Credit Risk Expected Return Classes #13; Chap 11

Lecture Outline Purpose: Gain a basic understanding of credit risk. Specifically, how it effects loan returns Brief Introduction to Credit Risk- what is it; why it is important? How to calculate expected loan return Contractually promised return Expected return Required return

Variation in asset prices due to the risk of default What is Credit Risk? Home Mortgage Losses Settlement It is the risk associated with a loan (or bond) having to do with a borrower’s unwillingness or inability to pay. Variation in asset prices due to the risk of default

Types of Loans Other loans include: C&I loans: Secured and unsecured Real Estate loans: Primarily mortgages Fixed vs. Floating Individual (consumer) loans: Non-revolving loans (Automobile, mobile home, personal loans) Revolving loans (Credit line) Growth in credit card debt (Visa, MasterCard ) Other loans include: Farm loans, Other banks, Nonbank FIs, Broker margin loans; Foreign banks and sovereign governments, State and local governments

Loan Returns Contractually Promised Return Expected Return Required Return

Contractually Promised Return

Contractually Promised Return Definition The return that the bank realizes if the loan does not default (best case) Origination fee – a one-time payment at origination usually used to cover administrative costs Interest Earned – total interest earned over the life of the loan Compensating Balance – a fraction of the loan principal required to be held in demand deposits at the bank Interest Expense – includes all interest expenses over the life of the loan that the bank incurs from issuing the loan Reserve Requirements – Reserves sent to the fed to cover additional reserve requirements incurred from issuing the new loan (from the compensating balance) Rcontractual Reserve Req. Rcontractual

Contractually Promised Return Loan Interest Rate How does the bank determine the interest rate it charges? Loan Interest Rate Bank will usually charge a base rate that is related to their funding costs (Libor) + some risk premium LIBOR Tied to funding cost Base Rate = 12% FICO Credit Risk Premium = 2% Tied to borrower credit risk Job/ Income Loan Interest Rate = 14%

Contractually Promised Return Book Formula The book provides a formula so we should discuss why we do not follow the book

Contractually Promised Return Book Formula The book provides a formula so we should discuss why we do not follow the book Origination fee – Usually a one-time upfront payment but it is being added in as if it were a continuous fee It can be done by converting the one-time fee into annual payments an then asking what percent of the loan value are those incremental payments – that gives you “of” Interest Expense – the formula only works if the compensating balance is held in non-interest bearing demand deposits. Federal Reserve Interest – the formula does not take into account interest paid on reserves held at the Fed.

Contractually Promised Return Summary So at this point we have k This is the return on our loan if there is no possibility of default (it is the best case scenario) Do we always get that return? What happens if the loan defaults? we do not get the promised return we may not even get back the full principal committed k Reserve Req. No!! – the loan can default

Expected Return

Loan Expected Return Uncertainty Why do we need to calculate an expected return? What don’t we know? What can we do if we don’t know how things will turn out? If or when the loan will be paid back This is the uncertainty – it is default risk: the risk that the borrower will default on their loan We can guess

Loan Expected Return Expected Return How to guess – we want our guess to be educated and reasonable We have two cases: The borrower has enough money to payoff the loan The borrower does not have enough money to payoff the loan Default E(R) = + P (1+k) (1-P) (R) We may be able to recover some money in default There is some likelihood (probability) that the borrower will payback the loan In this case we get our full return – but we know this doesn't happen all the time There are only 2 cases payment and default. So the likelihood (probability) of default is 1- probability of payment

Loan Expected Return Expected Return How to guess – we want our guess to be educated and reasonable We have two cases: The borrower has enough money to payoff the loan The borrower does not have enough money to payoff the loan Recovery – is the percent of value recovered in default Suppose we can recover 20% of the principal? When we talk about the recovery rate we just say R or 20% but it is really 1+kD where kD is the loan return in default Default Recovery is the recovery principal net of what is earned on fees interest … up to the point when the company defaults. E(R) = + P (1+k) (1-P) (R) = (1 – 0.80) = 0.20 = (1+k) – what is our return -80%

Loan Expected Return Default vs. payment (survival) probabilities How to guess – we want our guess to be educated and reasonable We have two cases: The borrower has enough money to payoff the loan The borrower does not have enough money to payoff the loan Default E(R) = + P (1+k) (1-P) (R) What if I told you that the probability of payment was 90% P = 0.90 1–P = 0.10 What if I told you that the probability of default was 15% P = 0.85 1–P = 0.15

Loan Expected Return Summary The expected return on a loan adjusts for default risk That is, it is a guess at what the loan return will be taking into account the possibility of default E(R) = P(1+k) + (1–P)(R) Survival Probability (prob of payment) Default Probability Contractually promised return Recovery Rate E(R) = (Survival Prob)(1+k) + (Default Prob)(R)

Required Return

Required Return How does a bank decide when they will issue a loan? Economic conditions Required Return Funding Costs 4% Global Markets To be profitable, the bank needs to earn more than 4% expected return on its loans In order to maintain positive expected profits the bank must only issue loans with an expected return greater than or equal to the required return, which means:

Required Return Net Present Value (NPV) Anything above the bank’s required compensation is positive value to the bank Net Value = Loan Proceeds – Loan Cost NPV = PV(Loan Proceed – Loan Cost )

