Credit & Debt
Credit Risk
- Credit risk is the possibility of losing a lender takes on due to the possibility of a borrower not paying back a loan.
- Consumer credit risk can be measured by the five Cs: credit history, capacity to repay, capital, the loan's conditions, and associated collateral.
- Consumers posing higher credit risks usually end up paying higher interest rates on loans.
- If it has a low rating (B or C), the issuer has a high risk of default. Conversely, if it has a high rating (AAA, AA, or A), it's considered to be a safe investment.
https://www.investopedia.com/terms/c/creditrisk.asp
Default Risk
Default risk is the chance that a company or individual will be unable to make the required payments on their debt obligation. Lenders and investors are exposed to default risk in virtually all forms of credit extensions. A higher level of risk leads to a higher required return, and in turn, a higher interest rate.
- A free cash flow figure that is near zero or negative indicates that the company may be having trouble generating the cash necessary to deliver on promised payments, and this could indicate higher default risk.
- Default risk can be gauged using standard measurement tools, including FICO scores for consumer credit, and credit ratings by the likes of S&P and Moody's for corporate and government debt issues
https://www.investopedia.com/terms/d/defaultrisk.asp
Default Rate
- The default rate is the percentage of all outstanding loans that a lender has written off after a prolonged period of missed payments.
- A loan is typically declared in default if payment is 270 days late.
- Defaulted loans are typically written off from an issuer's financial statements and transferred to a collection agency.
- Default rates are an important statistical measure used by economists to assess the overall health of the economy.
- A default record stays on the consumer's credit report for six years, even if the amount is eventually paid.
- Indexes from S&P/Experian include the following:
- The S&P/Experian Consumer Credit Default Composite Index
- The S&P/Experian First Mortgage Default Index
- The S&P/Experian Second Mortgage Default Index
- The S&P/Experian Auto Default Index
- The S&P/Experian Bankcard Default Index
- Bank credit cards tend to have the highest default rate
Delinquency Rate
Delinquency rate refers to the percentage of loans within a financial institution's loan portfolio whose payments are delinquent. When analyzing and investing in loans, the delinquency rate is an important metric to follow; it is easy to find comprehensive statistics on the delinquencies of all types of loans.
Tracking Delinquency Rates
Typically, a lender will not report a loan as being delinquent until the borrower has missed two consecutive payments, after which a lender will report to the credit reporting agencies, or "credit bureaus," that the borrower is 60 days late in his or her payment. If late payments persist, then each month that the borrower is late, the lender may continue reporting the delinquency to the credit agencies for as long as 270 days.
After 270 days of late payments, the code of federal regulations considers any type of federal loan to be in default. Loans between borrowers and private-sector lenders follow individual U.S. state codes that define when a loan is in default. To begin the process of retrieving delinquent payments, lenders generally work with third-party collection agents.
Calculating Delinquency Rates
To calculate a delinquency rate, divide the number of loans that are delinquent by the total number of loans that an institution holds. For example, if there are 1,000 loans in a bank's loan portfolio, and 100 of those loans have delinquent payments of 60 days or more, then the delinquency rate would be 10% (100 divided by 1,000 equals 10%).
https://www.investopedia.com/terms/d/delinquency-rate.asp
Credit Utilization Ratio
The credit utilization ratio is the percentage of a borrower's total available credit that is currently being utilized. The credit utilization ratio is a component used by credit reporting agencies in calculating a borrower's credit score. Lowering the credit utilization ratio can help a borrower to improve their credit score.
https://www.investopedia.com/terms/c/credit-utilization-rate.asp
Triggering Term
A triggering term is a word or phrase that when used in advertising literature requires the presentation of the terms of a credit agreement. Triggering terms are intended to help consumers compare credit and lease offers on a fair and equal basis. Triggering terms are set and monitored by the U.S.Federal Trade Commission (FTC).
https://www.investopedia.com/terms/t/triggering-term.asp
Notching
Notching is the practice by rating agencies to give different credit ratings to obligations of a single entity or closely related entities. Rating distinctions among obligations are made based on differences on their security or priority of claim. With varying degrees of losses in the event of default, obligations are subject to being notched higher or lower.
https://www.investopedia.com/terms/n/notching.asp
Credit Rating Agencies
Both Experian and Equifax rely on a FICO score, which provides a score from 300 to 850 based on an algorithm.
