Instructor

1. Preview:
X 430.611 Credit:
commercial, personal, and
global

2. X 430.611 CREDIT:
COMMERCIAL, PERSONAL, AND
GLOBAL
Joe El Rady

3. X 430.611 will provide students:
 An overview of the macroeconomics of credit.
 Details of firm level economics , finance, and accounting of leverage.
 Knowledge about various credit instruments, their behavior, and
pricing.
 Focus on both credit markets (primary as well as secondary) and firm-
level credit decisions.
 Examination of consumer credit both from the standpoint of markets
and individual level credit decisions.
 Analysis of bubbles, bank runs, liquidity crises and default (both
corporate and consumer/individual).
The following slides present a sampling of class content.
Class Content

4. Why is Credit Important?
The Importance of Credit

5. Credit – Why Is It
Important?
 Firm has ability to lend / invest.
 Opportunity to generate income and create
long-term value for the firm.
 Business dependent on credit –
Trade, Operations, Capital Raising, M&A and
Restructuring.
5

6. Bank
Debt
Other
Loans
Bonds
Mezzanine
Preferred Equity
Common Equity
What is
Capital
Structure?

7. 7
Capital Structure Overview

8. How are different credit
instruments prioritized in
capital structure?

9. 9
Who provides the various
credit instruments in the
capital structure?
 Banks (BofA,Wells Fargo, Citibank, JP Morgan)
 Senior, Second Lien, Limited Mezzanine
 Focus: Relationship focused, preservation of principal, cross-selling of services
 Financial Services Firms (G.E., CIT)
 Senior, Second Lien, Mezzanine and Minority Equity
 Focus: Relationship minded but transaction oriented; focus on lending
 Second Lien Funds (Canyon Capital, Contrarian Capital)
 Second Lien and Limited Mezzanine
 Focus:Transaction oriented
 Mezzanine Funds (Caltius Mezzanine, Key Mezzanine, Blackstone Mezzanine)
 Mezzanine and Minority Equity
 Focus: Relationship minded but transaction oriented
 Hedge Funds (Cerberus, Silver Point, Fortress)
 Senior, Second Lien, Mezzanine, Structured Equity, Minority Equity and Control Equity
 Focus:Transaction oriented
 Private Equity Funds (Centre Partners, Kirtland Capital, Summit Partners)
 Minority and Control Equity
 Focus: Relationship minded

10. 10
How do the broad categories
of loans differ?
 Asset Based
 Extend credit based on underlying value of assets
 % of Receivables and inventory
 % of Net “Orderly LiquidationValue” of equipment
 Potential advance against intangibles
 Multiple of cash flow and P&L performance of secondary importance
 Cash Flow
 Based on multiple of cash flow – EBITDA
 Influenced by (i) level of free cash flow, (ii) stability and predictability of
cash flow, (iii) nature of business and industry, (iv) cyclicality, (v)
enterprise value, (vi) size of company
 Greater perceived risk than ABL given that cash flow can evaporate
 EnterpriseValue
 Approach is closely aligned to cash flow
 Level of debt is geared to enterprise value and level of equity cushion
required
 Ability to potentially provide more capital than cash flow approach

11. Key Questions and Characteristics of the Money Market
The Money Market

12. How do we determine the
Federal Funds Rate?

13. How do we determine short
term interest rates?

14. How do we determine yield
spreads?

15. How do we determine the TED
Spread?

16. What is Commercial Paper and
why do Corporations use it?

17. What are bankers
acceptances?

18. An Overview of the Syndicated Loan Market
The Syndicated Loan Market

19. What is the syndicated loan
market?

20. What is the syndicated loan
market?
 What is a loan?
 How do we define different loan segments?
 How large is the loan market?
 What are the differences between loans and
bonds?
 How do the primary and secondary markets
differ?

21. What is a syndicated loan?
 Large loan that is sold in pieces to lenders
 Floating rate, senior debt in borrower’s
capital structure
 Senior, secured debt sold to non-bank
investors
 Senior debt which moves in tandem with the
bond market

22. Syndicated loan issuance is
more than US$1.6 Trillion

23. US Syndicated Loan Market is
larger than US High Yield
Bond Market

24. What is a Syndicated Loan?
 Generally a senior debt instrument
 Dominant types include revolvers, term loans
 Revolvers can be undrawn, partially drawn or fully drawn
 Term loans usually are fully drawn at close
 Generally syndicated by a lead bank to a group of
banks and/or institutional investors
 Usually floating rate
 Tenor can range from several months to 10+ years
 Generally have more covenants than a bond issue
 FOUR KEY LOAN MARKET SEGMENTS

25. There are four key large
corporate loan market
segments
U.S. Syndicated Loan Market 10
September 24, 2007 Slide 1
4 key large corporate loan market segments
Investment grade loan market
• Loans to companies rated >= BBB-/Baa3
AND with a relatively low LIBOR spread
• Investment grade issuance totaled roughly
$667 billion in LTM ending 2Q07
Leveraged loan market
• Loans to companies rated < BBB-/Baa3 or
unrated
• AND with a spread >= LIB+150 bps
• Leveraged loan issuance totaled roughly
$753 billion in LTM 2Q07
Institutional loan market
• Loans structured to be sold to institutional
investors (which include mutual funds,
CLOs, insurance companies, hedge
funds, etc)
• Institutional issuance totaled roughly $474
billion in LTM 2Q07
Secondary loan market
• Market in which loans “trade” following the
close of primary syndication
• Most U.S. loan trading involves leveraged
loans
• Loan trading totaled nearly $278 billion in
LTM 2Q07

