02.2 credit products

Copyright © 2018 CapitaLogic Limited
Chapter 2
Credit Products
This presentation file is prepared in accordance with
Chapter 2 of the text book
“Managing Credit Risk Under The Basel III Framework, 3rd ed”
Website : https://sites.google.com/site/crmbasel
E-mail : crmbasel@gmail.com

Copyright © 2018 CapitaLogic Limited 2
Declaration
 Copyright © 2018 CapitaLogic Limited.
 All rights reserved. No part of this presentation file may be
reproduced, in any form or by any means, without written
permission from CapitaLogic Limited.
 Authored by Dr. LAM Yat-fai (林日辉),
Director, CapitaLogic Limited,
Adjunct Professor of Finance, City University of Hong Kong,
Doctor of Business Administration,
CFA, CAIA, CAMS, FRM, PRM.

Credit products
 Personal loan
 Term loan
 Student loan
 Credit card
 Credit line
 Property loan
 Mortgage
 Bridging loan
 SME loan
 Equipment finance
 Trade finance
 Corporate loan
 Project finance
 Syndicate loan
 Corporate bond
 Tradable loan
http://www.hsbc.co.uk/1/2/personal

Credit products
 Risk-return characteristics and investment
horizon preferred by the lenders
vs
 Payment amounts and schedules affordable by
the borrowers

Cash flows

 Term loan
 Credit card
 Mortgage
 Corporate bond
 Appendices
Outline

Term loan
 Functional purpose
 Borrower
 Need immediate cash
 Lender
 With short to medium
term spare cash
 To seek a medium to
higher return
 Cash flows
 Out
 Principal at origination
 In
 Principal at maturity
 Monthly interests

Term loan
 Risk factors
 Fixed EAD = Principal + Monthly interest
 Large LGD
 Borrower targeted by lender determines the PD
 Short to medium term initial RM
 Credit risk
 Medium in general

Term loan
 Interest rate
 Monthly interest / principal × 12 × 100%
 Moderate 12% to 30% annually
 Cash inflows assumed to be collected in full on
schedule
 Default
 Monthly interest and/or principal not collected in
full on schedule
 Debt collection actions by lender or agency

A typical term loan
 Lending amount – USD 10,000
 Your bank pays the borrower USD 10,000 today
 Maturity – one year
 The borrower will pay your bank at most USD 10,000 after one year
 Interest frequency – monthly
 The borrower will pay your bank interest on monthly basis
 Interest rate – 12 %
 The borrower will pay your bank at most
USD 10,000 × 12% / 12= USD 100 monthly
1 2 3
100 100 100 100 100+10,000
1211
10,000
Example 2.1

 Term loan
 Credit card
 Mortgage
 Corporate bond
 Appendices
Outline

Credit card
 Borrower
 Cash need to spend
 Lender
 With on-going spare cash
 To seek a higher return
 Cash flows
 Out
 Each spending
transaction
 In
 Statement balance on a
monthly basis
 Minpay =
Max[Statement balance
× 10%, USD 100] on a
monthly basis

Credit card
 Risk factors
 Variable EAD = Potential outstanding balance
 Approaching credit limit
 Large LGD
 Uncertain PD due to the potential deterioration of
borrower’s credit quality after card issuance
 No fixed RM
 Credit risk
 Higher

Credit card
 Interest rate
 Higher interest rate 16% to 30% annually
 Minpay assumed be collected in full on schedule
 Default
 Even minpay not collected in full on schedule
 Debt collection actions by lender or agency

A typical credit card
 Credit limit – USD 4,000
 Your bank will lend the borrower up to USD 4,000,
including principal and interest
 Outstanding balance – USD 3,000
 Your bank has lent the borrower USD 3,000
 Statement balance – USD 2,000
 Your bank has lent the borrower USD 2,000 as at the last
statement day
 Minimum payment
 The borrower must pay your bank at least USD 200
=Max[USD 2,000 × 10%, USD 100]
Example 2.2

 Term loan
 Credit card
 Mortgage
 Corporate bond
 Appendices
Outline

Mortgage
 Borrower
 Cash need to purchase a
property
 Lender
 With very long term
spare cash
 To seek a stable return
and cash inflows
 Cash flows
 Out
 In
 Interest + partial
principal on a monthly
basis

Mortgage
 Risk factors
 Amortizing EAD
= Outstanding principal + Monthly interest
 Very small LGD
 Uncertain PD due to the potential deterioration of
borrower’s credit quality over a long lending period
 Long initial RM
 Credit risk
 Very low

