1. McGraw-Hill/Irwin Copyright © 2012 by The McGraw-Hill Companies, Inc. All rights reserved. Chapter Twenty Managing Credit Risk on the Balance Sheet

2. 20-2 Credit Risk Management Financial institutions (FIs) are special because of their ability to transform financial claims of household savers efficiently into claims issued to corporations, individuals, and governments FIs’ ability to process and evaluate information and control and monitor borrowers allows them to transform these claims at the lowest possible cost to all parties Credit allocation is an important type of financial claim transformation for commercial banks FIs make loans to corporations, individuals, and governments FIs accept the risks of loans in return for interest that (hopefully) covers the costs of funding net of defaults and, as a result, are exposed to credit risk Financial institutions (FIs) are special because of their ability to transform financial claims of household savers efficiently into claims issued to corporations, individuals, and governments FIs’ ability to process and evaluate information and control and monitor borrowers allows them to transform these claims at the lowest possible cost to all parties Credit allocation is an important type of financial claim transformation for commercial banks FIs make loans to corporations, individuals, and governments FIs accept the risks of loans in return for interest that (hopefully) covers the costs of funding net of defaults and, as a result, are exposed to credit risk

3. 20-3 Credit Risk Management The credit quality of many FIs’ lending and investment decisions has been called into question in the past 25 years Problems related to real estate and junk bond lending surfaced at banks, thrifts, and insurance companies in the late 1980s and early 1990s Concerns related to the rapid increase of credit cards and auto lending occurred in the late 1990s Commercial lending standards declined in the late 1990s, which led to increases in high-yield business loan delinquencies Concerns shifted to technology loans in the late 1990s and early 2000s Mortgage delinquencies, particularly with subprime mortgages, surged in 2006 and mortgage and credit card delinquencies continue to be a concern The credit quality of many FIs’ lending and investment decisions has been called into question in the past 25 years Problems related to real estate and junk bond lending surfaced at banks, thrifts, and insurance companies in the late 1980s and early 1990s Concerns related to the rapid increase of credit cards and auto lending occurred in the late 1990s Commercial lending standards declined in the late 1990s, which led to increases in high-yield business loan delinquencies Concerns shifted to technology loans in the late 1990s and early 2000s Mortgage delinquencies, particularly with subprime mortgages, surged in 2006 and mortgage and credit card delinquencies continue to be a concern

4. 20-4 Credit Risk Management Larger banks are generally more likely to accept riskier loans than smaller banks Larger banks are also exposed to more counterparty risk off-the-balance-sheet than smaller banks Managerial efficiency and credit risk management strategies directly affect the return and risk of the loan portfolio At the extreme, credit risk can lead to insolvency as large loan losses can wipe out an FI’s equity capital Larger banks are generally more likely to accept riskier loans than smaller banks Larger banks are also exposed to more counterparty risk off-the-balance-sheet than smaller banks Managerial efficiency and credit risk management strategies directly affect the return and risk of the loan portfolio At the extreme, credit risk can lead to insolvency as large loan losses can wipe out an FI’s equity capital

5. 20-5 Credit Risk Management Losses from both on- and off-balance sheet claims resulting from the subprime crisis are expected to reach $4 trillion worldwide with $2.7 trillion in losses from assets originated at U.S. institutions Net charge-off rates reached record highs in the fourth quarter of 2008 at 1.95% and remained high in early 2009 at 1.94% The high loss rates led to the failures or buyouts of Countrywide and IndyMac Bank The seizure of IndyMac cost the FDIC between $4 billion and $8 billion and was the largest bank failure in over 20 years Losses from both on- and off-balance sheet claims resulting from the subprime crisis are expected to reach $4 trillion worldwide with $2.7 trillion in losses from assets originated at U.S. institutions Net charge-off rates reached record highs in the fourth quarter of 2008 at 1.95% and remained high in early 2009 at 1.94% The high loss rates led to the failures or buyouts of Countrywide and IndyMac Bank The seizure of IndyMac cost the FDIC between $4 billion and $8 billion and was the largest bank failure in over 20 years

