Get documents about "Cred Risk _07-9 alternate_
Document Sample
Week 07-7
CREDIT RISK
Topics:
• Lending Process: Duties of Due Diligence Include
Calculating The Cost of Providing Risk Support
• Use of Scoring Software
• Credit-Risk Issues: Pricing Quality in a Portfolio
Context
• Book-Cooking Opportunities in Loan Accounting
1
Edward J. Kane, BC 07-7
1st Topic: Duty of Due Diligence
Lending is Banks’ Principal Product-Management
Chain and Counterparties are Looking for Weak
Links
2
Edward J. Kane, BC 07-7
Important Slide: All forms of dealmaking have to be funded
in part by an appropriate allocation of FSF capital. To
Assure Due Diligence at the staff level, a Loan-Review
Committee Should Ask Deal-Making Staff to Report Four
Features of Every Deal
1. What are the risks?
2. What are the costs of capital and loss reserves that must be
allocated to cover the portfolio risks the loan entails.
3. What explicit and implicit returns does the proposed
contract offer the firm for bearing the costs of supporting
these risks?
4. Allowing for differences in risk, how does the risk-
adjusted return line up with other deals that we are or
might be making?
3
Edward J. Kane, BC 07-7
Modern FSFs Can Outsource Some of
These Questions
4
Edward J. Kane, BC 07-7
Each Lender Employs Multiple Technologies of
Lending: Deal Formats Must Adapt to the
Informational and Regulatory Environments in
Which FSF and the Borrower Operate
Three Mutually Reinforcing Components Define the
Technology Used in a Particular “Lending
Chain:”
1. Screening Mechanisms
2. Contract Structure (e.g., covenants, collateral
rights, enhancements, amortization schedule,
reporting requirements)
3. Monitoring Strategy
5
Edward J. Kane, BC 07-7
LOAN COVENANTS
Definition: Loan covenants are forms of implicit interest that
restrict a borrower’s future activities in ways designed to
lessen conflicts of interest between the borrower and lender. If
not waived, any violation of the covenant package results in
so-called “technical default.”
1. “Negative Covenants”- restrict future production,
investment, or financing decisions: especially
limitations on dividend payouts and on future debt.
2. “Affirmative Covenants”- impose contractual
obligations to submit financial statements and to
report other material issues.
6
Edward J. Kane, BC 07-7
Some Different Business Lending
Technologies
• Financial-Statement Lending
• Relationship Lending
• Business Credit Scoring
• Asset-Based Lending (Collateralization &
Leasing)
• Trade Credit
• Factoring (Purchase of Receivables)
• Credit “Insurance” (enhancements)
Classroom Exercise: What are the Strengths and
Weaknesses of each?
7
Edward J. Kane, BC 07-7
Asset-Based Lending
Many Business Loans and All Household Mortgage
and Auto Loans pledge property to lender as
“security” for a loan.
• What is a mortgage loan? Who is the Mortgagor?
ANS. The borrower. Who is the Mortgagee?
• First Mortgages vs. Second Mortgages
• Lender must assess prospects of borrower default and
the possible correlation of “default events” with
changes in collateral value
8
Edward J. Kane, BC 07-7
In All Technologies, Loan Officers Must
Efficiently Collect Appropriate Information to
Make Optimally Four Decisions About Each
Customer
1. How much to lend?
2. In what form: i.e., with what safeguards?
– Covenants
– Monitoring Rights
– Default Remedies
3. At what price? implicit & explicit compensation
4. On what repayment schedule?
9
Edward J. Kane, BC 07-7
Vocabulary Lesson
Holism is the belief that once an entity has
existence its parts do not. The idea is that
the parts stick together in an inseparable
way (e.g., life-force of a person vs. mortar
in a brick wall).
Test is reversibility.
10
Edward J. Kane, BC 07-7
Historically, lending was an holistic process.
Modern Lending Deconstructs the Steps Traversed in
Making a Loan
Allows FSFs either to specialize in-house or to
“outsource” the subset of risks and skills
needed at each particular stage.
