Defaulted loans

Practitioners increasingly model credit risk as they do interest rates and use spread models to price associated derivatives. One such model is the Heath-Jarrow-Morton (HJM) model described in chapter 4. This analyzes interest rate risk, default risk, and recovery risk—that is, the rate of recovery on a defaulted loan, which is always assumed to retain some residual value. 

Completion risks are primarily related to commissioning delays, contractor default and cost overruns. Typical outcomes of such events would be the loss of revenue, difficulties in servicing debts, the calling-in of bonds, the need to refinance or seek new loans. Prudent strategies would involve the use of reputable contractors, early triggers of performance bonds, etc. 

All debt contracts require payment of interest on the loan and repayment of the principal (either at the end of the loan period or amortized over the period of the loan). Interest payments are a fixed cost, and if a company defaults on these payments, then its ability to borrow money will be drastically reduced. Since interest is deducted from earnings, the greater the leverage of the company, the higher the risk to future earnings, and hence to future cash flows and the financial solvency of the company. In the worst case, the company could be declared bankrupt and the assets of the company sold off to repay the debt. Finance managers therefore carefully adjust the amount of debt owed by the company so that the cost of servicing the debt (the interest payments) does not place an excessive burden on the company. 

At the heart of the Merton s assumptions, equity holders have an embedded put option by which if at maturity the firm value is greater than promised obligation ox face value, the lender gets back the bond s amount and shareholder maintains the ownership of the company otherwise, if the firm value is lower than the promised payment, the bondholders receive an amount less than bond s face value and the firm defaults. Therefore, in the case of high-put option value, shareholders will have an advantage to walk away from the loan payment, leaving the asset value to the bondholders. 

The different types of bonds in the European market reflect the different types of issuers and their respective requirements. Some bonds are safer investments than others. The advantage of bonds to an investor is that they represent a fixed source of current income, with an assurance of repayment of the loan on maturity. Bonds issued by developed country governments are deemed to be guaranteed investments in that the final repayment is virtually certain. For a corporate bond, in the event of default of the issuing entity, bondholders rank above shareholders for compensation payments. There is lower risk associated with bonds compared to shares as an investment, and therefore almost invariably a lower return in the long term. 

In the US market there have been cases in which securities houses that went into bankruptcy and defaulted on loans were found to have pledged the same collateral for multiple HIC repo trades. Investors dealing in HIC repo must ensure ... 

The key to assessing the probability of borrower default lies in assessing their ability and willingness to pay. Affordability is usually measured either as an income multiple for the loan or the ratio of the borrower s monthly debt obligations to their monthly net income. The higher the level of borrower income is relative to debt obligations, the better the ability of the borrower to absorb any financial shocks. 

The loan-to-value ratio (LTV) gives a measure of the equity a borrower has invested in a property. A large equity stake provides an important motivation to avoid defaulting on a loan. The ability to save a large deposit may indicate a higher level of financial discipline by the borrower, which should also indicate a lower likelihood of default. 

The LTV ratio also has an important impact on the extent of any losses sustained in the event that a loan goes into default. A lower LTV... 

The type of mortgage can also influence the credit quality of the loan. In summary, mortgage products that exaggerate payment shocks are likely to experience increased levels of defaults, whereas those that provide a degree of stability or payment shock protection are likely to see fewer defaults. 

S P s analysis of historical data for UK mortgages indicates that a borrower is most likely to default in the first five years of a loan. So a mortgage that has been outstanding for some time and is up to date with its payments should represent a lower risk than a new loan. As earnings and wages tend to rise over the long term, the borrower s ability and incentive to maintain the mortgage payments should increase over time. 

The first step in the Fitch rating process is to estimate the probability of default for each loan in the collateral pool. This will take into account all the factors discussed in the previous section. 

