MONAS

H
BUSINE
SS

Lecture 6
Loan Defaults and Credit Default Swaps

BFW 3841 Credit Analysis and Management

Tee Chwee Ming

Accredited by: Advanced

Signatory:
Learning Objectives Problem loans
 Understand why loans default
 Explain the extent of problem loans
 Understand the importance of the business cycle
and how it is important for problem loans
 Define problem loans, provisions and regulatory
issues
 Discuss the capital issues of problem loans
 Define ‘structure dynamic provisioning’
 Restructure problem loans
 Illustrate a case from law

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Introduction Problem loans
 When financial institutions make loans, returns
generated mean accepting some default risk.

 It is imperative that default risk is managed so that

the solvency of the bank is not threatened.

 Should the problem loan be foreclosed or actively

managed?

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Some Pointers on Default
 Default does not necessarily mean that all of the
loan extended is lost.

 Default is defined here as ‘a loan where

repayments are overdue’.

 Better lending procedures can minimize, but not

eliminate, the risk of default.

 Harder to manage default risk as loan book

becomes larger

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Causes of Default
Likely causes of default
1.Lack of compliance with loan policies
2.Lack of clear standards and
excessively lax loan terms
3.Inadequate controls over loan
officers
4.Over-concentration of bank lending
5.Loan growth exceeding bank’s
capital
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Causes of Default
Likely causes of default
6. Insufficient knowledge of customer’s
finance
7. Lending in unfamiliar markets
8. Unfavorable market conditions:
Depression
9.Natural calamities: Covid-19

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Extent of Problem Loans
 All banks experience bad debts,
but the management of them becomes critical

 Banks should consider:

 Timing of loan in economic cycle
 Larger exposures to individual borrowers
 Larger exposures to single sectors
 Close monitoring of exposures during unfavorable
economic periods

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The Business Cycle
 The business cycle is characterized by three
phases:
 Recovery and Expansion:
 Flourishing economy with increased spending
leading to higher deposits and interest rates.
 Boom:
 Major asset inflation with business overconfidence
and declining credit standards.

 Downturn:
 Declining asset values and economic activity
generally accompanied by increased defaults

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Problem Loans, Provisions and
Regulatory Issues
 When borrower misses payments, two questions
arise within lending institution
 Is missed payment temporary?
 Is missed payment likely to be permanent?

 If payment more than 90 days, loan is

considered an ‘impaired asset’ as return on loan
is not achieved
 Value of impaired loan must be downgraded on
statement of financial position

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Problem Loans, Provisions and
Regulatory Issues
 If one asset is impaired, all loans to that client is
considered impaired
 When loans are impaired, institution must create
a ‘provision’ for loan loss
 Provisions are classified in three ways:
 Specific Provisions
 General Provision
 Bad-Debt / Write-Offs

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Problem Loans, Provisions and
Regulatory Issues
 Specific Provisions:
 These are provisions set aside for a specifically
identifiable loan where the institution assesses
the:
• Condition of the loan;
• Condition of the borrower;
• Impact of economic events.

 Not all of the loan must have provisions made as

lender may assess the likely losses from the asset
after taking into consideration the value of the
collateral.

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Problem Loans, Provisions and
Regulatory Issues
 General Provisions
 These are provisions that are made as a
proportion of the entire loan portfolio.
 Suitable for large loan portfolios of similar assets,
e.g. mortgages, where specific provisioning
unsuitable.
 Can adjust general provisions level depending
on economic activity or risk levels.

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Problem Loans, Provisions and
Regulatory Issues
 Bad Debts:
 Recognition of bad debts occurs where:
• All security liquidated;
• Guarantees have been enforced;
• Remaining remedial actions explored; and
• No remaining sources of cash can be called.
 Once the above steps are completed, the financial institution
must write off the bad debt with asset valued at zero and a
charge made against profits.

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Other Considerations with Problem
Loans
 The provisions made minimize the efficient use
of capital that could otherwise be used for
lending purposes
 Institutions often have provisioning systems
exceeding regulator requirements to reflect
bank’s risk profile
 Higher provisions indicate higher risk and/or more
conservative management
 Lower provisions indicate lower risk and/or more
aggressive management

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Dynamic Provisioning
 The risk profile of the loan portfolio is sensitive
to a point in the economic cycle, e.g. greatest
defaults occur at bottom of economic cycle
 Therefore:
 Credit risk is not static but changes over time
 Bad debt should not come as a surprise
as modeling should detect changes to probable
default risk in portfolio segments

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Dynamic Provisioning
 Key principles in dynamic provisioning:
 Classify loans into homogeneous groups
 Sub-classify groups by maturity length
• Determine probability of loss for each group
• Determine likely severity of loss for each
group [LGD]
 Use the historical loan-loss information to create
predictive model incorporating economic conditions,
interest rates, investment activity, etc.
 Apply model outcome to current provisions

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Dealing with Defaults
 If the loan is in default, bank must act to
minimize the losses arising from defaulting
clients and may reschedule payments rather
than liquidate loan
 Classify defaulting clients into three
categories:
 Mild financial distress;
 Moderate financial distress; and
 Severe financial distress.

