CREDIT RISK - INDIVIDUAL LOAN

As a senior loan officer at AM Bancorp, you have the following loan applications waiting for review.The bank uses Altman's Z score, default probabilities, mortality rates, and RAROC to assess loan acceptability The bank's cost of equity (the RAROC benchmark) is 9 percent.The bank's loan policy states that the maximum probability of default for loans by type is as follows:

___________________________________________________________________

Loan Type and MaturityMaximum Allowable Default Probability

AAA-rated0.50%

A-rated1.25

___________________________________________________________________

Which loans should be approved and which rejected?

1.A AAA-rated, one-year C&I loan from a firm with a liquidity ratio of 2.15, a debt-to-asset ratio of 45 percent, volatility in earnings of 0.13, and a profit margin of 12 percent.AM Bancorp uses a linear probability model to evaluate AAA-rated loans as follows:

PD = -0.08X1 + 0.15X2 + 1.25X3 -0.45X4

Where

X1 = Liquidity ratio

X2 = Debt-to-asset ratio

X3 = Volatility in earnings

X4 = Profit margin

2.An AA-rated, one year C&I loan from a firm with the following financial statement information (in millions of dollars):

_____________________________________________________________________

AssetsLiabilities and Equity

_____________________________________________________________________

Cash$40Accounts payable$55

Accounts receivable 120Notes payabl60

Inventory210Accruals70

Long-term debt550

Plant and equipment 1,100Equity (ret. Earnings=$200)735

Total assets$1,470Total liabilities and equity$1,470

____________________________________________________________________

Also assume sales = $1,250m, cost of goods sold=$930m, and the market value of equity is equal to 2.2 times the book value.AM Bancorp uses the Altman's Z score model to evaluate AA-rated loans.

3.An A-rated corporate loan with a maturity of three years.A-rated corporate

loans are evaluated using the maturity rate approach.A schedule of historical defaults (annual and cumulative) experienced by the bank on its A-rated corporate loans is as follows:

________________________________________________________________________Years of issuance

__________________________________________

Loan type1-year 2 years3 years4 years

A-rated corporate loans

Annual default0.10%0.25%0.40%0.65%

Cumulative default0.100.3250.5951.858

4.A $2 million, five-year loan to a BBB-rated corporation in the computer parts industry.AM Bancorp charges a servicing fee of 75 basis points.The duration on the loan is 4.5 years.The cost of funds for the bank (the RAROC benchmark) is 8 percent.Based on four years of historical data, the bank has estimated the maximum change in the risk premium on the computer parts industry to be approximately 5.3 percent.The current market rate for loans in this industry is 10 percent.