Cred Risk (07-9 alternate)

8/8/2019 Cred Risk (07-9 alternate)

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Edward J. Kane, BC 07-71

Week 07-7

CREDIT RISK

Topics:

Lending Process: Duties of Due Diligence IncludeCalculating The Cost of Providing Risk Support

Use of Scoring Software

Credit-Risk Issues: Pricing Quality in a PortfolioContext

Book-Cooking Opportunities in Loan Accounting


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1st Topic: Duty of Due DiligenceLending is Banks Principal Product-ManagementChain and Counterparties are Looking for Weak

Links


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Important Slide: All forms of dealmaking have to be funded

in part by an appropriate allocation of FSF capital. To

Assure Due Diligence at the staff level, a Loan-ReviewCommittee Should Ask Deal-Making Staff to Report Four

Features of Every Deal

1. What are the risks?

2. What are the costs of capital and loss reserves that must beallocated to cover the portfolio risks the loan entails.

3. What explicit and implicit returns does the proposed

contract offer the firm for bearing the costs of supportingthese risks?

4. Allowing for differences in risk, how does the risk-adjusted return line up with other deals that we are ormight be making?


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Modern FSFs Can Outsource Some of

These Questions


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Each Lender Employs Multiple Technologies of

Lending: Deal Formats Must Adapt to the

Informational and Regulatory Environments inWhich FSF and the Borrower Operate

Three Mutually Reinforcing Components Define the

Technology Used in a Particular Lending

Chain:

1. Screening Mechanisms

2. Contract Structure (e.g., covenants, collateralrights, enhancements, amortization schedule,

reporting requirements)

3. Monitoring Strategy


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LOAN COVENANTSDefinition: Loan covenants are forms of implicit interest thatrestrict a borrowers future activities in ways designed to

lessen conflicts of interest between the borrower and lender. If

not waived, any violation of the covenant package results inso-called technical default.

1. Negative Covenants- restrict future production,

investment, or financing decisions: especially

limitations on dividend payouts and on future debt.

2. Affirmative Covenants- impose contractual

obligations to submit financial statements and to

report other material issues.


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Some Different Business Lending

Technologies

Financial-Statement Lending

Relationship Lending

Business Credit Scoring Asset-Based Lending (Collateralization &

Leasing)

Trade Credit

Factoring (Purchase of Receivables) Credit Insurance (enhancements)

Classroom Exercise: What are the Strengths andWeaknesses of each?


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Many Business Loans and All Household Mortgage

and Auto Loans pledgeproperty to lender as

security for a loan.

What is a mortgage loan? Who is the Mortgagor?

ANS. The borrower. Who is the Mortgagee?

First Mortgages vs. Second Mortgages

Lender must assess prospects of borrower default andthe possible correlation of default events with

changes in collateral value

Asset-Based Lending


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In All Technologies, Loan Officers Must

Efficiently Collect Appropriate Information to

Make Optimally Four Decisions About Each

Customer

1. How much to lend?

2. In what form: i.e., with what safeguards? Covenants

Monitoring Rights

Default Remedies3. At what price? implicit & explicit compensation

4. On what repayment schedule?


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Vocabulary LessonHolism is the belief that once an entity has

existence itsparts do not. The idea is that

the partsstick togetherin an inseparable

way (e.g., life-force of a person vs. mortar

in a brick wall).

Test is reversibility.


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Historically, lending was an holistic process.

Modern Lending Deconstructs the Steps Traversed in

Making a Loan

Allows FSFs either to specialize in-house or tooutsource the subset of risks and skills

needed at each particular stage.1. Applications Generation2. Processing

3. Underwriting

4. Closing

5. Servicing/Collection[6. Insuring risk of shortfalls in payments due]

7. Funding (temporary vs. permanent risk support)

8. Postloan monitoring and risk support or transfer

Origination


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Unbundled Parts of Lending Process are