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Dealing with Defaults
 Mild Financial Distress
 Often occurs when borrower faces short-term cash
flow problems, e.g. late receipts
 If default less than 90 days, remedies include:
• Changing/lengthening repayment schedules
• Encouraging firm to sell non-core assets
• Requesting/demanding equity capital
injection

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Dealing with Defaults
 Moderate Financial Distress
 May occur if cash flow problems coincide with
borrower’s asset values declining
 Course of action determined by nature of collateral,
e.g. foreclose on mortgage

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Dealing with Defaults
 Severe Financial Distress
 Characterized by missed payments and value of
borrower less than loan amount
 Lender needs to very carefully evaluate whether it is
better to:
• Liquidate firm to recover greatest percentage
of loan possible; or
• Restructure debt (inclusive of debts to other
lenders) to maintain operations to allow firm
to trade out of current crisis or be sold as
going concern

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Dealing with Defaults
 Other Breaches
 Corporate loans may have a variety of covenants
imposed to protect loan quality
 Lender may place a variety of conditions to strengthen
loan repayment probability:
• No excessive withdrawal of cash flows
• Risk profile of firm to remain unchanged
• Specification of various ratios including gearing,
dividend payout and interest coverage
• Continued involvement of key staff
• Application of risk management strategies

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Examples from the Law
 Winding-up generally performed by registered
liquidators who sell assets for the benefit of
creditors
 State Bank of Victoria relied on collateral of
sophisticated rescue equipment stored in barrels.
Barrels empty and not worth $250,000 as noted,
but only $1,592 each.
 Information supplied by Harris Scarfe and HIH
Insurance grossly inaccurate and little collateral
available when default occurred.

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Examples from the Law
 Auction off collateral and properties through
proceedings in the courts or land office
 Civil action in the courts proceedings for
seizure and sale of properties
 Civil proceedings against guarantors
 Bankruptcy proceedings against borrower
and guarantors.

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BFW3841 CREDIT ANALYSIS AND
LENDING MANAGEMENT
CREDIT DEFAULT SWAP (CDS)

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Credit Default Swap (CDS):
Introduction
A credit default swap (CDS) is a kind of insurance
against credit risk. It is a privately negotiated
bilateral contract between seller and buyer.
The buyer of protection pays a fixed fee or
premium to the seller of protection for a period of
time and if a certain pre-specified “credit event”
occurs, the protection seller pays compensation to
the protection buyer.
A “credit event” can be a bankruptcy of a
company, called the “reference entity,” or a default
of a bond or other debt issued by the reference
entity.

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Credit Default Swap (CDS):
Introduction
If no credit event occurs during the term of
the swap, the protection buyer continues to
pay the premium until maturity.

In contrast, should a credit event occur at

some point before the contract’s maturity,
the protection seller owes a payment to the
buyer of protection, thus insulating the
buyer from a financial loss.

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Uses of CDS
 CDSs can also be used as a way to gain exposure to
credit risk.
 A CDS does not require an initial funding, which allows
leveraged and speculative positions.
 A buyer of CDS need not be the bondholder. It can be
used to speculate on default risks.
 CDS is not issued by the borrower or bond issuer.
 With all these attributes, CDSs can be a great tool for
diversifying or hedging one’s portfolio.

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What Does the Global CDS Market
Look Like Today?
The CDS market originally evolved from privately
tailored agreements between banks and their
customers.
Perhaps because of its over-the-counter
character, it is not clear exactly when the CDS
market came into existence.

