McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Chapter Twenty-one Managing Risk on the Balance Sheet I: Credit Risk

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Overview: Credit Risk Management An FI’s ability to evaluate information and control and monitor borrowers allows them to transform financial claims of household savers efficiently into claims issued to corporations, individuals, and governments An FI accepts credit risk in exchange for a fair return sufficient to cover the cost of funding (e.g., covering the cost of borrowing, or issuing deposits) and a competitive profit margin An FI’s ability to evaluate information and control and monitor borrowers allows them to transform financial claims of household savers efficiently into claims issued to corporations, individuals, and governments An FI accepts credit risk in exchange for a fair return sufficient to cover the cost of funding (e.g., covering the cost of borrowing, or issuing deposits) and a competitive profit margin

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Credit Analysis Real Estate Lending –Residential mortgage loan applications are among the most standardized of all credit applications –Two considerations: the applicant’s ability and willingness to make timely interest and principal repayments the value of the borrower’s collateral –GDS (gross debt service) ratio - gross debt service ratio calculated as total accommodation expenses (mortgage, lease, condominium, management fees, real estate taxes, etc.) divided by gross income –TDS (total debt service) ratio - total debt ratio calculated as total accommodation expenses plus all other debt service payments divided by gross income Real Estate Lending –Residential mortgage loan applications are among the most standardized of all credit applications –Two considerations: the applicant’s ability and willingness to make timely interest and principal repayments the value of the borrower’s collateral –GDS (gross debt service) ratio - gross debt service ratio calculated as total accommodation expenses (mortgage, lease, condominium, management fees, real estate taxes, etc.) divided by gross income –TDS (total debt service) ratio - total debt ratio calculated as total accommodation expenses plus all other debt service payments divided by gross income

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Credit Scoring Credit scoring system –a mathematical model that uses observed loan applicant’s characteristics to calculate a score that represents the applicant’s probability of default Perfecting collateral –ensuring that collateral used to secure a loan is free and clear to the lender should the borrower default Foreclosure –taking possession of the mortgaged property to satisfy a defaulting borrower’s indebtedness Power of sale –taking the proceedings of the forced sale of property to satisfy the indebtedness Credit scoring system –a mathematical model that uses observed loan applicant’s characteristics to calculate a score that represents the applicant’s probability of default Perfecting collateral –ensuring that collateral used to secure a loan is free and clear to the lender should the borrower default Foreclosure –taking possession of the mortgaged property to satisfy a defaulting borrower’s indebtedness Power of sale –taking the proceedings of the forced sale of property to satisfy the indebtedness

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Credit Scoring Consumer (Individual) and Small-Business Lending –techniques for scoring consumer loans very similar to mortgage loan credit analysis but more emphasis placed on personal characteristics such as annual gross income and the TDS score –small-business loans more complicated, requiring FIs to build more sophisticated scoring models combining computer- based financial analysis of borrower financial statements with behavioral analysis of the owner Consumer (Individual) and Small-Business Lending –techniques for scoring consumer loans very similar to mortgage loan credit analysis but more emphasis placed on personal characteristics such as annual gross income and the TDS score –small-business loans more complicated, requiring FIs to build more sophisticated scoring models combining computer- based financial analysis of borrower financial statements with behavioral analysis of the owner

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Mid-Market Commercial and Industrial Lending Definition of Mid-market –offered some of the most profitable opportunities for credit- granting FIs –sales revenues from $5 million to $100 million/year –recognizable corporate structure –do not have ready access to deep and liquid capital markets Credit Analysis - Five C’s of Credit –character, capacity, collateral, conditions, and capital Cash Flow Analysis –provides relevant information about the applicant’s cash receipts and disbursements Definition of Mid-market –offered some of the most profitable opportunities for credit- granting FIs –sales revenues from $5 million to $100 million/year –recognizable corporate structure –do not have ready access to deep and liquid capital markets Credit Analysis - Five C’s of Credit –character, capacity, collateral, conditions, and capital Cash Flow Analysis –provides relevant information about the applicant’s cash receipts and disbursements

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Ratio Analysis Historical audited financial statements and projections of future needs Calculation of financial ratios in financial statement analysis Relative ratios offer information about how a business is changing over time Particularly informative when they differ either from an industry average or from the applicant’s own past history Historical audited financial statements and projections of future needs Calculation of financial ratios in financial statement analysis Relative ratios offer information about how a business is changing over time Particularly informative when they differ either from an industry average or from the applicant’s own past history

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Calculating Ratios Liquidity Ratios Current Ratio = Current assets Current liabilities Quick ratio = Cash + Cash equivalents + Receivables Current liabilities (continued) Liquidity Ratios Current Ratio = Current assets Current liabilities Quick ratio = Cash + Cash equivalents + Receivables Current liabilities (continued)

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Asset Management Ratios Number of days sales = Accounts receivable x 365 in receivables Credit sales Number of days = Inventory x 365 in inventory Cost of goods sold Sales to working = Sales capital Working capital Sales to fixed = Sales assets Fixed assets Sales to total assets = Sales Total assets Asset Management Ratios Number of days sales = Accounts receivable x 365 in receivables Credit sales Number of days = Inventory x 365 in inventory Cost of goods sold Sales to working = Sales capital Working capital Sales to fixed = Sales assets Fixed assets Sales to total assets = Sales Total assets (continued)

