EOC solutions Chapter 20

EOC solutions Chapter 20 - Answers to Chapter 20 Questions...

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Answers to Chapter 20 Questions: 1. Credit risk management is important for FI managers because it determines several features of a loan: interest rate, maturity, collateral and other covenants. Riskier projects require more analysis before loans are approved. If credit risk analysis is inadequate, default rates could be higher and push an FI into insolvency, especially if lending markets are competitive and the margins are low. 2. Two considerations dominate an FI’s decision to approve a mortgage loan application: (1) the applicant’s ability and willingness to make timely interest and principal repayments and (2) the value of the borrower’s collateral. Ability and willingness of the borrower to repay debt outstanding is usually established by application of qualitative and quantitative models. The character of the applicant is also extremely important. Stability of residence, occupation, family status (e.g., married, single), previous history of savings, and credit (or bill payment) history are frequently used in assessing character. The loan officer must also establish whether the applicant has sufficient income. In particular, the loan amortization (i.e., principal and interest payments) should be reasonable when compared with the applicant’s income and age. The loan officer should also consider the applicant’s monthly expenditures. Family responsibilities and marital stability are also important. Monthly financial obligations relating to auto, personal, and credit card loans should be ascertained, and an applicant’s personal balance sheet and income statement should be constructed. 3. Credit scoring models are used to calculate the probability of default or to sort borrowers into different default risk classes. The primary benefit of credit scoring models is to improve the accuracy of predicting borrower’s performance without using additional resources. This benefit results in fewer defaults and chargeoffs to the FI. The models use data on observed economic and financial borrower characteristics to assist an FI manager in (a) identifying factors of importance in explaining default risk, (b) evaluating the relative degree of importance of these factors, (c) improving the pricing of default risk, (d) screening bad loan applicants, and (e) more efficiently calculating the necessary reserves to protect against future loan losses. 4. The techniques used for mortgage loan credit analysis are very similar to those applied to individual and small business loans. Individual consumer loans are scored like mortgages, often without the borrower ever meeting the loan officer. Unlike mortgage loans for which the focus is on a property, however, nonmortgage consumer loans focus on the individual’s ability to repay. Thus, credit scoring models put more weight on personal characteristics such as annual gross income, the TDS score, and so on.
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