Deck 11: Credit Risk: Individual Loan Risk

Question 1

11-9 The amount of security or collateral on a loan and the interest rate or risk premium on a loan normally are negatively related.

Answer 1

True

Question 2

11-2 Junk bonds are bonds that are rated less than investment grade by bond-rating agencies.

Answer 2

True

Question 3

11-12 Long-term loans are more likely to be made under a loan commitment agreement than short-term loans.

Answer 3

False

Question 4

11-19 Because they are secured by homes,residential mortgages have demonstrated very little credit risk for FIs.

Question 5

11-11 The exact interest rate to be charged on a fixed-rate loan is agreed upon by all parties at the time the commitment is negotiated.

Question 6

11-7 A secured loan has a specific claim to the assets of the borrower in the case of default.

Question 7

11-15 Commercial loans have bee decreasing in importance in bank loan portfolios.

Question 8

11-3 During the decade of the 1990s the asset quality of U.S.banks continued to improve.

Question 9

11-20 Adjustable rate mortgages have interest rates that adjust periodically according to the movement in some index.

Question 10

11-10 A loan commitment is an agreement involving the amount of loan available and the amount of time during which the loan can be initiated.

Question 11

11-5 Credit risk applies only to bond investment and loan portfolios of FIs and banks.

Question 12

11-16 Commercial real estate mortgages have been the fastest growing component of real estate loans.

Question 13

11-18 Since their introduction,the proportion of ARMs to fixed-rate residential mortgages has remained very stable over interest rate cycles.

Question 14

11-4 Sustained credit quality problems can drain an FI's capital and net worth.

Question 15

11-17 Residential mortgages are the smallest component of bank real estate loan portfolios.

Question 16

11-8 Unsecured debt is considered to be senior to secured debt.

Question 17

11-1 Default by a large corporation is seldom a problem for FIs since these corporations have many different sources of borrowed funds.

Question 18

11-6 The primary difficulty in arranging a syndicated loan is having all of the various lending and borrowing parties reach agreement on terms,rates,and collateral.

Question 19

11-14 Commercial paper typically is secured by specific assets of the borrower.

Question 20

11-13 Commercial paper has become an acceptable substitute source for bank loans for all corporations.

Question 21

11-29 There is a positive relationship between the interest rate charged on a retail loan and the expected return on the loan.

Question 22

11-34 Willingness to post collateral may be a signal of more rather than less credit risk on the part of the borrower.

Question 23

11-39 The risk premium,or spread,between corporate bonds and Treasury securities tends to increase as the time to maturity increases.

Question 24

11-22 Relationship pricing involves pricing for specific services which depend,in part,on the amount or number of services that are used by the customer.

Question 25

11-32 The amount of leverage of a borrower and the probability of default are positively related,but only after some minimum level of debt.

Question 26

11-27 Credit rationing is a form of managing credit risk.

Question 27

11-23 LIBOR,the London Interbank Offered Rate,is the rate for short-term interbank dollar loans in the domestic money-center bank market.

Question 28

11-35 Credit scoring models are advantageous because of their ability to sort borrowers into different default risk classes.

Question 29

11-31 A borrower's reputation is an example of a market-specific factor in the credit decision.

Question 30

11-26 At some point,further increases in interest rates on specific loans may decrease expected loan returns because of increased probability of default by the borrower.

Question 31

11-21 Usury ceilings are maximum rates imposed by federal legislation that FIs can charge on consumer and mortgage debt.

Question 32

11-30 Covenants are restrictions in loan and bond agreements that encourage or forbid certain actions by the borrower.

Question 33

11-36 A major advantage of discriminant models is the stability of the coefficient weights over time.

Question 34

11-33 Recessionary phases in the business cycle typically cause greater hardship on companies that borrow large amounts.

Question 35

11-40 The probability that a borrower would default in any specific time period is a marginal default probability.

Question 36

11-37 Discriminant models often ignore hard-to-quantify factors in the credit decision.

Question 37

11-24 Because a compensating balance is the proportion of a loan that must be kept on deposit at the lending institution,the actual interest rate on the usable portion of these loans is higher.

