1. Credit Risk Expected Return
Classes #13; Chap 11

2. Lecture Outline
Purpose: Gain a basic understanding of credit risk. Specifically, how it effects loan returns
Brief Introduction to Credit Risk- what is it; why it is important?
How to calculate expected loan return
Contractually promised return
Expected return
Required return

3. Variation in asset prices due to the risk of default
What is Credit Risk?
Home Mortgage Losses
Settlement
It is the risk associated with a loan (or bond) having to do with a borrower’s unwillingness or inability to pay.
Variation in asset prices due to the risk of default

4. Types of Loans Other loans include: C&I loans: Secured and unsecured
Real Estate loans: Primarily mortgages
Fixed vs. Floating
Individual (consumer) loans:
Non-revolving loans (Automobile, mobile home, personal loans)
Revolving loans (Credit line)
Growth in credit card debt (Visa, MasterCard )
Other loans include:
Farm loans, Other banks, Nonbank FIs, Broker margin loans; Foreign banks and sovereign governments, State and local governments

5. Loan Returns Contractually Promised Return Expected Return
Required Return

6. Contractually Promised Return

7. Contractually Promised Return Definition
The return that the bank realizes if the loan does not default (best case)
Origination fee – a one-time payment at origination usually used to cover administrative costs
Interest Earned – total interest earned over the life of the loan
Compensating Balance – a fraction of the loan principal required to be held in demand deposits at the bank
Interest Expense – includes all interest expenses over the life of the loan that the bank incurs from issuing the loan
Reserve Requirements – Reserves sent to the fed to cover additional reserve requirements incurred from issuing the new loan (from the compensating balance)
Rcontractual
Reserve Req.
Rcontractual

8. Contractually Promised Return Loan Interest Rate
How does the bank determine the interest rate it charges?
Loan Interest Rate
Bank will usually charge a base rate that is related to their funding costs (Libor) + some risk premium
LIBOR
Tied to funding cost
Base Rate = 12%
FICO
Credit Risk Premium = 2%
Tied to borrower credit risk
Job/
Income
Loan Interest Rate = 14%

9. Contractually Promised Return Book Formula
The book provides a formula so we should discuss why we do not follow the book

10. Contractually Promised Return Book Formula
The book provides a formula so we should discuss why we do not follow the book
Origination fee – Usually a one-time upfront payment but it is being added in as if it were a continuous fee
It can be done by converting the one-time fee into annual payments an then asking what percent of the loan value are those incremental payments – that gives you “of”
Interest Expense – the formula only works if the compensating balance is held in non-interest bearing demand deposits.
Federal Reserve Interest – the formula does not take into account interest paid on reserves held at the Fed.

11. Contractually Promised Return Summary
So at this point we have k
This is the return on our loan if there is no possibility of default (it is the best case scenario)
Do we always get that return?
What happens if the loan defaults?
we do not get the promised return
we may not even get back the full principal committed k
Reserve Req.
No!!
– the loan can default

12. Expected Return

13. Loan Expected Return Uncertainty
Why do we need to calculate an expected return?
What don’t we know?
What can we do if we don’t know how things will turn out?
If or when the loan will be paid back
This is the uncertainty – it is default risk: the risk that the borrower will default on their loan
We can guess

14. Loan Expected Return Expected Return
How to guess – we want our guess to be educated and reasonable
We have two cases:
The borrower has enough money to payoff the loan
The borrower does not have enough money to payoff the loan
Default
E(R) = + P
(1+k)
(1-P)
(R)
We may be able to recover some money in default
There is some likelihood (probability) that the borrower will payback the loan
In this case we get our full return – but we know this doesn't happen all the time
There are only 2 cases payment and default. So the likelihood (probability) of default is 1- probability of payment

15. Loan Expected Return Expected Return
How to guess – we want our guess to be educated and reasonable
We have two cases:
The borrower has enough money to payoff the loan
The borrower does not have enough money to payoff the loan
Recovery – is the percent of value recovered in default
Suppose we can recover 20% of the principal?
When we talk about the recovery rate we just say R or 20% but it is really 1+kD where kD is the loan return in default
Default
Recovery is the recovery principal net of what is earned on fees interest … up to the point when the company defaults.
E(R) = + P
(1+k)
(1-P)
(R)
= (1 – 0.80) = 0.20
= (1+k)
– what is our return
-80%

16. Loan Expected Return Default vs. payment (survival) probabilities
How to guess – we want our guess to be educated and reasonable
We have two cases:
The borrower has enough money to payoff the loan
The borrower does not have enough money to payoff the loan
Default
E(R) = + P
(1+k)
(1-P)
(R)
What if I told you that the probability of payment was 90%
P = 0.90
1–P = 0.10
What if I told you that the probability of default was 15%
P = 0.85
1–P = 0.15

17. Loan Expected Return Summary
The expected return on a loan adjusts for default risk
That is, it is a guess at what the loan return will be taking into account the possibility of default
E(R) = P(1+k) + (1–P)(R)
Survival Probability
(prob of payment)
Default
Probability
Contractually promised return
Recovery Rate
E(R) = (Survival Prob)(1+k) + (Default Prob)(R)

18. Required Return

19. Required Return How does a bank decide when they will issue a loan?
Economic
conditions
Required Return
Funding Costs 4%
Global Markets
To be profitable, the bank needs to earn more than 4% expected return on its loans
In order to maintain positive expected profits the bank must only issue loans with an expected return greater than or equal to the required return, which means:

