Presentation on theme: "11-1 Chapter 11 Overview – Part A This chapter discusses types of loans, and the analysis and measurement of credit risk on individual loans. This is."— Presentation transcript:
11-1 Chapter 11 Overview – Part A 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:
11-9 Credit Quality Problems 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.
11-10 Credit Quality Problems 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
11-11 Credit Quality Problems 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
11-16 Recall Bank Balance Sheets from Ch 2
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!
11-19 Loan Growth and Asset Quality
11-20 Annual Net Charge-Off Rates on Loans
11-32 Moody’s Default Rates Investment GradeHigh Yield OriginalRe-weightedOriginalRe-weighted Mean Worst Single Year Worst 3-Year Period Worst 6-Year Period Worst 3 Years