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 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  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

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: 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

11-8 Performance  Varies by loan type and lending quality  Some aggregate Data:

11-9 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.

11-10 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

11-11 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

11-12 Credit Quality Problems  New types of credit risk related to loan guarantees and off-balance-sheet activities.  Increased emphasis on credit risk evaluation.

11-13 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

11-14 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

11-15 Other loans  Other loans include: Farm loans Other banks Nonbank FIs Broker margin loans Foreign banks and sovereign governments State and local governments

11-16 Recall Bank Balance Sheets from Ch 2

11-17 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!

11-18

11-19 Loan Growth and Asset Quality

11-20 Annual Net Charge-Off Rates on Loans

11-21

11-22

11-23

11-24

11-25

11-26

11-27

11-28

11-29

11-30

11-31

11-32 Moody’s Default Rates Investment GradeHigh Yield OriginalRe-weightedOriginalRe-weighted Mean Worst Single Year Worst 3-Year Period Worst 6-Year Period Worst 3 Years