- Experian
- Equifax
- CIBIL
Closed-End Credit
Closed-end credit includes debt instruments that are acquired for a particular purpose and a set amount of time. At the end of a set period, the individual or business must pay the entirety of the loan, including any interest payments or maintenance fees.
Common types of closed-end credit instruments include mortgages and car loans.
Open-End Credit
Open-end credit is not restricted to a specific use or duration. Credit card accounts, home equity lines of credit(HELOC), and debit cards are all common examples of open-end credit (though some, like the HELOC, have finite payback periods). The issuing bank allows the consumer to utilize borrowed funds in exchange for the promise to repay any debt in a timely manner.
Line of Credit
A line of credit is a type of open-end credit. Under a line of credit agreement, the consumer takes out a loan that allows payment for expenses using special checks or, increasingly, a plastic card. The issuing bank agrees to pay on any checks written on or charges against the account, up to a certain sum.
Revolving credit and Line of credit
- A revolving line of credit is a dynamic financial product, as you pay the credit down, you may be offered more credit to spend, especially if you make regular, consistent payments on a revolving credit account.
- A line of credit is a one-time financial arrangement or a static product. When you have spent the set amount of credit, the account is closed.
- Personal loans or loans tailored to a home or automobile may offer better rates, and more security for the borrower, than a line of credit.
- Both revolving credit and credit lines come in unsecured and secured versions.
- Revolving credit or a line of credit both have many of the same risks as credit cards.
Charge-off
A charge-off is a debt, for example on a credit card, that is deemed unlikely to be collected by the creditor because the borrower has become substantially delinquent after a period of time. However, a charge-off does not mean a write-off of the debt entirely.What does having a charge-off mean? For starters, it can mean serious repercussions on your credit and future borrowing ability.
A charge-off usually occurs when the creditor has deemed anoutstanding debt isuncollectible; this typically follows 180 days or six months of non-payment. In addition, debt payments that fall below the required minimum payment for the period will also be charged off if the debtor does not make up for the shortfall. The creditor crosses off the consumer's debt as uncollectible and marks it on the consumer's credit report as a charge-off.
- Charged-off debt does not mean that the consumer does not have to repay the debt anymore.
- After a lender has charged off a debt, it could sell the debt to a third-party collections agency that would attempt to collect on the delinquent account.
- Basically, a consumer owes the debt until it is paid off, settled, discharged in a bankruptcy proceeding, or in case of legal proceedings, becomes too old due to the statute of limitations.
https://www.investopedia.com/terms/c/chargeoff.asp
Roll Rate
In the credit card industry, the roll rate is the percentage of cardholders who become increasingly delinquent on their account balances due. The roll rate is essentially the percentage of card users who "roll" from the 60-days late category to the 90-days late category, or from the 90-days late to the 120-days late category, and so on.
Roll rates are used to estimate financial losses due to future defaults
For example, if 20 out of 100 credit card users who were delinquent after 60 days are still delinquent after 90 days, the 60-to-90 days roll-rate is 100%. Furthermore, if only 10 out of 20 credit card issuers who were delinquent at 60 days are now delinquent at 90 days, the roll rate would be 50%.
Once roll rates are determined, they are applied to the outstanding receivables within each bucket, and the results are aggregated to estimate the required allowance level for credit losses. Financial institutions typically update credit loss provisions in their financial statements quarterly. Credit loss provisions are generally an expense or liability that a bank writes off. Banks have differing methodologies for determining credit loss provisions with typically only a portion of delinquent balances written off in early delinquencies. Banks closely monitor roll rates and credit loss provisions to gauge the risks of borrowers. Roll rates can also help credit issuers to set underwriting standards based on repayment trends for various types of products and different types of borrowers.
https://www.investopedia.com/terms/r/roll-rate.asp
Cure Rate
Cure Rateis a metric used in the context of Non-Performing Loan management and Loss Given Default risk assessment. It denotes the percentage of loans that previously presented arrears (where in delinquency) and, post restructuring, present no arrears.
