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  1. #7871
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    As far as I understand it, the credit rating is the probability that the bank will default in the next 5 years from the time the credit rating was issued. Therefore whatever probability that is (e.g. 1 in 30), it's only valid to estimate the risk for the whole 5 year period starting at that point in time. You can't use that probability to estimate the risk for any given year (e.g. you can't say for any particular year that the bank has a 1/30 chance of defaulting). So if the BBB rating was issued 2 years ago, you don't know what probability of the bank failing this year or next year is. If you want the probability of it defaulting in next 5 years, you'd need the credit rating to be reassessed again based on current information.

  2. #7872
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    That's how I see it too Cricketfan.

    Interestingly though banks rated AA are rated a 1 in 300 chance of failure. Banks like ASB, BNZ, Westpac and ANZ are all rated AA- so technically within the definitions as laid out by S&P and Fitch your money is ten times safer there than with a bank rated BBB. I doubt many depositors have a handle on that. In my view this also explains why HBL's PE must be a lower multiple than a major AA rated bank because the same risk premium needs to apply to equity investors who are first cab off the rank when it comes to taking a haircut.
    Last edited by Beagle; 01-07-2016 at 08:12 PM.

  3. #7873
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    I would assume with the rating being a one in 30 over 5 years that the rating would have "good" and "bad" years calculated in the mix. Note that it is not a one in 30 chance in a year - it is a one in 30 chance over five years - so the chance may be lower or greater for an individual year. I do not believe the risk rating of BBB is wrong.

    "bbb Good fundamental credit quality‘bbb’ ratings denote good prospects for on-going viability. The bank’s fundamentals are adequate, such that there is alow risk that it would have to rely on extraordinary support to avoid default. However, adverse business or economicconditions are more likely to impair this capacity." https://www.fitchratings.com/web_con...and_scales.pdf


    Quote Originally Posted by Snoopy View Post
    I don't disagree with anything you have written above regarding probability theory Axe.

    But I do think that in relation to any particular example (in this case Heartland) that just because you are applying probability theory, that doesn't mean that all years in which Heartland operates neatly organize themselves into "independent events." For example, consider Heartland's non-core property portfolio.

    If the bad property is a drag on the company one year, and there is no significant improvement in selling down that portfolio or writing it down over that year, then it will be a drag on the company the next year too. IOW because loans 'span the years', this means that successive years in which Heartland operates are clearly not independent of each other.

    I would imagine the statisticians who draw up these loan ratings know that each business year of Heartland is not independent of the next. So they will have adjusted their risk model to compensate. To give a very simple (oversimplified for any reality, but useful for explaining the concept) example of this to make the point.

    Consider 30 years of a financial institution in business, made up of two types of years: 'good' years and 'bad' years. Let's assume for the purposes of this example that there are an equal number of 'good' and 'bad' years. Let's assume that the chance of going bust in a 'bad' year is 1 in 15. Let's further assume that the chance of going bust in a 'good' year is 1 in 45. Because there are an equal number of 'good' years and 'bad' years the average chance of going bust when any year is picked at random, with no knowledge as to whether that year is good or bad, is 1 in 30. Spookily similar to a finance institution with a BBB rating!

    So when you see a BBB rating applied to a finance institution like this, what is the chance that in any particular year the chance of going bust is 1 in 30? There is actually no chance at all that this will happen! But that doesn't mean the 1 in 30 year risk ratio when applied to this particular financial organization is wrong.

    SNOOPY

  4. #7874
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    I think you are confusing the 1 in 30 chance over a 5 year period with a one in 30 year event. In weather terms a one in 30 year event is "expected" to occur within the 30 years. In probability one in 30 chance is different.

    Let use the odds of rolling 2x D6 and both coming up with a 6.
    There is a 1 in 36 chance of this occurring on each roll. Over 36 rolls what is the chance that you have not rolled 2x D6?

  5. #7875
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    I would say around 0.36721

    What this 1:30 year rating really means is that the chances of not going bust in the next 30 years is slightly better than a third. A better question may be 'Over what period is there an equal lilelyhood of going bust or of staying in business?"
    That works out to just over 24.5 years
    Last edited by Jantar; 02-07-2016 at 06:29 AM.

