Economy & Credit Chest

The break-even in the IRR profile of the AAAtranche is a multiple of the annualized historical average loss for BBB-rated corporates (10x in this case). The BBB-class hits the IRR of the portfolio at around 0.9 percent which is 4.5 times the historical average loss. Static synthetic mezzanines normally exhibit a lower rating stability than mezzanine notes of managed synthetic CDOs, depending on the skill of the manager.

Assumption: The 5-year cumulative default rate for BBB is around 1.60 percent, assuming a 40 percent recovery rate. This equals an annualized 0.2 percent expected loss rate. The size of the mezzanine tranches affects the expected loss (probability of loss unaffected). As the size of the mezzanine class decreases the expected loss tends to increase hyperbolically as seen (binomial expansion technique with a diversity score of 55 was used). The ratio of the expected tranche losses to the expected CDS portfolio losses would define the risk leverage. When the ratio is above 1 the mezzanine note has a greater expected percentage loss than the underlying portfolio. The percentage of the first loss class has a major impact on the leverage of the mezzanine class (assuming the same underlying exposure in size.

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.

Many people have trouble in coming up with new ideas or solutions to a problem. The answer often lies in fostering innovation, by creating the right conditions to be innovative or simply to see the best way forward. If this is to work and be sustainable, the climate for decision-making must be as positive, open and encouraging as possible. Linked with this is the need for people to feel valued. If they do not, there is a risk that they will be negative about the change, reactive rather than proactive.

Or they may decide to leave. One way of fostering innovation is to encourage employees to question the way things are done or decisions that have been made. Removing or minimising barriers (such as bureaucracy and hierarchy) can drive innovation, and so can an ability to exert mild pressure, perhaps by setting deadlines. Techniques that help spur creativity and innovation include brainstorming and mind mapping, as they help individuals to come up with ideas and to see patterns or organise information in such a way that patterns and ideas develop.