1. Applications Generation
2. Processing
3. Underwriting Origination
4. Closing
5. Servicing/Collection
[6. Insuring risk of shortfalls in payments due]
7. Funding (temporary vs. permanent risk support)
8. Postloan monitoring and risk support or transfer
11
Edward J. Kane, BC 07-7
Unbundled Parts of Lending Process are
Automating, Digitizing, and Globalizing
• Outsourcing may slow some decisions intensifies
“Ethical Risk”: the problem of assuring “due diligence”
is performed in individual functions
– with holistic loan-officer model, a continuous double-checking
role is played by high-level committees who are subject to legal
penalties for negligence and malfeasance. [“Good judgment
comes from experience. Experience comes from exercising poor
judgment” = error-learning.]
– with outsourcing model, loan committee must rely on reputations,
bonding agreements, and fraud & negligence laws
• We explore these Issues in the last 2 Weeks of the
course
12
Edward J. Kane, BC 07-7
Even Flexible
Deal-Making
must be
Supported by
“Due Diligence”
in Prospecting,
Information
Gathering, and
Analysis
13
Edward J. Kane, BC 07-7
First Link in Chain =
Generating Applications
• Referrals, Prospecting, and Prequalifications
[Computer “cross-sell triggers]
• Product Selection
• Application Completion
• Document Collection
14
Edward J. Kane, BC 07-7
Due Diligence in Information
Gathering uses 3d- Party sources
• Application Verification (must guard
against identity theft; false data)
• Credit Investigation
• Collateral Valuation
– Blue-Book Values for Autos
– Repeat-Sales Data Base (Automated Appraisal)
vs. Custom Appraisal for Houses
15
Edward J. Kane, BC 07-7
Underwriting: What Constitutes
Due Diligence in Analysis?
• Credit Analysis: standards, guidelines vs.
credit scoring
• Pricing
• Mortgage Insurance Decision
– Single payment vs. cancelable
• Commitment Issuance
16
Edward J. Kane, BC 07-7
Operational Links: Closing and
Postclosing Activities
1. Closing
– Document Preparation
– Compliance with Commitment Conditions
– Packaging and Delivery
2. Post-Loan
– Postclosing Document Tracking
– Set up Servicing System
– Collections/Monitoring/Dunning
17
Edward J. Kane, BC 07-7
“Fin”al Link: Funding Decision
• Temporary “warehousing” prior to choosing
how to permanently finance the deal.
• Three main alternatives for permanent
funding:
1. Own debt and capital (=intermediation)
2. Loan sales
• whole
[
• partial (syndication)
3. Securitization (pooling & pricing loan packages)
18
Edward J. Kane, BC 07-7
The Funding Decision Also Affects the
Allocation Across the Bank’s Counterparties of
the Risks That Are Left Unhedged
• Self-Insurance = supporting with Loan-Loss reserves
and Ownership Capital
• External Credit Enhancement (partial recourse vs.
complete risk transfer to borrower or third parties)
– Collateral (puts some risk back on borrower)
– Recourse to borrower or corporate officers (ditto)
– Personal or Corporate Cosignors or Guarantors
– Private Mortgage Insurance (Mort. Guaranty Ins. Corp.; GE
Capital Mort. Ins. Corp.; United Guaranty Corp.)
19
Edward J. Kane, BC 07-7
2nd Topic: Automation of Due-Diligence
and Pricing Activity: Computer Scoring
• Theme: Scoring is Driving Automation of all links
in the lending chain
• Value of scores depends on size of underlying sample and
representativeness of its relevant subsample cells.
• Mines or Tortures Data to make them “sing” = Uncover
Recognizable Patterns and Convert them into Point scores that
classify customers in terms of probability of some targeted form of
behavior
• Credit scores can be fed directly into an implicit and explicit loan
pricing matrix.
• Targeted behavior can be anything. “AI” Expert Systems can
identify loan leads, slow payers, deadbeats, profitable customers,
volatility of collateral value, etc.