Question 38

11-25 Adjusting interest rates,fees,and other terms upward for increasing amounts of default risk is a way to attempt to realize the expected return on the loan.

Question 39

11-38 In terms of rating agencies such as S&P,investment grade companies are those whose bond ratings are grade B or above.

Question 40

11-28 Generally,at the retail level,an FI controls credit risks solely by using a range of interest rates or prices and not by credit rationing.

Question 41

11-41 The cumulative default probability of a borrower in a given time period is one minus the product of the marginal default probabilities for all time periods up to that time period.

Question 42

11-54 Which of the following observations concerning floating-rate loans is NOT true?

A)They are less credit risky than fixed-rate loans.
B)They better enable FIs to hedge the cost of rising interest rates on liabilities.
C)They pass the risk of interest rate changes onto borrowers.
D)In rising interest rate environments,borrowers may find themselves unable to pay the interest on their floating-rate loans.
E)The loan rate can be periodically adjusted according to a formula.

Question 43

11-52 From the perspective of an FI,which of the following is an advantage of a floating-rate loan?

A)Stable interest payments will be received throughout the loan period.
B)The pre-specified interest rate remains in force over the loan contract period no matter what happens to market rate.
C)The bank can request repayment of a loan at any time in the contract period.
D)The default risk is completely eliminated.
E)The interest rate risk is transferred to the borrower.

Question 44

11-44 The marginal mortality rate is the probability of a bond or loan defaulting in any given year of the issue.

Question 45

11-42 The condition of no arbitrage profits implies that profits cannot be made without taking some risk.

Question 46

11-50 Which of the following is not a characteristic of a loan commitment?

A)The maximum amount of the loan is negotiated at the time of the loan agreement.
B)The interest rate on fixed-rate loans is determined at the time of the loan takedown.
C)Floating-rate loans transfer the interest rate risk to the borrower.
D)The time period for which the loan is available is negotiated at the time of the loan agreement.
E)In a floating-rate loan the borrower pays interest rate in force when the loan is actually taken down.

Question 47

11-57 Which of the following is NOT characteristic of the consumer loans at U.S.banks?

A)Non revolving consumer loans is the largest class of loans.
B)Credit card loans often have default rates between four and eight percent.
C)Usury ceilings affect the rate structure for consumer loans.
D)Consumer loans differ widely with respect to collateral,rates,maturity,and noninterest fees.
E)Revolving consumer loans include new and used automobile loans,mobile home loans,and fixed-term consumer loans.

Question 48

11-46 The payoff function of a loan to a debt holder is similar to writing a call option on the value of the borrower's assets with the face value of the debt as the exercise price.

Question 49

11-58 Revolving loans are credit lines

A)that allow the borrower to borrow the repeat credit only after the first loan is repaid.
B)that specify a maximum size and a maximum period of time over which the borrower can withdraw funds.
C)whose interest rate adjusts with movements in an underlying market index interest rate.
D)on which a borrower can both draw and repay many times over the life of the loan contract.
E)that include new and used automobile loans,mobile home loans,and fixed-term consumer loans.

Question 50

11-49 The traditional duration equation can be used to measure the capital at risk on the loan.

Question 51

11-55 Which of the following is true of commercial paper?

A)It is a secured long-term debt instrument issued by corporations.
B)It is always issued via an underwriter.
C)It may help a corporation to raise funds often at rates below those banks charge.
D)All corporations can tap the commercial paper market.
E)Total commercial paper outstanding in the US is very small compared with C&I loans.

Question 52

11-51 Which of the following observations is true of a spot loan?

A)It involves a maximum size and a maximum period of time over which the borrower can withdraw funds.
B)It involves immediate withdrawal of the entire loan amount by the borrower.
C)It is an unsecured short-term debt instrument issued by corporations.
D)It is a nonbank loan substitute.
E)It is a line of credit.

Question 53

11-59 Which of the following factors may affect the promised return an FI receives on a loan?

A)The collateral backing of the loan.
B)Fees relating to the loan.
C)The interest rate on the loan.
D)The credit risk premium on the loan.
E)All of the above.