Automating, Digitizing, and Globalizing

Outsourcing may slow some decisions intensifiesEthical Risk: the problem of assuring due diligenceis performed in individual functions

with holistic loan-officer model, a continuous double-checkingrole is played by high-level committees who are subject to legal

penalties for negligence and malfeasance. [Good judgmentcomes from experience. Experience comes from exercising poor

judgment = error-learning.]

with outsourcing model, loan committee must rely on reputations,

bonding agreements, and fraud & negligence laws

We explore these Issues in the last 2 Weeks of thecourse


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Even Flexible

Deal-Making

must be

Supported byDue Diligence

in Prospecting,

InformationGathering, and

Analysis


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First Link in Chain =

Generating Applications

Referrals, Prospecting, and Prequalifications[Computer cross-sell triggers]

Product Selection

Application Completion Document Collection


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Due Diligence in Information

Gathering uses 3d- Party sources

Application Verification (must guard

against identity theft; false data) Credit Investigation

Collateral Valuation

Blue-Book Values for Autos Repeat-Sales Data Base (Automated Appraisal)

vs. Custom Appraisal for Houses


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Underwriting: What Constitutes

Due Diligence in Analysis?

Credit Analysis: standards, guidelines vs.

credit scoring Pricing

Mortgage Insurance Decision

Single payment vs. cancelable

Commitment Issuance


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Operational Links: Closing and

Postclosing Activities

1. Closing

Document Preparation Compliance with Commitment Conditions

Packaging and Delivery

2. Post-Loan

Postclosing Document Tracking

Set up Servicing System

Collections/Monitoring/Dunning


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Final Link: Funding Decision

Temporary warehousing prior to choosing

how to permanently finance the deal.

Three main alternatives forpermanent

funding:1. Own debt and capital (=intermediation)

2. Loan sales

whole partial (syndication)

3. Securitization (pooling & pricing loan packages)

[


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The Funding Decision Also Affects the

Allocation Across the Banks Counterparties of

the Risks That Are Left Unhedged

Self-Insurance = supporting with Loan-Loss reserves

and Ownership Capital

External Credit Enhancement (partial recourse vs.complete risk transfer to borrower or third parties)

Collateral (puts some risk back on borrower)

Recourse to borrower or corporate officers (ditto)

Personal or Corporate Cosignors or Guarantors

Private Mortgage Insurance (Mort. Guaranty Ins. Corp.; GE

Capital Mort. Ins. Corp.; United Guaranty Corp.)


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2nd Topic: Automation of Due-Diligence

and Pricing Activity: Computer Scoring

Theme: Scoring is Driving Automation of all linksin the lending chain

Value of scores depends on size of underlying sample and

representativeness of its relevant subsample cells. Mines or Tortures Data to make them sing = Uncover

Recognizable Patterns and Convert them into Point scores thatclassify customers in terms of probability of some targeted form of

behavior

Credit scores can be fed directly into an implicit and explicit loan

pricing matrix. Targeted behavior can be anything. AI Expert Systems can

identify loan leads, slow payers, deadbeats, profitable customers,volatility of collateral value, etc.

In use at all large U.S. banks & most small ones. 33% of small banksby early 2001.


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Table 1

Survey Results for Large U.S. Banks Using Small Business Credit

Scoring Data as of January 31, 1998

Number % of Scoring Banks

Loan Sizes Scored:

Under $100,000 62 100.0

$100,000-$250,000 46 74.2

$250,000-$1,000,000 13 21.0

Automatic Approval/Rejection 26 41.9

Setting Loan Terms 20 32.3Use Proprietary Models 8 12.9

Average Number of Month 24 ---

Source: Frame, Srinivasan, and Woosley (2001)


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When Automated Lending Works


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Use of Scoring Presupposes and Shapes the

Collection and

Verification of Databases

Individual Application input

External Credit Bureau Input (will score for

and sell credit directly to customers)

KnowX.com and Lexis-Nexus: input data on

arrests, scandals

Internal Credit Information File (CIF) from

data warehouse (FSF base of information bywhich it manages)

Lenders must address customer and legal

concerns about privacy and accuracy


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Computer credit-scoring models objectify credit standards.