• In use at all large U.S. banks & most small ones. 33% of small banks
by early 2001. 20
Edward J. Kane, BC 07-7
Table 1
Survey Results for Large U.S. Banks Using Small Business Credit
Scoring Data as of January 31, 1998
Number % of Scoring Banks
Loan Sizes Scored:
Under $100,000 62 100.0
$100,000-$250,000 46 74.2
$250,000-$1,000,000 13 21.0
Automatic Approval/Rejection 26 41.9
Setting Loan Terms 20 32.3
Use Proprietary Models 8 12.9
Average Number of Month 24 ---
Source: Frame, Srinivasan, and Woosley (2001)
21
Edward J. Kane, BC 07-7
When Automated Lending Works
22
Edward J. Kane, BC 07-7
Use of Scoring Presupposes and Shapes the
Collection and Verification of Databases
• Individual Application input
• External Credit Bureau Input (will score for
and sell credit directly to customers)
• KnowX.com and Lexis-Nexus: input data on
arrests, scandals
• Internal Credit Information File (CIF) from
“data warehouse” (FSF base of information by
which it manages)
– Lenders must address customer and legal
concerns about privacy and accuracy 23
Edward J. Kane, BC 07-7
Intuitive Basis for Scoring
Computer credit-scoring models objectify credit standards.
They input multiple “proxies” for ageold Five C’s of Credit.
• The 5 C’s of Credit: a checklist of informational items that
track a customer’s unobservable repayment speed and
repayment probability. Scores should be tracked both before
and after making a loan. Why?
• Scores on proxy items can be used also to size and price a
customer’s serviceable demand for borrowed funds.
• Increasingly, computer credit-scoring models re-estimate the
rate outstanding loan portfolios should carry and business
loan contracts reset the loan rate when and as a borrower’s
score changes.
24
Edward J. Kane, BC 07-7
Character: customer’s reputation for probity and fairness (past
willingness to pay bills can be checked with credit agencies)
Capacity: projected future income of customer; “payment-
coverage ratio.”
Capital: strength of customer’s balance sheet
Collateral: any credit enhancement offered --consists of implicit
and explicit guarantees, including right of “recourse”
Conditions re economic “cycles”: how changing economic
environment affects the customer’s other Cs; measures of
vulnerability or fragility.
[Modern financial economists add 4 more C’s: Regulatory
Compliance Costs, Customer Relationships, Correlation,
and “Costs of a borrower’s opportunities for hidden actions and
hidden information disadvantage a lender.”]
25
Edward J. Kane, BC 07-7
Major External Vendors of
Online Scoring Services
• Fair Isaac (Grandaddy of scoring)
• Fiserv
• Credit Bureaus
– Global & national (Transunion, Experian, Equifax)
– Local
• Mark-It Partners credit database (shareholders are
an evolving member of European and US
megabanks): “Partner” banks supply price
information.
26
Edward J. Kane, BC 07-7
About Fair Isaac’s Scores
The formula for the Fair Isaac creditworthiness score deals only
with financial information about a borrower and doesn’t consider
such factors as place of residence, age, race, sex, or nationality.
• Factors in determining the credit score and the weight they are given:
27
Edward J. Kane, BC 07-7
How the Fair Isaac Score Works:
Fair Isaac licenses its software to credit bureaus.
Based on the credit information on file, the credit bureau uses
Fair Isaac’s formula to generate a credit score, also known as
a FICO score. Scores are on a 900-point scale. Generally, a
score of 640 or higher results in a mortgage on favorable
terms: subprime (<640), prime, superprime ratings (>720)
Lenders acquire from a credit bureau a borrower’s credit
report and FICO score to evaluate the applicant’s
creditworthiness and price loans.
High Score = High Probability of complete and timely
performance by borrower.
Fair Isaac traditionally limited the information passed to
borrower. Now, loan applicants can purchase their scores and
use experts to improve their score to a lender’s threshold.
