Good century-old DuPont-analysis helps Banks SAVE CAPITAL : what an explosive surprise !
ALGOSAVE confirms DuPont analysis profound wisdom : LGD CORRELATION is ROCK-BOTTOM LOW and helps financial institutions SAVE CAPITAL.
And, especially for high grade borrowers, ALGOSAVE has another BIG surprise in store on PD-LGD correlations.
DuPont Analysis comes from the DuPont Corporation that started using this formula in the 1920s.
DuPont explosives salesman Donaldson Brown invented this formula in an internal efficiency report in 1912.
More than a century after that, ALGOSAVE CORPORATE DATABASE shows that DuPont analysis also hides another even more profound wisdom : the CORRELATION of Loss Given Default (LGD) between corporates in a given industry is ROCK BOTTOM LOW to negative. This means IMMEDIATE CAPITAL SAVING for corporate lenders.
In The Beginning, long time ago.
DuPont analysis tells us that the Return On Equity – ROE – can be decomposed in 3 items
Net Income / Sales = Profitability
Sales / Total Assets = Asset Efficiency
Total Assets / Average Shareholder Equity = Financial Leverage
- DuPont analysis also tells us that profitability is mostly matter of technology.
In other word, when a company is part of a given industry, it “inherits” the industry profitability which is technology-dependent.
For instance, if you distribute food in the US, your expected Net Income / Sales cannot be too-far away from your peers. Unless you have a completely different service or…technology.
- DuPont analysis also tells us that Asset Efficiency is mostly a matter of the corporate competitive landscape.
Indeed, in order to increase this ratio, the company will have to gain market share <=> increase marketing expenses, lower price, increase inventories to prepare for increased sales, and give longer credit to its clients <=> lower net Income and higher Total Assets.
Profitability and Asset Efficiency are interdependent.
- So, in order to increase its ROE and make a difference, the company’s management is mostly left with the latest ROE key driver : ITS degree of Financial Leverage. Let’s also keep in mind that an increase in financial leverage also means an increase in the Equity BETA, with its consequence on WACC and ultimately on the Expected ROE.
From DuPont analysis … to rock-bottom LOW LGD CORRELATION
If DuPont analysis holds true – and indeed corporates in the same industry mostly drive their ROE thru financial leverage – then when they go bankrupt together, we should be expecting little correlation between their respective Loss Given Default : they all finance their assets in a different way to make a difference in their respective ROE.
The challenge : historical high-grade corporates LGDs are scarce <=> Default of large and solid corporates are a rare event.
Concomitant defaults of such corporates are even rarer. So that measuring historical LGD correlation is a challenge.
Estimating forward looking and Point in Time LGD correlation is a double-challenge.
Algosave technology raises to the challenge and delivers its clients exactly that : forward looking and Point in Time stress-tested LGD correlations.
ALGOSAVE delivers those for all the 5000 borrowers in ALGOSAVE CORPORATE DATABASE.
Let’s take an example on our favorite Integrated Oil and Gas basket : 11 high-grade global corporates
ALGOSAVE CORPORATE DATABASE delivers the following data : average 5-year unsecured stressedLGD, current and stressed cumulative 5 year PD
- Before the bigger surprise, let’s have a look at 5-year average stressed unsecured LGDs for each of those 11 corporates.Although the average LGD of those asset-heavy corporates is close to 49% – which is close to CDS standard LGD – there is a marked difference between BP P.L.C. 81% 5-year LGD and Husky Energy 22% 5-year LGD.
This already confirms DuPont analysis differing financial structure, albeit in a static and average way.
- Let’s also compare current market 5-year PDs and ALGOSAVE stressed 5-year PDs.
Although current 5-year cumulated PDs are multiplied by a factor of 5 when stressed (increase from 4% to 20%), BP and Statoil are multiplied by a factor of more than 10, whereas Husky Energy is only multiplied by a factor of 2.5.
This also confirms DuPont analysis about differing financial structure, albeit in a static and average way.
- Finally, last but not least, ALGOSAVE CORPORATE DATABASE unique and CAPITAL SAVING deliverable : Forward-looking, Point in Time and stressed 5 year unsecured LGD correlations
On average stressed LGD correlation is a ROCK BOTTOM -0.01
The highest LGD correlation is a small 0.11, between Royal Dutch Shell and EXXON.
The lowest LGD correlation is also a small -0.13, between TOTAL SA and Suncor Energy.
Thinking “DuPont”, this should not be surprising. Indeed, DuPont analysis implicitly states that in order to drive its ROE, company management is mostly left with carefully choosing its Degree of Financial Leverage. Hence is case of concomitant default of two corporates, lenders should not expect to loose the same amount of money on their debt.As a conclusion, ALGOSAVE confirms DuPont analysis profound wisdom : LGD CORRELATION is a ROCK-BOTTOM LOW and CAPITAL SAVING critical metric.
- Last but not least ALGOSAVE ALSO offers a surprise on PD-LGD correlation in stressed scenario for high-grade borrowers.
This will be the object our our next post. Please stay tuned.If you like this post, do not hesitate to ask for you free subscription :