Chapter Twenty

Managing Credit Risk on the Balance Sheet

McGraw-Hill/Irwin Copyright 2012 by The McGraw-Hill Companies, Inc. All rights20-1 reserved.

Credit Risk Management

Financial institutions (FIs) are special because of their ability to transform financial claims of household savers efficiently into claims issued to corporations, individuals, and governments FIs ability to process and evaluate information and control and monitor borrowers allows them to transform these claims at the lowest possible cost to all parties Credit allocation is an important type of financial claim transformation for commercial banks FIs make loans to corporations, individuals, and governments FIs accept the risks of loans in return for interest that (hopefully) covers the costs of funding net of defaults and, as a result, are exposed to credit risk

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Credit Risk Management

The credit quality of many FIs lending and investment decisions has been called into question in the past 25 years

Problems related to real estate and junk bond lending surfaced at banks, thrifts, and insurance companies in the late 1980s and early 1990s Concerns related to the rapid increase of credit cards and auto lending occurred in the late 1990s Commercial lending standards declined in the late 1990s, which led to increases in high-yield business loan delinquencies Concerns shifted to technology loans in the late 1990s and early 2000s Mortgage delinquencies, particularly with subprime mortgages, surged in 2006 and mortgage and credit card delinquencies continue to be a concern

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Credit Risk Management

Larger banks are generally more likely to accept riskier loans than smaller banks Larger banks are also exposed to more counterparty risk off-the-balance-sheet than smaller banks Managerial efficiency and credit risk management strategies directly affect the return and risk of the loan portfolio At the extreme, credit risk can lead to insolvency as large loan losses can wipe out an FIs equity capital

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Credit Risk Management

Losses from both on- and off-balance sheet claims resulting from the subprime crisis are expected to reach $4 trillion worldwide with $2.7 trillion in losses from assets originated at U.S. institutions Net charge-off rates reached record highs in the fourth quarter of 2008 at 1.95% and remained high in early 2009 at 1.94% The high loss rates led to the failures or buyouts of Countrywide and IndyMac Bank The seizure of IndyMac cost the FDIC between $4 billion and $8 billion and was the largest bank failure in over 20 years

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Credit Risk Management

Number of bank failures per year:

2007 2008 2009 2010 3 25 140 157

At the end of 2010 there were 860 banks on the FDICs problem bank list

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Credit Risk Management

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Credit Analysis

Real estate lending

mortgage loan applications are among the most standard of all credit applications decisions to approve or disapprove a mortgage application depend on: the applicants ability and willingness to make timely interest and principal payments the value of the borrowers collateral the ability to maintain mortgage payments is measured by GDS and TDS

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Credit Analysis

Real estate lending (cont.)

GDS refers to the gross debt service ratio equal to the total accommodation expenses (mortgage, lease, condominium, management fees, real estate taxes, etc.) divided by gross income acceptable threshold generally set around max. 25% to 30% TDS refers to the total debt service ratio equal to the total accommodation expenses plus all other debt service payments divided by gross income acceptable threshold generally set around max. 35% to 40%
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Credit Analysis
A mortgage loan applicant has the following data:
Gross Income $175,000

Monthly Mortgage P&I Payment $3,500

Annual Property Taxes $4,500

Annual Other Debt Homeowners Payments / Insurance year $950 $29,000

GDS Ratio = (Annual mortgage payments + Property taxes) / Annual gross income = (($3,500*12) + $4,500) / $175,000 = 26.57% Conclusion: Pass TDS Ratio = Annual total debt payments / Annual gross income = (($3,500*12) + $4,500 + $950 + $29,000) / $175,000 = 43.69% Conclusion: Fail

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Credit Analysis

Real estate lending (cont.)

FIs also use credit scoring systems to evaluate potential borrowers credit scoring systems are mathematical models that use observed loan applicants characteristics to calculate a score that represents the applicants probability of default loan officers can often give immediate yes or no answersalong with justifications for the decision

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Sample Credit Score Characteristic Gross Income Score TDS Score Relation with FI Score Major credit card Score Age Score Residence Score Length of residence Score Job stability Score Credit history Score <$10,000 0 >50% 0 None 0 None 0 <25 5 Live w/ parent 0 < 1 year 0 < 1 year 0 No record 0 $10,000$25,000 15 35%-50% 10 Checking 30 1 or more 20 25-60 30 Rent 5 1-5 years 20 1-5 years 25

