Docstoc

PowerPoint Presentation - Drake College of Business and Public ..._1_

Document Sample
PowerPoint Presentation - Drake College of Business and Public ..._1_ Powered By Docstoc
					        Credit Risk


              Fin 129
Financial Institutions Management



                             Drake Fin 129
                             DRAKE UNIVERSITY
                                           Drake
  Assessment of Credit Risk                 Drake University

                                             Fin 129



FI manager must be able to:
  Price Loan correctly based upon risk
  evaluate possibility of default and make sure
  total risk limits are not violated
                                          Drake
       Credit Quality                     Drake University

                                           Fin 129


Recent concern over the quality of credit:
  Rapid growth in loans (over 10% a year in
  the late 1990’s
  Commercial Real Estate Loans
  Low-quality auto loans
  Credit cards
Impact on charge offs
  Since 1991, the ratio of nonperfoming
  loans (90 days past due) has actually
  increased while growth has increased.
  Commercial and Industrial              Drake
                                         Drake University

          Loans                           Fin 129



Syndicated Loan -- provided by a group of FI’s
instead of an individual lender -- spreads risk
Secured Loan - backed by specific assets
Unsecured Loan - only a general claim on
assets
Spot Loan --borrower takes entire amount at
one point in time in contrast to a loan
commitment
Commercial paper -- short term unsecured
borrowing by firms
                                              Drake
       Real Estate Loans                      Drake University

                                               Fin 129



Mainly Mortgage Loans
  creates prepayment risk and default risk.

Adjustable Rate Mortgages
  interest rate is adjusted periodically.
                                        Drake
       Consumer Loans                   Drake University

                                         Fin 129



Credit Card loans
Revolving Credit- Open line of credit where
the borrower can borrow and repay at will
Usury Ceilings -- maximum rate that an FI can
charge on consumer and mortgage debt
                                           Drake
         Credit Analysis                   Drake University

                                            Fin 129


Essentially default risk analysis
  investigating the borrowers


Evaluating Credit risk inherent in the
operations of the business (or activities of the
individual)?
What can be done by the borrower to lower
the risk?
How can the lender control and structure the
risk? (execution and administration of loan)
      Evaluating Credit Risk               Drake
                                           Drake University

           the 5 c’s +1                     Fin 129


 Character --
 Capacity --
 Capital --
 Conditions –
 Collateral --
 Cash --
Which of the characteristics is the most
 important?
                                          Drake
      Evaluating the 5 c’s                Drake University

                                           Fin 129


                 Character
Based upon reputation of firm and past
borrowing experience with the lender.
Creates an implicit contract that guarantees
loans will be made and repaid
Works to the disadvantage of small and first
time lenders
                  Capacity
Does the representative have the legal ability
to commit the firms resources
                                                   Drake
       Evaluating the 5 c’s                        Drake University

                                                    Fin 129


                      Capital
Borrowers wealth position and can it withstand
changes in economic conditions
Look at simple ratio analysis, Debt equity ratio

Volatility of earnings - more volatility implies higher
probability of default
                        (Cash)
Liquidity of capital
                                         Drake
      Evaluating the 5 c’s               Drake University

                                          Fin 129


                  Conditions
Market Specific Factors, common to all firms
Current phase of business cycle and relation
to business of firm

                 Collateral
What assets can be pledged to secure the
loan?
Are claims on assets senior to other claims?
  Stages of Credit Evaluation                      Drake
                                                       Drake University

     Historical Perspective                             Fin 129


Overview of management & operations
  Business and industry outlook report
  i.e. competitors, suppliers (conditions)
  Background info (character)
Common size financial ratio analysis
  compare to industry averages (liquidity, leverage,
  profitability) (capital, collateral, cash)
Analysis of cash flows (capital and cash)
  Cash based income statement,
  Investigate sources and uses of cash
                                                    Drake
   Stages of Credit Evaluation                      Drake University

                                                     Fin 129



First three provide historical perspective -- then
  look at future
  Projections of borrowers financial condition
    Pro forma Financial Statements
    Attempt to provide an objective outlook at the future
    prospects
    Run sensitivity and Scenario Analysis on the
    projections
      Credit Execution and                  Drake
                                            Drake University