Question 54

11-47 RAROC is a measure of a firm's cost of debt.

Question 55

11-45 One of the problems with estimating expected default rates is that the analysis is based on historic data.

Question 56

11-48 A major problem in estimating RAROC is the measurement of loan risk.

Question 57

11-56 Which of the following is NOT characteristic of the real estate portfolio for most banks?

A)Commercial real estate mortgages have been the fastest growing component of real estate loans.
B)Adjustable rate mortgages have rates that are periodically adjusted to some index.
C)Borrowers prefer fixed-rate loans to ARMs during periods of high interest rates.
D)Residential mortgages are the largest component of the real estate loan portfolio.
E)The proportion of ARMs to fixed-rate mortgages can vary considerably over the rate cycle.

Question 58

11-43 The mortality rate is the past default experience of all asset quality,or risk,classes.

Question 59

11-53 All other things equal,longer term loans are more likely to be

A)variable-rate loans.
B)fixed-rate loans.
C)commitment loans.
D)lowest risk category loans.
E)high interest rate loans.

Question 60

11-60 Which of the following is not a qualitative factor in credit risk analysis?

A)Borrower reputation.
B)Borrower ethnic origin.
C)Leverage position of the borrower.
D)The level of interest rates.
E)Collateral available.

Question 61

11-74 Which of the following is the major weakness of the linear probability model?

A)Based on market expectations.
B)Measurement of the loan risk is difficult.
C)Estimated probabilities of default may lie outside the interval 0 to 1.
D)Neither the market value of a firm's assets nor the volatility of the firm's assets is directly observed.
E)Answers A and D only.

Question 62

11-81 What is the essential idea behind RAROC?

A)Evaluating the actual or contractually promised annual ROA on a loan.
B)Analyzing historic or past default risk experience.
C)Balancing expected interest and fee income less the cost of funds against the loan's expected risk.
D)Extracting expected default rates from the current term structure of interest rates.
E)Dividing net interest and fees by the amount lent.

Question 63

11-69 In making credit decisions,the following item is considered a market-specific factor.

A)Whether the borrower's capital structure is beyond the point where additional debt increases the probability of loss of principal or interest.
B)Whether the relative level of interest rates will encourage the borrower to take excessive risks.
C)Whether property can be pledged as collateral.
D)Whether the volatility of earnings could present a period where the periodic payment of interest and principal would be at risk.
E)Whether the record of the borrower is sufficient to create an implicit contract.

Question 64

11-70 Borrower reputation is important in assessing credit quality because

A)good past payment performance perfectly predicts future behavior.
B)preservation of a good customer/FI relationship acts as an additional incentive to encourage loan repayment.
C)FIs only lend to customers they know.
D)customers with poor credit histories always default on their loans.
E)a reputation for honesty is important in credit appraisal.

Question 65

11-66 What refers to the risk that the borrower is unable or unwilling to fulfill the terms promised under the loan contract?

A)Liquidity risk.
B)Interest rate risk.
C)Sovereign risk.
D)Default risk.
E)Solvency risk.

Question 66

11-73 Suppose that debt-equity ratio (D/E)and the sales-asset ratio (S/A)were two factors influencing the past default behavior of borrowers.Based on past default (repayment)experience,the linear probability model is estimated as: PDi = 0.5(D/Ei)+ 0.1(S/Ai).If a prospective borrower has a debt-equity ratio of 0.4 and sales-asset ratio of 1.8,the expected probability of default is

A)0.02.
B)0.35.
C)0.38.
D)0.62.
E)0.98.

Question 67

11-63 Credit rationing by an FI

A)involves restricting the quantity of loans made available to individual borrowers.
B)results from a monotonic relationship between interest rates and expected loan returns.
C)is not used by FIs at the retail level.
D)involves rationing consumer loans using price or interest rate differences.
E)is only relevant to banks.

Question 68

11-82 Marginal default probability refers to the

A)probability that a borrower will default over a specified multiyear period.
B)marginal increase in the default probability due to a change in credit premium.
C)historic default rate experience of a bond or loan.
D)expected maximum change in the loan rate due to a change in the credit premium.
E)probability that a borrower will default in any given year.