6. 20-6 Credit Risk Management Number of bank failures per year: At the end of 2010 there were 860 banks on the FDIC’s ‘problem bank list’ Number of bank failures per year: At the end of 2010 there were 860 banks on the FDIC’s ‘problem bank list’ 20073 200825 2009140 2010157

7. 20-7 Credit Risk Management

8. 20-8 Credit Analysis Real estate lending mortgage loan applications are among the most standard of all credit applications decisions to approve or disapprove a mortgage application depend on: the applicant’s ability and willingness to make timely interest and principal payments the value of the borrower’s collateral the ability to maintain mortgage payments is measured by GDS and TDS Real estate lending mortgage loan applications are among the most standard of all credit applications decisions to approve or disapprove a mortgage application depend on: the applicant’s ability and willingness to make timely interest and principal payments the value of the borrower’s collateral the ability to maintain mortgage payments is measured by GDS and TDS

9. 20-9 Credit Analysis Real estate lending (cont.) GDS refers to the gross debt service ratio equal to the total accommodation expenses (mortgage, lease, condominium, management fees, real estate taxes, etc.) divided by gross income acceptable threshold generally set around max. 25% to 30% TDS refers to the total debt service ratio equal to the total accommodation expenses plus all other debt service payments divided by gross income acceptable threshold generally set around max. 35% to 40% Real estate lending (cont.) GDS refers to the gross debt service ratio equal to the total accommodation expenses (mortgage, lease, condominium, management fees, real estate taxes, etc.) divided by gross income acceptable threshold generally set around max. 25% to 30% TDS refers to the total debt service ratio equal to the total accommodation expenses plus all other debt service payments divided by gross income acceptable threshold generally set around max. 35% to 40%

10. 20-10 Credit Analysis A mortgage loan applicant has the following data: GDS Ratio= (Annual mortgage payments + Property taxes) / Annual gross income =(($3,500*12) + $4,500) / $175,000 = 26.57% Conclusion: Pass TDS Ratio = Annual total debt payments / Annual gross income = (($3,500*12) + $4,500 + $950 + $29,000) / $175,000 = 43.69% Conclusion: Fail A mortgage loan applicant has the following data: GDS Ratio= (Annual mortgage payments + Property taxes) / Annual gross income =(($3,500*12) + $4,500) / $175,000 = 26.57% Conclusion: Pass TDS Ratio = Annual total debt payments / Annual gross income = (($3,500*12) + $4,500 + $950 + $29,000) / $175,000 = 43.69% Conclusion: Fail

11. 20-11 Credit Analysis Real estate lending (cont.) FIs also use credit scoring systems to evaluate potential borrowers credit scoring systems are mathematical models that use observed loan applicant’s characteristics to calculate a score that represents the applicant’s probability of default loan officers can often give immediate “yes” or “no” answers—along with justifications for the decision Real estate lending (cont.) FIs also use credit scoring systems to evaluate potential borrowers credit scoring systems are mathematical models that use observed loan applicant’s characteristics to calculate a score that represents the applicant’s probability of default loan officers can often give immediate “yes” or “no” answers—along with justifications for the decision

12. 20-12 Sample Credit Score Criteria

13. 20-13 Credit Analysis Real estate lending (cont.) Lender may use standard FICO credit scores FICO scores run from 300 to 850, with the majority of scores between 600 and 800 Scores of 720 or higher are usually sufficient to receive a good mortgage rate FIs also verify borrower’s financial statements perfecting collateral is the process of ensuring that collateral used to secure a loan is free and clear to the lender should the borrower default on the loan Real estate lending (cont.) Lender may use standard FICO credit scores FICO scores run from 300 to 850, with the majority of scores between 600 and 800 Scores of 720 or higher are usually sufficient to receive a good mortgage rate FIs also verify borrower’s financial statements perfecting collateral is the process of ensuring that collateral used to secure a loan is free and clear to the lender should the borrower default on the loan