         Administration                      Fin 129


Loan Covenants
Specific requirements either party must adhere to
 Affirmative requires borrower to take certain
 actions (Maintain liquidity position)
 Negative -- restricts the borrower from certain
 actions (acquiring more debt)
Credit Review
  Review outstanding loans and monitor problems
  loans
     Credit Execution and                  Drake
                                           Drake University

        Administration                      Fin 129



Default Scenarios
  What actions (or inactions) would constitute
  default
  Who is responsible for collection costs,
  attorney fees etc…
  What actions the are the lender legally allowed
  to take.
     Credit Execution and                    Drake
                                             Drake University

        Administration                        Fin 129



Documentation
  Collateral needs to be “perfected” -- FI wants
  to have senior claims
Position Limits
  The maximum amount of allowable credit to a
  single borrower
Risk Rating
  FI can grade (rank) individual loans and
  counter parties (we explain how soon)
 The 5 bad c’s the FI should                      Drake
                                                  Drake University

           avoid                                      Fin 129


Complacency -- assumes that since things were
good in the past
Carelessness --    Poor underwriting techniques

Communication -- Loan policy needs to be
communicated to loan officers and enforced
Contingencies --    tendency to downplay or ignore

Competition --     Following changes in competitors
practices instead of following own policies.
      Evaluating Credit Risk               Drake
                                           Drake University

      Credit Scoring Models                 Fin 129


Quantitative models that use observable
characteristics to score or rank borrowers based
on probability of default.
Credit scoring provides a measure of the
possibility of default based upon characteristics
of borrowers.
Characteristics cannot be prohibited info
(antidiscrimination laws - sex, race, not
included) and must be statistically justified in
relation to default risk.
                                         Drake
    Credit Scoring Models                Drake University

                                          Fin 129



Linear Probability and Logit Models
Uses historical data to explain the repayment
experience of old loans.
Divide loans into two categories those that did
default (prob of default =1) and those that
did not default (prob of default = 0)
                                                  Drake
Linear Prob. and Logit models                      Drake University

                                                    Fin 129



For the given set of variables the following
regression can be estimated:
                         n
                   Zi    jX ij  e
                         j1

          Zi  1 for default, 0 for no default
  B j  the estiamted importance of the jth variab le
            X ij  the observeabl e variable
                                         Drake
Linear Prob and Logit Models             Drake University

                                          Fin 129



Given the estimated values of Bj, you can
take the loan applicants current values often
variables and estimate the expected
probability of default Z.
                                                          Drake
Linear Prob and Logit Models                              Drake University

                                                           Fin 129



Strengths



Weaknesses

  Use of logit solves this
                                   1
                      F (Zi ) 
                                1  e Z i
    F(Zi )  the logistical ly transfo rmed value of Zi
      Liner Discriminate                    Drake
                                            Drake University

    Credit Scoring Models                    Fin 129



Divides borrowers into risk classes based
upon aggregate score, does not estimate

For each observable variable, a weight is
determined based upon past experience of
loans.
Then an aggregate value is calculated and the
loans are separated by the high or low
probability of default.
                                        Drake
       A second version                 Drake University

                                         Fin 129



Points assigned based on characteristic and
past experience (For example length of time
in current job (more than a year add 5, less
than a year add 2). Then Aggregate score is
calculated.
                                         Drake
           Fico Scores                   Drake University

                                          Fin 129



Most credit scores in the US are calculated by
software developed by Fair Issac and
Company
There are three main providers of credit
scores: Equifax, Experian and TransUnion
Most lending institutions will obtain scores
from multiple services when evaluating credit
risk.
                                                                               Drake
          Distribution of Fico Scores*                                             Drake University

                                                                                    Fin 129


          >800                            11%

        750-799                                                              29%

        700-749                                                 20%
Score




        650-699                                        16%

        600-649                           11%

        550-599                   7%

        500-549              5%

          <500        1%

                  0        0.05    0.1          0.15          0.2     0.25   0.3          0.35
                                               Percentage
                                       Source www.Fico .com
                                                    Drake
     Fico Score Comparison                          Drake University

                                                     Fin 129


$150,000 30 year fixed rate mortgage national averages
                                               Additional
 Score           Rate                 Spread
                                                 Cost
720-850         5.783
700-719         5.903                  .125     $4,308
675-699         6.446                  .663    $23,139
620-674         7.596                  1.813    $64,870
560-619         8.531                   2.74   $100,138
500-559         9.289                  3.506   $129,139
                      source www.fico.com
                                     Drake
 Components of Credit Score (Fico)   Drake University

