates, property values, as well as second-order measures of the volatility of, and correlations between, these key indices) The Implementation: The firm established for Ambit ERisk Advisory & Consulting Services a tight implementation time table of three months. In January of 2008, the Ambit ERisk Consulting team began the first stage of the project: polling the firm s credit experts to identify some 40+ financial and non-financial variables the internal experts thought were the most important risk factors for the firm s particular CRE portfolios. The fact that the Ambit ERisk Consulting team went through extra rounds of testing and adaption to make quite sure all our insights were incorporated is a tribute to their attitude throughout the project. The fact that the Ambit ERisk Consulting team went through extra rounds of testing and adaption to make quite sure all our insights were incorporated is a tribute to their attitude throughout the project, says the firm s credit executive. The firm appreciated the way the model built a customized picture of the potential severity of losses for participation loans. Many traditional CRE risk models use historical data to estimate the average loss rates associated with buckets of various kinds of loans an approach that makes it difficult to capture the uniqueness of different kinds of participation. The Ambit model, on the other hand, was driven by a bottom-up picture of each loan in terms of the extent of the firm s participation, loan seniority (e.g., senior position), the size of associated first-loss positions, and the simulated value of the collateral making it possible to estimate unique loss severities for each transaction. As well as building executive confidence in the power of the model, the feedback process helped Ambit ERisk Advisory & Consulting Services to tailor the model around executive insights such as the:

4 Mitigating effects of cash reserves build up over time for some CRE projects in line with the firm s particular loan terms and conditions Appropriate default-indicator threshold for the LTV ratio (which executives felt should be a conservative 95%, rather than 100%) Lender Insights Objectivity, Transparency and Modeling Working together, the firm s credit executives and Ambit ERisk Advisory & Consulting Services then built a methodology for layering lender insights about objective non-financial variables (e.g., the extent to which the amount or type of a borrower s equity in a project improved its credit worthiness) onto the fundamental model output. monitoring system that made the number, type and effect of adjustments clear to management. Business Benefits and Plans for the Future From late Spring 2008, some 90-days following project launch, the firm began to use the model in a central location to significantly improve risk and business decisions. To make sure the impact of each variable was assessed accurately, the implementation team polled the firm s most experienced CRE lenders and senior risk management executives to determine the appropriate weight assignment for each non-financial risk factor when adjusting the fundamental model results. For example, should a lack of borrower cash equity in the deal pull the rating down by a single rating grade, or more? Ambit ERisk Advisory & Consulting Services analyzed the results to build a transparent scorecard system for adjustments that would ensure consistency between lenders into the future. Meanwhile, the firm put in place a system to escalate adjustments above a certain size to an ever-higher level of seniority for approval, and a robust exceptions We are already using the model to drive our internal CRE portfolio review discussions at the most senior risk committee level, for both large transactions and the portfolio as a whole. Through the early summer we ran our entire CRE portfolio through the model, and the results have become one of the key inputs into how we estimate our ALLL and economic capital, says the credit executive in charge. The model has also proved critical to instituting true risk-based pricing for the firm s large CRE-linked transactions. The key differentiator between loans when we run our risk-adjusted pricing model is the expected loss number taken direct from the new fundamental model, says the executive. The firm s credit executive also emphasizes the enterprise-wide risk management benefits. We are already using the model to drive our internal CRE portfolio review discussions at the most senior risk committee level, for both large transactions and the portfolio as a whole, he says. It allows our CRE group to begin to talk about risk in terms of accurate probability of default and loss given default in a way consistent with the rest of our portfolios. In particular, the firm is using the new model to direct management attention towards any potential problem loans in its portfolio in the light of CRE market deteriorations.

5 The Ambit ERisk Consulting team contains some of the smartest people we ve worked with but the real key was their understanding of CRE risk and the way they took responsibility for making the project such a success. The firm is so impressed with the results that it has taken the decision to roll out the technology to the local level. By early Fall 2008, lenders will be able to use the model as an aggressive competitive tool to identify, price, structure, and ultimately manage the CRE deals that are the most profitable for the firm on a risk-adjusted basis. We are very happy with the project results, says the senior credit executive, The Ambit ERisk Consulting team contains some of the smartest people we ve worked with but the real key was their understanding of CRE risk and the way they took responsibility for making the project such a success. For more information contact ambitinfo@sungard.com Regulatory Trends and CRE Risk: the December 2006 guidance As conditions worsened in the US economy during 2007 and 2008, CRE lenders took stock of a December 2006 regulatory guidance that reminded them to: Tailor credit analysis to reflect both the borrower s overall creditworthiness and projectspecific considerations Ensure risk ratings are risk sensitive, objective and appropriate for the types of CRE loans Identify potential concentrations by stratifying the CRE portfolio into segments that have common risk characteristics (e.g., property type, debt service coverage) or common sensitivities to economic, financial or business developments Make sure CRE risk management efforts and capital levels are commensurate with the bank s CRE concentration risks Perform periodic market analyses for the various property types and geographic markets in the firm s portfolio, and conduct ad hoc analyses in response to potential market events Establish board-approved policy guidelines and CRE lending strategy including any specific commitments to particular borrowers or property types, and report concentrations to the board Abridged and adapted from Concentrations in Commercial Real Estate Lending, Sound Risk Management Practices, December 12, 2006, OCC/Federal Reserve/FDIC

6 About Ambit Economic Capital SunGard s Ambit Economic Capital is today s best practice solution for enterprise-wide risk and capital management, delivering the tools you need for measuring risk, quantifying capital needs and determining risk-adjusted performance. The Ambit ERisk consulting team provides a range of methodological, tactical and strategic insights that can help banks assess and improve their risk and performance management infrastructure. About Ambit SunGard s Ambit is a banking solution suite for retail, commercial and private banks. It provides banking professionals with solutions that support front-, middle- and back-office operations, as well as solutions for financial management, risk and compliance. Ambit helps banks improve customer service management, streamline business processes, comply with regulations and capture growth opportunities. For more information, visit About SunGard With annual revenue of $5 billion, SunGard is a global leader in software and processing solutions for financial services, higher education and the public sector. SunGard also helps information dependent enterprises of all types to ensure the continuity of their business. SunGard serves more than 25,000 customers in more than 50 countries, including the world s 50 largest financial services companies. Visit SunGard at SunGard. Trademark Information: SunGard, the SunGard logo and Ambit, Apsys, BancWare, STeP and System Access are trademarks or registered trademarks of SunGard Data Systems Inc. or its subsidiaries in the U.S. and other countries. All other trade names are trademarks or registered trademarks of their respective holders.