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: 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 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 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 Drake University Fin 129 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: 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 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. 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 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 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 Drake Variance of Returns Drake University Fin 129 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 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 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 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 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.
Pages to are hidden for
"PowerPoint Presentation - Drake College of Business and Public "Please download to view full document