          Types                       Fin 129
        of Credit
           Used
New Credit 10%         Payment
  10%                  History
                        35%
Length of
 Credit
 History
  15%
             Amounts
              Owed
              30%
                                        Drake
       Payment History                  Drake University

                                         Fin 129



Payment Info on specific types of accounts
Public Records (bankruptcy, suits, wage
adjustments, past due items, etc.)
Severity of past delinquencies
Time since delinquency or poor public rec.
Number of
Number of
                                     Drake
        Amounts Owed                 Drake University

                                      Fin 129



Total amount owed on accounts
Amount owed on specific accounts
Lack of a specific type of balance
Proportion of
Proportion of
                                        Drake
   Length of Credit History             Drake University

                                         Fin 129



Time since account opened
Time since account opened, by type of
account
Time since account activity
                                        Drake
          New Credit                    Drake University

                                         Fin 129


Number of recently opened accounts and
proportion of accounts recently opened by
type
Number of recent credit inquiries
Time since recent account openings by type
Time since credit inquiry
Re-establishment of positive credit history
following past problems
                                       Drake
     Type of credit used               Drake University

                                        Fin 129



Number of (presence, prevalence, and recent
info on) various types of accounts (credit
cards, installment loans, mortgage etc)
                                        Drake
              Note                      Drake University

                                         Fin 129



The same factors may impact different
applicants in different ways. Some factors
may be more or less important depending
upon the other factors.
No one piece of info will determine your
score.
                                             Drake
     Not in your credit score                Drake University

                                              Fin 129


Race, age, religion, nationality, sex, marital
status (Regulation B)
Salary, Occupation, title, employer, date
employed, employment history
Location
Rates charged on outstanding credit
Child/family support obligations and rental
agreements.
                                              Drake
   Average Credit Statistics                  Drake University

                                               Fin 129


Number of Obligations: 11, 7 credit cards, 4
installment loans
Past Payment Performance: 4/10 30 days late or
greater 2/10 60 days late or later, 85% never had
loan 90+days overdue.
Credit Utilization:
  Credit Cards 48%<$1000 54% < 10% > $10,000
  Total (less mortgages) 54% < $5,000, 30% >
  $10,000
                                               Drake
   Average Credit Statistics                    Drake University

                                                 Fin 129


Total Available Credit: $12,190 combined on all
credit cards, 1/8 uses more than 80% of available
credit, over 50% use less than 30% of available
credit
Length of Credit History: average 12 years1 in 5
have histories over 20 years, 1 in 20 shorter than 2
years
Inquires: one a year average, less than 7% have
more than 4 inquiries in past year.
Problems with Credit Scoring           Drake
                                        Drake University

     Models in general                   Fin 129



Limited number of cases (in the extreme only
two are considered - default no default)
No obvious economic reason that future will
reflect the past. Need to adjust the model
constantly to account for possible changes
Ignores some relationships such as borrower
lender relationships.
No centralized database of business loans to
provide measure of market risk.
                              Drake
Newer Models of Credit Risk   Drake University

                               Fin 129



Term Structure Approaches
Mortality Rate Approaches
RAROC models
Option Models
Credit Metrics
Credit Risk +
                                         Drake
 Term structure approaches               Drake University

                                          Fin 129



The goal of a term structure approach is to
derive the probability of default from
observed differences in yield (risk premiums).
Construct zero coupon treasury yield curves
and zero coupon corporate curves for similar
rated debt.
Look at risk premium for a given maturity.
                                            Drake
   Term structure approaches                Drake University

                                             Fin 129



  Assume that the yield on the low grade bond
  is 8% and the yield on the treasury is 5%.
  If an investor is indifferent between the two
  options it implies that the expected return on
  the risky asset equals the return on the risk
  free asset or
                  p(1+k) = (1+i)
       where p = probability of no default,
k = return on risky asset, i = return on treasury
                                           Drake
 Term structure approaches                 Drake University

                                            Fin 129



Assume that k = 8% and i = 5% then the
implied probability of no default, p, is found
by:
               (1  i ) 1.05
           p                .9722
              (1  k ) 1.08
                                         Drake
 Term structure approaches                Drake University

