Chapter 11 Overview

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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
• Setting limits on credit risk exposure

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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

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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 1970s
• Only implemented recently
• Key Equipment Financial uses this

4
Forms of Credit Risk

• Default
• Down-grade
• Spread

5
Where Banks Face Credit Risk

• Loans
• Usually secured
• Loan Commitments
• Letters of Credit
• Derivative positions (fundamental)
• Counter-party risk

6
Default does not 100 loss

• Often, some amount is recovered
• Estimate loss EDF x (1-recovery rate)

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

8
Performance

• Varies by loan type and lending quality
• Some aggregate Data

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.

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
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

12
Credit Quality Problems

• New types of credit risk related to loan
  guarantees and off-balance-sheet activities.
• Increased emphasis on credit risk evaluation.

13
Types of Loans

• CI loans secured and unsecured
• Solo or syndication
• Spot loans, Loan commitments
• Decline in CI 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

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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, ATT
• Consolidation among credit card issuers
• Bank of America MBNA
• Risks affected by competitive conditions and
  usury ceilings
• Bankruptcy Reform Act of 2005

15
Other loans

• Other loans include
• Farm loans
• Other banks
• Nonbank FIs
• Broker margin loans
• Foreign banks and sovereign governments
• State and local governments

16
Recall Bank Balance Sheets from Ch 2
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!

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Loan Growth and Asset Quality
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Annual Net Charge-Off Rates on Loans
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Moodys Default Rates 1920-2006


  Investment Grade Investment Grade High Yield High Yield
  Original Re-weighted Original Re-weighted
         
Mean .146 1.52 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