credit analsys

8/13/2019 Credit Analsys

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Loan Eligiblity


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Agenda

1. Theory of Bank Credit

2. Analyzing Bank Credit Risk

3. Credit Process4. Credit Derivatives


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Lemon Problem: Used Cars

Two indistinguishable (to buyers) types of cars:lemons (often breaking down) and creampuffs (neverbreaking down).

If buyers will pay $3000 for a creampuff and $3000for a lemon.

Sellers will part with a creampuff for $2500 and partwith a lemon for $1000.

One third of cars are creampuffs and two thirds arelemons.


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Symmetric Information

If borrowers and sellers

both can easily distinguish

lemons from creampuffs,

there is a simple market

solution. Buyers will pay $3000 for a

creampuff and $2000 for a

lemon and sellers will be

happy to sell.

If neither borrowers nor

sellers can distinguish

between types, there is still

a solution.

Buyers could pay the average

of their values

($2000)+($3000) =

$2,333.

This would be higher than the

average value to sellers:($1000)+($2500) =

$1500.


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Asymmetric Information

What happens if buyers cant distinguish between

types but sellers can?

Buyers might be willing to offer $2,333 for a car ofunknown type, but owners of creampuffs would value

their car more highly than that. Only lemon owners

would sell at that price. Buyers would have no reason

to offer more than $2000. Only lemons will be boughtand sold.

No market for creampuffs will exist.


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Lemon Problem: Bond Market

Some firms have risky prospects (lemons) and somefirms have safe prospects (creampuffs).

Bond buyers cannot distinguish between them. Theyoffer bond prices which are an average of the price ofcreampuff bonds and lemon bonds. [Another way ofputting this is that interest rates are an average ofcreampuff and lemon rates].

Potential borrowers with creampuff prospects mayfinance their own projects.


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Raising Interest Rates May Not Compensate

for Risks in Bond Markets

Only borrowers with lemon prospects will join bond

markets.

Typically we think bond buyers might take riskierassets if they were offered a higher interest rate.

But if savers demand a higher interest rate under

asymmetric informationthis will only exacerbate thelemon problem if higher interest rates drive

creampuff borrowers out of the market.


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Adverse Selection: The Bond Market

Consider a bond market with three types of bond sellers.

1. Safe: Financing a safe, low-return project. Can onlypay 7.5% interest rate but will never default.

2. Speculative: Financing a high risk/high return projectwill pay a 15% interest rate, but a high probability ofdefault.

3. Crooks: Will offer to pay any interest rate, but will

never repay.Assume that 75% of bond issuers are safe, 20% of bond

issuers are speculative, and just 5% are crooks.


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Bond Buyers Bond buyers will pay:

97 for a discount bond issued by a borrower identified assafe;

90 for a bond issued by a borrower identified as speculative

0 for bond issued by a crook.

If they cannot distinguish, they will pay a value equal

to the expected value of the pool.

In this pool, the expected value is

(.75*97)+(.2*90)+(0.05*0) = 90.75 which implies ayield to maturity of i = .102.


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Borrower Investor

will Pay will pay or get

Share at Most at Most at leastSafe 0.75 7.50% 97 1.030928 3.09%

Speculative 0.2 15% 90 1.111111 11.11%

Crook 0.05 Anything 0

Unknown Type 90.75 1.101928 10.19%


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Bond market breaks down!

Rate of interest offered by uninformed investor isattractive to speculative borrowers but to expensivefor safe borrowers.

They will drop out of the market. As bond buyers begin

to realize the riskiness of pool is changing, they willreassess price that they will pay for bonds.

The pool will now be 80% speculative and 20% crooks.The expected value of bonds in this pool is

(.8*90)+(.2*0)=72 implying a yield of i = .3889. This istoo much for speculative borrowers.

Only crooks will stay in the market. Ultimately thebond market will disappear.


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Adverse Selection

Actions that lenders take to protect

themselves from consequence of a lack of

information lead to a worsening of the risk

pool.

In the extreme case, adverse selection can

cause an entire market to disappear.


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Business of Banking & Comparative

Advantage

Comparative advantage of banking.

Banking exists as a specialist in acquiringinformation and eliminating adverse selection

problems. A key comparative advantage of banks is their

ability to evaluate information on borrowers.

Banking business should attempt to make bestuse of that advantage.


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Credit Risk: the risk that a borrower will not

pay back interest or principal on a loan.Evaluating Bank Credit Risk

History of Credit Performance (Charge-offs)

Future expected losses (non-performing

loans, types of lending, diversification)

Current Strength of bank preparation

(reserves, earnings coverage).


