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 Designing loan products 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 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

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: 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

11-8 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

11-9 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

11-10 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

11-11 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

11-12 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

11-13 Other loans  Other loans include: Farm loans Other banks Nonbank FIs Broker margin loans Foreign banks and sovereign governments State and local governments

11-14 Recall Bank Balance Sheets from Ch 2

11-15 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!

11-16 Non-Performing Loans – US Banks

11-17 Annual Net Charge-Off Rates on Loans

11-18 Performance  Varies by loan type and lending quality  Some aggregate Data:

11-19 Loan Growth and Asset Quality

11-20 C&I Loans – Just a Bad Recession

11-21 Recent Credit Trends – FDIC site

11-22 Resulting in Fewer Bank Failures

11-23 Maybe, Just in Time for the DIF

11-24 Capital Ratios Alos Rebuilding

11-25 Disasterous Performance

11-26

11-27 Why the Difference in Rates?

11-28 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

11-29 DIRECTV: On Demand

11-30

11-31 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

11-32 Altman’s Linear Discriminant Model:  Z=1.2X X X X X 5 Critical value of Z = X 1 = Working capital/total assets. X 2 = Retained earnings/total assets. X 3 = EBIT/total assets. X 4 = Market value equity/ book value of total liabilities X 5 = Sales/total assets.

11-33 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.