28
Edward J. Kane, BC 07-7
DISCUSSION QUESTIONS ON SCORING
Please indicate in one paragraph whether you agree or
disagree with the following statements and why:
1. Credit-scoring software is making human loan
officers obsolete. Software can identify several
times as many potential losses as most
institutions’ best human underwriters can.
2. Credit-scoring is a new and untested idea.
3. Scoring software is useful only in originating and
pricing loans.
4. Once an institution switches to credit-scoring
software, its approval rates usually decrease.
29
Edward J. Kane, BC 07-7
DISCUSSION QUESTIONS ON SCORING
(continued)
5. Credit-scoring software can be used only on loan
applicants that have a prior credit history.
6. Is scoring fair to immigrants and low-income households?
7. Mortgage-Loan automation can consolidate the many steps
on mortgage lending into a single virtual “back office” that
can bid on (but not seal) a deal in a matter of minutes.
8. It is good practice to explain and doctor credit scores for
rejected customers.
9. It should be a source of pride to some bankers that they
don’t use credit scoring.
30
Edward J. Kane, BC 07-7
Course Theme: Reshaping of Job
Opportunities and Branch Architecture by
New Lending Technologies
1. Calling Officers (Salespersons or
Drummers).
2. Credit Analysts
3. Loan Review Committee
4. Workout Specialists
31
Edward J. Kane, BC 07-7
Business-Loan Officers: Going the Way of the Dodo?
MINICASE
On Morphing
of Firms &
Employee
Skillsets
32
Edward J. Kane, BC 07-7
33
Edward J. Kane, BC 07-7
3rd Topic: Credit-Risk Issues
• What is risk? The downside of a deal caused by
its negatives.
• What is a loan’s credit risk? Obverse* of “Asset
Quality”
– Danger that an individual counterparty won’t perform as
promised in a contract = a priceable chance of suffering
default losses - e.g., in loans to customers who go bankrupt.
– Delinquent vs. truly “nonperforming” loans
– workouts on partial vs. complete defaults show some
“chargeoff” against bank loan reserves or net worth
* An obverse is the positive quality that can be obtained from a
negative or the negative quality corresponding to a positive. 34
Edward J. Kane, BC 07-7
Risk Management Risk Avoidance. Ways an institution
can price, support, diversify or transfer credit risk
introduce the concept of financial engineering.
• Develop and maintain an accurate and consistent risk-grading system.
• Establish a credit culture that reflects the risk appetite of your institution.
• Use a loan approval process, by committee or otherwise, that provides a
formal, systematic review of total exposure to a borrower in different products.
• Implement credit scoring, though it need not be the sole factor in lending
decisions.
• Establish a credit database with heavy emphasis on the collection and retention
of risk ratings.
• Develop a process to review and control exceptions to credit policy.
• Introduce a pricing model, even a rudimentary one, to bring disciplined risk-
based pricing into the underwriting and review process. Even better, use a
pricing model, either internally or vendor purchased, to price your credits to
reflect risk, relationship, and capital allocation.
• Manage your loans as portfolio investments. Quantify the return relative to the
risk and manage portfolio diversification.
35
Edward J. Kane, BC 07-7
Managing Risk in Loan Origination
• Adage: Every debt is paid, if not by the
borrower, by the lender.
– How does a lender pay for borrower defaults?
– Lending officers may be disciplined for defaults or
credit deterioration on loans they originate.
– Computer scoring cannot capture every negative:
Jürgen Schneider Warning Signal: Wasteful excess
shown in personal life by CEO’s gilding an iron fence
in 1994 was used by a smart lender to be an indication
of bad character.
36
Edward J. Kane, BC 07-7
Recognizing Loan Scamsters
“Top Ten” Warning Signs
(Paul Nadler, American Banker, March 1996)
Beware of Customers who:
10. Soft-soap you.
9. Seem too dumb to fool you.
8. Pride themselves on breaking rules.
7. Focus on what your firm will do in the event of delinquency.
6. Seem unusually charming.
5. Seem unusually optimistic.
4. Challenge your policy on overdrafts or on the use of uncollected funds.
3. Always want to meet you on your premises.
2. Whose buildings and equipment show signs of neglect.
1. Who appeal to your greed.
[0. Seem unconcerned about payments Schedules and Interest Costs.]
