Average Credit Quality Research Articles

Who Borrows? Firm Performance Predictability of Bank Lending Decisions to Small Firms

We investigate two questions: (1) Do bank lending decisions to small and medium-sized firms provide information about these fi rms' future fi nancial performance? (2) Does this predictability vary across different stages of the credit cycle? Based on a unique, detailed data set of all Norwegian firms' bank accounts and financial statements, the answer to both questions is yes. Competing 'outside' bank lenders lend to fi rms who subsequently perform worse than other borrowers, and this relationship is primarily present in the expansionary stages of the credit cycle. This suggests that a fi rm's current bank lender has private information about its borrowers, while 'outsider' banks face a winner's curse when approached by new loan applicants. The fi nding that this primarily occurs in credit cycle expansions is consistent with theory models that predict that banks reduce screening of new borrowers in these periods, leading to lower average credit quality of bank borrowers when growth in aggregate credit is high.

What Does a Mutual Fund’s Term Tell Investors?

In a previous article, we highlighted a flaw in the average credit quality statistic frequently reported by bond mutual funds. That statistic understates the credit risk in bond portfolios if the portfolios contain bonds of disperse credit ratings. We explained that portfolio managers wanting to increase their yields could adjust their holdings to increase the credit risk investors were exposed to without increasing the risk signaled by the average credit quality statistic. In this article we address a similar problem with bond mutual funds’ reporting of the average term of their portfolios. The somewhat ambiguous nature of this statistic provides an opportunity for portfolio managers to significantly increase the funds’ risks, credit risk in particular, by holding very long-term bonds while claiming to expose investors to only the risks of very short-term bonds. <b>TOPICS:</b>Statistical methods, portfolio construction, credit risk management

The Effects of Formal and Informal Contracting in Credit Availability

This paper investigates how the use of collateral (formal contracting), along with the market power of banks (which facilitates relational contracts), affects the availability of credit for business firms. Using loan data from the Spanish Credit Register, we show that the average credit quality of borrowers in a provincial market decreases with market concentration and the availability of collateral. Additionally, the marginal effect of each variable decreases with the higher values of the other variable. We also find that credit line interest rates increase with the availability of collateral, although the increase is lower for banks operating in more concentrated credit markets. Therefore, market power (relations) and collateral (formal contracting) act as substitutes to increase the availability of bank finance under asymmetric information.

What Does a Mutual Fund’s Average Credit Quality Tell Investors?

Managers of bond mutual funds frequently report an “Average Credit Quality” statistic in their marketing materials. This statistic is based on Standard &amp; Poor’s and Moody’s assessment of the credit risk of the individual bonds in the portfolio and is reported to mutual fund investors using the familiar letter scale for rating the credit risk of bonds. However, the Average Credit Quality statistic as typically calculated by the mutual fund companies and by Morningstar significantly overstates mutual funds’ true credit quality. Given how this statistic is calculated, portfolio managers can easily manipulate their holdings to significantly increase their credit risk and thereby their yield without increasing their <i>reported</i> credit risk. Since bond fund managers compete for investors based on yield and risk, fund managers who report Average Credit Quality have the ability and the incentive to increase but underreport the credit risk in their bond mutual fund portfolios. In this note, the authors explain the methodological flaw in the way Average Credit Quality statistics are calculated and provide simple examples of its systematic understatement in credit risk. <b>TOPICS:</b>Credit risk management, fixed-income portfolio management, statistical methods

The Role of the Securitization Process in the Expansion of Subprime Credit

We analyze the structure and attributes of subprime mortgage-backed securitization deals originated between 1997 and 2007. Our data set allows us to link loan-level data for over 6.7 million subprime loans to the securitization deals into which the loans were sold. We show that the securitization process, including the assignment of credit ratings, provided incentives for securitizing banks to purchase loans of poor credit quality in areas with high rates of house price appreciation. Increased demand from the secondary mortgage market for these types of loans appears to have facilitated easier credit in the primary mortgage market. To test this hypothesis, we identify an event which represents an external shock to the relative demand for subprime mortgages in the secondary market. We show that following the SEC&amp;amp;#x27;s adoption of rules reducing capital requirements on certain broker dealers in 2004, five large deal underwriters disproportionately increased their purchasing activity relative to competing underwriters in ZIP codes with the highest realized rates of house price appreciation but lower average credit quality. We show that these loans subsequently defaulted at marginally higher rates. Finally, using the event as an instrument, we demonstrate a causal link between the demand for mortgages in the secondary mortgage market and the supply of subprime credit in the primary mortgage market.

