Deck 10: Credit Risk: Individual Loan Risk

Question 1

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

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.

Answer 2

False

Question 3

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

Answer 3

False

Question 4

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 5

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

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

Question 7

Commercial paper has become an acceptable substitute source for bank loans for many large corporations.

Question 8

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

Question 9

Commercial loans have been decreasing in importance in bank loan portfolios.

Question 10

Unsecured debt is considered to be senior to secured debt.

Question 11

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

Question 12

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

Question 13

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

Question 14

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

Question 15

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

Question 16

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

Question 17

Credit risk applies only to bond investment and loan portfolios of depository institutions and other FIs.

Question 18

Residential mortgages are a relatively small component of bank real estate loan portfolios.

Question 19

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

Question 20

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

Question 21

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 22

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

Question 23

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

Question 24

Usury ceilings are maximum interest rates imposed by federal legislation that FIs are allowed to charge on consumer and mortgage debt.

Question 25

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

Question 26

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

Question 27

Because a compensating balance is the proportion of a loan that must be kept on deposit at the lending institution,the actual return to the lender on the usable portion of these loans is higher.

Question 28

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

Question 29

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 30

Because of compensating balances and fees used to increase return on a loan,the credit risk premium is not the fundamental factor driving the promised return once the base rate on the loan has been set.

Question 31

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

Question 32

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

Question 33

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

Question 34

Credit rationing is a form of managing credit risk.

Question 35

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 36

A major advantage of discriminant models to assess the credit risk of a customer is the stability of the coefficient weights over time.

Question 37

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 38

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

Question 39

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

Question 40

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

Question 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

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.

Question 43

Risk-adjusted return on capital (RAROC)models serve as both a credit risk measure and a pricing tool for a loan officer.

Question 44

Equity holders of a levered corporation have no incentive to invest the borrowed funds in risky capital investments.

Question 45

The traditional duration equation can be used to measure the capital at risk of a loan.

Question 46

RAROC (Risk-adjusted return on capital)is a measure of a firm's cost of debt.

Question 47

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

Question 48

A major difficulty in estimating RAROC for a loan is the measurement of individual loan risk.

Question 49

The debt holders a corporation essentially hold a call option on the value of the firm's assets.

Question 50

The probability that a borrower would default in any specific time period is the marginal default probability.

Question 51

The mortality rate measures the past default experience of all loans,regardless of quality.

Question 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 interest rates.
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 53

One of the weaknesses of estimating expected default rates is that the analysis is based on historic data.

Question 54

The marginal mortality rate is the probability of a bond or loan defaulting in any given year after it is issued.

Question 55

Simulations conducted by Moody's Analytics have shown that expected default frequency (EDF)models outperform Z-score type models in predicting borrower failure or financial distress.

Question 56

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 57

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.

Question 58

According to option pricing models of credit risk and default,the debt holders of a corporation may have to accept assets which have a value less than the face value of the debt.

Question 59

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

A)They have less credit risk 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.

Question 60

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 is actually taken down.
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.

Question 61

Which of the following statements involving the promised return on a loan is NOT true?

A)Credit risk may be the most important factor affecting the return on a loan.
B)Compensating balances reduce the effective cost of loans for the borrower because the deposit interest rate is typically greater than the loan rate.
C)Compensating balances represents the portion of the loan that must be kept on deposit at the bank.
D)Compensating balance requirements provide an additional source of return for the lending institution.

Question 62

Credit rationing by an FI

A)involves restricting the quantity of loans made available to individual borrowers.
B)results from a positive linear 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.

Question 63

Which of the following statements does NOT reflect credit decisions at the retail level?

A)Loans to retail customers are more likely to be rationed through interest rates than loan quantity restrictions.
B)Most loan decisions at the retail level tend to be accept or reject decisions.
C)Mortgage loans often are discriminated based on loan to price ratios rather than interest rates.
D)Household borrowers require higher costs of information collection for lenders.

Question 64

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.

Question 65

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.

Question 66

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 options.

Question 67

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 68

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 options.

Question 69

In making credit decisions,which of the following items 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.

Question 70

In making credit decisions,which of the following items 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.

Question 71

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.

Question 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.

Question 73

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.

Question 74

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.

Question 75

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.

Question 76

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: PD_i = 0.5(D/E_i)+ 0.1(S/A_i).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.

Question 77

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.

Question 78

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.

Question 79

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.

Question 80

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.