14. 20-14 Credit Analysis Real estate lending (cont.) FIs do not desire to become involved in loans that are likely to go into default In the event of default, lenders usually have recourse foreclosure is the process of taking possession of the mortgaged property in satisfaction of a defaulting borrower’s indebtedness and forgoing claim to any deficiency power of sale is the process of taking the proceedings of the forced sale of a mortgaged property in satisfaction of the indebtedness and returning to the mortgagor the excess over the indebtedness or claiming any shortfall as an unsecured creditor Real estate lending (cont.) FIs do not desire to become involved in loans that are likely to go into default In the event of default, lenders usually have recourse foreclosure is the process of taking possession of the mortgaged property in satisfaction of a defaulting borrower’s indebtedness and forgoing claim to any deficiency power of sale is the process of taking the proceedings of the forced sale of a mortgaged property in satisfaction of the indebtedness and returning to the mortgagor the excess over the indebtedness or claiming any shortfall as an unsecured creditor

15. 20-15 Credit Analysis Real estate lending (cont.) before an FI accepts a mortgage, it: confirms the title and legal description of the property obtains a surveyor’s certificate confirming that the house is within the property’s boundaries checks with the tax office to confirm that no property taxes are unpaid requests a land title search to determine that there are no other claims against the property obtains an independent appraisal to confirm that the purchase price is in line with the market value of the property Real estate lending (cont.) before an FI accepts a mortgage, it: confirms the title and legal description of the property obtains a surveyor’s certificate confirming that the house is within the property’s boundaries checks with the tax office to confirm that no property taxes are unpaid requests a land title search to determine that there are no other claims against the property obtains an independent appraisal to confirm that the purchase price is in line with the market value of the property

16. 20-16 Credit Analysis Consumer and small business lending Techniques are very similar to that of mortgage lending However, non-mortgage consumer loans focus on the ability to repay rather than on the property credit models put more emphasis on personal characteristics Small-business loan decisions often combine computer- based financial analysis of borrower financial statements with behavioral analysis of the business owner Consumer and small business lending Techniques are very similar to that of mortgage lending However, non-mortgage consumer loans focus on the ability to repay rather than on the property credit models put more emphasis on personal characteristics Small-business loan decisions often combine computer- based financial analysis of borrower financial statements with behavioral analysis of the business owner

17. 20-17 Credit Analysis Mid-market commercial and industrial lending is generally a profitable market for credit-granting FIs Typically mid-market corporates: have sales revenues from $5 million to $100 million per year have a recognizable corporate structure do not have ready access to deep and liquid capital markets Commercial loans can be for as short as a few weeks to as long as 8 years or more short-term loans are used to finance working capital needs long-term loans are used to finance fixed asset purchases Mid-market commercial and industrial lending is generally a profitable market for credit-granting FIs Typically mid-market corporates: have sales revenues from $5 million to $100 million per year have a recognizable corporate structure do not have ready access to deep and liquid capital markets Commercial loans can be for as short as a few weeks to as long as 8 years or more short-term loans are used to finance working capital needs long-term loans are used to finance fixed asset purchases

18. 20-18 Credit Analysis Mid-market C&I lending (cont.) generally at least two loan officers must approve a new loan customer large credit requests are presented formally to a credit approval officer and/or committee five C’s of credit character capacity collateral conditions capital Mid-market C&I lending (cont.) generally at least two loan officers must approve a new loan customer large credit requests are presented formally to a credit approval officer and/or committee five C’s of credit character capacity collateral conditions capital

19. 20-19 Credit Analysis Mid-market C&I lending (cont.) FIs perform cash flow analyses, which provide information regarding an applicant’s expected cash receipts and disbursements statements of cash flows separate cash flows into: cash flows from operating activities cash flows from investing activities cash flows from financing activities FIs may also perform ratio analyses time-series analyses cross-sectional analyses Mid-market C&I lending (cont.) FIs perform cash flow analyses, which provide information regarding an applicant’s expected cash receipts and disbursements statements of cash flows separate cash flows into: cash flows from operating activities cash flows from investing activities cash flows from financing activities FIs may also perform ratio analyses time-series analyses cross-sectional analyses

