Economy & Credit Chest

The senior and mezzanine return profile has an option-like feature, like short puts out-of-the-money (BBB) and far-out-of-the money (AAA) in return terms. When investment grade default rates rise significantly above their long-term historical average, mezzanine notes become impaired. On the other hand, CDS portfolio deterioration causes in general mark-to-market losses and might result in rating downgrades with respect to the notes.

Assumption: The annualized 5-year cumulative BBB credit loss rate is 0.20 percent, assuming a recovery rate of 40 percent. The size of the first loss tranche equals 4 percent, the size of the BBB-note 2.5 percent and the AAA note 3 percent in the example with a portfolio of BBB rated CDS.

A natural tendency to evaluate the present or focus on the immediate decision should be tempered with a sense of perspective and the past. As discussed previously, you need to avoid misinterpreting the lessons of the past or using events to justify current decisions but with a spurious logic. The anchoring, sunk-cost and confirming evidence traps are all behavioural flaws that rely on specific attitudes to past events. A genuine understanding of the past is crucial, but it needs to be related to what is happening in the present and kept in perspective. As Julian Barbour, a theoretical physicist, says:

The higher we climb, the more comprehensive the view. Each new vantage point yields a better understanding of the interconnection of things. What is more, gradual accumulation of understanding is punctuated by sudden and startling enlargements of the horizon, as when we reach the brow of a hill and see things never conceived of in the ascent. Once we have found our bearings in the new landscape, our path to the most recently attained summit is laid bare and takes its honourable place in the new world.

Scenario thinking, and in particular the notion of the strategic conversation described by Kees van der Heijden, enables us to build our knowledge and understanding of the past and present, making connections and creating original insights that inform our decisions.

• Brand management
• What is the purpose of the brand? What values does it need to emphasise to customers?
• How can the brand be used to greatest effect?
• Is sufficient attention given to building and publicising the brand?
• Is the brand used consistently?
• Is the product in the best part of the market, or is repositioning needed?
• What is the best way to appeal to customers? How should the product be sold?
• Avoiding a head-on confrontation with the market leader is often a wise course. Is this happening, or are you in danger of waking a sleeping giant?
• Is a simple, consistent and compelling message being used to sell the product?
• Do you measure the profitability of customers?
• Are you targeting, attracting and retaining the most profitable customers?
• What plans are in place to keep customers loyal? Are they appealing to customers and difficult for  competitors to copy?