Basic Understanding

What is Credit?

Definition and Nature of Credit

Credit is derived from the Latin word Credere trust or belief the capacity to get economic value on trustin return for expected future payment i.e. promise and trust

Credit markets are different: - Price is not a good allocator - Contracts are incomplete - Information is asymmetric - Information is crucial
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Typology of Credit
Financial Institutions Corporate Sector Financial Institutions
Company Loan/OD Secured/Unsecured Companies deferred payment, credit account
Consumer/House hold fixed term loans/revolving credit(OD/Cards)

Bank Credit Trade Credit Consumer Credit

Trade & Consumer Credit
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Utilities

Household/Busi ness (deferred payment or payment plans)

Credit Crisis and Lending: What went wrong ?

The Credit Crisis

Causes: - there was a credit boom, a housing bubble and a crash debt/income increases house prices 11% pa - But why was such a severe financial crisis? widespread failure of financial institutions freezing of capital market reduced supply of capitals to creditworthy companies/individuals amplification of crisis - Bad lending decisions (why) - Securitization process - Opaque structured products - LCFIs (Large Complex Financial Institutions) Universal Banks, Investment Banks, insurance companies, hedge funds - Shadow Banking Sectors (SICs) to side-step Basel II
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The US Housing and Mortgage Market

In the period 2000-2005 house prices increased by over 50% In 2005 over 50% of GDP growth in the US was housing related Between 1997-2007 over $9 trillion was withdrawal from home

equity In the 2000s home equity withdrawal financed 3% of total personal consumption In 2005, 40% of all homes purchased were investments or second homes In 2006 home equity withdrawal was equivalent to 10% of personal disposable income During this period the growth in wages and salaries was mediocre (except in planet finance(1): in 2007 the Chief Exec of Goldman Sachs was paid $68 million)
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Source: George Soros New Paradigms for Financial Markets (2008) (1) planet finance is a term used by Niall Ferguson, The Ascent of Money (2008)

Where it Starts
CHEAP MONEY + LEVERAGE FINANCIAL INNOVATION

ASSET BUBBLE

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TOP 10 Changes in Credit Markets in the Last Decade

New product innovations, particularly in the credit

derivatives and structured finance areas; standardization of older innovations Growing sophistication of the major players in the credit markets in terms of techniques and strategies Increased use of scientific and mathematical models (credit scoring; correlation) New Basel accords shaped the banking markets (regulatory capital arbitrage) Growth of credit information globally available 24/7 and online
Source: Altman 2008 11

TOP 10 Changes in Credit Markets in the Last Decade

Growth in technology and systems capabilities at

affordable prices leading to better reporting and modeling Huge changes in markets size, liquidity, globality Emergence of hedge funds as major investors in markets Growing influence of rating agencies Lower levels of loss and higher liquidity led to reduced credit spreads
Source: Altman 2008

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Where it all disconnects..

Microlevel lending decisions
imperfect credit information becomes more distorted

and unreliable as credit expands

Governance
key decisionmakers decision internal to the lender

loose sight of the risk models underpinning their business model and decisions have insufficient understanding of complex financial instruments

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Where it all disconnects..

Globalization and Financial Intermediation creates a new world old world methods and data applied to planet finance they overestimate the predictability of the past and hence underestimate the surprise of the future .. (Ferguson, 2008) Cutting and Splicing: Diversified or Correlated ? -losing sight of the underlying assets (CDO, CDO2, CDO3) transferring ownership of mortgages from bankers who knew their customers to investors who did not Regulation of new financial instruments nobody looking at the whole picture; lack of transparency Failures of selfregulation bankers deciding the rules for 14 bankers

The Credit Crisis

Blame: Bankers & Regulators
Banks: incentive structure (short term; profit centers; cash

bonuses) Regulators: micro regulation (individual risk) macro (systematic risk)

Fix:
Regulatory overlay to tackle systemic fragility but

encourage innovation and economic growth

- think about it !
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Lending Decisions Principles and Practice

We should not forget that the basic economic function of these regulated entities (banks) is to take risk. If we minimize risk taking in order to reduce failure rates to zero, we will, by definition, have eliminated the purpose of the banking system.
Alan Greenspan President, Federal Reserve Board

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Credit Risk Assessment : PreAutomation

Lending the old fashioned way The 5 Cs of credit: The borrower should demonstrate: - Character (quality of management; experience; compliance; operational risk etc.) - Capacity (sufficient cash flow to service debt) - capital (net worth to cover unforeseen events) - collateral (assets to secure the debt; guarantees etc.) - conditions (economic outlook; competition; market structure e.g. motor industry; industry risk)
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Overview of Credit Risk

Three types of Risks for Banks For Trade Creditors
Political Risk Economic Risk Currency Risk

Credit Risk : Corporate and Retail (default)

Country Risk

Operational Risk: Internal or external events

Market Risk: Value of financial instruments

Industry Risk

Corporate Risk

Business Risk Financial Risk Management

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Essential Readings:
Altman, E.I. et. al. (2008). Measuring Credit Risk, 2nd

Edition. John Wiley USA. Chapter 1.

Study Material. Chapter 1.

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Assignment:
Group assignment followed by presentation on: Asian Crisis The Great Depression of 1930s Recent Euro-Zone Crisis Financial Crisis of 2007-2008
The assignment should be about 3-4 pages in length and the presentation will be of 15 minutes not exceeding 12 slides.

Please submit the assignments latest by the next class and presentation date and time will be provided in the next class.
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Forthcoming Session:
Credit Rating Agencies

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to get a copy of this presentation visit www.jairajgupta.weebly.com

by jairaj gupta e-mail: jairajgupta89@gmail.com

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