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LECTURE 7 NOTES - LECTURE 7 NOTES CREDIT RISK...

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LECTURE 7 NOTES CREDIT RISK DEFINITION --Credit risk is the risk that promised cash flows from loans and securities held by FIs may not be paid in full. --If the principal on all financial claims held by FIs were paid in full on maturity and interest payments were made on their promised payment dates, FIs would face no credit risk!! --Banks, life insurance companies are more exposed to this type of risk than money market mutual funds, property-casualty insurance companies, etc. --Firm-specific credit risk: is the risk of default by the borrowing firm associated with specific types of project risks taken by that firm. --Systematic credit risk: is the risk of default associated with general macro conditions affecting all borrowers, e.g. 2008-2009 financial crises. --What can the FIs do to control/eliminate risk? They should collect detailed information about borrowers (screening) and monitor them over time (Managerial/Monitoring Efficiency). They should diversify credit risk across assets/eliminate firm-specific credit risk. They could participate in loan sales or rescheduling of loans. CREDIT ANALYSIS REAL ESTATE LENDING CONSUMER AND SMALL-BUSINESS LENDING MID-MARKET COMMERCIAL AND INDUSTRIAL LENDING LARGE COMMERCIAL AND INDUSTRIAL LENDING CALCULATING THE RETURN ON A LOAN RETURN ON ASSETS RISK-ADJUSTED RETURN ON CAPITAL (RAROC) ESTIMATING CREDIT LOSSES CREDIT VALUE AT RISK (VaR) CREDITMETRICS CREDIT DEFAULT SWAPS 1
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CREDIT ANALYSIS How can you avoid a potential loss on a loan? --Collect information about borrowers whose assets are in the portfolio and monitor those borrowers over time (through managerial efficiency and credit risk management strategies). --Diversification across assets exposed to credit risk reduces the overall credit risk in the asset portfolio. REAL ESTATE LENDING --Two considerations dominate a FI’s decision to approve a mortgage loan application: a) the applicant’s ability and willingness to make timely interest and principal repayments, b) the value of the borrower’s collateral. --Mortgage lenders calculate the following ratios for each applicant before they make decisions: Gross Debt Service (GDS) = (Annual mortgage payments + Property taxes)/Annual gross income Total Debt Service (TDS) = Annual total debt payments/Annual gross income --These ratios must be less than an acceptable threshold. The threshold is commonly 25%-30% for the GDS ratio, and 35%-40% for the TDS ratio. Exmp: Consider two customers who have applied for a mortgage from a FI with a GDS threshold of 25% and a TDS threshold of 40%. Gross Monthly Annual Monthly Annual Mortgage Property Other Debt Customer Income Payments Taxes Payments 1 $150,000 $3,000 $3,500 $2,000 2 60,000 500 1,500 200 GDS ratio for the 1 st customer=26.33% TDS ratio for the 1 st customer=42.33% GDS ratio for the 2 nd customer=12.50% TDS ratio for the 2 nd customer=16.50% 2
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Decision: 1 st customer does not meet the GDS or TDS thresholds.
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