Fortin Bank and Trust (Fortin) is a US commercial bank located in Brandywine, Pennsylvania. Fortin’s credit portfolio includes loans to both consumers and businesses and investments in debt instruments, such as corporate bonds. Thad Haas (chief executive officer), Bob Cane (chief lending officer), and Joe Haggerty (chief credit risk officer) are meeting to discuss Fortin’s credit policy in preparation for the bank’s annual credit review with banking regulators.
Haggerty begins the meeting by stating that Fortin uses various credit risk models to analyze risky loans and bonds. Haggerty illustrates his point by comparing the credit risk measures of three companies, presented in Exhibit 1. The risk-free interest rate is 2.00%.
Exhibit 1. Measures of Credit Risk For One Year, $1,000 Par Value, Zero-Coupon Bonds of Three Companies
| Company | Default Intensity | Loss Given Default | Present Value Expected Loss | Credit Ratings (Moody’s) |
|---|---|---|---|---|
| Eagle Manufacturing | 3.00% | 60.00% | $17.50 | Ba1 |
| Ithica Distribution | 3.25% | 75.00% | $23.60 | Ba2 |
| Bartram Chemical | 3.50% | 40.00% | $13.60 | Ba3 |
Haas examines Exhibit 1 and asks Haggerty to explain why the order of the rankings for “Credit Ratings” and “Loss Given Default” appear to be inconsistent with each other. Haggerty explains that these two measures do not provide comparable indications of credit risk. He states that credit ratings provide a single statistic that summarizes borrowers’ creditworthiness, while default intensity and loss given default are components of reduced form credit risk models. Haggerty makes the following statements:
| Statement 1: | Credit scores explicitly depend on current economic conditions. |
| Statement 2: | Credit ratings tend to be stable over time and across the business cycle. |
| Statement 3: | Credit ratings and credit scoring each provide an estimate of default probability. |
Cane tells Haas that structural models incorporate and apply options theory to a company’s assets and liabilities. To illustrate, Cane compiles a simplified pro-forma balance sheet one forward for Ithica Distribution (“Ithica”) as seen in Exhibit 2:
Exhibit 2.Pro-Forma Balance Sheet of Ithica Distribution ($ millions)
| Current Assets | 50 | Debt (Face Value) | 50 |
| Fixed Assets | 50 | Equity | 50 |
| Total Assets | 100 | Total Debt + Equity | 100 |
Cane explains that the value of Ithica’s assets ultimately determines whether the company’s shareholders will repay or default on its debt. From the perspective of an equityholder, and because of limited liability, Ithica’s equity is economically equivalent to the payoff of a long call option (European style) on Ithica’s assets (call strike equal to the debt amount). From the perspective of a lender, Ithica’s debt is economically equivalent to the payoff of a risk-free bond (equal to the debt amount) and a short put option (European Style) on Ithica’s assets (put strike equal to the risk-free bond).
Haas reminds Cane and Haggerty that the banking regulators were critical of Fortin during last year’s regulatory credit review. The banking regulator’s specific criticisms included the following:
| Criticism 1: | Fortin’s credit risk models do not consistently reflect changes in the business cycle. |
| Criticism 2: | Fortin should ensure that its credit models focus on using historical data as model inputs. |
| Criticism 3: | Fortin places excessive reliance on the borrower’s balance sheet assets for which a market value is not readily available. |
Haggerty promises to prepare a report addressing the banking regulators’ criticisms noted above. The discussion turns to the term structure of credit spreads. Haggerty states that the term structure of credit spreads is a measure for calculating credit loss inferred from credit spreads. Fortin uses the credit spread to estimate the potential loss caused by credit risk on a loan or bond issued by any particular company. To illustrate, in Exhibit 3 he provides credit spread information for a $1,000 par, 3-year, and 7.50% fixed-coupon bond issued by Howard 382 Corp.
Exhibit 3.Credit Spread Information for Howard 382 Corp Bond
| Payment in Year | Yield for Risk-Free | Credit Spread | Yield for Note | Discount Factor Risk-Free | Discount Factor Note |
| 1 | 2.00% | 3.25% | 5.25% | 0.98039 | 0.95012 |
| 2 | 2.50% | 4.00% | 6.50% | 0.95181 | 0.88166 |
| 3 | 3.00% | 4.50% | 7.50% | 0.91514 | 0.80496 |
Haas states that he understands that asset-backed securities (ABS) and corporate debt are similar to the extent that both are rated by the credit rating agencies. Haggerty acknowledges this similarity but cautions that the credit rating scale for corporate debt may not be appropriate for ABS because of the complex nature of the waterfall for an ABS. Accordingly, Haggerty states that any interest payment default within the pool of securitized assets will trigger a default in the ABS senior bond tranche.