LO 16.3: Describe, compare and contrast various credit risk mitigants and their

LO 16.3: Describe, compare and contrast various credit risk mitigants and their role in credit analysis.
The four primary components of credit risk evaluation are as follows.
1. The borrowers (or obligors) capacity and willingness to repay the loan. Questions the
lender must consider include: What is the financial capacity to pay?
Is it likely the borrower can fulfill its financial obligations through the maturity of the loan?
Are there outside forces that affect the borrowers capacity and/or willingness to pay?
For example, does the ownership structure of the firm, relationships within and outside the firm, and other obligations of the firm affect the borrowers ability to pay?
How does the business itself affect the borrowers capacity to pay? Are there credit risk characteristics tied to this particular industry or sector? Does the firm have a niche within the industry or sector?
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2018 Kaplan, Inc.
Topic 16 Cross Reference to GARP Assigned Reading – Golin and Delhaise, Chapter 1
2. The external environment and its effect on the borrowers capacity and willingness to repay the borrowed funds. Factors such as the business climate, country risk, and operating conditions are relevant to the lender. Are there cyclical changes that will affect the level of credit risk? Will political risks affect the likelihood of repayment?
3. The characteristics of the credit instrument. The credit instrument might be a bond issue, a bank loan, a loan from a finance company, trade credit, or other type of debt agreement/security. Concerns include: Risk characteristics that are inherent in the credit instrument, including legal risks
and obligations that are specific to the instrument.
The maturity (also called tenor) of the instrument.
Is the debt secured or unsecured? Is there collateral backing the loan? Are there loan guarantors? Is the debt subordinated or senior to other obligations? What is the priority assigned to the creditor? Flow do loan/bond covenants increase or decrease the credit risk for each party? Can the borrower repay the loan early without penalty? Can the lender call the loan? Can the security be converted to another form (e.g., a convertible bond)?

What is the denominated currency of the obligation? Are there any contingent risks?
4. The quality and adequacy of risk mitigants such as collateral, credit enhancements, and loan guarantees. Secured lending (i.e., using risk mitigants in the lending process) is generally the preferred method of lending. If there is collateral, a bank or other lender may not have to force a delinquent borrower into bankruptcy but may instead sell the collateral to satisfy the financial obligation. Secured lenders are also generally in a better position than unsecured lenders in the event of bankruptcy. The use of collateral not only mitigates losses in the event of default, but also lowers the probability of default because the obligor typically does not want to lose the collateral. Flistorically, banks have substituted collateral for analysis of the borrowers ability to pay. In some sense, the use of collateral eliminates the need for credit analysis, or at the very least makes the credit decision simpler. A lender can normally put a market value on collateral and determine if it is sufficient to cover potential losses. Three issues regarding risk mitigants include:

Is the collateral pledged to, or likely to be pledged to, another loan? lias there been an estimation of the value of the collateral? If there is a loan guarantor, has there been sufficient credit analysis of the third Is the collateral pledged to, or likely to be pledged to, another loan? lias there been an estimation of the value of the collateral? If there is a loan guarantor, has there been sufficient credit analysis of the third partys willingness and ability to pay in the event the borrower does not pay? A guarantor accepts liability for debt if the primary borrower defaults. The bank is able to substitute analysis of the guarantors creditworthiness for that of the primary borrower. Typically, the guarantor has a greater ability to pay than the primary borrower (e.g., a parent guaranteeing a childs car loan or a parent company guaranteeing a loan to a subsidiary).
2018 Kaplan, Inc.
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Topic 16 Cross Reference to GARP Assigned Reading – Golin and Delhaise, Chapter 1
Q u a l it a t iv e a n d Q u a n t it a t iv e Te c h n iq u e s

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