MANAGING CREDIT RISK

Credit Risk

Credit risk is the risk of loss due to a debtor's non-payment of a loan or other line of credit (either the principal or interest (coupon) or both)

• Faced by lenders to consumers • Faced by lenders to business • Faced by business

• Faced by individuals

Faced by lenders to consumers

• Credit Scorecards to rank potential and existing customers according to risk

• With products such as unsecured personal loans or mortgages, lenders charge a higher price for higher risk customers and vice versa.

• With revolving products such as credit cards and overdrafts, risk is controlled through careful setting of credit limits.

• Some products also require security, most commonly in the form of property.

Faced by lenders to business

• Lenders will trade off the cost/benefits of a loan according to its risks and the interest charged.

• Protective covenants are written into loan agreements that allow the lender some controls. These covenants may:

– limit the borrower's ability to weaken his balance sheet voluntarily e.g., by buying back shares, or paying dividends, or borrowing further.

– allow for monitoring the debt requiring audits, and monthly reports – allow the lender to decide when he can recall the loan based on specific

events or when financial ratios like debt/equity, or interest coverage deteriorate.

• A recent innovation to protect lenders and bond holders from the danger of default are credit derivatives, most commonly in the form of a credit default swap. These financial contracts allow companies to buy protection against defaults from a third party, the protection seller. The protection seller receives a periodic fee (the credit spread) as compensation for the risk it takes, and in return it agrees to buy the debt should a credit event ("default") occur.

TYPE OF DEBTS

• Term loans

• Standby loans

• Senior and subordinate debt

• Mezzanine finance instruments

• Project finance

TERM LOAN

• Negotiated between borrower and financial institutions

• Fees involved :– Management fee : for managing the facility– Commitment fee : % of undrawn portion– Agency fee : fee for lead banker in

syndication– Underwriting fee : % for underwriting the total

amount of loan– Success fee : fee for securing loan– Guarantee fee : guarantee against default

STANDBY LOANS

• More expensive than term loans

• Used to meet draw-down in excess of term loans

• Can be in form of overdraft facility

SENIOR & SUBORDINATE DEBT

• Senior debt : – In the event of default, the lenders of

senior debt have the first right for claim

• Subordinate debt :– Subordinate position than senior debt– Higher interest

MEZZANINE FINANCE INSTRUMENTS

• Typically bonds• Characteristics :

– Par value– Coupon rate– Maturity date– Bond yield– Yield to maturity– Sinking fund

• Bond rating :– Likelihood of interest payment default– Likelihood of principal / installment payment default– Creditors protection against default– Nature of bond– Provisions of the obligation– S&P and Moody’s

TYPES OF BONDS

• Plain vanilla bonds

• Floating rate bonds

• Zero coupon bonds

• Junk bonds

• Municipal bonds

• Income bonds

CREDIT CONVENTIONAL RISK MANAGEMENT TECHNIQUES

• Credit insurance• Guarantees• Collateral• Early termination• Reassignment• Netting• Marking to market• Put options• Syndication

Faced by business

Companies carry credit risk when, for example, they do not demand up-front cash payment for products or services.

By delivering the product or service first and billing the customer later - if it's a business customer the terms may be quoted as net 30 - the company is carrying a risk between the delivery and payment.

• Tightening payment terms

• Selling fewer products on credit to the retailer • Cutting off credit entirely, and demanding payment in advance. Such

strategies impact sales volume but reduce exposure to credit risk and subsequent payment defaults.

• Credit risk is not really manageable for company with limited customers or weak bargaining position

• The use of a collection agency is not really a tool to manage credit risk; rather, it is an extreme measure closer to a write down in that the creditor expects a below-agreed return after the collection agency takes its share (if it is able to get anything at all).

Credit Exposure Management

• Formalize the credit risk function– Setting a separate function in organization– Set appropriate credit exposure limits– Monitor and report exposure– Consider individual as well as portfolio

exposures

• Consider opportunities for credit exposure diversification– Difficult to diversify business activities

adequately

Credit Exposure Management

• Require settlement and payment techniques that provide certainty– Risk – return tradeoff higher return

on capital to higher risk transactions

• Use collateral where appropriate– Repos : repurchase transactions– Bank guarantee– SBLC– etc

Credit Exposure Management

• Use netting agreements where possible– Amongst financial institutions– Amongst associated companies– Amongst counterparties

• Monitor and limit market value of outstanding contracts– Manage potential losses in the event of

failure/unwillingness of counterparty to realize its losses

– Pricing reset if the value of a contract goes beyond a predetermined limit / renegotiate periodically

Credit Exposure Management

• Credit Limits– Credit limit versus credit overdue

• Contingent Actions– If a counterparty’s credit quality falls

below a predetermined level, one or both party may trigger a termination

– Used in legal contracts

Credit Exposure Management

• Debt Covenants :– Paying dividends if certain covenants

are breached– No additional borrowing if certain

covenants are breached

• Secured Lending Transactions– Receivables insurance

PROJECT FINANCE• Special Project Vehicle

– Special company set up to run a specific project– Usually for a concession granted by government– Highly geared

• Non recourse or Limited Recourse Funding– No or limited recourse to the project owner’s general

assets/transactions. Limited only if a certain payment is guaranteed for certain risks

– Collateral used is the project – Lender can take over the project if management is deemed

unsuitable• Wrapped or unwrapped bonds

– Wrapped bonds is guaranteed by project owner

Usually is a off balance sheet transaction Used if project owner is unwilling to expose its total assets Or project owner not credible enough to obtain financing

based on its own asset

CREDIT DERIVATIVES

• Contractual agreements based on credit performance – swaps or options

• Transfer of unwanted risk between willing counterparties

• Insurance underwriting business• Facilitate a portfolio approach to

credit risk management, to be able to enter into a contract of credit risk transfer

CREDIT DEFAULT SWAPS

• The protection seller makes a contingency payment to protection buyer if a predetermined event occurs to be specified.