                                           Fin 129



If the loan is perceived to have a 1-.9722 =
.0277 or 2.77% probability of default it
should have a risk premium set equal to 3%.
Can be extended to account for a partial
recovery of principle and interest in the case
of default. Let g represent the proportion of
the loan that is recoverable
         (1-p)g(1+k) +p(1+k) =(1+i)
This can also be extended to the case of
multi period debt instruments
                                        Drake
 Term structure approaches               Drake University

                                          Fin 129



For multiperiod debt instruments you need to
calculate the marginal probability of default
for each time period then aggregate this into
a cumulative probability of default.
Using the forward rate and the cumulative
probability, an expected probability (or
implied) probability of default can be found.
                                                                    Drake
         Marginal Mortality Rate                                    Drake University

                                                                     Fin 129



  The marginal mortality rate of the loan is the
  probability of the of the loan defaulting in a
  given year of issue

              total value of loan class defaulting in year i of issue
MMRi 
             total value of loan class outstanding in year i of issue
         adjusted for defaults, calls, sinking funds and maturities in i - 1
                                         Drake
        RAROC Models                     Drake University

                                          Fin 129



Risk Adjusted Return on Capital Models
Income should be adjusted for fees and
interest spread
                                                           Drake
                    RAROC                                  Drake University

                                                            Fin 129



 The most difficult part of the analysis is
 finding the capital at risk.
 One approach would be to use duration.

capital     duration of    size of  expected maximum change 
         
            the loan       loan 
                                                             
                                                                 
at risk                                 in credit premium   
  L  -          DL          L          (R/(1  R))
                                           Drake
CreditMetrics and Credit Risk +            Drake University

                                            Fin 129


Credit Metrics
Uses value at risk to find the possible loss on
the loan portfolio given the assumption of “a
bad” outcome over the given time period.

Credit Risk +
Similar to Value at Risk
Calculating the FI’s required capital reserves
to meet losses above a given level.
Loan Portfolio and
Concentration Risk




                 Drake Fin 129
                 DRAKE UNIVERSITY
                                           Drake
         Migration Risk                     Drake University

                                             Fin 129



The risk that the quality of a loan or portfolio
of loans will decrease (credit risk increase)
If the credit rating of a given industry or
group of loans declines then lending in that
industry will decrease.
                                      Drake
       Migration matrix               Drake University

                                       Fin 129



Presents the probability of a loan being
upgraded or down graded over a given period
of time.
Generally the matrix represents a given
industry or region, but could be more
widespread.
             Rating Migration                           Drake
                                                        Drake University

             Corporate Debt                              Fin 129



                                                 C or
      Aaa      Aa     A     Baa    Ba     Bb                total
                                                  D
Aaa   91.9    7.38   0.72    0      0      0      0          100

Aa    1.13 91.26 7.09       0.31   0.21    0      0          100

A     0.10    2.56   91.2   5.33   0.61   0.2     0          100

Baa   0.00    0.21   .36    87.94 5.46    0.82   0.21        100
                                           Drake
        Using the matrix                   Drake University

                                            Fin 129



If the FI realizes that a larger portion of loans
in a category has been downgraded it can
chose to reallocate its loans moving some into
a higher rating class.
                                         Drake
     Concentration Limits                Drake University

                                          Fin 129



Limits placed externally on the total amount
of credit placed with a given borrower.
The concentration limit is a function of the
maximum loss as a percent of total capital
and the amount lost in the event of default.
                                               Drake
       Concentration Limit                      Drake University

                                                 Fin 129




Concentrat ion     Maximum loss as a       1     
                   percent of capital  loss rate 
                                     
    Limit                                        
Assume that the Maximum loss is 10%
Loans in the sector on average loose 40% of
capital in the event of default
                                            Drake
   Concentration limit con’t                 Drake University

                                              Fin 129



If the firm has $100 million in total capital it
would be willing to place 25% of its capital in
this sector.
If all $25 Million defaulted, there is a loss rate
of 40% (60% gets recovered) or an expected
loss of
         $25 Million (.4) = $10 Million
          which is 10% of total capital
                                           Drake
   Modern Portfolio Theory                 Drake University