Mortgage
 Interest rate
 Monthly interest / outstanding principal × 12 × 100%
 Lower interest rate 3% to 10% annually
 Monthly payment assumed to be collected in full on
schedule
 Default
 Monthly payment not collected in full on schedule
 Property sold by the lender to recover EAD completely or
partially

A typical mortgage
 Lending amount – USD 700,000
 Your bank pays the borrower USD 700,000 today
 Maturity – 20 years
 The borrower will pay your bank monthly for a period of 20 years
 Payment frequency – monthly
 The borrower will pay your bank interest and partial principal on a
monthly basis
 Interest rate – 3 %
 The borrower will pay your bank at most USD 3,882 monthly
1 2 3
3,882 3,882 3,882 3,882 3,882
240239
700,000
Example 2.3

 Term loan
 Credit card
 Mortgage
 Corporate bond
 Appendices
Outline

Corporate bond
 Issued by a large corporation for fund raising
at a lower cost
 Subject to credit risk
 Cash inflows not guaranteed
 Illiquid secondary market
 Mis-match between demand and supply
 Information asymmetry

Zero coupon bond
 Market price – USD 950
 Principal – USD 1,000
 At maturity
 Survive – USD 1,000
 Default
 USD 0
 USD 500
 USD 999

Coupon bond
 Market price – 95%
 Your bank pays the corporation USD 950 today
 Principal – USD 1,000
 The corporation will pay your bank at most USD 1,000 at maturity
 Maturity – 5 years
 The corporation will pay your bank at most USD 1,000 in 5 years
 Coupon rate – 6 %
 The corporation will pay your bank at most USD 30 every 6 months
 Coupon frequency – semi-annual
 The corporation will pay your bank interest every 6 month
1 2 3
30 30 30 30 30+1,000
109
950
Example 2.4

EAD estimation
 EAD = Principal + Accrued interest
 Accrued interest
 Accumulated on a daily basis
 0 just after interest payment
 Principal × interest rate / interest frequency just
before interest payment
Principal Interest rate
Average EAD = Principal +
Interest frequency 2


Example 2.5

EAD collection process
 Cross default provision
 The default of a corporate bond will trigger the
default of the corporation and all corporate bonds
issued by the same corporation
 EAD to be collected according to seniority

Seniority of corporate debts
 Top priority
 Governments, employees, liquidators and bank loans
 First priority
 Senior secured
 After governments, employees, liquidators and bank loans
 Second priority
 Senior unsecured
 After senior secured
 Third priority
 Subordinated senior
 After senior unsecured
 Forth priority
 Subordinated
 After subordinated senior

Loss given default of corporate bond
Seniority Average LGD (%)
Senior
Secured 37.4
Unsecured 51.6
Subordinated 72.0
Example 2.6

Standard loss given defaults
Seniority
Basel III (%)
Foundation IRB
ISDA (%)
CDS valuation
Senior 45 60
Subordinated 75 80

Qualitative credit risk analysis
at origination
Credit risk
factor
Term loan Credit card Mortgage Corporate bond
EAD
Small to
medium
Small to
medium
Large Large
LGD Large Large Very small Vary
PD Stable Vary Stable
Initial RM Short to medium
Medium to
very long
Medium
Credit risk level Medium Higher Lower Vary
No. of credit
risk factors
4 3 4 4
Credit risk
measure
EL 1-year EL 1-year EL EL

 Term loan
 Credit card
 Mortgage
 Corporate bond
 Appendices
Outline

Risk-free securities
 Created by financial
economists
 For theory development
 Never exists in the
world
 Not a credit product
 Proxy by top quality
assets
 Cash flows
 Out
 In
 Principal at maturity
 Scheduled interests
 Credit risk
 No

Day count convention
 0 – 30/360
 Corporate, municipal and agency bonds
 Mortgage backed securities
 1 – Actual/Actual
 2 – Actual/360
 US treasury bills
 Commercial papers
 Short term debts
 3 – Actual/365
 US treasury notes and bonds

Accrued interest
 Principal USD 1,000
 Coupon rate 6%
 Coupon frequency Semi-annual
 Maturity 31 Dec 2021
 Today 31 Mar 2017
 What is the accrued interest?

Accrued interest
 30/360
 Accrued interest = 1,000 × 6% / 2 × (30 + 30 + 30) / 180
 Actual/Actual
 Actual/360
 Actual/365
 Accrued interest = 1,000 × 6% / 2 × (31 + 28 + 31) / 182.5
Example 2.7

02.2 credit products

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02.2 credit products