Values and Weights $25,000$50,000$50,000 $100,000 35 15%-35% 20 Savings 30 50 5%-15% 35 Both 60

>$100,000 75 <5% 50

Sample Credit Score Criteria

Characteristic Gross Income TDS Relation with FI Major credit card Age Residence Length of residence Job stability Credit history Value $95,000 39% Checking 3 45 Own/Finance 3 years 2 years Met all payments Total Score 50 10 30 20 30 20 20 25 50 255

>60 35 Own/Finance Own Outright 20 > 5 years 45 > 5 years 50 Met all pmts 50 50

Real Estate loan is automatically approved

Pmt missed in last 5 yars e -15

Automatic rejection levelscore 120 : Automatic acceptance levelscore 190 : Scores between 120 and 190 are reviewed by a loan officer or loan committee

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Credit Analysis

Real estate lending (cont.) Lender may use standard FICO credit scores FICO scores run from 300 to 850, with the majority of scores between 600 and 800 Scores of 720 or higher are usually sufficient to receive a good mortgage rate FIs also verify borrowers financial statements perfecting collateral is the process of ensuring that collateral used to secure a loan is free and clear to the lender should the borrower default on the loan

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Credit Analysis

Real estate lending (cont.)

FIs do not desire to become involved in loans that are likely to go into default In the event of default, lenders usually have recourse foreclosure is the process of taking possession of the mortgaged property in satisfaction of a defaulting borrowers indebtedness and forgoing claim to any deficiency power of sale is the process of taking the proceedings of the forced sale of a mortgaged property in satisfaction of the indebtedness and returning to the mortgagor the excess over the indebtedness or claiming any shortfall as an unsecured creditor
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Credit Analysis

Real estate lending (cont.)

before an FI accepts a mortgage, it: confirms the title and legal description of the property obtains a surveyors certificate confirming that the house is within the propertys boundaries checks with the tax office to confirm that no property taxes are unpaid requests a land title search to determine that there are no other claims against the property obtains an independent appraisal to confirm that the purchase price is in line with the market value of the property
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Credit Analysis

Consumer and small business lending

Techniques are very similar to that of mortgage lending However, non-mortgage consumer loans focus on the ability to repay rather than on the property credit models put more emphasis on personal characteristics Small-business loan decisions often combine computerbased financial analysis of borrower financial statements with behavioral analysis of the business owner

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Credit Analysis

Mid-market commercial and industrial lending

is generally a profitable market for credit-granting FIs Typically mid-market corporates:

have sales revenues from $5 million to $100 million per year have a recognizable corporate structure do not have ready access to deep and liquid capital markets

Commercial loans can be for as short as a few weeks to as long as 8 years or more

short-term loans are used to finance working capital needs long-term loans are used to finance fixed asset purchases

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Credit Analysis

Mid-market C&I lending (cont.)

generally at least two loan officers must approve a new loan customer large credit requests are presented formally to a credit approval officer and/or committee five Cs of credit

character capacity collateral conditions capital

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Credit Analysis

Mid-market C&I lending (cont.)

FIs perform cash flow analyses, which provide information regarding an applicants expected cash receipts and disbursements statements of cash flows separate cash flows into:

cash flows from operating activities cash flows from investing activities cash flows from financing activities time-series analyses cross-sectional analyses

FIs may also perform ratio analyses

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Sample Cash Flow Analysis

Change Assets ($60) Cash $200 Accounts rec. ($240) Inventory Total current $1,500 Fixed assets Total assets 2010 $170 500 1,240 1,910 2,000 $3,910 2011 $110 700 1,000 1810 3,500 Liabilities & Equity Accounts payable Notes payable Total current liabilities Long-term debt 2010 $135 1,200 1,335 2,005 100 470 $3,910 2011 Change $120 ($15) 1,400 1520 2,620 200 970 $5,310 615 100 500 $200

Common stock Retained earnings $5,310 Total liab. & equity

Income Statement 2011 Sales $8,800.00 Costs ($5,600.00) Depreciation ($900.00) EBIT $2,300.00 Interest ($350.00) Expense EBT $1,950.00 Taxes ($760.50) Net Income $1,189.50 Dividends $689.50 Change RE $500.00

Summary Cash Flow Statement 2011 A: Cash Flow From Operations $ B. Cash Flow From Investing C. Cash Flow From Financing D. Change in Cash

2,464.50

($ 2,400.00) ($ ($ 124.50) 60.00)

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Credit Analysis

Mid-market C&I lending (cont.)