Question 69

11-67 Which of the following refers to restrictions in loan and bond agreements that encourage or forbid certain actions by the borrower?

A)Mortality rates.
B)RAROC.
C)Implicit contracts.
D)Covenants.
E)Credit rationing.

Question 70

11-76 How can discriminant analysis be used to make credit decisions?

A)By discriminating between good and bad borrowers.
B)By using statistical analysis to predict the default probabilities.
C)By using statistical analysis to isolate and weight factors to arrive at default risk classification of a commercial borrower.
D)By using statistical analysis to bypass qualitative credit decision making.
E)By updating FI bankruptcy experiences.

Question 71

11-71 Which of the following loan applicant characteristics is not relevant in the credit approval decision?

A)Leverage position of the borrower.
B)Borrower income.
C)Value of collateral.
D)Borrower reputation.
E)None of the above.

Question 72

11-80 Confidence Bank has made a loan to Risky Corporation.The loan terms include a default risk-free borrowing rate of 8 percent,a risk premium of 3 percent,an origination fee of 0.1875 percent,and a 9 percent compensating balance requirement.Required reserves at the Fed are 6 percent.What is the expected or promised gross return on the loan?

A)11.19 percent.
B)11.90 percent.
C)12.29 percent.
D)12.02 percent.
E)12.22 percent.

Question 73

11-65 In making credit decisions,the following item is considered a market-specific factor.

A)Whether the reputation of the borrower enhances the credit application.
B)Whether the current debt-equity ratio is sufficiently low to not impact the probability of repayment.
C)Whether the debt can be secured by specific property.
D)Whether the position of the economy in the business cycle phase would affect the probability of borrower default.
E)Whether the volatility of earnings could present a period where the periodic payment of interest and principal would be at risk.

Question 74

11-78 What is the least important factor determining bankruptcy,according to the Altman Z?score model?

A)Working capital to assets ratio
B)Retained earnings to assets ratio
C)Earnings before interest and taxes to assets ratio
D)Market value of equity to book value of long-term debt ratio
E)Sales to assets ratio

Question 75

11-75 According to Altman's credit scoring model,which of the following Z scores would indicate a low default risk firm?

A)Less than 1.
B)1.
C)Between 1 and 1.81.
D)Between 1.81 and 2.99.
E)Greater than 2.99.

Question 76

11-64 Which of the following statements does not reflect a borrower-specific factor often used in qualitative default risk models?

A)Reputation is an implicit contract regarding borrowing and repayment that extends beyond the formal explicit legal contract.
B)A borrower's leverage ratio is positively related to the probability of default over all levels of debt.
C)Firms with high earnings variance are less attractive credit risks than those firms that have a history of stable earnings.
D)Loans can be collateralized or uncollateralized.
E)Reputation is a key reason why initial public offering of debt securities by small firms have a higher interest rate than do debt issues of more seasoned borrowers.

Question 77

11-77 What is the most important factor determining bankruptcy,according to the Altman Z?score model?

A)Working capital to assets ratio.
B)Retained earnings to assets ratio.
C)Earnings before interest and taxes to assets ratio.
D)Market value of equity to book value of long-term debt ratio.
E)Sales to assets ratio.

Question 78

11-72 Which of the following is true of the prime lending rate?

A)It is most commonly used in pricing longer-term loans.
B)It is the lending rate charged to the FI's lowest-risk customers.
C)It is also known as LIBOR.
D)It is the rate for interbank dollar loans of a given maturity in the Eurodollar market.
E)The best and largest borrowers commonly pay above this lending rate.

Question 79

11-68 Credit scoring models include all of the following broad types of models EXCEPT

A)Linear discriminant models.
B)Linear probability models.
C)Term structure models.
D)Logit models.
E)More than one of the above is correct.

Question 80

11-79 Which of the following is a problem in using discriminant analysis to evaluate credit risk?

A)It does not consider gradations of default.
B)The weights in the discriminant function are assumed to be dynamic.
C)It can include hard-to-quantify factors.
D)Data on loan specific information of banks are readily available.
E)It does not assume that variables are independent of one another.