ch11 1

1
BUFN 722

• ch-11
• Credit Risk
• Individual loans

2
Overview

• This chapter discusses types of loans, and the
  analysis and measurement of credit risk on
  individual loans. This is important for purposes
  of
• Pricing loans and bonds
• Setting limits on credit risk exposure

3
Credit Quality Problems

• Problems with junk bonds, LDC loans, residential
  and farm mortgage loans.
• More recently, credit card loans and auto loans.
• Crises in Asian countries such as Korea,
  Indonesia, Thailand, and Malaysia.

4
outline

• Types of Loans
• Commercial and Industrial Loans
• Real Estate Loans
• Individual (Consumer) Loans
• Other Loans
• The Return on a Loan
• The Contractually Promised Return on a Loan
• The Expected Return on a Loan
• Retail versus Wholesale Credit Decisions
• Retail
• Wholesale
• Measurement of Credit Risk
• Default Risk Models
• Qualitative Models
• Borrower-Specific Factors
• Market-Specific Factors
• Credit Scoring Models
• Newer Models of Credit Risk Measurement and
  Pricing
• Term Structure Derivation of Credit Risk

5
Credit Quality Problems

• Over the 90s, improvements in NPLs for large
  banks and overall credit quality.
• Recent exposure to borrowers such as Enron.
• New types of credit risk related to loan
  guarantees and off-balance-sheet activities.
• Increased emphasis on credit risk evaluation.

6
Types of Loans

• CI loans secured and unsecured
• Spot loans, Loan commitments
• Decline in CI loans originated by commercial
  banks and growth in commercial paper market.
• RE loans primarily mortgages
• Fixed-rate, ARM
• Mortgages can be subject to default risk when
  loan-to-value declines.

7
Consumer loans

• Individual (consumer) loans personal, auto,
  credit card.
• Nonrevolving loans
• Automobile, mobile home, personal loans
• Growth in credit card debt
• Visa, MasterCard
• Proprietary cards such as Sears, ATT
• Risks affected by competitive conditions and
  usury ceilings

8
Other loans

• Other loans include
• Farm loans
• Other banks
• Nonbank FIs
• Broker margin loans
• Foreign banks and sovereign governments
• State and local governments

9
Return on a Loan

• Factors interest payments, fees, credit risk
  premium, collateral, other requirements such as
  compensating balances and reserve requirements.
• A number of factors impact the promised return
  that an FI achieves on any given dollar loan
• the interest rate on the loan
• any fees relating to the loan
• the credit risk premium on the loan
• the collateral backing the loan
• other non-price terms (such as compensating
  balances and reserve requirements)
• Return inflow/outflow
• k (f (L M ))/(1-b(1-R))
• 1 k 1 f (L m)
  
• 1 - (b(1 - R))
• Expected return E(r) p(1k)
• If we know the risk premium we can infer the
  probability of default. Expected return equals
  risk free rate after accounting for probability
  of default.
• p (1 k) 1 i
• where
• k the contractually promised gross return
  on the loan
• f direct fees, such as loan origination
  fee
• L base lending rate
• m risk premium

10
Lending Rates and Rationing

• At retail Usually a simple accept/reject
  decision rather than adjustments to the rate.
• Credit rationing.
• If accepted, customers sorted by loan quantity.
• At wholesale
• Use both quantity and pricing adjustments.

11
Measuring Credit Risk

• Qualitative models borrower specific factors are
  considered as well as market or systematic
  factors.
• Specific factors include reputation, leverage,
  volatility of earnings, covenants and collateral.
• Market specific factors include business cycle
  and interest rate levels.

12
Credit Scoring Models

• Linear probability models
• Zi
• Statistically unsound since the Zs obtained are
  not probabilities at all.
• Since superior statistical techniques are
  readily available, little justification for
  employing linear probability models.

13
Other Credit Scoring Models

• Logit models overcome weakness of the linear
  probability models using a transformation
  (logistic function) that restricts the
  probabilities to the zero-one interval.
• Other alternatives include Probit and other
  variants with nonlinear indicator functions.

14
Altmans Linear Discriminant Model

• Used for analyzing publicly traded manufacturing
  firms
• Z1.2X1 1.4X2 3.3X3 0.6X4 1.0X5
• Critical value of Z 1.81.
• Z an overall measure of the borrowers default
  risk
• X1 Working capital/total assets ratio
• X2 Retained earnings/total assets.
• X3 EBIT/total assets.
• X4 Market value equity/ book value LT debt.
• X5 Sales/total assets.
• The higher the value of Z, the lower the default
  risk

15
Linear Discriminant Model

• Problems
• Only considers two extreme cases (default/no
  default).
• Weights need not be stationary over time.
• Ignores hard to quantify factors including
  business cycle effects.
• Database of defaulted loans is not available to
  benchmark the model.

16
Term Structure Based Methods

• If we know the risk premium we can infer the
  probability of default. Expected return equals
  risk free rate after accounting for probability
  of default.
• p (1 k) 1 i
• May be generalized to loans with any maturity or
  to adjust for varying default recovery rates.
• The loan can be assessed using the inferred
  probabilities from comparable quality bonds.