                                            Fin 129



Basics of diversification (review)
By increasing the number of assets in the
portfolio we can eliminate systematic risk.
The amount of risk that can be eliminated
depends upon the correlation of the assets.
As long as the assets are not perfectly
correlated there is a gain to diversification.
The same idea can be applied to loans.
                                        Drake
  Expected Portfolio Return             Drake University

                                         Fin 129



The combined return of two assets is simply
the weighted average of their returns


     n
   (Weight t )(Return t )
    t 1
                                         Drake
      Variance of Returns                Drake University

                                          Fin 129


       n                n    n
   X    X i X j ij i j
  2
  p          i
              2
                  i
                   2

      i 1             i 1 j 1
                            i j


as long as the correlations are less than one
(preferably some being negative) the portfolio
variance will be reduced.
                                         Drake
       Efficient Frontier                Drake University

                                          Fin 129



By changing the weights in a portfolio you get
different return and risk combinations.
It is often possible to rearrange a portfolio
and produce a higher return without changing
the risk.
The efficient frontier provides the set of
portfolios that produces the highest return at
each level of risk.
                                           Drake
        Efficient Frontier                  Drake University

                                             Fin 129



Given four assets, the next slide shows a
graph of 76 different portfolios created by
changing only the weights in the portfolio.
The vertical axis is the return on the portfolio,
the horizontal axis represents the standard
deviation of the portfolio.
The efficient frontier is the set of points that
provides the highest return for each level of
risk.
                             Drake
                             Drake University

                              Fin 129
7



6



5



4



3



2



1



0
    0   2   4   6   8   10
                                          Drake
    Available combinations                Drake University

                                           Fin 129



Given the efficient frontier you can increase
return for a given level of risk.

You can also decrease risk to find the
minimum risk portfolio.
     Problems with MPT                 Drake
                                        Drake University

    and loan management                  Fin 129



Loans and many other assets held by FI’s are
often:
                                          Drake
    KMV Portfolio Manger                   Drake University

                                            Fin 129



Since many assets are non traded it is difficult
to calculate the inputs in used in modern
portfolio theory
Three inputs are needed: return, variance of
each asset and correlations (or covariances)
                                            Drake
   KMV portfolio manager                    Drake University

                                             Fin 129



Return on Loan
Ri  AIS i  E ( Li )  AIS i  [ EDFi  LGD i ]
AISi = All in Spread
      = Spread on the loan + fees
E(Li) = expected loss on loan
   EDFi = Expected default frequency
   LGDi = Loss given default
                                            Drake
     KMV Portfolio Manger                   Drake University

                                             Fin 129



Risk of the loan

 i  ULi   Di  LGDi  EDFi (1  EDFi )  LGDi
ULi=“unexpected” loss on the loan
Assumes defaults are binomially distributed.
                                          Drake
    KMV Portfolio Manager                 Drake University

                                           Fin 129



Correlations are based upon the default risk
correlation of the firms assets over time.
The correlations are therefore relatively low
ranging from .002 to .15.
                                          Drake
    KMV Portfolio Manager                 Drake University

                                           Fin 129



Given the individual returns, variances, and
correlations the portfolio returns can be
calculated using the standard portfolio theory.
                                        Drake
 Loan Volume Based Models               Drake University

                                         Fin 129


Concentration risk can be analyzed based
upon data established for large volumes of
data for example:
Commercial bank call reports: reports to the
Federal Reserve loan allocation among
different asset classes. Can be aggregated
and used as a benchmark.
Shared National Credits - based on SIC codes.
Again can be used for benchmarking
                                                           Drake
      Factor based analysis                                Drake University

                                                            Fin 129



Based on the systematic loan loss for a given
sector
 Sectoral losses in the ith sector           Total Loan Loss 
                                      i                  
     Loans in the ith sector                 Total Loans 
Bi is the systematic loss sensitivity of the ith
sector. Where the entire portfolio has a
B =1
                                          Drake
      Regulatory models                    Drake University

                                            Fin 129



General limits are often also set by regulatory
agencies.
For example life-health insurers can have at
most 3% of their portfolio in a single issuer or
security.

				
DOCUMENT INFO
Shared By:
Categories:
Tags:
Stats:
views:3
posted:5/17/2012
language:
pages:72
fanzhongqing fanzhongqing http://
About