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The Players in CDS Market
Indeed, commercial banks are among the most active
in this market, with the top 25 banks holding more
than $13 trillion in credit default swaps - where they
acted as either the insured or insurer - at the end of
the third quarter of 2007.
Credit default swaps were seen as easy money for
banks when they were first launched more than a
decade ago. Reason? The economy was booming
and corporate defaults were few back then, making
the swaps a low-risk way to collect premiums and
earn extra cash. The swaps focused primarily on
municipal bonds and corporate debt in the 1990s, not
on structured finance securities. Investors flocked to
the swaps in the belief that big corporations would
seldom go bust in such flourishing economic times.
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The Players in CDS Market
 Insurance companies are increasingly becoming
dominant participants in the CDS market, primarily as
sellers of protection, to enhance investment yields.
Insurers also invest heavily in so-called “structured
credit” products, such as credit link notes (CLNs) and
collateralized debt obligations (CDOs). Globally,
insurance companies had net sold positions of $137
billion in 2008.
 Other players include financial guarantors, who are also
big sellers of protection, with net sold positions of $166
billion. Global hedge funds are also rumoured to be
active players in the CDS market, but their activities
are notoriously opaque and are not detected on any
survey’s radar screen.

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The Players in CDS Market
The CDS market then expanded into structured
finance, such as CDOs, that contained pools of
mortgages. It also exploded into the secondary
market, where speculative investors, hedge funds
and others would buy and sell CDS instruments
from the sidelines without having any direct
relationship with the underlying investment.

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The Players in CDS Market
But as the economy soured and the
subprime credit crunch began expanding
into other credit areas over the past year
CDS investors became jittery.
They wondered if the parties holding the
CDS insurance after multiple trades would
have the financial wherewithal to pay up in
the event of mass defaults.

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The Players in CDS Market
The situation was already taking a toll on
insurers, who have been forced to write down
the value of their CDS portfolios. American
International Group (AIG), the world's largest
insurer, reported the biggest loss in the
company's history largely due to an $11 billion
write-down on its CDS holdings.

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How Does it work?
As described above, in a credit default swap,
the buyer and the seller of protection enter
into a contract where the protection buyer
pays a fixed premium for protection against a
certain “credit event,” such as a bankruptcy
of the reference entity, or a default on debt
issued by the reference entity.
Usually there is no exchange of money when
two parties enter in the contract, but they
make payments during the term of the
contract, thus explaining the term credit
default “swap.”

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CDS Spreads
 The premium paid by the protection buyer to the seller,
often called “spread,” is quoted in basis points per
annum of the contract’s notional value and is usually
paid quarterly.
 Note that these spreads are NOT the same type of
concept as “yield spread” of a corporate bond to a
government bond. Rather, CDS spreads are the annual
price of protection quoted in bps of the notional value,
and not based on any risk-free bond or any benchmark
interest rates.

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CDS Spreads
 Therefore, a CDS is like a put option written on a
corporate bond. Like a put option, the protection buyer is
protected from losses incurred by a decline in the value
of the bond as a result of a credit event.
 Accordingly, the CDS spread can be viewed as a premium
on the put option, where payment of the premium is
spread over the term of the contract.
 For example, the 5 - year credit default swap for Ford
was quoted around 160 bps (p.a.) on April 27, 2007. This
means that if you want to buy the 5-year protection for a
$10 million exposure to Ford credit, you would pay 40 bps
(0.4%), or $40,000, every quarter as an insurance
premium for the protection you receive.

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Contract Size and Maturity
There are no limits on the size or maturity of
CDS contracts. However, most contracts fall
between $10 million to $20 million in notional
amount. Maturity usually ranges from one to ten
years, with the 5-year maturity being the most
common tenor.

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Trigger Events
ISDA’s standard documents for CDS provide
for three to be the most important credit
events:
Bankruptcy, the clearest concept of all, is
the reference entity’s insolvency or inability
to repay its debt.
Failure-to-Pay occurs when the reference
entity, after a certain grace period, fails to
make payment of principal or interest.
Restructuring refers to a change in the terms
of debt obligations that are adverse to the
creditors.

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So... What Happens If the Bad Thing
Happens?
The first step taken after a credit event occurs
is a delivery of a “Credit Event Notice,” either
by the protection buyer or the seller.
Then, the compensation is to be paid by the
protection seller to the buyer via either (1)
physical settlement, or (2) cash settlement, as
specified in the contract.

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So... What Happens If the Bad Thing
Happens?
 Physical Settlement: In a physical settlement, the protection
seller buys the distressed loan or bond from the protection
buyer at par. Here the bond or loan purchased by the seller of
protection is called the “deliverable obligation.” Physical
settlement is the most common form of settlement in the CDS
market, and normally takes place within 30 days after the
credit event.
 Cash Settlement: In case of the cash settlement, the protection
seller makes payment equal to a pre-determined value to the
protection buyer. The obligation will be valued and the protection
seller will pay the protection buyer the full face value of the
reference obligation less its current value, that is, it will compensate
the protection buyer for the decline in the obligation’s value.

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