BUFN 722

1. BUFN 722 ch-11 Credit Risk Individual loans BUFN722- Financial Institutions

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 BUFN722- Financial Institutions

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. BUFN722- Financial Institutions

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 • Mortality Rate Derivation of Credit Risk • RAROC Models • Option Models of Default Risk • Summary • Appendix 11A: Cash Flow Analysis and Financial Ratios Used to Analyze Commercial Loans • Cash Flow Analysis • Common Size Analysis and Growth Rates • Appendix 11B: CreditMetrics • Rating Migration • Valuation • Calculation of VAR • Capital Requirements • Appendix 11C: Credit Risk+ • The Frequency Distribution of Default Rates BUFN722- Financial Institutions

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. BUFN722- Financial Institutions

6. Types of Loans: • C&I loans: secured and unsecured • 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 declines. BUFN722- Financial Institutions

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, AT&T • Risks affected by competitive conditions and usury ceilings BUFN722- Financial Institutions

8. Other loans • Other loans include: • Farm loans • Other banks • Nonbank FIs • Broker margin loans • Foreign banks and sovereign governments • State and local governments BUFN722- Financial Institutions

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(1+k) • 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 • b = compensating balances • R = reserve requirement charge BUFN722- Financial Institutions

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. BUFN722- Financial Institutions

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. BUFN722- Financial Institutions

12. Credit Scoring Models • Linear probability models: Zi = • Statistically unsound since the Z’s obtained are not probabilities at all. • *Since superior statistical techniques are readily available, little justification for employing linear probability models. BUFN722- Financial Institutions

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. BUFN722- Financial Institutions

14. Altman’s Linear Discriminant Model: • Used for analyzing publicly traded manufacturing firms • Z=1.2X1+ 1.4X2 +3.3X3 + 0.6X4 + 1.0X5 Critical value of Z = 1.81. Z = an overall measure of the borrower’s 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 BUFN722- Financial Institutions

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. BUFN722- Financial Institutions

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. BUFN722- Financial Institutions

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) BUFN722- Financial Institutions

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/(1+R)) 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 loan’s expected income against the loan’s expected risk • RAROC = One-year income on a loan/Loan (asset risk or capital at risk) BUFN722- Financial Institutions

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. BUFN722- Financial Institutions

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 firm’s stock • the firm’s leverage • A model developed by KMV corporation is being widely used by banks for this purpose BUFN722- Financial Institutions

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)ln[N(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. BUFN722- Financial Institutions

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 borrower’s credit rating; (ii) Rating transition matrix; (iii) Recovery rates on defaulted loans; (iv) Yield spreads. BUFN722- Financial Institutions

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. BUFN722- Financial Institutions

24. Credit Risk Management • An FI’s 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) BUFN722- Financial Institutions

25. Credit Analysis • Real Estate Lending • residential mortgage loan applications are among the most standardized of all credit applications • Two considerations • the applicant’s ability and willingness to make timely interest and principal repayments • the value of the borrower’s 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 BUFN722- Financial Institutions

26. Credit Scoring • Credit scoring system • a mathematical model that uses observed loan applicant’s characteristics to calculate a score that represents the applicant’s 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 borrower’s indebtedness • Power of sale • taking the proceedings of the forced sale of property to satisfy the indebtedness BUFN722- Financial Institutions

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 BUFN722- Financial Institutions

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 C’s of Credit • customer’s character, capacity, collateral, conditions, and capital • Cash Flow Analysis • provides relevant information about the applicant’s cash receipts and disbursements BUFN722- Financial Institutions

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 applicant’s own past history BUFN722- Financial Institutions

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) BUFN722- Financial Institutions

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) BUFN722- Financial Institutions

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) BUFN722- Financial Institutions

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 BUFN722- Financial Institutions

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 BUFN722- Financial Institutions

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 BUFN722- Financial Institutions

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 9.289%*Information for 30-year fixed rate mortgages, updated daily   BUFN722- Financial Institutions

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 lifecycle—in 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 BUFN722- Financial Institutions

38. Fair Isaac & Co (FICO) score • 35% of FICO score based on borrower’s history of paying back debt • 30% on how much of the credit available a borrower has used • 15% on the length of the borrower’s credit history • 10% each on type of credit & pattern of credit use • FICO scores generally >550 & <800 • 20% of US population has FICO score <620, generally the cutoff for a prime-rate loan. (i.e., these would be sub-prime borrowers) BUFN722- Financial Institutions

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 BUFN722- Financial Institutions

40. Pertinent Websites The Economist www.economist.com Fed. Reserve Bank St. Louis www.stls.frb.gov Federal Housing Finance Board www.fhfb.gov Moody’s www.moodys.com Standard & Poors www.standardandpoors.com FairIsaac http://www.myfico.com/ Equifax Experian TransUnion http://www.fairisaac.com/Fairisaac/Solutions/Scoring+-+Predictive+Modeling/ Web Surf BUFN722- Financial Institutions