  6. #7876
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    Quote Originally Posted by axe View Post
    I think you are confusing the 1 in 30 chance over a 5 year period with a one in 30 year event. In weather terms a one in 30 year event is "expected" to occur within the 30 years. In probability one in 30 chance is different.
    I would argue that the probability of a bank failing is more atune to a 'weather' event. A bank must navigate financial storms. There is nothing in the reserve bank statement on 'Explaining Credit Ratings'

    http://www.rbnz.govt.nz/-/media/Rese...8179.pdf?la=en

    that says anything about each year bering independent, and risk being a summation of independent trials. That is something that you introduced into the explanation Axe.

    Let use the odds of rolling 2x D6 and both coming up with a 6.
    There is a 1 in 36 chance of this occurring on each roll. Over 36 rolls what is the chance that you have not rolled 2x D6?
    When throwing two dice, the chance that you roll a 6 on both dice is 1/6 x 1/6 = 1/36

    Therefore the chance you will not do this is 35/36

    The chance of not rolling a double six twice in a row is 35/36 x 35/36

    The chance of not rolling a double six 36 times in a row is: (35/36)^36 = 0.367 as Jantar said.

    Now your question Axe. What is the relevance of this to assessing a credit risk of a bank like Heartland?

    SNOOPY
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    Quote Originally Posted by axe View Post
    I think you are confusing the 1 in 30 chance over a 5 year period with a one in 30 year event. In weather terms a one in 30 year event is "expected" to occur within the 30 years. In probability one in 30 chance is different.
    Let's put this question in a more Heartland relevant way. There are two investors, each investing $10,000 with Heartland on the same day.

    1/ Investor A puts their money in a Heartland term deposit for 5 years. Interest is compounded annually.

    2/ Investor B puts their money in a one year Heartland term deposit. Upon maturity, investor B reinvests their term deposit plus interest earned for another year. Investor B does this for five years in total.

    Over the five years the credit rating of Heartland does not change and the interest rate curve remains flat (i.e. the one year interest rate is the same as the five year interest rate). The actual interest rate earned from Heartland does not change over the five year period.

    Now hopefully Axe, you will agree with me that at the end of the five years both Investor A and Investor B will have excatly the same amount of money in their Heartland account. But which investor, A or B, has taken the greatest risk over the five year investment period?

    SNOOPY
    Last edited by Snoopy; 02-07-2016 at 11:23 AM.
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  8. #7878
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    Quote Originally Posted by Cricketfan View Post
    As far as I understand it, the credit rating is the probability that the bank will default in the next 5 years from the time the credit rating was issued. Therefore whatever probability that is (e.g. 1 in 30), it's only valid to estimate the risk for the whole 5 year period starting at that point in time. You can't use that probability to estimate the risk for any given year (e.g. you can't say for any particular year that the bank has a 1/30 chance of defaulting). So if the BBB rating was issued 2 years ago, you don't know what probability of the bank failing this year or next year is. If you want the probability of it defaulting in next 5 years, you'd need the credit rating to be reassessed again based on current information.
    Aren't credit ratings regularly reassessed as part of the normal ratings process?

    SNOOPY
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  9. #7879
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    Quote Originally Posted by Jantar View Post
    What this 1:30 year rating really means is that the chances of not going bust in the next 30 years is slightly better than a third.
    If you assume that all years are independent (which I would argue they are not), and the chance of going bust in one year is one in thirty (which some others don't agree is the right interpretation of reserve bank risk) then.

    The chances of not going bust in any one year is 29/30. So taken of 30 consecutive years

    (29/30)^30 = 0.3616

    or 'slightly better than a third'.

    A better question may be 'Over what period is there an equal lilelyhood of going bust or of staying in business?"
    That works out to just over 24.5 years
    (29/30)^y = 0.5

    => ln(29/30)^y = ln0.5
    => y x ln(29/30) = ln0.5

    Working out the natural logs then solving for y, gives y = 20.4 years

    SNOOPY
    Last edited by Snoopy; 02-07-2016 at 03:22 PM.
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  10. #7880
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    Quote Originally Posted by Snoopy View Post
    If you assume that all years are independent (which I would argue they are not), and the chance of going bust in one year is one in thirty (which some others don't agree with) then.

    (29/30)^30 = 0.3616

    or 'slightly better than a third'.



    (29/30)^y = 0.5

    => ln(29/30)^y = ln0.5
    => y x ln(29/30) = ln0.5

    Working out the natural logs then solving for y, gives y = 20.4 years

    SNOOPY
    Correct. I had continued with Axe's dice and 1:36. For a 1:30 it is indeed 20.4 yesrs.

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