20. Required Return Net Present Value (NPV)
Anything above the bank’s required compensation is positive value to the bank
Net Value = Loan Proceeds – Loan Cost
NPV = PV(Loan Proceed – Loan Cost )

21. Required Return Net Present Value (NPV) – Example
Example: Consider a 1-year loan for $500M. Calculate the loan NPV if its expected return is 6% and the bank’s required return is 4%

22. Example

23. Loan Return Example a) Contractually Promised Return
Asolo bank issues a 3-year $15M balloon payment loan to Kemp Inc. The loan has an annual interest rate of 6%, origination fee of 2% and compensating balance of 4% to be held in demand deposits that pay 1.5%. Kemp has a 13% probability of default over the next 3 years and expected recovery rate of 40%. Asolo’s cost of capital is 3% and the fed requires 10% of demand deposits to be held on reserve.
Calculate the contractually promised return
Calculate the expected return of the loan
Find the NPV of the loan
a) Contractually Promised Return
Step #1: Calculate interest Earned
Step #2: Fee Income

24. Loan Return Example a) Contractually Promised Return
Asolo bank issues a 3-year $15M balloon payment loan to Kemp Inc. The loan has an annual interest rate of 6%, origination fee of 2% and compensating balance of 4% to be held in demand deposits that pay 1.5%. Kemp has a 13% probability of default over the next 3 years and expected recovery rate of 40%. Asolo’s cost of capital is 3% and the fed requires 10% of demand deposits to be held on reserve.
Calculate the contractually promised return
Calculate the expected return of the loan
Find the NPV of the loan
a) Contractually Promised Return
Step #3: Compensating Balance
Step #4: Reserve Requirements
Step #5: Interest Expense

25. Loan Return Example a) Contractually Promised Return
Asolo bank issues a 3-year $15M balloon payment loan to Kemp Inc. The loan has an annual interest rate of 6%, origination fee of 2% and compensating balance of 4% to be held in demand deposits that pay 1.5%. Kemp has a 13% probability of default over the next 3 years and expected recovery rate of 40%. Asolo’s cost of capital is 3% and the fed requires 10% of demand deposits to be held on reserve.
Calculate the contractually promised return
Calculate the expected return of the loan
Find the NPV of the loan
a) Contractually Promised Return

26. k is the contractually promised return from the last slide
Loan Return Example
Asolo bank issues a 3-year $15M balloon payment loan to Kemp Inc. The loan has an annual interest rate of 6%, origination fee of 2% and compensating balance of 4% to be held in demand deposits that pay 1.5%. Kemp has a 13% probability of default over the next 3 years and expected recovery rate of 40%. Asolo’s cost of capital is 3% and the fed requires 10% of demand deposits to be held on reserve.
Calculate the contractually promised return
Calculate the expected return of the loan
Find the NPV of the loan
b) Expected Return
What is P?
In this case you are given the default probability so you need to calculate the survival probability
k is the contractually promised return from the last slide

27. Loan Return Example b) Expected Return
Asolo bank issues a 3-year $15M balloon payment loan to Kemp Inc. The loan has an annual interest rate of 6%, origination fee of 2% and compensating balance of 4% to be held in demand deposits that pay 1.5%. Kemp has a 13% probability of default over the next 3 years and expected recovery rate of 40%. Asolo’s cost of capital is 3% and the fed requires 10% of demand deposits to be held on reserve.
Calculate the contractually promised return
Calculate the expected return of the loan
Find the NPV of the loan
b) Expected Return
This is the gross expected return it includes the initial investment and tells us that we would expect the have 111% of what we started with in 3 years. Note this is not an annualized rate.
Annualize return: What rate would we need to invest $1 at for 3 years to get $1.11?

28. Question: Why don’t we consider interest payments fees …
Loan Return Example
Asolo bank issues a 3-year $15M balloon payment loan to Kemp Inc. The loan has an annual interest rate of 6%, origination fee of 2% and compensating balance of 4% to be held in demand deposits that pay 1.5%. Kemp has a 13% probability of default over the next 3 years and expected recovery rate of 40%. Asolo’s cost of capital is 3% and the fed requires 10% of demand deposits to be held on reserve.
Calculate the contractually promised return
Calculate the expected return of the loan
Find the NPV of the loan
C) Loan NPV
Question: Why don’t we consider interest payments fees …
The returns we have calculated – the expected return and required return are “all inclusive” – they include interest fees …, remember when we calculated the expected return we took all of that into account
We expect our $15M investment to return 3.66% per year over the next 3 years so this is the expected value in 3 years
But the bank only requires 3% (that is the return they need to break-even) so we discount at 3% anything over 3% is positive value (gravy)

29. Example: ConocoPhillips borrows $3M from Bank of America for one year to cover a short-term capital shortage. They agree to pay 9% interest per annum on the loan. Bank of America charges a 3% origination fee and requires an 8% compensating balance to be held in demand deposits. Bank of America pays 2% on demand deposits. The Federal Reserve requires that 10% of deposits be held in reserves at the Fed. In the case of default, Bank of America expects to recover 60% of the loan value. Bank of America’s cost of capital is 2.5%
Find the contractually promised return
What is Bank of America’s maximum acceptable probability of default for ConocoPhillips over the coming year

30. Lecture Summary Loan Contractually Promised Return
Is the total return that the bank realizes over the life of the loan if the borrower does not default
Loan Expected Return
Adjusts for the possibility that the firm will default
Decreases the return relative to the contractually promised
Loan NPV
Bank profit on the loan after taking into account the banks cost of capital.