DEFAULT AND DOWNGRADING
Counterparties may decide to default or may be under distress which implies an increase of probability to be unable to fulfil the contractual obligations. The latter results in a downgrading or, in other words, the change of credit quality into default over time.
We classify default as a behavior element as it can be driven by the counterparty decision not to fulfil the agreed obligations. Moreover, it is mainly the idiosyncratic characteristics of the counterparty, e.g., decisions and plans of business strategies, operations, financial performance, etc., that indicate the credit rating.As we discussed in Chapter 7, the default probability changes over time, which in fact impacts the credit rating. In the rating system, the changes in credit rating are mapped by employing transition8 matrixes. As illustrated in Table 8.1, within a certain time horizon, a credit rating has a high probability of staying steady whereas there are some probabilities of migration to a higher or lower rating. For instance, in the example in Table 8.1, within a time horizon of one year, the BBB rating has 89.26% probability not to change, 4.83% to upgrade one notch, 4.44% to downgrade one notch, 0.12% to default and so on. The typical horizon of credit migration matrixes is one year. Of course the highest probability is for the rating not to change, which is the case under normal market and credit conditions. However, when such
TABLE 8.1 Example of a Transition Matrix where ratings may change from AAA to D (Default)
| Rating | Probability of rating migration | |||||||
| AAA | AA | A | BBB | BB | B | CCC | Default | |
| AAA | 93.66 | 5.83 | 0.4 | 0.08 | 0.03 | 0 | 0 | 0 |
| AA | 0.06 | 91.8 | 5.8 | 1.3 | 0.9 | 0.14 | 0 | 0 |
| A | 0.06 | 2.27 | 91.86 | 5.09 | 0.29 | 0.26 | 0.1 | 0.07 |
| BBB | 0.03 | 0.25 | 4.83 | 89.26 | 4.44 | 0.81 | 0.26 | 0.12 |
| BB | 0.02 | 0.09 | 0.44 | 6.67 | 83.31 | 7.47 | 1.5 | 0.5 |
| B | 0 | 0.1 | 0.33 | 0.46 | 5.77 | 84.19 | 3.85 | 5.3 |
| CCC | 0 | 0 | 0.16 | 0.34 | 2.2 | 8.4 | 73.9 | 15 |
conditions are under stress, counterparties are likely to change their ratings. We can say that transition (migration) matrices describe the current and future behavior default probability of the counterparty.
As in all behavior elements, their main parameters are the time and degree of rating transition. Under stress conditions the real-world probabilities must be considered. This means that both parameters will be under stress, e.g., the probability of downgrading will increase or may become a reality. This will also be reflected in the corresponding default probability and credit losses. Let's remember that marketplace lending platforms refrain from changing the ratings of borrowers while loans are still current. Rating transition therefore currently has little merit for marketplace loans, but it may become relevant in the future.
The process and effort to identify such matrixes can be significantly high. Additionally, the complexity increases as they need to be updated, especially when market conditions are changing and/or new types of counterparties are linked to the contracts of credit portfolios. Even though there are many challenges in identifying transition rating matrixes, they play a key role in mapping the counterparty status over time. As such matrixes include the change of credit ratings, they also define the changes of the corresponding spreads and thus impact the pricing and valuation adjustment of credit portfolios. Finally, they are used in identifying the rating correlation among counterparties.
8.4