Chapter Twenty Managing Credit Risk on the Balance Sheet McGraw-Hill/Irwin 8-1 ©2009, The McGraw-Hill Companies, All Rights Reserved Credit Risk Management • Financial institutions (FIs) are special because of their ability to transform financial claims of household savers efficiently into claims issued to corporations, individuals, and governments • FIs’ ability to process and evaluate information and control and monitor borrowers allows them to transform these claims at the lowest possible cost to all parties • Credit allocation is an important type of financial claim transformation for commercial banks – FIs make loans to corporations, individuals, and governments – FIs accept the risks of loans in return for interest that (hopefully) covers the costs of funding—and are thus exposed to credit risk McGraw-Hill/Irwin 20-2 ©2009, The McGraw-Hill Companies, All Rights Reserved Credit Risk Management • The credit quality of many FIs’ lending and investment decisions has been called into question in the past 25 years – problems related to real estate and junk bond lending surfaced at banks, thrifts, and insurance companies in the late 1980s and early 1990s – concerns related to the rapid increase of credit cards and auto lending occurred in the late 1990s – commercial lending standards declined in the late 1990s, which led to increases in high-yield business loan delinquencies – concerns shifted to technology loans in the late 1990s and early 2000s – mortgage delinquencies, particularly with subprime mortgages, surged in 2006 and continue to be a concern McGraw-Hill/Irwin 20-3 ©2009, The McGraw-Hill Companies, All Rights Reserved Credit Risk Management • Larger banks are generally more likely to accept riskier loans than smaller banks • Larger banks are also exposed to more counterparty risk off-the-balance-sheet than smaller banks • Managerial efficiency and credit risk management strategies directly affect the return and risk of the loan portfolio • At the extreme, credit risk can lead to insolvency as large loan losses can wipe out an FI’s equity capital McGraw-Hill/Irwin 20-4 ©2009, The McGraw-Hill Companies, All Rights Reserved Credit Analysis • Real estate lending – mortgage loan applications are among the most standard of all credit applications – decisions to approve or disapprove a mortgage application depend on • the applicant’s ability and willingness to make timely interest and principal payments • the value of the borrower’s collateral – the ability to maintain mortgage payments is measured by GDS and TDS McGraw-Hill/Irwin 20-5 ©2009, The McGraw-Hill Companies, All Rights Reserved Credit Analysis • Real estate lending (cont.) – GDS refers to the gross debt service ratio • equal to the total accommodation expenses (mortgage, lease, condominium, management fees, real estate taxes, etc.) divided by gross income • acceptable threshold generally set around 25% to 30% – TDS refers to the total debt service ratio • equal to the total accommodation expenses plus all other debt service payments divided by gross income • acceptable threshold generally set around 35% to 40% McGraw-Hill/Irwin 20-6 ©2009, The McGraw-Hill Companies, All Rights Reserved Credit Analysis • Real estate lending (cont.) – FIs also use credit scoring systems to evaluate potential borrowers • credit scoring systems are mathematical models that use observed loan applicant’s characteristics to calculate a score that represents the applicant’s probability of default • loan officers can often give immediate “yes” or “no” answers—along with justifications for the decision – FIs also verify borrower’s financial statements • perfecting collateral is the process of ensuring that collateral used to secure a loan is free and clear to the lender should the borrower default on the loan McGraw-Hill/Irwin 20-7 ©2009, The McGraw-Hill Companies, All Rights Reserved Credit Analysis • Real estate lending (cont.) – FIs do not desire to become involved in loans that are likely to go into default – in the event of default lenders usually have recourse • foreclosure is the process of taking possession of the mortgaged property in satisfaction of a defaulting borrower’s indebtedness and forgoing claim to any deficiency • power of sale is the process of taking the proceedings of the forced sale of a mortgaged property in satisfaction of the indebtedness and returning to the mortgagor the excess over the indebtedness or claiming any shortfall as an unsecured creditor McGraw-Hill/Irwin 20-8 ©2009, The McGraw-Hill Companies, All Rights Reserved Credit Analysis • Real estate lending (cont.) – before an FI accepts a mortgage, it • confirms the title and legal description of the property • obtains a surveyor’s certificate confirming that the house is within the property’s boundaries • checks with the tax office to confirm that no property taxes are unpaid • requests a land title search to determine that there are no other claims against the property • obtains an independent appraisal to confirm that the purchase price is in line with the market value of the property McGraw-Hill/Irwin 20-9 ©2009, The McGraw-Hill Companies, All Rights Reserved Credit Analysis • Consumer and small business lending – techniques are very similar to that of mortgage lending – however, non-mortgage consumer loans focus on the ability to repay rather than on the property • credit models put more emphasis on personal characteristics – small-business loan decisions often combine computerbased financial analysis of borrower financial statements with behavioral analysis of the business owner McGraw-Hill/Irwin 20-10 ©2009, The