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Net Charge-offs to Loans

0.00%

0.50%

1.00%

1.50%

2.00%

2.50%

3.00%

Total loans &

leases

Total real estate

loans

Commercial &

industrial loans

Loans to individuals All other loans &

leases (including

farm)

2007 2006 2005 2004

Statistic on Depository Institutions
http://www2.fdic.gov/sdi/index.asphttp://www2.fdic.gov/sdi/index.asp


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Stages of Bad Loans

Past Due Loans: Loans for which contracted

payments have not been made, but which still areaccruing interest.

More than 90 days past due is Nonperforming Loans

Nonaccrual Loans: Loans that are habitually past due

and no longer accruing interest.

Total Noncurrent = Past Due + Nonaccrual

Charge-offs: Loans written off as uncollectable

Recoveries: Sums later collected on loans written off.

Net Chargoffs = Charge-offs - Recoveries


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Past Due Loans

(Contractual Payment not

Made)

90 Days Non Performing

Loans

Full Payment

Not Expected

Non-accrualLoans

NonCurrent Loans

Total

Chargeoffs

Uncollect

ible

Loans

Written

off

Collection

Process

Recovery

Net

Chargeoffs


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Non Current Assets to Loans

0.00%

0.20%

0.40%0.60%

0.80%

1.00%

1.20%

1.40%

1.60%

1.80%

Total loans &

leases

All real estate

loans

Commercial &

industrial

loans

Loans to

individuals

All other

loans &

leases

(including

farm)

Commercial

real estate

loans not

secured by

real estate

2007 2006 2005 2004

Statistic on Depository Institutions
http://www2.fdic.gov/sdi/index.asphttp://www2.fdic.gov/sdi/index.asphttp://www2.fdic.gov/sdi/index.asp


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Measuring a Banks Credit Risk/Key Ratios

Loans are assets with the most credit risk (also themost profitable). Other types of assets are typically

more transparent and have less risk of default.

Large quantities of loans make banks riskier.

Higher Loans to Assets means higher risk.

Rapid expansion of credit means banks may not be

discriminating

Higher Loan Growth Rate means higher risk

Measure banks chargeoffs, loan composition, non-

performing & non current loans, earnings coverage,

loan loss allowances on page 8 & page 9 of UBPRs.


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Composition of a Banks Loan Portfolio

Some loans are riskier than others, so a highshare of loans in risky categories involveshigher risk.

Banks concentrate on real estate lending whichtends to have very low default rates.

An undiversified portfolio also exposes a bankto risk. Concentration in the property marketexposes the bank to systematic risk ofproperty collapse.


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Protection from Bad Loans

US Commercial Banks, 2004

0

1

2

3

4

5

6

7

2004 2003 2002 2001

Loan Loss/Net Charge Offs Earnings/Net Charge Offs Loan Loss/Gross Loans (%)

Source: SDI, FDIC Statistics on Depository Institutions, FDIC
http://www2.fdic.gov/sdi/index.asphttp://www2.fdic.gov/sdi/index.asphttp://www2.fdic.gov/sdi/index.asp


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Credit Process

I. Credit Policy

II. Business Development and Credit Analysis .

III. Credit ExecutionIV. Loan Review


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I. Credit Policy

Loan Policy

Loan Culture

1. Values DrivenRisk Averse

2. Current Profit DifferentHigh risk/return

lending, Cyclical Profits

3. Market Share DrivenLow returns, large scale.


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Written Loan Policy FDIC recommends, A loan policy should address:

General fields of lending Normal trade area

Lending authority of loan officers and committees

Responsibility of the board of directors in approving loans

Guidelines for portfolio mix, risk diversification, appraisals, unsecured

loans, and rates of interest Limitations on loan-to-value, aggregate loans, and overdrafts

Credit and collateral documentation standards

Collection procedures

Guidelines addressing loan review/grading systems and the allowance

for loan and lease losses Safeguards to minimize potential environmental liability

Source

http://www.fdic.gov/regulations/examinations/supervisory/insights/siwin04/policy_tune

_up.html
http://www.fdic.gov/regulations/examinations/supervisory/insights/siwin04/policy_tune_up.htmlhttp://www.fdic.gov/regulations/examinations/supervisory/insights/siwin04/policy_tune_up.htmlhttp://www.fdic.gov/regulations/examinations/supervisory/insights/siwin04/policy_tune_up.htmlhttp://www.fdic.gov/regulations/examinations/supervisory/insights/siwin04/policy_tune_up.html


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Business Development & Credit Analysis

MarketingFind customers

Loan InterviewMeet potential borrower andevaluate for character and sincerity

Evaluation of BusinessGather information aboutthe borrowers business.