What was Wrong with Credit Ratings for Securitizations? - Evidence from ABS, CDO and MBS Markets

This paper compares and analyzes cross-sectional and time-series characteristics of credit rating agency (CRA) ratings, implied impairment rate estimates and realized impairment rates of asset portfolio securitizations. This is of highest importance as past shortcomings may have been instrumental to past, current and possibly future loss rates of financial institutions in relation to securitizations. The disappointment of investors manifested in the criticism of models applied by CRAs. Examples are VECTOR from Fitch, CDOROM from Moody's and CDO Evaluator from Standard and Poor's. Our most substantial finding is that rating agencies do not include all factors explaining securitization impairment risk. In particular, the state of the economy is not addressed as CRAs average over the business cycle. The results are threefold. Firstly, CRA ratings are unable to predict impairment risk. Secondly, CRA ratings over-predict impairment risk in boom years and under-predict impairment risk during economic downturns. Thirdly, the recent deterioration CRA rating standards can not be confirmed and may be a result of an economic downturn which was not predicted by CRA ratings. Additional results are that CRA ratings for securitizations do not fully account for the average credit quality in asset portfolios and do not fully account for structural elements of structured finance transactions. Such elements include the subordination level, the resecuritization status and principal payment years. The inclusion of missing information, in particular the impact of the economy, is paramount to a sound measurement and management of impairment risk. Transparency may increase with the accurate econometric forecasting of such risk. Credibility in internal and external models may not be restored otherwise.

The Role of the Securitization Process in the Expansion of Subprime Credit

We analyze the structure and attributes of subprime mortgage-backed securitization deals originated between 1997 and 2007. Our data set allows us to link loan-level data for over 6.7 million subprime loans to the securitization deals into which the loans were sold. We show that the securitization process, including the assignment of credit ratings, provided incentives for securitizing banks to purchase loans of poor credit quality in areas with high rates of house price appreciation. Increased demand from the secondary mortgage market for these types of loans appears to have facilitated easier credit in the primary mortgage market. To test this hypothesis, we identify an event which represents an external shock to the relative demand for subprime mortgages in the secondary market. We show that following the SEC's adoption of rules reducing capital requirements on certain broker dealers in 2004, five large deal underwriters disproportionately increased their purchasing activity relative to competing underwriters in ZIP codes with the highest realized rates of house price appreciation but lower average credit quality. We show that these loans subsequently defaulted at marginally higher rates. Finally, using the event as an instrument, we demonstrate a causal link between the demand for mortgages in the secondary mortgage market and the supply of subprime credit in the primary mortgage market.

Approximating Correlated Defaults

Modeling defaults is critical to risk management as well as pricing debt portfolios and portfolio derivatives. In the recent financial crisis, multi-billion-dollar losses resulted from correlated defaults that were improperly modeled. This paper proposes statistical approximations which are more general than those used previously, follow from an intensity-based risk-factor model, and allow consistent parameter esti- mation. The parameters imply an approximating portfolio of independent, identical-credit loans and characterize both average credit quality and default-relative diversification (aka the “diversity score”). Unlike previous approaches, these metrics are derived jointly from theory. The approach addresses weaknesses in the typical diversity score-based methods by allowing for fatter tails as well as loans differing in size and credit quality. The approximations may also be used to model complete portfolio default and help set capital adequacy requirements. An example shows how to estimate the approximating portfolio.

The characteristics and evolution of credit default swap trading

This is the first systematic empirical study of the characteristics and the evolution of credit default swap (CDS) trading. We study single name reference entities and find a prevalence of five-year maturities, US$5 million and US$10 million notional amounts, senior-ranked underlying debt and modified restructuring clauses. We find increased trading up to 2003 and an increased ratio of trades to quotes in recent years. A decrease in daily volume since 2004 is likely to be caused by the recent increased use of CDS index-related products. The majority of reference entities have credit ratings from at least one international rating agency, and the average credit quality of the universe fluctuates during the sample period. Trading activity demonstrates an inverse U shape across the week.