37
Edward J. Kane, BC 07-7
Concept of Pricing a Loan
• Concept of a loan’s price as an opportunity cost = value
of all implicit and explicit compensation received for
extending this credit.
– Every contractual requirement is a potential burden. “Nonprice
terms” is an oxymoron.
• Benchmark-plus Pricing: In practice, rates are set as
“spreads” above a low-risk “benchmark” interest rate.
a. Libor
b. Treasury yields
c. Own CD or prime rate
*Etymology of “benchmark” – known height of a prominent
landmark or some kind
38
Edward J. Kane, BC 07-7
Explicit Interest is Not the Full Price of a
Loan
Why do the following items Constitute Implicit
Interest on a Business Loan?
1. Compensating-Balance Requirements (a legal “tying” of
use of deposit and loan products).
[Does it ever make sense to pay interest on one’s own
money? Credit repairs/ money laundering]
2. Collateral Requirements.
3. Covenant Rights.
4. Monitoring requirements.
5. Coercive tie-in arrangements (mostly unwritten): though
illegal, these are alleged to exist
39
Edward J. Kane, BC 07-7
The “credit risk” bankers must
Price and Manage is a Portfolio
Concept
• Measures of this risk must identify and account for:
1. Correlations in underlying “risk factors” that cause
individual-customer “default events”
2. Correlations in the size of the losses driven by
different events and risk factors
[3. Last half of course will introduce the effects of
“hedging transactions” that mitigate or transfer particular
categories of loss exposures (hedging will be the focus of
the middle weeks of this course).]
40
Edward J. Kane, BC 07-7
GOOD AND BAD
LOANS CAN BE SOLD
41
Edward J. Kane, BC 07-7
Memory Device: A Financial-Company Portfolio
Garages a Fleet of Investment and Funding Vehicles
• With tangible long positions in, e.g.,
– Loans
– Marketable Securities
– Real Estate and Equipment
• With tangible short positions in
– Deposit-like accounts
– Debt
– Explicit commitments (insurance obligations; securities
held in street names)
• With numerous harder-to-monitor derivative and
intangible positions
42
Edward J. Kane, BC 07-7
To Manage the Risk of Operating This Fleet, One Must
Understand the Dangers the Fleet Faces: Its Exposure to
Deterioration in Net Value from Various Kinds of Adversity
• Unexpected market moves.
• Model risk: a source of hedging errors.
• Insufficient management oversight.
• Carrying too much risk relative to capital.
• Internal & external fraud
• Counterparty lawsuits.
• Unsupportable Debts.
43
Edward J. Kane, BC 07-7
Risk Landscape for Banks
Institutional Systemic Risk
Event Risk Market Risk Risk
(Devaluation Risk (FX., interest
Large moves in Asset Prices) rate)
Liquidity Risk
(Inability to
unwind a
Credit Risk position without
loss of value)
(Default counterparty
Potential loss due to change Bank
in credit quality)
Reputational Risk
(environment)
Legal Risk
(contracts are not
Settlement Risk
documented
E-business (not receiving funds)
correctly or cannot Operational Risk
be enforced) (loss due to
execution error) 44
Edward J. Kane, BC 07-7
Focus on Correlations is the
Element in Portfolio Analysis
• Definition: Correlated items undergo mutual or
reciprocal movements
• Why are correlations in default and collateral
value relevant? ANS. In Bivariate Models of
Repayment, Expected Loss = Product of
(Probability of Default) and (Loss Given Default).
When collateral value falls whenever probability
of default rises, loss exposure worsens on both
counts.
