Michael K. Ong Professor and Director, Finance Program

1. Michael K. Ong Professor and Director, Finance Program Executive Director, Center for Financial Markets Stuart Graduate School of Business Illinois Institute of Technology 312.906.6568. ong@stuart.iit.edu Return to Risk Limited website: www.RiskLimited.com Managing Credit Risk in Volatile Environments Energy Credit Risk Congress 2003 The Houstonian Hotel, Houston, TX November 12-13, 2003 Organized by Risk Limited

2. Source: William J. Bernstein, “Credit Risk: How Much? When?”, www.efficientfrontier.com. Widening of Credit Spreads - a Precursor of Something Ominous

3. Source: Moody’s Special Comment “Default & Recovery Rates of Corporate Bond Issuers”, February 2003. Sharp Increase in Default Rates

4. 5.0% 4.5% +2 Std Dev 4.0% 3.5% +1 Std Dev 3.0% 2.5% Average 2.0% 1.5% 1.0% 0.5% 0.0% 1980 1981 1982 1983 1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 Source: David Hamilton, “Historical Corporate Rating Migration, Default, and Recovery Rates”, 2002 Default Rate for All Corporate Issuers Reached Extreme in 2001

5. 1) WorldCom, Inc. $23.2 Billion 2) Enron Corp. $9.9 Billion 3) NTL Communications Corp. $8.5 Billion 4) Adelphia Communications Corp. $6.9 Billion 5) Finova Capital Corp. $6.3 Billion 6) United Pan-Europe Communications $5.1 Billion 7) Pacific Gas & Electric Co. $5.0 Billion 8) XO Communications Inc. $4.9 Billion 9) Southern California Edison Co. $4.7 Billion 10) Global Crossing Holdings LTD $3.8 Billion Total: $78.3 Billion Source: David Hamilton, “Historical Corporate Rating Migration, Default, and Recovery Rates”, 2002 10 Largest Rated Corporate Bond Defaults

6. Funded Bank Bank Maturities Exposure Maturing As % of Total Debt in 2003-2006 Maturities Rating Outlook ($ Millions) 2003-2006 American Electric Power BBB+ Stable 1,244 16 AES Corp. B+ Watch Negative 2,483 47 Allegheny Energy BB Watch Negative 1,040 46 Aquila BBB- Negative 356 36 Black Hills Corp BBB Stable 558 99 Calpine Corp BB Negative 5,500 75 CMS Energy BB Negative 2,740 69 Constellation Energy Group A- Stable 296 19 Dominion Resources BBB+ Stable 640 10 Duke Energy A Stable 2,350 27 Dynegy B+ Watch Negative 1,900 64 El Paso Corp BBB+ Watch Negative 920 17 Edison Mission Energy BBB- Watch Negative 1,838 100 Entergy BBB Stable 950 36 Mirant BB Negative 3,614 71 PG& E National Energy Group B- Watch Negative 2,458 91 NRG Energy D - 4,287 92 PPL BBB Negative 248 16 Public Service Enterprise Group BBB Stable 833 27 Teco Energy BBB Watch Negative 340 59 TXU BBB Negative 1,094 13 Williams Companies B+ Watch Negative 2,000 32 Total 37,570 Mean 48 Source: Standard and Poors, November 2002, as reported by James Ockendon, “Delaying the Inevitable?”, Energy Power Risk Management, May 2003 Energy Company Profiles

7. Defining credit culture “A credit culture is made up of principles that need to be communicated. A credit culture is rooted in corporate attitudes, philosophies, traditions, and standards that require administrative underpinnings. The role of credit culture is to create a risk management climate that will foster … good banking …” Henry Muller* • Corporate priorities “How much risk?” versus “How much return?” • Credit discipline Proper metrics for risk and performance measurement. * Henry Muller, “Risk Management and the Credit Culture - A Necessary Interaction”, Credit Risk Management (Robert Morris Associates) 1995. Behavioral Reactions to Uncertainty

8. * Sample for illustrative purposes only. Quantitative Tools for Managing Credit Risk • Loan Loss Reserves and Capital Allocation

9. * Sample for illustrative purposes only. Quantitative Tools for Managing Credit Risk • Measures for Concentration Risk

10. Chicago Portfolio’s 10 Largest Expected Losses* Expected LossCommitmentOutstanding 1) American Airlines $16,765,137 $65,000,000 $65,000,000 2) Enron Corp. $14,223,195 $92,500,000 $50,000,000 3) FMI International, LLC $14,052,022 $28,000,000 $19,342,252 4) Xerox Corp. $13,996,139 $95,000,000 $45,000,100 5) Viasystems, Inc. $10,000,001 $18,250,000 $12,500,000 6) Napoleon Holdings, Inc. $9,875,325 $27,500,000 $25,333,333 7) Pacific Gas & Electric Co. $9,750,386 $20,000,000 $20,000,000 8) Revlon Consumer Products Corp. $8,491,111 $15,000,000 $14,923,021 9) Texas Industries, Inc. $8,477,299 $25,750,000 $15,000,000 10) Hamilton Beach Proctor Silex $7,768,894 $17,000,000 $17,000,000 * Sample for illustrative purposes only. Quantitative Tools for Managing Credit Risk • Top 10 Exposures, Risk and Return Characteristics, etc.