Common ratio analysis includes: liquidity ratios

current ratio quick ratio (i.e., the acid test) number of days in receivables number of days in inventories sales to working capital sales to fixed assets sales to total assets (i.e., the asset turnover ratio)

asset management ratios

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Credit Analysis

Mid-market C&I lending (cont.)

debt and solvency ratios

debt-to-assets ratio times interest earned ratio cash-flow-to-debt ratio gross margin operating profit margin return on assets (ROA) return on equity (ROE) dividend payout ratio
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profitability ratios

Sample Ratio Analysis

Change Assets ($60) Cash $200 Accounts rec. ($240) Inventory Total current $1,500 Fixed assets Total assets
Income Statement 2011 Sales $8,800.00 Costs ($5,600.00) Depreciation ($900.00) EBIT $2,300.00 Interest ($350.00) Expense EBT $1,950.00 Taxes ($760.50) Net Income $1,189.50 Dividends $689.50 Change RE $500.00

2010 $170 500 1,240 1,910 2,000 $3,910

2011 $110 700 1,000 1810 3,500

Liabilities & Equity Accounts payable Notes payable Total current liabilities Long-term debt

2010 $135 1,200 1,335 2,005 100 470 $3,910

2011 Change $120 ($15) 1,400 1520 2,620 200 970 $5,310 615 100 500 $200

Common stock Retained earnings $5,310 Total liab. & equity

Liquidity ratios (2011) Current ratio = Current Assets / Current Liabilities = 1.19 Quick ratio (acid test) = (Cash + Cash equivalents + Receivables) / Current Liabilities = 0.53

Asset management ratios (2011) Days sales in receivables = (Receivables 365) / Credit Sales Days in inventory = (Inventory 365) / Cost of Goods Sold Sales to fixed assets = Sales / Fixed Assets Asset turnover = Sales / Total Assets

= = = =

29 65 4.40 1.66

Debt (long term solvency) ratios (2011) Debt to asset or total debt ratio = Total Liabilities / Total Assets = 78% Times Interest Earned: EBIT / Interest Expense = 6.57 Cash flow to debt ratio = (EBIT + Depreciation ) / Debt = 77.3% EBIT is earnings before interest and taxes, EAT is earnings after taxes
Profitability ratios (2011) Gross margin = Gross profit / Sales = 36% Operating profit margin = Operating profit / Sales = 26% Net profit margin = EAT / Sales = 13.5% Return on assets = EAT / Average total assets = 22% Return on equity = EAT / Total equity = 101.7% Dividend payout = Dividends / EAT = 57.9%

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Credit Analysis

Mid-market C&I lending (cont.)

Ratio analysis has limitations: diverse firms are difficult to compare versus benchmarks different accounting methods can distort industry comparisons applicants can distort financial statements common-size analysis and growth rates common-size financial statements present values as percentages to facilitate comparison versus competitors year-to-year growth rates can identify trends loan covenants can be used as part of the loan agreement to mitigate credit risk

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Credit Analysis

Mid-market C&I lending (cont.)

Following approval, the account officer ensures that conditions precedent have been cleared

those conditions specified in the credit agreement or terms sheet for a credit that must be fulfilled before drawings are permitted includes title searches, perfecting of collateral, etc.

FIs typically wish to develop permanent, long-term, mutually beneficial relationships with their mid-market commercial and industrial customers

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Credit Analysis

Large commercial and industrial lending

fees and spreads are smaller relative to small and midsize corporate loans, but the transactions are often large enough to make them worthwhile FIs relationships with large clients often center around broker, dealer, and advisor activities with lending playing a lesser role Large corporations often use: loan commitments performance guarantees term loans

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Credit Analysis

Large C&I lending (cont.)

Account officers often rely on rating agencies and market analysts to aid in their credit analysis Sophisticated credit scoring models are also used Altmans Z-score: Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5 where X1 = working capital total assets
X2 = retained earnings total assets X3 = earnings before interest and taxes total assets X4 = market value of equity book value of long-term debt X5 = sales total assets

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Altman Z Analysis

Large C&I lending (cont.)

