11. To diversify the loan portfolio => Use retail (countercyclical) and hotel (cyclical) to lower risks Within the USA the diversification is limited (high correlation) but it’s interested to invest worldwide
12. Tools for the loan portfolio management 1 is the most important tool !!
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Editor's Notes
Well I am going to present you how banks access credit risks and optimize their profitability in the practical example of commercial real estate financing. Commercial real estate is composed of offices, retail centers, hotels, warehouses.
Companies specialized in real estate of funds invest around 30% of their equity to acquire the buildings and get a loan for the remaining part. They rent them and they use the rents to service the debt. Finally they sell the buildings after a period of time which goes from 3 to 15 years. With that sell, they can repay the entire loan and et get a pretty high return on investment. This is the typical scheme for such a financing. A SPV is created only for the project and owns the assets in its balance sheet, all the rents go to the SPV and serve to pay the debt service. As Cameron told you the SPV allows the investors to secure their other assets in case of default on the loan. Indeed they grant mortgages only on the financed assets. On the contrary, the bank control that all the rents will be used to repay the loan. The financings is consequently only base on the profitability of the investment. It transforms the counterparty risk, which is the risk that investors will not pay, in a risk on the assets and the cash flows they provide.
First as you can see the most used profitability measure in a bank is the RAROC. This is a measure of risk-adjusted profitability. Its formula is composed of the expected revenues of a transaction reduced by the expected loss. Then it is divided by the risk capital that needs to be hold to secure survival in a worst case scenario.
As you have seen they need to asses credit risks in order to know the expected loss, economic capital of a financing and its profitability. There are four main elements to assess it: the default probability (degree of likelihood that the borrower will not pay), the exposure at default (expected drawn amount at the default), the loss given default (fraction of the exposure at default that will not be recovered following a default) and the average weighted remaining maturity (duration) First I am going to focus on default probability, and then I am going to present the loss given default.
Having a good collateral (high value, liquid…) is highly important for transactions with low risks. Indeed it makes the RAROC significantly increase. After A and BBB, the expected loss increase so quickly that their impact offset the good collaterals. The most important for you is to see the differences of profitability according to different levels of PD and LGD.
To determinate the default probability, bankers have to rate the financing and assess the following risks. The market risk is the risk that the value of the investment will decrease due to moves in market factors. Therefore bankers have to evaluate the supply/ demand balance, make some projections on the rents and prices of the buildings. They also have to judge the future liquidity of those assets. The assets also carry some asset risks. Indeed the credit analysts have to take into account the type, (office, retail center…), location, shape, value and the rental situation of the buildings. The latter includes an analysis of its vacancy, the quality and diversity of its tenants as well as the rents level comparing to market rents.
Other main sources of risks are the financing risks. Actually, analysts have to consider the subordination. If the financing includes subordinated and mezzanine tranches, it will be more risky because those tranches are paid after senior tranches in the waterfall (ranking) of payments. And the more the default correlation between tranches increases the more the value in time to market of subordinated tranches increase at the expense of senior tranches. Then, the leverage of the financing is highly important. It is measured by the loan to value ratio which is the amount of the loan divided by the value of the assets. The more important the leverage is the more risky the financing is. Afterwards, the amortizing process is also highly important because it determinates the duration of the financing and the evolution of the leverage. Indeed the financing can be bullet, interest only or linearly repaid. The last LTV ratio is also an extremely important factor of the refinancing risk. This is the possibility that a borrower cannot refinance by borrowing to repay existing debt . Usually, analysts run base and stress cases to see if the debt service coverage ratio and interest coverage ratios respect the covenants. The more the cash flows are predictable the less risky the financing is. And in order to add some liquidity and flexibility, bankers add cash reserve and cash sweep mechanisms (prepay of the loan in case of excess cash and if covenants are not meet) Finally, country risks can be also important and change the business environment, adversely affect operating profits or the value of assets in a specific country. Some factors are the currency rate, regulatory changes, mass riots, civil war and so on. Counterparties risks have been underestimated before the crisis but the bankruptcy of Lehman made us aware the importance of such risks. With all those risks we can rate the financing, and define the default probability by the means if a rating migration table such as this table.
The default probability is represented by D. You can see than the AAA rating is very likely to remain AAA and the default probability for such rating is very low.
Now I am going to assess the loss given default. It depends on the subordination and the collaterals. Indeed, analysts have to consider if the assets are office, retail centers, …. and if they are diversified and liquid. Moreover, the country of the assets matter because some country are favorable to lenders in case of default such as United Kingdom. On the contrary Italy has very low recovery rates. Furthermore, you can see that LGD and PD are cyclical and correlated and haircut to the collateral value should also be cyclical.
Now I am going to present you how to optimize the RAROC of a portfolio of loans. Bankers need to focus on liquid assets in attractive locations with experienced asset managers. They also need to focus on short duration with limited Loan to value and significant amortization. It is also good to focus on stable revenues and increasing solvability ratios to make increase their rating. The origination-distribution model used to be highly profitable especially because the weight of fees increased. The underwritings were followed by distribution of the less profitable tranches and deals in terms of RAROC. Finally, it is important to diversify the portfolio with low correlations between countries, asset types and investment strategies of the sponsors (more aggressive or prudent). But they really need to target clients and markets with high potential of selling and cross selling.
To diversify a portfolio, we need to use assets with low or negative correlation. Indeed It makes reduce the volatility of the portfolio. As you can see, within the USA the diversification is limited (high correlation) but it’s interested to invest worldwide. And it is highly interesting to mix retail centers which are countercyclical with hotel which are highly cyclical in order to reduce the risks.
First syndication is the process of reducing large loan s risks by sharing the risks with a group of banks which provide funds. Then securitization is the process of pooling and repackaging the cash flow s produced by assets into securities that are then sold to investors. As you can see, the most used tool for the portfolio management is just the approval of disapproval of new loans. Then the syndication is also widely use and finally portfolio managers use credit derivatives and securitization. Within the derivatives, Credit Default Swaps are the most used with 73% of market share.