• The protection seller receives a certain premium for its protection of bankruptcy, restructuring, payment failure etc

• In case of credit portfolio hedging, compensation can be based on first default basis

• For creditor/debtor

CREDIT DEFAULT SWAPS

Protection Seller (buying credit risk)

Protection Buyer (selling credit risk)

x Basis Points p.a. x Notional Amount

No Credit EventCredit Event

Zero

Default Payment

Credit Default event

• Bankruptcy, insolvency or payment default

• Obligation acceleration

• Fall in the underlying asset value

• Rating downgrade

• Restructuring ???

• Repudiation

• Moratorium

Amount of Default payment

• Par Value – appraised value of underlying asset

• Par Value – stipulated recovery value (estimated value of collateral)

• Par Value in exchange for physical delivery of collateral

CREDIT SPREAD DERIVATIVES

• Protection against widening spread between underlying credit and a benchmark (SBI or cost of money) due to credit rating drop

• Can be in form of option or forward• Spreadlock provides protection in

case a company ‘s credit quality declines to enter an Interest Rate Swap Agreement

• For debtor

CREDIT SPREAD DERIVATIVESFORWARD

• Current interest paid LIBOR + 2.5% • LIBOR rate 2.0%• Company experiences performance

decline possibility of credit rating drop• Closes forward spread lock in 3 months

time• Spread lock provides protection in case a

company ‘s credit quality declines to enter an Interest Rate Swap Agreement

• After 3 months company pays fixed interest converted from spot LIBOR + 2.5% + forward spread

CREDIT SPREAD DERIVATIVESOPTION

• Current interest paid LIBOR + 2.5% • LIBOR rate 2.0%• Company experiences performance

decline possibility of credit rating drop• Closes forward spread lock option in 3

months time• Spread lock provides protection in case a

company ‘s credit quality declines to enter an Interest Rate Swap Agreement

• After 3 months company has the option to pay fixed interest converted from spot LIBOR + 2.5% + forward spread

Total Return Swap

• Exchange of total return from an underlying reference asset against a predetermined fixed or variable reference rate in case of any type of default

• For creditor

TOTAL RETURN SWAPS

Protection Seller (buying credit risk)

e.g. Bank

Protection Buyer (selling credit risk)

e.g. Investor

Libor + x bp

No DefaultFirst Default

Par at Maturity

Delivery of FirstDefaulted Bond

Credit-linked Notes

• Debt instrument where the investor receives par value at credit maturity unless a predetermined event occurs, in which case he receives only the recovery amount (<par value)

• For creditor

ASSET-BACKED CREDIT-LINKED NOTES

BANKINVESTOR

TRUST$105Mio

Non-Investment Grade LoanCoupon=LIBOR+250bps

US Treasury Notes$15Mio

Coupon=6.5%

Pays LIBOROn US$ 105Mio

Earns 100bps

CLN Certificates + US$ 105 Mio

150 bps

LIBOR + 250bps Yield of17%

$ 15 Mio

Leveraged Yield : 6.5% US Treasury Notes + 150bps x 7= 17%

If Loan issuer defaults, loss of Investor US$ 15Mio, Bank will pursue collection of debt

CONVERTIBLE BOND

• Exchange from debt to equity

• Or in a milder form : Debt to Equity Swap

• For debtor

OPTION – ARM (Adjustable Rate Mortgage)

• It is an ARM on which the interest rate adjusts monthly and the payment adjusts annually, with borrowers offered options on how large a payment they will make.

• The options include interest-only, and a "minimum" payment that is usually less than the interest-only payment. The minimum payment option results in a growing loan balance, termed "negative amortization".

“BENEFITS” OF OPTION-ARM

• Their main selling point is the low minimum payment in year 1. It is calculated at the interest rate in month 1, which can be as low as 1%, and it rises by only 7.5 % a year for some years.

• The low initial payment entices some borrowers into buying more costly houses than would have otherwise, or into using the monthly payment savings for other purposes, including investment.

RISKS OF OPTION - ARM

• For those electing the minimum payment option, the major risk is "payment shock" – a sudden and sharp increase in the payment for which they are not prepared.

Payment shock is due to :

• every 5 or 10 years the payment must be "recast" to become fully-amortizing. It is raised to the amount that will pay off the loan within the remaining term at the then current interest rate – regardless of how large an increase in payment is required.

And :

• the loan balance cannot exceed a negative amortization maximum, which can range from 110% to 125% of the original loan balance.

• If the balance hits the negative amortization maximum, which can happen before 5 years have elapsed if interest rates have gone up, the payment is immediately raised to the fully amortizing level.

ALT-A: ALTERNATIVE-A-PAPER

• A classification of mortgages where the risk profile falls between prime and subprime. The borrowers behind these mortgages will typically have clean credit histories, but the mortgage itself will generally have some issues that increase its risk profile. These issues include higher loan-to-value and debt-to-income ratios or inadequate documentation of the borrower's income.

PRO&CONS OF INESTING IN ALT-A

• These types of loans are attractive to lenders because the rates are higher than rates on prime classified mortgages, but they are still backed by borrowers with stronger credit ratings (issued by Fannie Mae & Freddy Mac) than subprime borrowers.

• However, with the higher rates comes additional risk for lenders because there is a lack of documentation - including limited proof of the borrower's income.