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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 Designing loan products Setting limits on credit risk exposure.

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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 • Designing loan products • 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 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

  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: 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

  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

  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

  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. 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

  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

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

  14. Recall Bank Balance Sheets from Ch 2

  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!

  16. Non-Performing Loans – US Banks

  17. Annual Net Charge-Off Rates on Loans

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

  19. Loan Growth and Asset Quality

  20. C&I Loans – Just a Bad Recession

  21. Recent Credit Trends – FDIC site

  22. Resulting in Fewer Bank Failures

  23. Maybe, Just in Time for the DIF

  24. Capital Ratios Alos Rebuilding

  25. Disasterous Performance

  26. Why the Difference in Rates?

  27. 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

  28. DIRECTV: On Demand

  29. Moody’s Default Rates 1920-2006%

  30. 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.

  31. 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.

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