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Chapter 11 Overview – Part A

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 Setting limits on credit risk exposure. Introduction To Credit Risk. Forms of credit risk

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Chapter 11 Overview – Part A

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  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 • Setting limits on credit risk exposure

  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

  3. Methods of Measuring/Monitoring Risk Linear-Discriminant Models Probability-based 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

  4. Forms of Credit Risk Default Down-grade Spread

  5. Where Banks Face Credit Risk Loans Usually secured Loan Commitments Letters of Credit Derivative positions (fundamental) Counter-party risk

  6. Default does not = 100% loss Often, some amount isrecovered Estimate loss = EDF x (1-recovery rate)

  7. How Loan Losses Impact Banks Expense loan loss costs each period: Allowance 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

  8. Performance Varies by loan type and lending quality Some aggregate Data:

  9. Credit Quality Problems • Historical problems with: • junk bonds • LDC loans • farm mortgage loans • Commercial real estate loans • Crises in Asian countries such as Korea, Indonesia, Thailand, and Malaysia.

  10. Credit Quality Problems • Current problems • Sub-prime mortgages • Spreading to prime mortgages • Economic recession impacting • Credit Card loans • Auto loans • Commercial & Industrial loans at “normal” recession levels so far

  11. Credit Quality Problems • Default of one major borrower can have significant impact on value and reputation of many FIs • Emphasizes importance of managing credit risk

  12. Credit Quality Problems • New types of credit risk related to loan guarantees and off-balance-sheet activities. • Increased emphasis on credit risk evaluation.

  13. 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. • Downgrades of Ford, General Motors and Tyco • 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

  14. 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

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

  16. Recall Bank Balance Sheets from Ch 2

  17. 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!

  18. Loan Growth and Asset Quality

  19. Annual Net Charge-Off Rates on Loans

  20. Moody’s Default Rates 1920-2006

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