45
Edward J. Kane, BC 07-7
4th Topic: Introduction to the Discipline
and Art of Loan Accounting
• GAAP Allows Considerable Leeway for timing reported
changes in economic value: Example of deferred interest (i.e.,
“negative amortization”) on option ARM loans at Golden West
• TRANSPARENCY of Accounting Reports of Bank Income and
Net Worth is deliberately weak (opacity)
– Book Value (usually par) and Market Value (=PDV of future cash
flows) of Loans can Diverge Greatly after a loan is made
• late payments
• changes in credit quality of borrowers
• changes in market risk premia
• changes in level of “riskless” rate
46
Edward J. Kane, BC 07-7
Parable can Illustrate Value to
Owners and Regulators of the
Transparency (=accuracy plus
meaningfulness) created by Prompt
and Accurate Provisioning:
In Sept. 2000, a convenience store clerk taped
up the store’s security camera prior to
emptying the cash drawer and claiming that
he was held up. Critical flaw in his plan: he
used transparent tape. 47
Edward J. Kane, BC 07-7
Age-Old Conflict Between Regulators of
FSFs and Watchdogs Who Regulate
Securities Markets and Auditing Activity
1. FSF regulators adopt rules and enforcement systems to assure
“safe and sound” operation of firms in their client industry.
These regulators want to entertain forward-looking
industrywide reasons to justify “unallocated LLR.”
2. Those whose set auditing standards are concerned with how to
document occurrences of revenues and expenses in an objective
and reproducible manner.
Prefer to emphasize historical loss experience or
observable changes in activities or skillsets of each
individual client.
48
Edward J. Kane, BC 07-7
• On average, borrowers are slow. Why?
– Expect to extract leniency
– Many plan to move in and out of delinquency
• Exercise In Booking Accruals, Provisions, and
Charges stresses two kinds of nontransparency:
1. Banks employ accrual accounting rather than cash
accounting for yet-to-be-received receipts on slow,
but “performing” loans. “Nonperforming Loans” are
shifted to a “nonaccrual status.”
2. They are obliged by rules to shift to cash accounting
only for loans on which payments are so far overdue
that they must be classified as “nonperforming”
(threshold varies across countries: 90 days in U.S.).
49
Edward J. Kane, BC 07-7
In U.S., Lightly Disciplined “Judgments” Shape Loan-
Loss Reserves (LLR) and Allowances for Loan and
Lease Losses (ALLL)
• Bathtub Analogy for LLR: ALLL is spigot; Chargeoffs are the
drain.
• Dedicated LLR are a contra-asset deducted promptly from a
loan’s principal (and therefore NW) to get the book value of
net loans (BVL).
• Assigning loss reserves when loans are made and adjusting
them as circumstances change is called prompt
“provisioning”
• Chargeoffs: When losses on uncollected loans are recognized,
they are usually “charged” against the LLR until LLR is
exhausted, then against income or capital.
• Notation: It is instructive to designate the level of LLR that
insiders would understand to be a fair and accurate measure
of expected loss exposure as LLR*.
50
Edward J. Kane, BC 07-7
Examiner Criticism May Sometimes
Force a Loan into Nonaccrual Status
• A four-way categorization of
“criticized loans” is used by
examiners: special mention,
substandard, doubtful, loss.
51
Edward J. Kane, BC 07-7
1. Definitions of Examiner categories of troubled loans:
− “Substandard” loans have one or more well defined weaknesses that
jeopardize full collection of that loan, and have a high probability of
payment default.
− “Doubtful” loans have all the weaknesses inherent in those classified as
substandard with the added characteristic that the weaknesses make
collection or liquidation in full, on the basis of currently existing facts,
conditions, and values, highly questionable and improbable.
− “Loss” loans are considered uncollectible and of such little value that
their continuance as bank assets is not warranted. Any recovery is
likely to occur only after lengthy recovery efforts such as litigation.
− “Special Mention” loans show distinct weaknesses, but collectibility
still seems likely.
− Substandard, doubtful, and loss loans are collectively referred to as
“adversely classified assets.”
2. Resemble categories in weekly NFL “injury reports:”
probable, questionable, doubtful, out.