They input multiple proxies for ageold Five Cs of Credit.

The 5 Cs of Credit: a checklist ofinformational items thattrack a customers unobservable repayment speed andrepayment probability. Scores should be tracked both beforeand after making a loan. Why?

Scores on proxy items can be used also to size and price acustomers serviceable demand for borrowed funds.

Increasingly, computer credit-scoring models re-estimate therate outstanding loan portfolios should carry and businessloan contracts reset the loan rate when and as a borrowersscore changes.

Intuitive Basis for Scoring


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Character: customers reputation for probity and fairness (pastwillingness to pay bills can be checked with credit agencies)

Capacity: projected future income of customer; payment-coverage ratio.

Capital: strength of customers balance sheet

Collateral: any credit enhancement offered --consists of implicitand explicit guarantees, including right of recourse

Conditions re economic cycles: how changing economicenvironment affects the customers other Cs; measures ofvulnerability or fragility.

[Modern financial economists add 4 more Cs: Regulatory

Compliance Costs, Customer Relationships, Correlation,and Costs ofa borrowers opportunities for hidden actions andhidden information disadvantage a lender.]


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Major External Vendors of

Online Scoring Services Fair Isaac (Grandaddy of scoring)

Fiserv

Credit Bureaus Global & national (Transunion, Experian, Equifax)

Local

Mark-It Partners credit database (shareholders are

an evolving member of European and USmegabanks): Partner banks supply price

information.


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About Fair Isaacs Scores

The formula for the Fair Isaac creditworthiness score deals onlywith financial information about a borrower and doesnt consider

such factors as place of residence, age, race, sex, or nationality.

Factors in determining the credit score and the weight they are given:


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How the Fair Isaac Score Works:

Fair Isaac licenses its software to credit bureaus.

Based on the credit information on file, the credit bureau usesFair Isaacs formula to generate a credit score, also known asa FICO score. Scores are on a 900-point scale. Generally, ascore of 640 or higher results in a mortgage on favorableterms: subprime (720)

Lenders acquire from a credit bureau a borrowers creditreport and FICO score to evaluate the applicantscreditworthiness andprice loans.

High Score = High Probability ofcomplete and timelyperformance by borrower.

Fair Isaac traditionally limited the information passed toborrower. Now, loan applicants can purchase their scores anduse experts to improve their score to a lenders threshold.


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DISCUSSION QUESTIONSON SCORINGPlease indicate in one paragraph whether you agree or

disagree with the following statements and why:

1. Credit-scoring software is making human loanofficers obsolete. Software can identify several

times as many potential losses as mostinstitutions best human underwriters can.

2. Credit-scoring is a new and untested idea.

3. Scoring software is useful only in originatingand

pricing loans.4. Once an institution switches to credit-scoring

software, its approval rates usually decrease.


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DISCUSSION QUESTIONSON SCORING

(continued)5. Credit-scoring software can be used only on loan

applicants that have a prior credit history.

6. Is scoring fair to immigrants and low-income households?

7. Mortgage-Loan automation can consolidate the many steps

on mortgage lending into a single virtual back office that

can bid on (but not seal) a deal in a matter of minutes.

8. It is good practice to explain and doctor credit scores for

rejected customers.9. It should be a source of pride to some bankers that they

dont use credit scoring.


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Course Theme: Reshaping ofJob

Opportunities and Branch Architectureby

New Lending Technologies

1. Calling Officers (Salespersons or

Drummers).

2. Credit Analysts

3. Loan Review Committee

4. Workout Specialists


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Business-Loan Officers: Going the Way of the Dodo?

MINICASEOn Morphing

of Firms &

Employee

Skillsets


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3rd Topic: Credit-Risk Issues

What is risk? The downside of a deal caused by

its negatives.

What is a loans credit risk? Obverse* of Asset

Quality Danger that an individual counterparty wont perform as

promised in a contract = a priceable chance of suffering

default losses - e.g., in loans to customers who go bankrupt.