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Debt and Solvency ratios Debt-asset ratio = Short-term liabilities + Long-term liabilities Total assets Fixed-charge = Earnings available to meet fixed charges coverage ratio Fixed charges Cash-flow-to-debt = EBIT + Depreciation ratio Debt where EBIT represents earnings before interest and taxes (continued) Debt and Solvency ratios Debt-asset ratio = Short-term liabilities + Long-term liabilities Total assets Fixed-charge = Earnings available to meet fixed charges coverage ratio Fixed charges Cash-flow-to-debt = EBIT + Depreciation ratio Debt where EBIT represents earnings before interest and taxes (continued)

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Profitability Ratios Gross margin = Gross profit Income to Sales = EBIT Sales Sales Operating profit margin = Operating profit Sales Return on assets = EAT_____ Average total assets Return on equity = EAT Dividend payout = Dividends Total equity EAT where EAT represents earnings after taxes, or net income Profitability Ratios Gross margin = Gross profit Income to Sales = EBIT Sales Sales Operating profit margin = Operating profit Sales Return on assets = EAT_____ Average total assets Return on equity = EAT Dividend payout = Dividends Total equity EAT where EAT represents earnings after taxes, or net income

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Common Size Analysis and After the Loan Analyst can divide all income statement amounts by total sales revenue and all balance sheet amounts by total assets Year to year growth rates give useful ratios for identifying trends Loan covenants reduce risk to lender Conditions precedent –those conditions specified in the credit agreement or terms sheet for a credit that must be fulfilled before drawings are permitted Analyst can divide all income statement amounts by total sales revenue and all balance sheet amounts by total assets Year to year growth rates give useful ratios for identifying trends Loan covenants reduce risk to lender Conditions precedent –those conditions specified in the credit agreement or terms sheet for a credit that must be fulfilled before drawings are permitted

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Large Commercial and Industrial Lending Very attractive to FIs because transactions are often large enough make them very profitable even though spreads and fees are small in percentage FIs act as broker, dealer, and adviser in credit management The standard methods of analysis used for mid- market corporates applied to large corporate clients but with additional complications Financial ratios such as the debt-equity ratio are usually key factors for corporate debt Very attractive to FIs because transactions are often large enough make them very profitable even though spreads and fees are small in percentage FIs act as broker, dealer, and adviser in credit management The standard methods of analysis used for mid- market corporates applied to large corporate clients but with additional complications Financial ratios such as the debt-equity ratio are usually key factors for corporate debt

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Altman’s Z-Score Used for analyzing publicly traded manufacturing firms Z = 1.2X X X X X 5 where Z = an overall measure of the borrower’s default risk X 1 = Working capital/Total assets X 2 = Retained earnings/Total assets X 3 = Earnings before interest and taxes/Total assets X 4 = Market value of equity/Book value of long-term debt X 5 = Sales/Total assets The higher the value of Z, the lower the default risk Used for analyzing publicly traded manufacturing firms Z = 1.2X X X X X 5 where Z = an overall measure of the borrower’s default risk X 1 = Working capital/Total assets X 2 = Retained earnings/Total assets X 3 = Earnings before interest and taxes/Total assets X 4 = Market value of equity/Book value of long-term debt X 5 = Sales/Total assets The higher the value of Z, the lower the default risk

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved The KMV Model Banks can use the theory of option pricing to assess the credit risk of a corporate borrower The probability of default is positively related to: –the volatility of the firm’s stock –the firm’s leverage A model developed by KMV corporation is being widely used by banks for this purpose Banks can use the theory of option pricing to assess the credit risk of a corporate borrower The probability of default is positively related to: –the volatility of the firm’s stock –the firm’s leverage A model developed by KMV corporation is being widely used by banks for this purpose

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Calculating the Return on a Loan A number of factors impact the promised return that an FI achieves on any given dollar loan –the interest rate on the loan –any fees relating to the loan –the credit risk premium on the loan –the collateral backing the loan –other nonprice terms (such as compensating balances and reserve requirements) A number of factors impact the promised return that an FI achieves on any given dollar loan –the interest rate on the loan –any fees relating to the loan –the credit risk premium on the loan –the collateral backing the loan –other nonprice terms (such as compensating balances and reserve requirements)

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Return on Assets (ROA) 1 + k =1 + f + (L + m) 1 - (b(1 - R)) where k = the contractually promised gross return on the loan f = direct fees, such as loan origination fee L = base lending rate m = risk premium b = compensating balances R = reserve requirement charge 1 + k =1 + f + (L + m) 1 - (b(1 - R)) where k = the contractually promised gross return on the loan f = direct fees, such as loan origination fee L = base lending rate m = risk premium b = compensating balances R = reserve requirement charge

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Risk-Adjusted Return on Capital (RAROC) Rather than evaluating the actual or promised annual cash flow on a loan as a percentage of the amount lent (ROA), the lending officer balances the loan’s expected income against the loan’s expected risk RAROC = One-year income on a loan divided by either Loan (asset) risk or capital at risk Rather than evaluating the actual or promised annual cash flow on a loan as a percentage of the amount lent (ROA), the lending officer balances the loan’s expected income against the loan’s expected risk RAROC = One-year income on a loan divided by either Loan (asset) risk or capital at risk