New software shows credit risk under-priced, Moody's says

Banks may have been consistently underestimating the risk involved in long-dated credit derivatives, if a new software package from Moody's KMV is correct.

The EDF 8.0 software predicts expected default rates for up to 10 years into the future, using a migration matrix, which predicts future default rates from current ones. It also uses an expanded database of previous defaults. Other similar programs use a migration table which predicts future credit ratings from current ratings.

"The migration table problem is that it reflects the relative caution of the rating agencies,” said Douglas Dwyer, a senior director at Moody's KMV. “Also, it doesn't measure the momentum of a movement – if a credit is moving in one direction, it is likely to keep going. Momentum matters. Our methodology allows this to be more visible."

John Gibbon, Moody's senior director of product development, said the change in method has produced an interesting result: "There is significantly more risk in credits at long horizons, when measured with the new model."

"This is a non-trivial observation," said Brian Ranson, head of credit strategies at Moody’s, although he pointed out that only a minority of investors are likely to be affected. "The vast majority of users are focused on the one-year expected default rate."

One customer, Katie Hysenbegasi, a vice-president in Bank of New York's portfolio risk management division, said the new software was likely to have a significant impact on economic capital and reserve calculations.