Delinquent vs. truly nonperforming loans

workouts on partial vs. complete defaults show somechargeoff against bank loan reserves or net worth

* An obverse is the positive quality that can be obtained from a

negative or the negative quality corresponding to a positive.


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RiskManagement { Risk Avoidance. Ways an institution

can price, support, diversify or transfer credit risk

introduce the concept offinancial engineering.

Develop and maintain an accurate and consistent risk-grading system.

Establish a credit culture that reflects the risk appetite of your institution.

Use a loan approval process, by committee or otherwise, that provides aformal, systematic review of total exposure to a borrower in different products.

Implement credit scoring, though it need not be the sole factor in lendingdecisions.

Establish a credit database with heavy emphasis on the collection and retentionof risk ratings.

Develop a process to review and control exceptions to credit policy.

Introduce a pricing model, even a rudimentary one, to bring disciplined risk-based pricing into the underwriting and review process. Even better, use a

pricing model, either internally or vendor purchased, to price your credits toreflect risk, relationship, and capital allocation.

Manage your loans as portfolio investments. Quantify the return relative to therisk and manage portfolio diversification.


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Managing Risk in Loan Origination Adage: Every debt is paid, if not by the

borrower, by the lender.

How does a lender pay for borrower defaults? Lending officers may be disciplined for defaults or

credit deterioration on loans they originate.

Computer scoring cannot capture every negative:

Jrgen Schneider Warning Signal: Wasteful excessshown in personal life by CEOs gilding an iron fence

in 1994 was used by a smart lender to be an indication

of bad character.


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Recognizing Loan Scamsters

Top Ten Warning Signs(Paul Nadler, American Banker, March 1996)

Beware ofCustomers who:10. Soft-soap you.

9. Seem too dumb to fool you.

8. Pride themselves on breaking rules.

7. Focus on what your firm will do in the event of delinquency.

6. Seem unusually charming.

5. Seem unusually optimistic.

4. Challenge your policy on overdrafts or on the use of uncollected funds.3. Always want to meet you on your premises.

2. Whose buildings and equipment show signs of neglect.

1. Who appeal to your greed.

[0. Seem unconcerned about payments Schedules and Interest Costs.]


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Concept of Pricing a Loan

Concept of a loans price as an opportunity cost = valueofall implicit and explicit compensation received forextending this credit.

Every contractual requirement is a potential burden. Nonpriceterms is an oxymoron.

Benchmark-plus Pricing: In practice, rates are set asspreads above a low-risk benchmark interest rate.

a. Libor

b. Treasury yields

c. Own CD or prime rate*Etymology of benchmark known height of a prominent

landmark or some kind


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Why do the following items Constitute Implicit

Interest on a Business Loan?1. Compensating-Balance Requirements (a legal tying of

use of deposit and loan products).[Does it ever make sense to pay interest on ones own

money? Credit repairs/ money laundering]

2. Collateral Requirements.

3. Covenant Rights.4. Monitoring requirements.

5. Coercive tie-in arrangements (mostly unwritten): thoughillegal, these are alleged to exist

Explicit Interest is Not the Full Price of a

Loan


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The credit risk bankers must

Price and Manage is aPo

rtfol

io

Concept Measures of this risk must identify and account for:

1. Correlations in underlying risk factors that causeindividual-customer default events

2. Correlations in the size of the losses driven bydifferent events and risk factors

[3. Last half of course will introduce the effects ofhedging transactions that mitigate or transfer particularcategories of loss exposures (hedging will be the focus ofthe middle weeks of this course).]


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GOOD AND BAD

LOANS CAN BE SOLD


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Memory Device: A Financial-Company Portfolio

Garages a Fleet of Investment and Funding Vehicles

With tangible longpositions in, e.g., Loans

Marketable Securities

Real Estate and Equipment

With tangible shortpositions in Deposit-like accounts

Debt

Explicit commitments (insurance obligations; securities

held in street names) With numerous harder-to-monitor derivative and

intangiblepositions


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To Manage the Risk ofOperating This Fleet, One Must

Understand the Dangers the Fleet Faces: Its Exposure to

Deterioration in Net Value from Various Kinds of Adversity

Unexpected market moves.