Credit Analysis: Numerical analysis of a businessesfinancial condition

Evaluation of Collateral Adequacy: Check whethercollateral that backs loans is of value commensuratewith loan.


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Credit Scoring Models

(1.2 ) (1.4 ) (3.3 )

(0.6 ) (.999 )

Z WC RE ROA

Equity AT

Banks use numerical models to evaluate thecredit of borrowing firms. Seminal model wasthe Z-score model of Edward Altman

WCWorking Capital to Assets

RE: Retained Earnings to Assets

ROA: EBIT/Assets

Equity: Market toBook Ratio

AT: Asset Turnover-

Sales to AssetsAbove 3, bankruptcy unlikely; below 1.8bankruptcy likely.


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FICO

In USA, Fair Isaac Corp. develops models that evaluateconsumer households likelihood of default.

FICO or similar score used for consumer credit

Late payments

The amount of time credit has been established

The amount of credit used versus the amount of credit available

Length of time at present residence

Negative credit information such as bankruptcies, charge-offs,collections, etc.

In Hong Kong, recent relaxation of some rules governingsharing of consumer credit information.


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5 Cs of Credit

1. CharacterPast history of borrower in payingbills.

2. CapitalBorrowers Wealth Position

3. Collateralpossession by the borrower ofassets that back up the loan.

4. Conditions - trends and volatility of theborrowers industry

5. CapacityLegal Standing and ability of theborrower to generate loan payments on aconsistent basis


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III. Execution

Documentation

Loan Agreements

Restrictive Covenants

Perfecting Claims to Collateral


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Parts of a Typical Loan Agreement

The Note: Specifies the principal and theinterest and the timing of repayment.

Collateral: Specifies assets assigned and terms

under which lender takes possession of assets. Covenants

Borrower Guarantees.

Events of Default: Exact conditions underwhich a loan is considered in default.


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Loan Covenants

A central part of the credit process is the monitoringof borrowers.

Banks restrict borrowers use of funds in the loanagreement.

Affirmative Covenants. Actions that the borrower musttake. Maintaining liquidity and equity as measured byfinancial ratios, maintaining insurance, file financialreports, pay taxes, etc.

Negative Covenants. Actions that the borrower cannottake. Taking on new debt, buying or selling assets, payingexcessive dividends, paying excessive salaries or bonuses,etc.


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IV. Credit Review

Monitor Covenants

Loan Review Process

Ex post evaluations of lending evaluation

Loan Workout

Process for dealing with defaulting creditors


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Credit Derivatives

Risk Management Tools Used to transfer risk from oneparty to another.

Credit SwapsA bank with credit risk exposure willpay X basis points per year and counter-party willmake payment if there is a pre-determined creditevent such as default or credit downgrade, etc.

Total Return Swap: Bank with credit risk will pay theincome stream from risky debt while counter-partywill pay some fixed rate to bank..


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Credit Swap

Bank A

Bank B

Fee Payment

Payment if negative

credit event


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Total Return Swap

Bank A

Intermediary

Bank B

Loan and Principal

Loan and Principal

Loan and Principal Loan and Principal


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Credit Derivatives

Global Credit Derivatives

0

2000

4000

6000

8000

10000

12000

14000

1H01 2H01 1H02 2H02 1H03 2H03 1H04 2H04 1H05

US$

Trillio

n

Source: www.creditderiv.com
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Extra Reading

HKMA Benefits of Sharing Positive Consumer

Credit Data

B. Hirtle, NY FED, 2007, Credit Derivatives and

Bank Credit Supply

BIS 2005 Credit Risk Transfer
http://www.info.gov.hk/hkma/eng/public/qb200603/fa1.pdfhttp://www.info.gov.hk/hkma/eng/public/qb200603/fa1.pdfhttp://www.newyorkfed.org/research/staff_reports/sr276.htmlhttp://www.newyorkfed.org/research/staff_reports/sr276.htmlhttp://www.bis.org/publ/joint13.pdf?noframes=1http://www.bis.org/publ/joint13.pdf?noframes=1http://www.newyorkfed.org/research/staff_reports/sr276.htmlhttp://www.newyorkfed.org/research/staff_reports/sr276.htmlhttp://www.info.gov.hk/hkma/eng/public/qb200603/fa1.pdfhttp://www.info.gov.hk/hkma/eng/public/qb200603/fa1.pdf

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