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CREDIT RISK EXPECTED RETURN Classes #13; Chap 11 Lecture Outline 2 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 What is Credit Risk? 3 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 Types of Loans 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 11-4 5 Loan Returns Contractually Promised Return Expected Return Required Return 6 Contractually Promised Return Contractually Promised Return Definition 7 Definition: The return that the bank realizes if the loan does not default (best case) Rcontractual Amount EarnedOrigination Fee Interest Earned Amount Loan AmCommitted ount Com p. Balance Interest Expence Reserve Req. 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) Contractually Promised Return Loan Interest Rate 8 How does the bank determine Loan Interest Rate the interest rate it charges? Bank will usually charge a base rate that is related to their funding costs (Libor) + some risk premium LIBOR Base Rate = 12% Credit Risk Premium = 2% Loan Interest Rate = 14% FICO Job/ Income Contractually Promised Return Book Formula 9 The book provides a formula so we should discuss why we do not follow the book 1 k 1 of (br m) [1 b(1 RR)] k of (br m) [1 b(1 RR)] Contractually Promised Return Book Formula 10 The book provides a formula so we should discuss why we do not follow the book k 1. of (br m) [1 b(1 RR)] 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” 2. Interest Expense – the formula only works if the compensating balance is held in non-interest bearing demand deposits. 3. Federal Reserve Interest – the formula does not take into account interest paid on reserves held at the Fed. Contractually Promised Return Summary 11 So at this point we have k k Origination Fee Interest Earned Loan Am ount Com p. Balance Interest Expence Reserve Req. 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? No!! – the loan can default What happens if the loan defaults? we do not get the promised return we may not even get back the full principal committed 12 Expected Return Loan Expected Return Uncertainty 13 Why do we need to calculate an expected return? What don’t we know? 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 What can we do if we don’t know how things will turn out? We can guess Loan Expected Return Expected Return 14 How to guess – we want our guess to be educated and reasonable We have two cases: 1. 2. 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) 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 (1-P)(R) We may be able to recover some money in default There are only 2 cases payment and default. So the likelihood (probability) of default is 1- probability of payment Loan Expected Return Expected Return 15 How to guess – we want our guess to be educated and reasonable We have two cases: 1. 2. 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) + – 0.80) = 0.20 (1-P)(R) = (1 (1+k) Recovery – is the percent of value recovered in default – what is our return -80% 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 Loan Expected Return Default vs. payment (survival) probabilities 16 How to guess – we want our guess to be educated and reasonable We have two cases: 1. 2. 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 Loan Expected Return Summary 17 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) Recovery Rate Default Probability Contractually promised return E(R) = (Survival Prob)(1+k) + (Default Prob)(R) 18 Required Return Required Return 19 How does a bank decide when they will issue a loan? Economic conditions Required Return 4% To be profitable, the bank needs to earn more than 4% expected return on its loans Funding Costs Global Markets 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: 1 Rrequired ERloan Required Return Net Present Value (NPV) 20 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 ) Required Return Net Present Value (NPV) – Example 21 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% Net Value (500M )(1.06) (500M )(1.04) NPV (500 M )(1.06) (500 M )(1.04) 1.04 NPV (500 M )(1.06) (500 M )(1.04) 1.04 1.04 1.06 NPV 500 M 500 M 1.04 NPV $9.62 M 22 Example Loan Return Example 23 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. a) Calculate the contractually promised return b) Calculate the expected return of the loan c) Find the NPV of the loan a) Contractually Promised Return Step #1: Calculate interest Earned Interest (15,000,000)(1.063 ) 15,000,000 2,865,240 Step #2: Fee Income Orignination Fee (15,000,000)(0.02) $300,000 ($300,000)(1.033 ) $327,818.10 Loan Return Example 24 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. a) Calculate the contractually promised return b) Calculate the expected return of the loan c) Find the NPV of the loan a) Contractually Promised Return Step #3: Compensating Balance Comp. Bal. (15,000,000)(0.04) $600,000 Step #4: Reserve Requirements RR (600,000)(0.10) $60,000 Step #5: Interest Expense Interest Expense (600,000 60,000)(1.0153 ) (600,000 60,000) $24,666.3225 Loan Return Example 25 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. a) Calculate the contractually promised return b) Calculate the expected return of the loan c) Find the NPV of the loan a) Contractually Promised Return k Amount Earned Amount Committed AmountEarned 2,865,240 327,818.10 3,193,058.10 AmountCommitted 15,000,000 600,000 60,000 24,666.32 14,484,666.32 k 3,193,058.10 22.04% 14,484,666.32 Loan Return Example 26 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. a) Calculate the contractually promised return b) Calculate the expected return of the loan c) Find the NPV of the loan b) Expected Return What is P? E ( R) P(1 k ) (1 P)(R) P 1 ( Default prob) 1 0.13 0.87 E ( R) 0.87(1 0.2204) (0.13)(0.40) k is the contractually promised E (from R) the 1.11 return last slide In this case you are given the default probability so you need to calculate the survival probability Loan Return Example 27 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. a) Calculate the contractually promised return b) Calculate the expected return of the loan c) Find the NPV of the loan b) Expected Return E ( R) P(1 k ) (1 P)(R) P 1 ( Default prob) 1 0.13 0.87 E ( R) 0.87(1 0.2204) (0.13)(0.40) E ( R) 1.11 1.11 (1 r )3 Expectedreturn 3.66% 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? Loan Return Example 28 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. a) Calculate the contractually promised return b) Calculate the expected return of the loan c) Find the NPV of the loan C) Loan NPV 15,000,000(1.033 ) PV ( Loan cost ) 15,000,000 1.033 15,000,000(1.03663 ) PV ( Loan proceeds) 15,289,083.63 3 1.03 NPV 15,289,083.63 15,000,000 289,083.63 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 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 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) 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% a) Find the contractually promised return b) What is Bank of America’s maximum acceptable probability of default for ConocoPhillips over the coming year 29 Lecture Summary 30 Loan Contractually Promised Return Loan Expected Return Is the total return that the bank realizes over the life of the loan if the borrower does not default 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.