17
Mortality Rate Models

• Similar to the process employed by insurance
  companies to price policies. The probability of
  default is estimated from past data on defaults.
• Marginal Mortality Rates
• MMR1 (Value Grade B default in year 1)
  (Value Grade B outstanding yr.1)
• MMR2 (Value Grade B default in year 2)
  (Value Grade B outstanding yr.2)

18
RAROC (Risk adjusted return on capital) Models

• Risk adjusted return on capital. This is one of
  the more widely used models.
• Incorporates duration approach to estimate worst
  case loss in value of the loan
• DL -DL x L x (DR/(1R)) where DR is an
  estimate of the worst change in credit risk
  premiums for the loan class over the past year.
• RAROC one-year income on loan/DL
• Rather than evaluating the actual or promised
  annual cash flow on a loan as a percentage of the
  amount lent (ROA), the lending officer balances
  the loans expected income against the loans
  expected risk
• RAROC One-year income on a loan/Loan (asset
  risk or capital at risk)

19
Option Models

• Employ option pricing methods to evaluate the
  option to default.
• Used by many of the largest banks to monitor
  credit risk.
• KMV Corporation markets this model quite widely.

20
The KMV Model

• Banks can use the theory of option pricing to
  assess the credit risk of a corporate borrower
• The probability of default is positively related
  to
• the volatility of the firms stock
• the firms leverage
• A model developed by KMV corporation is being
  widely used by banks for this purpose

21
Applying Option Valuation Model

• Merton showed value of a risky loan
• F(t) Be-it(1/d)N(h1) N(h2)
• Written as a yield spread
• k(t) - i (-1/t)lnN(h2) (1/d)N(h1)
• where k(t) Required yield on risky debt
• ln Natural logarithm
• i Risk-free rate on debt of equivalent maturity.

22
CreditMetrics

• If next year is a bad year, how much will I lose
  on my loans and loan portfolio?
• VAR P 1.65 s
• Neither P, nor s observed.
• Calculated using
• (i)Data on borrowers credit rating (ii) Rating
  transition matrix (iii) Recovery rates on
  defaulted loans (iv) Yield spreads.

23
Credit Risk

• Developed by Credit Suisse Financial Products.
• Based on insurance literature
• Losses reflect frequency of event and severity of
  loss.
• Loan default is random.
• Loan default probabilities are independent.
• Appropriate for large portfolios of small loans.
• Modeled by a Poisson distribution.

24
Credit Risk Management

• An FIs ability to evaluate information and
  control and monitor borrowers allows them to
  transform financial claims of household savers
  efficiently into claims issued to corporations,
  individuals, and governments
• An FI accepts credit risk in exchange for a fair
  return sufficient to cover the cost of funding
  (e.g., covering the cost of borrowing, or issuing
  deposits)

25
Credit Analysis

• Real Estate Lending
• residential mortgage loan applications are among
  the most standardized of all credit applications
• Two considerations
• the applicants ability and willingness to make
  timely interest and principal repayments
• the value of the borrowers collateral
• GDS (gross debt service) ratio - gross debt
  service ratio calculated as total accommodation
  expenses (mortgage, lease, condominium,
  management fees, real estate taxes, etc.) divided
  by gross income
• TDS (total debt service) ratio - total debt ratio
  calculated as total accommodation expenses plus
  all other debt service payments divided by gross
  income

26
Credit Scoring

• Credit scoring system
• a mathematical model that uses observed loan
  applicants characteristics to calculate a score
  that represents the applicants probability of
  default e.g., FICO score http//www.myfico.com/
  
• Perfecting collateral
• ensuring that collateral used to secure a loan is
  free and clear to the lender should the borrower
  default
• Foreclosure
• taking possession of the mortgaged property to
  satisfy a defaulting borrowers indebtedness
• Power of sale
• taking the proceedings of the forced sale of
  property to satisfy the indebtedness

27
Credit Scoring

• Consumer (individual) and Small-business lending
• techniques for scoring consumer loans very
  similar to mortgage loan credit analysis but more
  emphasis placed on personal characteristics such
  as annual gross income and the TDS score
• small-business loans more complicated and has
  required FIs to build more sophisticated scoring
  models combining computer-based financial
  analysis of borrower financial statements with
  behavioral analysis of the owner

28
Mid-Market Commercial and Industrial Lending

• Definition of Mid-market
• offered some of the most profitable opportunities
  for credit-granting FIs
• sales revenues from 5 million to 100
  million/year
• recognizable corporate structure
• do not have ready access to deep and liquid
  capital markets
• Credit Analysis - Five Cs of Credit
• customers character, capacity, collateral,
  conditions, and capital
• Cash Flow Analysis
• provides relevant information about the
  applicants cash receipts and disbursements

29
Ratio Analysis

• Historical audited financial statements and
  projections of future needs
• Calculation of financial ratios in financial
  statement analysis
• Relative ratios offer information about how a
  business is changing over time
• Particularly informative when they differ either
  from an industry average or from the applicants
  own past history