20. 20-20 Sample Cash Flow Analysis

21. 20-21 Credit Analysis Mid-market C&I lending (cont.) Common ratio analysis includes: liquidity ratios  current ratio  quick ratio (i.e., the acid test) asset management ratios  number of days in receivables  number of days in inventories  sales to working capital  sales to fixed assets  sales to total assets (i.e., the asset turnover ratio) Mid-market C&I lending (cont.) Common ratio analysis includes: liquidity ratios  current ratio  quick ratio (i.e., the acid test) asset management ratios  number of days in receivables  number of days in inventories  sales to working capital  sales to fixed assets  sales to total assets (i.e., the asset turnover ratio)

22. 20-22 Credit Analysis Mid-market C&I lending (cont.) debt and solvency ratios  debt-to-assets ratio  times interest earned ratio  cash-flow-to-debt ratio profitability ratios  gross margin  operating profit margin  return on assets (ROA)  return on equity (ROE)  dividend payout ratio Mid-market C&I lending (cont.) debt and solvency ratios  debt-to-assets ratio  times interest earned ratio  cash-flow-to-debt ratio profitability ratios  gross margin  operating profit margin  return on assets (ROA)  return on equity (ROE)  dividend payout ratio

23. 20-23 Sample Ratio Analysis

24. 20-24 Credit Analysis Mid-market C&I lending (cont.) Ratio analysis has limitations: diverse firms are difficult to compare versus benchmarks different accounting methods can distort industry comparisons applicants can distort financial statements common-size analysis and growth rates common-size financial statements present values as percentages to facilitate comparison versus competitors year-to-year growth rates can identify trends loan covenants can be used as part of the loan agreement to mitigate credit risk Mid-market C&I lending (cont.) Ratio analysis has limitations: diverse firms are difficult to compare versus benchmarks different accounting methods can distort industry comparisons applicants can distort financial statements common-size analysis and growth rates common-size financial statements present values as percentages to facilitate comparison versus competitors year-to-year growth rates can identify trends loan covenants can be used as part of the loan agreement to mitigate credit risk

25. 20-25 Credit Analysis Mid-market C&I lending (cont.) Following approval, the account officer ensures that conditions precedent have been cleared those conditions specified in the credit agreement or terms sheet for a credit that must be fulfilled before drawings are permitted includes title searches, perfecting of collateral, etc. FIs typically wish to develop permanent, long-term, mutually beneficial relationships with their mid-market commercial and industrial customers Mid-market C&I lending (cont.) Following approval, the account officer ensures that conditions precedent have been cleared those conditions specified in the credit agreement or terms sheet for a credit that must be fulfilled before drawings are permitted includes title searches, perfecting of collateral, etc. FIs typically wish to develop permanent, long-term, mutually beneficial relationships with their mid-market commercial and industrial customers

26. 20-26 Credit Analysis Large commercial and industrial lending fees and spreads are smaller relative to small and mid- size corporate loans, but the transactions are often large enough to make them worthwhile FIs’ relationships with large clients often center around broker, dealer, and advisor activities with lending playing a lesser role Large corporations often use: loan commitments performance guarantees term loans Large commercial and industrial lending fees and spreads are smaller relative to small and mid- size corporate loans, but the transactions are often large enough to make them worthwhile FIs’ relationships with large clients often center around broker, dealer, and advisor activities with lending playing a lesser role Large corporations often use: loan commitments performance guarantees term loans

27. 20-27 Credit Analysis Large C&I lending (cont.) Account officers often rely on rating agencies and market analysts to aid in their credit analysis Sophisticated credit scoring models are also used Altman’s Z-score: Z = 1.2X 1 + 1.4X 2 + 3.3X 3 + 0.6X 4 + 1.0X 5 where X 1 = working capital ÷ total assets X 2 = retained earnings ÷ total assets X 3 = earnings before interest and taxes ÷ total assets X 4 = market value of equity ÷ book value of long-term debt X 5 = sales ÷ total assets Large C&I lending (cont.) Account officers often rely on rating agencies and market analysts to aid in their credit analysis Sophisticated credit scoring models are also used Altman’s Z-score: Z = 1.2X 1 + 1.4X 2 + 3.3X 3 + 0.6X 4 + 1.0X 5 where X 1 = working capital ÷ total assets X 2 = retained earnings ÷ total assets X 3 = earnings before interest and taxes ÷ total assets X 4 = market value of equity ÷ book value of long-term debt X 5 = sales ÷ total assets