Required Return Net Present Value (NPV) – Example Example: Consider a 1-year loan for $500M. Calculate the loan NPV if its expected return is 6% and the bank’s required return is 4%

Example

Loan Return Example a) Contractually Promised Return Asolo bank issues a 3-year $15M balloon payment loan to Kemp Inc. The loan has an annual interest rate of 6%, origination fee of 2% and compensating balance of 4% to be held in demand deposits that pay 1.5%. Kemp has a 13% probability of default over the next 3 years and expected recovery rate of 40%. Asolo’s cost of capital is 3% and the fed requires 10% of demand deposits to be held on reserve. Calculate the contractually promised return Calculate the expected return of the loan Find the NPV of the loan a) Contractually Promised Return Step #1: Calculate interest Earned Step #2: Fee Income

Loan Return Example a) Contractually Promised Return Asolo bank issues a 3-year $15M balloon payment loan to Kemp Inc. The loan has an annual interest rate of 6%, origination fee of 2% and compensating balance of 4% to be held in demand deposits that pay 1.5%. Kemp has a 13% probability of default over the next 3 years and expected recovery rate of 40%. Asolo’s cost of capital is 3% and the fed requires 10% of demand deposits to be held on reserve. Calculate the contractually promised return Calculate the expected return of the loan Find the NPV of the loan a) Contractually Promised Return Step #3: Compensating Balance Step #4: Reserve Requirements Step #5: Interest Expense

Loan Return Example a) Contractually Promised Return Asolo bank issues a 3-year $15M balloon payment loan to Kemp Inc. The loan has an annual interest rate of 6%, origination fee of 2% and compensating balance of 4% to be held in demand deposits that pay 1.5%. Kemp has a 13% probability of default over the next 3 years and expected recovery rate of 40%. Asolo’s cost of capital is 3% and the fed requires 10% of demand deposits to be held on reserve. Calculate the contractually promised return Calculate the expected return of the loan Find the NPV of the loan a) Contractually Promised Return

k is the contractually promised return from the last slide Loan Return Example Asolo bank issues a 3-year $15M balloon payment loan to Kemp Inc. The loan has an annual interest rate of 6%, origination fee of 2% and compensating balance of 4% to be held in demand deposits that pay 1.5%. Kemp has a 13% probability of default over the next 3 years and expected recovery rate of 40%. Asolo’s cost of capital is 3% and the fed requires 10% of demand deposits to be held on reserve. Calculate the contractually promised return Calculate the expected return of the loan Find the NPV of the loan b) Expected Return What is P? In this case you are given the default probability so you need to calculate the survival probability k is the contractually promised return from the last slide

Loan Return Example b) Expected Return Asolo bank issues a 3-year $15M balloon payment loan to Kemp Inc. The loan has an annual interest rate of 6%, origination fee of 2% and compensating balance of 4% to be held in demand deposits that pay 1.5%. Kemp has a 13% probability of default over the next 3 years and expected recovery rate of 40%. Asolo’s cost of capital is 3% and the fed requires 10% of demand deposits to be held on reserve. Calculate the contractually promised return Calculate the expected return of the loan Find the NPV of the loan b) Expected Return This is the gross expected return it includes the initial investment and tells us that we would expect the have 111% of what we started with in 3 years. Note this is not an annualized rate. Annualize return: What rate would we need to invest $1 at for 3 years to get $1.11?

Question: Why don’t we consider interest payments fees … Loan Return Example Asolo bank issues a 3-year $15M balloon payment loan to Kemp Inc. The loan has an annual interest rate of 6%, origination fee of 2% and compensating balance of 4% to be held in demand deposits that pay 1.5%. Kemp has a 13% probability of default over the next 3 years and expected recovery rate of 40%. Asolo’s cost of capital is 3% and the fed requires 10% of demand deposits to be held on reserve. Calculate the contractually promised return Calculate the expected return of the loan Find the NPV of the loan C) Loan NPV Question: Why don’t we consider interest payments fees … The returns we have calculated – the expected return and required return are “all inclusive” – they include interest fees …, remember when we calculated the expected return we took all of that into account We expect our $15M investment to return 3.66% per year over the next 3 years so this is the expected value in 3 years But the bank only requires 3% (that is the return they need to break-even) so we discount at 3% anything over 3% is positive value (gravy)

Example: ConocoPhillips borrows $3M from Bank of America for one year to cover a short-term capital shortage. They agree to pay 9% interest per annum on the loan. Bank of America charges a 3% origination fee and requires an 8% compensating balance to be held in demand deposits. Bank of America pays 2% on demand deposits. The Federal Reserve requires that 10% of deposits be held in reserves at the Fed. In the case of default, Bank of America expects to recover 60% of the loan value. Bank of America’s cost of capital is 2.5% Find the contractually promised return What is Bank of America’s maximum acceptable probability of default for ConocoPhillips over the coming year

Lecture Summary Loan Contractually Promised Return Is the total return that the bank realizes over the life of the loan if the borrower does not default Loan Expected Return Adjusts for the possibility that the firm will default Decreases the return relative to the contractually promised Loan NPV Bank profit on the loan after taking into account the banks cost of capital.