11A

					        Chapter 11 Overview – Part A             11-1




   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:
      Credit Quality Problems
                                             11-9




 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.
             Credit Quality Problems
                                                    11-10




   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
       Credit Quality Problems
                                            11-11




 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
Recall Bank Balance Sheets from Ch 2
                                       11-16
                                            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

				
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