11-1Chapter 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

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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

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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

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Forms of Credit Risk

Default

Down-grade

Spread

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Where Banks Face Credit Risk

Loans Usually secured

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

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Default does not = 100% loss

Often, some amount is recovered

Estimate loss = EDF x (1-recovery rate)

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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

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Performance

Varies by loan type and lending quality Some aggregate Data:

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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.

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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

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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

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Credit Quality Problems

New types of credit risk related to loan guarantees and off-balance-sheet activities.

Increased emphasis on credit risk evaluation.

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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

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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

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Other loans

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

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Recall Bank Balance Sheets from Ch 2

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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!

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Loan Growth and Asset Quality

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Annual Net Charge-Off Rates on Loans

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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