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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.

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chapter 11 overview part a
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
introduction to credit risk
Introduction To Credit Risk

Forms of credit risk

Where do banks face credit risk?


Impact on bank profits


Methods of measuring/Monitoring Risk

methods of measuring monitoring risk
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

forms of credit risk
Forms of Credit Risk




where banks face credit risk
Where Banks Face Credit Risk


Usually secured

Loan Commitments

Letters of Credit

Derivative positions (fundamental)

Counter-party risk

default does not 100 loss
Default does not = 100% loss

Often, some amount isrecovered

Estimate loss = EDF x (1-recovery rate)

how loan losses impact banks
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

credit quality problems pre crisis
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
credit quality problems
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
additional issues in credit quality
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
types of loans
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
consumer loans
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
other loans
Other loans
  • Other loans include:
    • Farm loans
    • Other banks
    • Nonbank FIs
    • Broker margin loans
    • Foreign banks and sovereign governments
    • State and local governments
impact of securities markets on banks
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!

Varies by loan type and lending quality

Some aggregate Data:

loan types differ in many ways
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
altman s linear discriminant model
Altman’s Linear Discriminant Model:
  • Z=1.2X1+ 1.4X2 +3.3X3 + 0.6X4 + 1.0X5

Critical value of Z = 1.81.

    • X1 = Working capital/total assets.
    • X2 = Retained earnings/total assets.
    • X3 = EBIT/total assets.
    • X4 = Market value equity/ book value of total liabilities
    • X5 = Sales/total assets.
linear discriminant model
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.