11. Commitment Amount * Banks 12% Diversified Financial 12% Remaining Industries 35% Electric Utilities 9% Communications Technology 3% General Index 6% Securities Brokers Oil Companies-Major 3% Chemicals 6% 4% Food Gas utilities 5% 5% * Sample for illustrative purposes only. Quantitative Tools for Managing Credit Risk • Top 10 Exposures, Risk and Return Characteristics, etc.

12. Utilization * Banks 15% Diversified Financial 2% Remaining Industries 37% Electric Utilities 14% General Index Communications 4% Technology 2% Oil Companies-Major 7% Securities Brokers Food 1% Chemicals Gas utilities 6% 3% 9% * Sample for illustrative purposes only. Quantitative Tools for Managing Credit Risk • Top 10 Exposures, Risk and Return Characteristics, etc.

13. Projected Annual Income * Diversified Financial Banks 2% 6% Electric Utilities 9% General Index 1% Oil Companies-Major 6% Remaining Industries Food 53% 5% Gas utilities 12% Chemicals 2% Securities Brokers Communications 0% Technology 4% * Sample for illustrative purposes only. Quantitative Tools for Managing Credit Risk • Top 10 Exposures, Risk and Return Characteristics, etc.

14. Expected Loss * Diversified Financial Banks 0% 1% Electric Utilities 18% General Index 2% OilCompanies-Major 1% Food Remaining 2% Industries 52% Gas utilities 9% Chemicals 13% Securities Brokers Communications 0% Technology 2% * Sample for illustrative purposes only. Quantitative Tools for Managing Credit Risk • Top 10 Exposures, Risk and Return Characteristics, etc.

15. Risk Capital * Electric Utilities Diversified Financial 7% Banks 1% 4% General Index 3% Oil Companies-Major 2% Food 1% Remaining Industries 53% Gas utilities 20% Chemicals 6% Securities Brokers 0% Communications Technology 3% * Sample for illustrative purposes only. Quantitative Tools for Managing Credit Risk • Top 10 Exposures, Risk and Return Characteristics, etc.

16. * Sample for illustrative purposes only. Quantitative Tools for Managing Credit Risk • Top 10 Exposures, Risk and Return Characteristics, etc.

17. * Sample for illustrative purposes only. Quantitative Tools for Managing Credit Risk • Top 10 Exposures, Risk and Return Characteristics, etc.

18. * Sample for illustrative purposes only. Quantitative Tools for Managing Credit Risk • Top 10 Exposures, Risk and Return Characteristics, etc.

19. * Sample for illustrative purposes only. Quantitative Tools for Managing Credit Risk • Top 10 Exposures, Risk and Return Characteristics, etc.

20. Loss Distribution 2.5% 2.0% 1.5% Probability 1.0% 0.5% 0.0% 0.0% 1.5% 2.9% 4.4% 5.9% 7.4% 8.8% 10.3% 11.8% 13.3% 14.7% 16.2% 17.7% 19.2% 20.6% 22.1% 23.6% 25.1% 26.5% 28.0% 29.5% 30.9% 32.4% 33.9% 35.4% 36.8% Loss/Outstanding Quantitative Tools for Managing Credit Risk • Scenario analysis Changes in exposure, risk ratings, etc. * Sample for illustrative purposes only.

21. Quantitative Tools for Managing Credit Risk • Scenario analysis Changes in exposure, risk ratings, etc. Loss Distribution 2.5% 2.0% 1.5% Probability 1.0% 0.5% 0.0% 0.0% 1.5% 2.9% 4.4% 5.9% 7.4% 8.8% 10.3% 11.8% 13.3% 14.7% 16.2% 17.7% 19.2% 20.6% 22.1% 23.6% 25.1% 26.5% 28.0% 29.5% 30.9% 32.4% 33.9% 35.4% 36.8% Loss/Outstanding * Sample for illustrative purposes only.

22. Quantitative Tools for Managing Credit Risk • Scenario analysis Changes in exposure, risk ratings, etc. Loss Distribution 2.5% 2.0% 1.5% Probability 1.0% 0.5% 0.0% 0.0% 1.5% 2.9% 4.4% 5.9% 7.4% 8.8% 10.3% 11.8% 13.3% 14.7% 16.2% 17.7% 19.2% 20.6% 22.1% 23.6% 25.1% 26.5% 28.0% 29.5% 30.9% 32.4% 33.9% 35.4% 36.8% Loss/Outstanding * Sample for illustrative purposes only.

23. Credit Approval Process • Credit culture and corporate governance • Committee structure and accountability • Loan commitments (“intermediary”) versus investment banking activities • “How many 364-day facilities to commit? How many loan • commitments are at risk of being drawn in a corporation downgrade? • Vital role of credit ratings • Internal risk ratings systems versus agencies ratings. • Links to private equity

24. Loan Review Process and the Role of Workout • Review process • Monitoring frequency. • What drives an upgrade/downgrade? • Disciplined approach • Close involvement of relationship managers, risk managers, and • investment bankers • When does “Workout” begin? • Asset and collateral valuation • Expected loss • Restructuring schemes

25. Credit Culture Revisited • Communicating risk and hedging policies • Limits on concentration risk. • Use of credit derivatives. • List of qualified buy/sell protection names • Curse of concentration

26. Underwriting Approval Hold on Balance Sheet Monitoring and Administration Underwriting Approval Securitize New Paradigm in Lending - “Credit Trading” • Traditional approach - “buy-and-hold” Try to Get I-Banking Business New paradigm in lending - “strategic credit risk management” Credit Risk Dispersion

27. Concluding Remark A good credit risk management process built on sound credit culture and solid principles can withstand any volatile market conditions.