Evolution of Credit Risk Models

The evolution of credit risk models and tools illustrates how credit trading progressively emerged.

• March 1991: Credit Monitor launched.

The firm KMV, today a unit of Moody's, introduces Credit Monitor, which models default probabilities for companies with publicly traded equity.

• 1992: credit derivatives emerge.

The ISDA, a professional association dedicated to the development of derivatives, first uses the term "credit derivatives" to describe these new contracts which are traded over-the-counter.

• 1993: Portfolio Manager released.

KMV introduces the first version of its Portfolio Manager model, the first credit portfolio model. Credit portfolio models allow determining economic capital (credit VaR) and the risk contributions to the overall risk of the portfolio of any single asset or sub-portfolio. This allows measuring whether it is economical, given risk contributions and spreads of assets to keep them or to sell them, and to do so on an active basis when risk and return changes through time.

• 1994: credit derivatives market begins to expand.

At this early stage, some commentators doubt the new credit derivatives market will take off, but by the end of the year, the volume of credit derivatives sold is $4-5 billion. The majority of contracts, whose usage expanded considerably in the last decade, are credit default swaps. Pricing models provided a conceptual framework for assigning a value to such derivatives.

• September 1996: the first CLO, or collateralized loan obligation, a new type of securitization.

The UK's National Westminster Bank issues the first collateralized loan obligation, securitizing $5 billion of its corporate loan book to shed regulatory capital. Formerly, securitizations had been used for decades for selling pools of retail banking loans into the capital market. Since then, various types of securitizations expanded very quickly until the 2007 financial crisis.