11-1Chapter 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 1920-2006
Investment Grade High Yield
Original Re-weighted Original Re-weighted
Mean .146 .152 2.69 4.34
Worst Single Year 1.55 1.66 15.90 23.50
Worst 3-Year Period 0.89 0.94 11.35 14.15
Worst 6-Year Period 0.88 0.91 8.13 11.30
Worst 3 Years 1.20 1.28 12.26 20.50