1. CHAPTER 5 CREDIT RISK 1

2. Chapter Focus Distinguishing credit risk from market risk Credit policy and credit risk Credit risk assessment framework Inputs to credit models 2

3. Credit risk definition The potential for loss due to failure of a borrower to meet its contractual obligation to repay a debt in accordance with the agreed terms Example: A homeowner stops making mortgage payments Commonly also referred to as default risk Credit events include bankruptcy, failure to pay, loan restructuring, loan moratorium, accelerated loan payments For banks, credit risk typically resides in the assets in its banking book (loans and bonds held to maturity) 3

4. Credit Risk vs. Market Risk Market risk is the potential loss due to changes in market prices or values  Assessment time horizon: typically one day Credit risk is generally more important than market risk for banks  Assessment time horizon: typically one year  Many credit risk drivers relate to market risk drivers, such as the impact of market conditions on default probabilities.  Differs from market risk due to obligor behavior considerations  The five “C’s” of Credit — Capital, Capacity, Conditions, Collateral, and Character 4

5. Credit Products — Loans vs. Bonds Loans A contractual agreement that outlines the payment obligation from the borrower to the bank  May be secured with either collateral or payment guarantees to ensure a reliable source of secondary repayment in case the borrower defaults  Often written with covenants that require the loan to be repaid immediately if certain adverse conditions exist, such as a drop in income or capital Generally reside in the bank’s banking book or credit portfolio  Although banks may sell loans another bank or entity investing in loans 5

6. Credit Products — Loans vs. Bonds Bonds A publicly traded loan — an agreement between the issuer and the purchasers  Collateral support, payment guarantees, or secondary sources of repayment may all support certain types of bonds  Structuring characteristics that determine a bond investor’s potential recovery in default Generally reside in the bank’s trading book 6

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11. Credit Ratings In the S&P rating system, AAA is the best rating. After that comes AA, A, BBB, BB, B, CCC, CC, and C The corresponding Moody’s ratings are Aaa, Aa, A, Baa, Ba, B,Caa, Ca, and C Bonds with ratings of BBB (or Baa) and above are considered to be “investment grade” 11

12. Historical Data Historical data provided by rating agencies are also used to estimate the probability of default 12

13. Cumulative Ave Default Rates (%) (1970-2009, Moody’s, Table 23.1, page 522) 13

14. Interpretation The table shows the probability of default for companies starting with a particular credit rating A company with an initial credit rating of Baa has a probability of 0.176% of defaulting by the end of the first year, 0.494% by the end of the second year, and so on 14

15. Do Default Probabilities Increase with Time? For a company that starts with a good credit rating default probabilities tend to increase with time For a company that starts with a poor credit rating default probabilities tend to decrease with time 15

16. Recovery Rate 16 The recovery rate for a bond is usually defined as the price of the bond immediately after default as a percent of its face value Recovery rates tend to decrease as default rates increase

17. Recovery Rates; Moody’s: 1982 to 2009 17

18. Estimating Default Probabilities Alternatives:  Use Bond Prices  Use CDS spreads  Use Historical Data  Use Merton’s Model 18

19. Using Bond Prices (Equation 23.2, page 524) Average default intensity over life of bond is approximately where s is the spread of the bond’s yield over the risk-free rate and R is the recovery rate 19

20. Possible Reasons for These Results (The third reason is the most important) Corporate bonds are relatively illiquid The subjective default probabilities of bond traders may be much higher than the estimates from Moody’s historical data Bonds do not default independently of each other. This leads to systematic risk that cannot be diversified away. Bond returns are highly skewed with limited upside. The non-systematic risk is difficult to diversify away and may be priced by the market 20

21. Using Equity Prices: Merton’s Model (page 530-531) Merton’s model regards the equity as a call option on the assets of the firm In a simple situation the equity value is max(V T −D, 0) where V T is the value of the firm and D is the debt repayment required 21

22. Equity vs. Assets The Black-Scholes-Merton option pricing model enables the value of the firm’s equity today, E 0, to be related to the value of its assets today, V 0, and the volatility of its assets,  V 22

23. Volatilities 23 This equation together with the option pricing relationship enables V 0 and  V  to be determined from E 0 and  E

24. Example A company’s equity is $3 million and the volatility of the equity is 80% The risk-free rate is 5%, the debt is $10 million and time to debt maturity is 1 year Solving the two equations yields V 0 =12.40 and  v =21.23% The probability of default is N (− d 2 ) or 12.7% 24

25. ALTMAN Z-SCORE 25

26. Z score – a multiple discriminant analysis technique, developed as a powerful diagnostic tool measuring solvency – with ability to identify bankrupt firms, 12 months in advance, at an accuracy rate of approximately 95% Professor Edward Altman, Stern School of Business, New York University 26

27. Z = 1.2 x1 + 1.4 x2 + 3.3 x3 + 0.6 x4 + 0.99 x5 Z = overall index of corporate health x1 = working capital/total assets x2 = retained earnings/total assets x3 = earnings before interest and taxes/total assets x4 = market value equity/book value of total liabilities x5 = sales/total assets 27

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31. Prediction accuracy of the Z score Year prior to failureAccuracy rate 195% 272% 348% 429% 536% 31

32. Most Mergers and acquisitions (M&A) due diligence approach consider the use a combination of :- 1.Financial; and 2.Non financial factors Financial Factors Non-financial Factors Debt service coverageSize and age of company Leverage Industry sector Profitability Age/experience managers Liquidity Location Net worthMarket position Share priceJudgement Z score Business synergies/strategies 32