McGraw-Hill Companies, All Rights Reserved Credit Analysis • Mid-market commercial and industrial lending – is generally a profitable market for credit-granting FIs – typically mid-market corporates • have sales revenues from $5 million to $100 million per year • have a recognizable corporate structure • do not have ready access to deep and liquid capital markets – commercial loans can be for as short as a few weeks to as long as 8 years or more • short-term loans are used to finance working capital needs • long-term loans are used to finance fixed asset purchases McGraw-Hill/Irwin 20-11 ©2009, The McGraw-Hill Companies, All Rights Reserved Credit Analysis • Mid-market C&I lending (cont.) – generally at least two loan officers must approve a new loan customer – large credit requests are presented formally to a credit approval officer and/or committee – five C’s of credit • • • • • McGraw-Hill/Irwin character capacity collateral conditions capital 20-12 ©2009, The McGraw-Hill Companies, All Rights Reserved Credit Analysis • Mid-market C&I lending (cont.) – FIs perform cash flow analyses, which provide information regarding an applicants expected cash receipts and disbursements – statements of cash flows separate cash flows into • cash flows from operating activities • cash flows from investing activities • cash flows from financing activities – FIs may also perform ratio analyses • time-series analyses • cross-sectional analyses McGraw-Hill/Irwin 20-13 ©2009, The McGraw-Hill Companies, All Rights Reserved Credit Analysis • Mid-market C&I lending (cont.) – common ratio analysis includes • liquidity ratios – current ratio – quick ratio (i.e., the acid test) • asset management ratios – number of days in receivables – number of days in inventories – sales to working capital – sales to fixed assets – sales to total assets (i.e., the asset turnover ratio) McGraw-Hill/Irwin 20-14 ©2009, The McGraw-Hill Companies, All Rights Reserved Credit Analysis • Mid-market C&I lending (cont.) • debt and solvency ratios – debt-to-assets ratio – times interest earned ratio – cash-flow-to-debt ratio • profitability ratios – gross margin – operating profit margin – return on assets (ROA) – return on equity (ROE) – dividend payout ratio McGraw-Hill/Irwin 20-15 ©2009, The McGraw-Hill Companies, All Rights Reserved Credit Analysis • Mid-market C&I lending (cont.) – ratio analysis has limitations • diverse firms are difficult to compare versus benchmarks • different accounting methods can distort industry comparisons • applicants can distort financial statements – common-size analysis and growth rates • common-size financial statements present values as percentages to facilitate comparison versus competitors • year-to-year growth rates can identify trends – loan covenants can be used as part of the loan agreement to mitigate credit risk McGraw-Hill/Irwin 20-16 ©2009, The McGraw-Hill Companies, All Rights Reserved Credit Analysis • Mid-market C&I lending (cont.) – following approval, the account officer ensures that conditions precedent have been cleared • those conditions specified in the credit agreement or terms sheet for a credit that must be fulfilled before drawings are permitted • includes title searches, perfecting of collateral, etc. – FIs typically wish to develop permanent, long-term, mutually beneficial relationships with their mid-market commercial and industrial customers McGraw-Hill/Irwin 20-17 ©2009, The McGraw-Hill Companies, All Rights Reserved Credit Analysis • Large commercial and industrial lending – fees and spreads are smaller relative to small and midsize corporate loans, but the transactions are often large enough to make them worthwhile – FIs’ relationships with large clients often center around broker, dealer, and advisor activities with lending playing a lesser role – large corporations often use • loan commitments • performance guarantees • term loans McGraw-Hill/Irwin 20-18 ©2009, The McGraw-Hill Companies, All Rights Reserved Credit Analysis • Large C&I lending (cont.) – account officers often rely on rating agencies and market analysts to aid in their credit analysis – sophisticated credit scoring models are also used • Altman’s z-score: Z = 1.2X1 + 1.4X2 + 3.3X3 + 0.6X4 + 1.0X5 where X1 = working capital ÷ total assets X2 = retained earnings ÷ total assets X3 = earnings before interest and taxes ÷ total assets X4 = market value of equity ÷ book value of long-term debt X5 = sales ÷ total assets • KMV Credit Monitor Model uses the option pricing model of Merton, Black, and Scholes to calculate expected default frequencies McGraw-Hill/Irwin 20-19 ©2009, The McGraw-Hill Companies, All Rights Reserved Credit Analysis • Calculating the return on a loan – the return on assets (ROA) approach uses the contractually promised gross return on a loan, k, per dollar lent f BR m 1 k 1 1 b1 R where McGraw-Hill/Irwin f = the loan origination fee b = the compensating balance requirement R = the reserve requirement ratio BR = the base lending rate m = the credit risk premium on the loan 20-20 ©2009, The McGraw-Hill Companies, All Rights Reserved Credit Analysis • Calculating the return on a loan (cont.) – the risk-adjusted return on assets (RAROC) model balances a loan’s expected income against its expected risk RAROC one - year income on a loan loan (asset) risk or value at risk • the RAROC is compared vis-à-vis the lender’s tax-adjusted return on equity (ROE) – if RAROC > ROE make the loan – if RAROC < ROE either adjust the loan such that RAROC > ROE or decline to make the loan McGraw-Hill/Irwin 20-21 ©2009, The McGraw-Hill Companies, All Rights Reserved