30
Calculating Ratios
Liquidity Ratios - measures of short-term
ability of the company to pay its maturing
obligations and to meet unexpected needs for cash
Current Ratio Current
assets
Current liabilities Working Capital
Current assets Current Liabilities
Quick ratio Cash Cash equivalents
Receivables
Current liabilities Current Cash Debt
Coverage Ratio Cash Provided by Operating
Activities
Average Current liabilities

(continued)
31
Asset Management Ratios -measure how effectively
a firm is managing its assets whether or not
the level of those assets is properly related to
level of operations as measured by sales Number
of days sales in Accounts receivable x
365 receivables (ACP) Credit
sales Number of days Inventory x
365 in inventory Cost of
goods sold Sales to working
Sales
capital Working capital
Sales to fixed Sales
assets
Fixed assets Sales to total
assets Sales
Total assets
(continued)
32
Debt and Solvency ratios
-measure the ability of a company
to survive over a long period of time
Debt-asset ratio Short-term liabilities
Long-term liabilities
Total assets
Fixed-charge Earnings available to meet fixed
charges coverage ratio
Fixed charges Cash-flow-to-debt
EBIT Depreciation
ratio Debt Times
Interest Earned EBIT
Interest
Expense where EBIT represents earnings before
interest and taxes

(continued)
33
Profitability Ratios -measures of the income or
operating success of a company for a given
period of time Gross margin Gross profit
Income to Sales EBIT
Sales
Sales Operating
profit margin Operating profit

Sales Return on assets
EAT
Average total
assets Return on equity EAT
Dividend payout Dividends
Total equity
EAT where EAT represents
earnings after taxes, i.e., Net Income
34
Common Size Analysis and After the Loan

• Analyst can divide all income statement amounts
  by total sales revenue and all balance sheet
  amounts by total assets
• Year to year growth rates give useful ratios for
  identifying trends
• Loan covenants reduce risk to lender
• Conditions precedent
• those conditions specified in the credit
  agreement or terms sheet for a credit that must
  be fulfilled before drawings are permitted

35
Large Commercial and Industrial Lending

• Very attractive to FIs because transactions are
  often large enough make them very profitable even
  though spreads and fees are small in percentage
• FIs act as broker, dealer, and adviser in credit
  management
• The standard methods of analysis used for
  mid-market corporates applied to large corporate
  clients but with additional complications
• Financial ratios such as the debt-equity ratio
  are usually key factors for corporate debt

36
FICO score

• What's a FICO score? Your FICO score is the
  numeric representation of your financial
  responsibility, based on your credit history.
  Based on a scale of 300 -850, there are three
  FICO scores - one from each national credit
  bureau. These three FICO scores are the measure
  that most lenders will look at when evaluating
  your credit or loan applications. More info...
  Here's how your FICO scores could affect your
  interest rate  FICO Score Interest Rate
• 720 - 850 5.658
• 700 - 719 5.783
• 675 - 699 6.320
• 620 - 674 7.470
• 560 - 619 8.531
• 500 - 559 9.289Information for 30-year fixed
  rate mortgages, updated daily  

37
Credit Risk Scores

• Fair Isaac credit risk scores are the predictive
  tools most widely used by credit grantors, as
  well as leading telecommunications providers and
  insurance companies, in the US, UK, Canada and
  South Africa. Companies rely on these scores to
  assess consumer credit and bankruptcy risk in
  order to make more profitable decisions at all
  stages of the credit lifecyclein customer
  acquisition (prescreening and marketing),
  originations and underwriting, and customer
  management.
• Credit bureau risk scores
• Application risk models
• Credit bureau bankruptcy scores
• Credit bureau score services
• PreScore Service
• ScoreNet Service

38
Fair Isaac Co (FICO) score

• 35 of FICO score based on borrowers history of
  paying back debt
• 30 on how much of the credit available a
  borrower has used
• 15 on the length of the borrowers credit
  history
• 10 each on type of credit pattern of credit
  use
• FICO scores generally 550
• 20 of US population has FICO score generally the cutoff for a prime-rate loan.
  (i.e., these would be sub-prime borrowers)

39
Pertinent Websites

• For more information visit
• Federal Reserve Bank www.federalreserve.gov
• OCC www.occ.treas.gov KMV www.kmv.com
• Card Source One www.cardsourceone.com
• FDIC www.fdic.gov
• Credit Metrics www.creditmetrics.com
• Robert Morris Assoc. www.rmahq.org

Web Surf
40
Pertinent Websites

• The Economist www.economist.com
• Fed. Reserve Bank St. Louis www.stls.frb.gov
• Federal Housing Finance Board www.fhfb.gov
• Moodys www.moodys.com
• Standard Poors www.standardandpoors.com
• FairIsaac http//www.myfico.com/
• Equifax Experian TransUnion
• http//www.fairisaac.com/Fairisaac/Solutions/Scori
  ng-PredictiveModeling/

Web Surf