11-1

Chapter 11 Overview – Part A

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

Designing loan products

Setting limits on credit risk exposure

11-2

Introduction To Credit Risk

Forms of credit risk Where do banks face credit risk? Performance Impact on bank profits

Accounting Methods of measuring/Monitoring Risk

11-3

Methods of Measuring/Monitoring Risk

Linear-Discriminant Models Altman Z-score

Term Structure of Credit Risk Option-based models

Value the default option Loan value = balance – option value Merton-Miller 1970’s Only implemented recently Key Equipment Financial uses this

11-4

Forms of Credit Risk

Default

Down-grade

Spread

11-5

Where Banks Face Credit Risk

Loans Usually secured

Loan Commitments Letters of Credit Derivative positions (fundamental) Counter-party risk

11-6

Default does not = 100% loss

Often, some amount is recovered

Estimate loss = EDF x (1-recovery rate)

11-7

How Loan Losses Impact Banks

Expense loan loss costs each period:

Provision for loan losses

Loan loss reserve

Charge-off a loan:

Loan loss reserve

Loan Balances

Note trends in allowance and adequacy of reserves versus loans outstanding

11-8

Credit Quality Problems Pre-Crisis

Historical problems with: junk bonds LDC loans & Debt

Argentina, Brazil, Russia, South Korea Farm mortgage loans Commercial real estate loans

11-9

Credit Quality Problems

Current problems Sub-prime mortgages Spread to prime mortgages due to LTV

Commercial & Industrial loans at “normal” recession levels so far

Sovereign debt of developed countries Greece Ireland Portugal Italy Spain

11-10

Additional issues in Credit Quality

Default of one major borrower can have significant impact on value and reputation of many FIs

Diversification may be illusory

Individual bank and systemic risk related to counterparty risk

11-11

Types of Loans:

C&I loans: secured and unsecured Solo or syndication Spot loans, Loan commitments Decline in C&I 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 increases. HELs Commercial RE loans totally separate market

11-12

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, AT&T

Consolidation among credit card issuers Bank of America & MBNA

Risks affected by competitive conditions and usury ceilings

Bankruptcy Reform Act of 2005

11-13

Other loans

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

11-14

Recall Bank Balance Sheets from Ch 2

11-15

Impact of Securities Markets on Banks

$2 trillion Commercial paper $2 trillion Investment grade bonds $4 trillion Residential mortgages Also:

Auto loans Credit card balances Commercial real estate loans Even commercial loans themselves!

11-16

Non-Performing Loans – US Banks

11-17

Annual Net Charge-Off Rates on Loans

11-18

Performance

Varies by loan type and lending quality Some aggregate Data:

11-19

Loan Growth and Asset Quality

11-20

C&I Loans – Just a Bad Recession

11-21

Recent Credit Trends – FDIC site

11-22

Resulting in Fewer Bank Failures

11-23

Maybe, Just in Time for the DIF

11-24

Capital Ratios Alos Rebuilding

11-25

Disasterous Performance

11-26

11-27

Why the Difference in Rates?

11-28

Loan Types Differ in Many Ways

Size of the typical loan Availability/quality of collateral Degree of credit screening Degree of credit monitoring Degree of customization Covenants Structure

11-29

11-30

11-31

Moody’s Default Rates 1920-2006

%

  Investment Grade High Yield

  Original Re-weighted Original Re-weighted

         

Mean .146 .152 2.69 4.34

         

Worst Single Year 1.55 1.66 15.90 23.50

         

Worst 3-Year Period 0.89 0.94 11.35 14.15

         

Worst 6-Year Period 0.88 0.91 8.13 11.30

         

Worst 3 Years 1.20 1.28 12.26 20.50

         

11-32

Altman’s Linear Discriminant Model:

Z=1.2X1+ 1.4X2 +3.3X3 + 0.6X4 + 1.0X5

Critical value of Z = 1.81. X1 = Working capital/total assets.

X2 = Retained earnings/total assets.

X3 = EBIT/total assets.

X4 = Market value equity/ book value of total liabilities

X5 = Sales/total assets.

11-33

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.