Model risk: a source ofhedging errors. Insufficient management oversight.

Carrying too much riskrelative to capital.

Internal & external fraud

Counterparty lawsuits.

Unsupportable Debts.


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Risk Landscape for Banks

Event Risk Market Risk (Devaluation Risk (FX., interest

Large moves in Asset Prices) rate)

Bank

Credit Risk

(Default counterparty

Potential loss due to change

in credit quality)

Legal Risk

(contracts are not

documented

correctly or cannot

be enforced)

E-businessOperational Risk

(loss due to

execution error)

Settlement Risk

(not receiving funds)

Reputational Risk

(environment)

Liquidity Risk

(Inability to

unwind a

position without

loss of value)

Systemic RiskInstitutional

Risk


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Focus on Correlations is the

Element in Portfolio Analysis

Definition: Correlated items undergo mutual orreciprocal movements

Why are correlations in default and collateralvalue relevant? ANS. In Bivariate Models ofRepayment, Expected Loss = Product of(Probability of Default) and (Loss Given Default).

When collateral value falls whenever probabilityof default rises, loss exposure worsens on bothcounts.


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Parable can Illustrate Value to

Owners and Regulators of theTransparency (=accuracy plus

meaningfulness) created by Prompt

and Accurate Provisioning:

In Sept. 2000, a convenience store clerk taped

up the stores security camera prior toemptying the cash drawer and claiming that

he was held up. Critical flaw in his plan: he

used transparent tape.


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Age-Old Conflict Between Regulators of

FSFs and Watchdogs Who Regulate

Securities Markets and Auditing Activity1. FSF regulators adopt rules and enforcement systems to assure

safe and sound operation of firms in their client industry.

y These regulators want to entertain forward-looking

industrywide reasons to justify unallocated LLR.2. Those whose set auditing standards are concerned with how to

document occurrences of revenues and expenses in an objectiveand reproducible manner.

y Prefer to emphasize historical loss experience or

observable changes in activities or skillsets of eachindividual client.


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On average, borrowers are slow. Why?

Expect to extract leniency Many plan to move in and out of delinquency

Exercise In Booking Accruals, Provisions, andCharges stresses two kinds of nontransparency:

1. Banks employ accrualaccountingrather than cashaccountingfor yet-to-be-received receipts on slow,

but performing loans. Nonperforming Loans areshifted to a nonaccrual status.

2. They are obliged by rules to shift to cash accounting

only for loans on which payments are so far overduethat they must be classified as nonperforming(threshold varies across countries: 90 days in U.S.).

I U S Li h l Di i li d J d Sh L


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In U.S., Lightly Disciplined Judgments Shape Loan-

Loss Reserves (LLR) and Allowances for Loan and

Lease Losses (ALLL)

Bathtub Analogy for LLR: ALLL isspigot; Chargeoffs are thedrain.

DedicatedLLRare a contra-asset deducted promptly from aloans principal (and therefore NW) to get the book value of

net loans (BVL). Assigning loss reserves when loans are made and adjusting

them as circumstances change is called promptprovisioning

Chargeoffs: When losses on uncollected loans are recognized,they are usually charged against the LLR until LLR isexhausted, then against income or capital.

Notation: It is instructive to designate the level of LLR thatinsiders would understand to be a fair and accurate measureof expected loss exposure as LLR*.


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A four-way categorization of

criticized loans is used by

examiners: special mention,

substandard, doubtful, loss.

Examiner Criticism May Sometimes

Force a Loan into Nonaccrual Status


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1. Definitions of Examinercategories of troubled loans: Substandard loans have one or more well defined weaknesses that

jeopardize full collection of that loan, and have a high probability ofpayment default.

Doubtful loans have all the weaknesses inherent in those classified assubstandard with the added characteristic that the weaknesses makecollection or liquidation in full, on the basis of currently existing facts,conditions, and values, highly questionable and improbable.