Fitch uses the combination of the LTV and the affordability measure for a loan in order to arrive at a base case default probability for any particular borrower in a particular rating test. In the United Kingdom, the income multiple has traditionally been used as the measure of loan affordability, and Fitch places loans in one of five classifications based on this measure (Exhibit 11.4). 

The base case default probability will then depend on the rating being considered and the LTV of the loan. Exhibit 11.5 shows the Fitch default probability assumptions for loans where the income multiple is between 2.75 and 3.00 for various ratings tests. 

The initial default probability assumption is then adjusted (usually increased) to take into account any other important features of the loan. These factors include ... 

Mortgage Type Interest-only mortgages that are not linked to a repayment vehicle will have the base case default probability increased by a factor up to 1.33, dependent on the time to maturity of the loan. 

Equity Withdrawal Loans taken out to refinance an existing mortgage will not be penalised unless the borrower uses the opportunity to withdraw equity from the property when the default probability will be increased by 1.10-1.25x. 

Buy-to-Let Properties These loans are assumed to have a higher probability of default as for a second home but the loss severity may be reduced due to an easier repossession process and the ability to appoint a receiver of rent. 

Many lenders require borrowers taking out high LTV loans to pay for mortgage indemnity guarantee (MIG) to cover the high LTV portion of the loan. If the borrower were to subsequently default, the lender would... 

The profile of the LTVs of individual loans in the portfolio should also be considered. For example, two portfolios, each with a weighted average LTV of 70% may have different profiles. One may have loans evenly spread around the 70% mark, whereas the other may be bar-belled, with a high number of very low LTV loans compensating for a high number of very high LTV loans. In most circumstances, if defaults were to occur, the loss severity would be higher for the bar-belled portfolio. 

It is often widely commentated that LTV is not an indicator of default probability. However, we would argue that a borrower with a 50% equity stake at risk from a potential forced sale of a property would have a greater incentive to maintain debt service payments than if the same borrower had an equity stake of, say, 20%, and so although it may not be the most important influence, the LTV of a loan could be expected to have some influence on the default rate. 

Similar considerations apply to the servicing capability. A good servicing operation can limit the instance of loans becoming delinquent and also maximise recoveries should loans default. 

Under the secured loan structure, the trustee might find it necessary under certain circumstances to enforce the fixed and floating charges. Such circumstances could include unremedied events of default under the issuer-borrower loan, or if third-party creditors were to attempt to put the company into administration. In this case, the trustee would seek to have an administrative receiver appointed on behalf of the secured creditors. However, the process could disrupt the receipt and payment of cash flows. The ratings of the notes are based on timely payment of interest (and sometimes principal) so the transaction will include some form of liquidity support, which is typically sized to enable the issuer to cover one year s debt service. 

Servicer default that would have a material adverse effect on the issuer of the loan notes. 

Model and make diversification are of particular importance if the loans included in the pool have a high RV component, because problems associated with the manufacturer or the car could then lead to depressed sales prices in the used-car market. This in turn could lead to higher loss levels if customers default due to lower recovery values realised by the originator. 

The loan-to-value ratio (LTV) represents the size of the loan relative to the sales price of the vehicle. The lower the LTV, the more equity a borrower has invested in the vehicle. The equity in the vehicle should act as an incentive to keep the borrower from defaulting, and thus losing the invested equity. Over time, the amount of the loan will decrease as principal is repaid by the borrower. However, the value of the vehicle will most likely be decreasing as well, based on the vehicle s depreciation curve. This makes it necessary to analyse the rate at which principal is being repaid (amortisation schedule) against the rate at which the vehicle is depreciating in order to determine the borrower s expected equity in the vehicle (see term distribution above). 

Although the products typically identify with structured credit seem extensive and often confusing, reflecting the numerous underlyings that are possible bonds, loans, credit default swaps, and so on versus CBOs, CLOs, CSOs, and so on. They all achieve a very similar value proposition they are vehicles to pool and redistribute risk. In many ways, all these products are best classified as derivative instruments given that they... 

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