The higher the Z-score, the lower the probability of borrower default A borrower with a Z-score less than 1.81 is considered to have high default risk Zscore of 2.99 or more indicates low default risk Zscore between 1.81 and 2.99 indicates that the loan applicants default risk is indeterminate

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Altman Z-Score Example

Using the data from before:
Z 1.2X 1 1.4X 2 3.3X 3 0.6X 4 1.0X 5
Coefficients Variables 1.2 1.4 3.3 0.6 1 Z-Score 5.46% 18.27% 43.31% 44.66% 165.73% 3.6758485

X1 = Working capital / Total assets X2 = Retained earnings / Total assets X3 = EBIT / Total assets X4 = Market value of equity / Book value of long term debt X5 = Sales / Total assets

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Credit Analysis

Large C&I lending (cont.)

KMV Credit Monitor Model uses the option pricing model of Merton, Black, and Scholes to calculate expected default frequencies for over 60,000 public companies and many private ones worldwide.

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Credit Analysis

Calculating the return on a loan the return on assets (ROA) approach uses the contractually promised gross return on a loan, k, per dollar lent f BR m 1 k 1 1 b1 RR

where

f = the loan origination fee b = the compensating balance requirement RR = the reserve requirement ratio BR = the base lending rate m = the credit risk premium on the loan
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ROA Analysis of a Loan

Example 1: A bank has a base lending rate of 8% (BR), and charges a certain customer a 110 basis point risk premium (m). The bank also charges a 1% origination fee (f). The bank requires the borrower to maintain compensating balances (b) of 7% of the loan amount. The reserve requirement (RR) is 10% and the loan amount is $1 million. Calculate the required gross return on a loan = k. f BR m

1 k 1

1 b1 RR

0.01 (0.08 0.011) 1 k 1 ; 1 [0.07(1 .10)]

k 10.78%

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RAROC Model

Calculating the return on a loan (cont.) The risk-adjusted return on assets (RAROC) model balances a loans expected income against its expected risk
one - year income on a loan RAROC loan (asset) risk or value at risk

The RAROC is compared vis--vis the lenders taxadjusted return on equity (ROE) o if RAROC > ROE, make the loan o if RAROC < ROE, either adjust the loan such that RAROC > ROE or decline to make the loan
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Example 1: RAROC

Example 1 (continued)

Total income to the bank (ignoring the timing of the receipts) is $ 80,000 = 0.08 $1 million (base loan rate) $ 11,000 = 0.011 $1 million (credit risk premium) $ 10,000 = 0.01 $1 million (loan origination fee) $ 101,000 = Total income The amount of funds invested by the bank is: $1,000,000 (the loan amount) ($ 70,000 ) (the compensating balance) $ 7,000 (the banks reserve requirement on the compensating balance) $ 937,000 = Net funds invested The gross ROA on the loan is then $101,000 / $937,000 = 10.78%.

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Total income to the bank (ignoring the timing of the receipts) is $ 80,000 = 0.08 $1 million (base loan rate) $ 11,000 = 0.011 $1 million (credit risk premium) $ 10,000 = 0.01 $1 million (loan origination fee) Total income Total income $ 101,000 = to the bank (ignoring the timing of the receipts) is The 80,000 of funds $1 million the bank is: $ amount = 0.08 invested by (base loan rate) (the $1 million $$1,000,000= 0.011loan amount) (credit risk premium) 11,000 1 compensating balance) ($ Example(the $1 million (loan origination fee) 70,000 $ 10,000 =) 0.01 (continued) RAROC $ 101,000 = Totalbanks reserve requirement on the compensating balance) 7,000 (the income $ $ 937,000 of fundsfunds invested bank is: The amount = Net invested by the The gross ROA (the loan amount) to fund the loan = 10.3% $1,000,000 on the cost then $101,000 / $937,000 = 10.78%. Suppose the loan is rate ($ 70,000 ) (the compensating balance) $ Dollar cost to finance the loan on $937,000 * 10.3% = $96,511 7,000 (the banks reserve requirement = the compensating balance) $ 937,000 th Net funds invested = The gross ROApercentile, or$101,000 / $937,000 = 10.78%. The 99 on the loan is then the extreme loss rate, for this loan

RAROC Example

category is 3% per year Recovery rate on this loan type is 25%, or 75% loss rate Capital at risk = 0.03 0.75 x $1,000,000 gross loan amount = $22,500
RAROC ($ 101,000 $96,511) 19 .95 % $22,500

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