Breaking New Boundaries

The innovative Essential Public Infrastructure Capital II (EPIC II) securitization will allow Depfa Bank, the originator and servicer for the transaction, to transfer the credit risk of a pool of PPP infrastructure loans, thereby providing regulatory capital relief, enhancing the bank9s return on equity, broadening the investor base for infrastructure financing paper, and further refining the template for future securitization of infrastructure loans. The EPIC II transaction, like its predecessor EPIC I, is structured as a synthetic, partially funded collateralized loan obligation (CLO). Credit strengths of the transaction include geographic diversity of the loan pool; the role of Kreditanstalt fur Wideraufbrau (KfW) as sponsor, collateral provider, and custodian; satisfactory project asset quality; an early redemption feature; and a structure that insulates investors from interest rate risk. Weaknesses include noteholders9 exposure to the default of reference loans if the first-loss piece is insufficient to cover such default, EPIC II9s ability to replenish the pool of assets in a way that would cause the weighted average credit quality to decrease, the credit risk of transportation assets in the reference pool – generally greater than the credit risk of traditional PPP availability-based projects, the limited source of cash flow for each underlying project, and uncertainty over the timing, costing, and life-cycle requirements for each project. Mitigating factors offsetting those weaknesses include rating agency credit estimates for unrated projects and the senior secured position of credit facilities in the capital structure of each project.

Credit Market Competition, Collateral and Firms' Finance

This paper investigates the relationship between credit market competition and the availability of bank credit for firms of unobserved credit quality when firms pledge collateral to secure the loans. Loan data from the Spanish Credit Register shows that the average credit quality of borrowers that get loans in a provincial market decreases with market concentration (which is shown to be positively correlated with market power) and with the availability of collateral, although the marginal effect of each variable decreases for higher values of the other. We also find that credit lines' interest rates increase with the availability of collateral, but the increase is lower for banks operating in more concentrated credit markets. Therefore market power in credit markets and collateral appear as substitutes to increase the availability of bank finance under asymmetric information.

Credit Market Competition, Collateral and Company Finance

This paper investigates the relationship between credit market competition and the availability of bank credit for firms of unobserved credit quality when firms pledge collateral to secure the loans. Loan data from the Spanish Credit Register shows that the average credit quality of borrowers receiving loans in a provincial market decreases with market concentration (which is shown to be positively correlated with market power) and with the availability of collateral, although the marginal effect of each variable decreases for higher values of the other. We also find that credit lines' interest rates increase with the availability of collateral, but the increase is lower for banks operating in more concentrated credit markets. Therefore market power in credit markets and collateral appear as substitutes to increase the availability of bank finance under asymmetric information.

Predicting Municipal Bond Fund Returns

This article examines municipal bond fund returns from 1991 through 2000. Four predictions of the efficient markets hypothesis are supported. First, among similar-style funds, there is a consistent negative relationship between expense ratios and net returns. Second, on average, a 1% higher expense ratio reduces returns by about 1%. Third, load funds do not provide higher net returns than no-load funds. Fourth, expense ratios consistently predict relative fund returns for one-year through five-year investment horizons. In addition, the authors present multiple regressions for a large sample of funds across fixed-income styles. While the influences of duration, average credit quality, and tax status are time dependent, a lower expense ratio produces a persistent advantage year after year after year.

The Effect of Consumer Interest Rate Deregulation on Credit Card Volumes, Charge-Offs, and the Personal Bankruptcy Rate

The rising level of credit card debt is often cited as one of the factors in the rising U.S. personal bankruptcy rate. Numerous theories have been advanced to explain the increases, including aggressive marketing by credit card issuers and a lack of discipline on the part of consumers. These explanations do not address the underlying reason for these trends. This paper argues that a 1978 Supreme Court decision (Marquette) fundamentally altered the market for credit card loans in a way that significantly expanded the availability of credit and increased the average risk profile of borrowers. Marquette ushered in deregulation of usury ceilings on consumer interest rates by allowing lenders in a state with liberal usury ceilings to export those rates to consumers residing in states with more restrictive usury ceilings. The result was a substantial expansion in credit card availability, a reduction in average credit quality, and a secular increase in personal bankruptcies. The Canadian experience with bankruptcies supports this argument. This paper contends that a tightly regulated world, marked by restricted access to consumer credit and a low level of personal bankruptcies was exchanged for a deregulated world, marked by expanded access to consumer credit and a higher level of personal bankruptcies. This argument implies that a return to the bankruptcy rates and charge-off levels that prevailed in the early 1980s or before may be unlikely.