3. “Loss” and “out” are the most-reliable categories.
[4. Regulators just postponed an effort to adopt a new
nomenclature.]
52
Edward J. Kane, BC 07-7
Workout Personnel Use a Different
Vocabulary From Examiners
A “slow” loan is one whose payments are noticeably or habitually
in arrears (in practice, late or past due by 30 days or more).
Bank Accountants accrue (I.e., credit) interest on these loans
when earned rather than when payment is received.
A nonperforming loan is one whose payments are overdue
enough (90 to 180 days or more) to be deemed severely
delinquent. Interest income on these loans is shifted from
accrual to a cash basis. Interest can no longer be credited until it
is actually received by the bank.
An impaired loan is one whose principal value has come into
serious question. FAS 114 defines a loan as impaired “when,
based on current information and events,” the loan is “judged
less than fully collectable.”
53
Edward J. Kane, BC 07-7
Chart 1: Aversely Rated Credits Over Two Business Cycles
54
Edward J. Kane, BC 07-7
Cross-Country Variation in the Timing and LLR Impact of NPL’s Status
Country Days to NPL status Min. initial provision Ranking
Argentina 90 25% 4
Hong Kong 180 n.a. 9
Peru 60/90 50-60% 2
Singapore sub. risk L-8C (50% min.) 6
Brazil 60 100 3
Malaysia 180 0/1% gen. provisions 9
Colombia 90 50% 4
Chile 30/90 60%/n.a. 1
Philippines sub. risk 25% 6
Korea 180 20% 9
Thailand 360 15% 11
Indonesia 90 10% 8
Source: World Bank
55
Edward J. Kane, BC 07-7
Exercise in Booking Accruals, Provisions, and
Chargeoffs
1. Eagle Bank lends $200,000 to BC Company on January 1 at 7 percent simple interest to be paid
quarterly on the unpaid balance. Payments of $50,000 plus quarterly interest are due on March 30,
June 30, September 29, and December 30.
a. Calculate the payments due at each payment date (in $ thousands).
March 30: 50
.07
200 53.5
4
June 30: 50
.07
150 52.625
4
September 29: 50
.07
100 51.75
4
December 30: 50
.07
50 50.875
4
56
Edward J. Kane, BC 07-7
b. Suppose the first payment is made on time and no further
payments are received until the following year.
Assuming a 180-day threshold for putting a slow loan into
nonaccrual status, what would the bank initially report as
current revenue on the loan in each quarter of the current
year ($ thousands)?
1Q: 3.5
2Q: 2.625 (Credited but not received)
3Q: 152.625(.07/4)=2.671 (Credited
but not received)
4Q: -5.296 (2Q & 3Q Accruals must
be reversed at year end and
$2.718 in unpaid interest added
to the outstanding balance
57
Edward J. Kane, BC 07-7
2. Suppose Eagle Bank set up a $1,000 loss reserve on this loan at its inception. How
would the first quarter and fourth quarter revenues on the loan change if the loss
reserve was made to absorb the first $1,000 in accounting losses that might be
recorded on the loan?
1Q: 3.5 - 1 (in provisioned funds on Jan. 1) = 2.5
4Q: -5.296 + 1 (in chargeoffs) = -4.296
58
Edward J. Kane, BC 07-7
3. Suppose on February 1 of year 2 federal bank examiners forced
Eagle Bank to restructure the loan and write off 10 percent of the
principal [including unpaid interest to this date] still due on the loan
against its net worth account. Suppose also that the new contract
structure required the BC Company to make only a single payment of
$155,000 on June 15 of year two. How would these events affect the
bank’s income in the first quarter and how would the timely receipt of
the settlement payment affect the income in the second quarter of year
two?
Year 2, 1Q: -15.893
[end-of-year principal + accrued interest = 158.934]
Year 2, 2Q: 155 – [158.934 - 15.893] = 11.959
59
Edward J. Kane, BC 07-7
60
Edward J. Kane, BC 07-7
61
Edward J. Kane, BC 07-7