Given the possibility that acuredcredit asset can relapse into delinquency, (Re-Default Rate) the time horizon over which the cure rate is defined must be explicit. Borrowers that go directly into default without any cure period are said be in Direct Default
Cure of arrears on facilities presenting arrears could take place either
- through forbearance measures of the credit facility (forborne cure) or
- naturally without modification of the original terms of the credit facility (natural cure).
https://www.openriskmanual.org/wiki/Cure_Rate
Loan to value
Theloan-to-value(LTV)ratiois a financial term used by lenders to express the ratio of a loan to the value of an asset purchased. The term is commonly used by banks and building societies to represent the ratio of the first mortgageline as a percentage of the total appraised value of real property. For instance, if someone borrows $130,000 to purchase a house worth $150,000, the LTV ratio is $130,000 to $150,000 or $130,000/$150,000, or 87%. The remaining 13% represent the lender's haircut, adding up to 100% and being covered from the borrower's equity. The higher the LTV ratio, the riskier the loan is for a lender.
The valuation of a property is typically determined by an appraiser, but a better measure is an arms-length transaction between a willing buyer and a willing seller. Typically, banks will utilize the lesser of the appraised value and purchase price if the purchase is "recent" (within 1--2 years).
CLTV - Combined Loan To Value - ratio of all secured loans on a property to the value of a property
https://en.wikipedia.org/wiki/Loan-to-value_ratio
https://www.investopedia.com/terms/l/loantovalue.asp
Cross collateralization
Cross-collateralizationis a term used when the collateral for one loan is also used as collateral for another loan.If a person has borrowed from the same bank a home loan secured by the house, a car loan secured by the car, and so on, these assets can be used as cross-collaterals for all the loans. If the person pays off the car loan and wants to sell the car, the bank may veto the deal because the car is still used to secure the home loan and other loans. Technically, cross-collateralization expires when the borrower has no outstanding loans with the bank. In the context of bankruptcy, cross-collateralization also means the collateralization of general unsecured prepetition debt by collateral securing postpetition loans.
Royalty advances paid by a publisher to authors of multiple books or to creators of multiple video games are often cross-collateralized; in book publishing this is sometimes called "basketing". In this scheme, the publisher pays no royalty checks to the creator until all of the books (or video games, or other works of authorship) have "earned out" their advances.
In the movie industry, cross-collateralize clauses in production deals allow the funding studio to recoup a part of its losses for money losing films from hit films produced.
https://en.wikipedia.org/wiki/Cross-collateralization
Haircut
In finance, ahaircutis the difference between the current market value of an asset and the value ascribed to that asset for purposes of calculating regulatory capital or loan collateral. The amount of the haircut reflects the perceived risk of the asset falling in value in an immediate cash sale or liquidation. The larger the risk or volatility of the asset price, the larger the haircut.
https://en.wikipedia.org/wiki/Haircut_(finance)
Arm's Length Principle
Thearm's length principle(ALP) is the condition or the fact that the parties of a transaction are independent and on an equal footing. Such a transaction is known as an "arm's-length transaction".
It is used specifically in contract law to arrange an agreement that will stand up to legal scrutiny, even though the parties may have shared interests (e.g., employer--employee) or are too closely related to be seen as completely independent (e.g., the parties have familial ties).
An arm's length relationship is distinguished from a fiduciary relationship, where the parties are not on an equal footing, but rather, power and information asymmetries exist.
https://en.wikipedia.org/wiki/Arm%27s_length_principle
Trade Line
A trade line is a record of activity for any type of credit extended to a borrower and reported to a credit reporting agency. A trade line is established on a borrower's credit report when a borrower is approved for credit. The trade line records all of the activity associated with an account.
Comprehensively, trade lines are used by credit reporting agencies to calculate a borrower's credit score. Different credit reporting agencies give differing weights to the activities of trade lines when establishing a credit score for borrowers.
https://www.investopedia.com/terms/t/trade-line.asp
Vintage
Vintage is a slang term used by mortgage-backed security(MBS) traders and investors to refer to an MBS that is seasoned over some time period. An MBS typically has a maturity of around 30 years, and a particular issue's "vintage" exposes the holder to less prepayment and default risk, although this decreased risk also limits price appreciation.
- Vintage is a colloquial term used to describe mortgage-backed securities (MBS) that have been "seasoned."
- That is, they've been issued long enough, and enough on-time payments have been made, that the risk of default is lower.
- Vintage is the age of an item as it relates to the year it was created. It's a way to assess the inherent risk of an MBS.
- Two MBS with the same vintage may have different levels of assumed risk, however, and as a result, different perceived values.