Loss loans are considered uncollectible and of such little value thattheircontinuance as bank assets is not warranted. Any recovery is

likely to occur only after lengthy recovery efforts such as litigation. Special Mention loans show distinct weaknesses, but collectibility

still seems likely.

Substandard, doubtful, and loss loans are collectively referred to asadversely classified assets.

2. Resemble categories in weeklyNFL injury reports:

probable, questionable, doubtful, out.3. Loss and out are the most-reliable categories.

4. Regulators just postponed an effort to adopt a newnomenclature.]

[

W k P l U Diff


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Workout Personnel Use a Different

Vocabulary From Examiners

A slow loan is one whose payments are noticeably or habituallyin arrears (in practice, late or past due by 30 days or more).Bank Accountants accrue (I.e., credit) interest on these loanswhen earned rather than when payment is received.

A nonperforming loan is one whose payments are overdueenough (90 to 180 days or more) to be deemed severelydelinquent. Interest income on these loans is shifted fromaccrual to a cash basis. Interest can no longer be credited until itis actually received by the bank.

An impaired loan is one whose principal value has come intoserious question. FAS 114 defines a loan as impaired when,

based on current information and events, the loan is judgedless than fully collectable.


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Chart 1: Aversely Rated Credits Over Two Business Cycles


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Cross-Country Variation in the Timing and LLR Impact of NPLs Status

Country Days to NPL status Min. initial provision Ranking

Argentina 90 25% 4

Hong Kong 180 n.a. 9

Peru 60/90 50-60% 2

Singapore sub. risk L-8C (50% min.) 6

Brazil 60 100 3

Malaysia 180 0/1% gen. provisions 9

Colombia 90 50% 4

Chile 30/90 60%/n.a. 1

Philippines sub. risk 25% 6Korea 180 20% 9

Thailand 360 15% 11

Indonesia 90 10% 8

Source: World Bank

E i i B ki A l P i i d


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March 30:

June 30:

September 29:

December 30:

5.532004

07.50 !

625.521504

07.50 !

75.51100407.50 !

875.50504

07.50 !

Exercise in Booking Accruals, Provisions, and

Chargeoffs1. Eagle Bank lends $200,000 to BC Company on January 1 at 7 percent simple interest to be paid

quarterly on the unpaid balance. Payments of $50,000 plus quarterly interest are due on March 30,June 30, September 29, and December 30.

a. Calculate the payments due at each payment date (in $ thousands).


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1Q:

2Q:

3Q:

4Q:

3.52.625 (Credited but not received)

152.625(.07/4)=2.671(Credited

but not received)

-5.296(2Q & 3Q Accruals mustbe reversed at year end and

$2.718 in unpaid interest added

to the outstanding balance

b. Suppose the first payment is made on time and no further

payments are received until the following year.

Assuming a 180-day threshold for putting a slow loan intononaccrual status, what would the bank initially report as

current revenue on the loan in each quarter of the current

year ($ thousands)?


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2. Suppose Eagle Bank set up a $1,000 loss reserve on this loan at its inception. Howwould the first quarter and fourth quarter revenues on the loan change if the lossreserve was made to absorb the first $1,000 in accounting losses that might berecorded on the loan?

1Q:

4Q:

3.5 - 1 (in provisioned funds on Jan. 1) = 2.5

-5.296 + 1 (in chargeoffs) = -4.296


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Year 2, 1Q: -15.893

[end-of-year principal + accrued interest = 158.934]

Year 2, 2Q: 155 [158.934 - 15.893] = 11.959

3. Suppose on February 1 of year 2 federal bank examiners forced

Eagle Bank to restructure the loan and write off 10 percent of the

principal [including unpaid interest to this date] still due on the loan

against its net worth account. Suppose also that the new contract

structure required the BC Company to make only a single payment of

$155,000 on June 15 of year two. How would these events affect the

banks income in the first quarter and how would the timely receipt of

the settlement payment affect the income in the second quarter of yeartwo?


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