28. 20-28 Altman Z Analysis Large C&I lending (cont.) The higher the Z-score, the lower the probability of borrower default A borrower with a Z-score less than 1.81 is considered to have high default risk Z–score of 2.99 or more indicates low default risk Z–score between 1.81 and 2.99 indicates that the loan applicant’s default risk is indeterminate Large C&I lending (cont.) The higher the Z-score, the lower the probability of borrower default A borrower with a Z-score less than 1.81 is considered to have high default risk Z–score of 2.99 or more indicates low default risk Z–score between 1.81 and 2.99 indicates that the loan applicant’s default risk is indeterminate

29. 20-29 Altman Z-Score Example Using the data from before:

30. 20-30 Credit Analysis Large C&I lending (cont.) KMV Credit Monitor Model uses the option pricing model of Merton, Black, and Scholes to calculate expected default frequencies for over 60,000 public companies and many private ones worldwide. Large C&I lending (cont.) KMV Credit Monitor Model uses the option pricing model of Merton, Black, and Scholes to calculate expected default frequencies for over 60,000 public companies and many private ones worldwide.

31. 20-31 Credit Analysis Calculating the return on a loan the return on assets (ROA) approach uses the contractually promised gross return on a loan, k, per dollar lent wheref = the loan origination fee b = the compensating balance requirement RR = the reserve requirement ratio BR = the base lending rate m = the credit risk premium on the loan Calculating the return on a loan the return on assets (ROA) approach uses the contractually promised gross return on a loan, k, per dollar lent wheref = the loan origination fee b = the compensating balance requirement RR = the reserve requirement ratio BR = the base lending rate m = the credit risk premium on the loan

32. 20-32 ROA Analysis of a Loan Example 1: A bank has a base lending rate of 8% (BR), and charges a certain customer a 110 basis point risk premium (m). The bank also charges a 1% origination fee (f). The bank requires the borrower to maintain compensating balances (b) of 7% of the loan amount. The reserve requirement (RR) is 10% and the loan amount is $1 million. Calculate the required gross return on a loan = k.

33. 20-33 RAROC Model Calculating the return on a loan (cont.) The risk-adjusted return on assets (RAROC) model balances a loan’s expected income against its expected risk The RAROC is compared vis-à-vis the lender’s tax- adjusted return on equity (ROE) o if RAROC > ROE, make the loan o if RAROC ROE or decline to make the loan Calculating the return on a loan (cont.) The risk-adjusted return on assets (RAROC) model balances a loan’s expected income against its expected risk The RAROC is compared vis-à-vis the lender’s tax- adjusted return on equity (ROE) o if RAROC > ROE, make the loan o if RAROC ROE or decline to make the loan

34. 20-34 Example 1: RAROC Example 1 (continued)

35. 20-35 RAROC Example Example 1 (continued) RAROC Suppose the cost rate to fund the loan = 10.3% Dollar cost to finance the loan = $937,000 * 10.3% = $96,511 The 99 th percentile, or the extreme loss rate, for this loan category is 3% per year Recovery rate on this loan type is 25%, or 75% loss rate Capital at risk = 0.03  0.75 x $1,000,000 gross loan amount = $22,500 Example 1 (continued) RAROC Suppose the cost rate to fund the loan = 10.3% Dollar cost to finance the loan = $937,000 * 10.3% = $96,511 The 99 th percentile, or the extreme loss rate, for this loan category is 3% per year Recovery rate on this loan type is 25%, or 75% loss rate Capital at risk = 0.03  0.75 x $1,000,000 gross loan amount = $22,500