26. What is syndication?
 Generally syndicated–
broken into pieces and
sold to lenders
 Lead arranger–
arranges loan and
theoretically holds the
biggest piece
 Syndicates remainder

27. How is Credit Priced?
Credit Pricing

28. Investment returns compensate
risks
 What is Risk?
 How is Risk related to
Return?
 What is the risk –
return tradeoff?
 How is Risk measured?
 How is Risk calculated?
Risk
Return

29. Risk measures the precise
probability and impact of
specific outcomes
 Risk measures both the likelihood of a hazardous
event and the harm of that event
EventofAmtEventofProbRisk
 Does a “risk free” investment exist?
 How is risk compensated?

30. How is risk measured or
calculated in finance?
 Financial risk is defined as the statistically
unexpected variability or volatility of returns (an
outcome different from the expectation)
 In statistics the expectation is called the “Mean”
 The variability about the expectation is called the
“Standard Deviation”
 In life, science, math and the universe all data
exhibit a central tendency.The distance from the
center defines the variability

32. Corporate Bonds and their
issuers have credit ratings
Quality Moody’s S&P
Investment Grade
Highest Aaa AAA
High Aa AA
Tier-1 Medium A-1, A A
Tier-2 Medium Baa-1, Baa BBB
Noninvestment Grade (Junk)
Speculative Ba BB
Extremely Speculative B,Caa B,CCC, CC
In Default Ca, C D

33. What is a Corporate Credit
Rating?

34. What is the relationship
between default risk and
ratings?

35. Bonds and the Bond Market
Bonds

36. Bond Characteristics

37. 10-37
Bond Basics
 Two basic yield measures for a bond are its
coupon rate and its current yield.
valuePar
couponAnnual
rateCoupon

38. How do we price bonds?

39. 10-39
Premium and Discount Bonds
 Premium bonds: price > par value
YTM < coupon rate
 Discount bonds: price < par value
YTM > coupon rate
 Par bonds: price = par value
YTM = coupon rate

40. 10-40
Relationships among Yield
Measures
for premium bonds:
coupon rate > current yield >YTM
for discount bonds:
coupon rate < current yield <YTM
for par value bonds:
coupon rate = current yield =YTM

41. 10-41
Interest Rate Risk and
Maturity

42. 10-42
Duration
 Bondholders know that the price of their bonds change when
interest rates change. But,
 How big is this change?
 How is this change in price estimated?
 Macaulay Duration, or Duration, is the name of concept that helps
bondholders measure the sensitivity of a bond price to changes in
bond yields.
2
YTM1
YTMinChange
DurationPriceBondinChangePct.

43. Duration Basics
 Duration measures how long, in years, it
takes for the price of the bond to be repaid by
its internal cash flows.

44. 10-44
Properties of Duration

45. Debt and Public Policy
Credit in the Macroeconomy

52. Bank Runs, Liquidity Crises, Bubbles
The Dark Side of Debt

53. How does debt fuel
consumption, increase asset
prices, and inflate bubbles?

54. How does excessive leverage
distort the economy?

55. Leverage!
1. Reversal of Glass-Steagall in 1999 set off a leverage race on
Wall Street
2. Leverage outside the banking system largely unregulated /
misunderstood
3. Explosion of credit markets allowed each segment of risk to
be isolated… and further leveraged
4. Tiering of risk allowed for multiple layers of leverage with
limited transparency
5. Investors became complacent while regulators became
overwhelmed

56. Extent of Leverage is a Differentiating
Feature of this Particular Cycle
Government Debt 1
Federal and
Consumer Debt
as % of GDP 2
$0
$1,000
$2,000
$3,000
$4,000
$5,000
$6,000
$7,000
$8,000
$9,000
$10,000
FederalDebt($bil)
0%
50%
100%
150%
200%
250%
300%
PercentofGDP
Total Consumer Debt Total Federal Debt
(1) Office of Management and Budget, Budget of the United States, FY 2007
(2) U.S. Chamber of Commerce as of 8/27/08

57. Bank Leverage 2
%
Extent of Leverage is a Differentiating
Feature of this Particular Cycle
Share of Intermediation Through
Banks & Securities Markets 1
(1) Morgan Stanley. “Levered Losses: Lessons Learned from the Mortgage Market Meltdown” 2/08
(2) SNL Financial. Data as of 7/31/08
20%
25%
30%
35%
40%
45%
50%
55%
60%
Intermediated Through Securities Markets
Intermediated Through Depository Institutions
0
1
2
3
4
5
6
7%
Reserves/Loans TCE/TA
6.4%
1.8%
1.2%
5.2%

58. $0.9
$1.4
$3.9
$0
$1
$2
$3
$4
$5
4Q1992 4Q2000 4Q2007
Total Assets of Top 5 Brokers 1
($ tril)
(1) SNL Financial. Top brokers traded on the NYSE and NASDAQ
(2) Source: Lehman Brothers. Data provided 8/28/08
Global Issuance of
Structured Finance Products 2
Extent of Leverage is a Differentiating
Feature of this Particular Cycle
-
100
200
300
400
500
600
700
800
900
1,000
(in
$ bil)
Total CDO Total ABS

59. Anecdotes of Leverage
 ~$2.3 tril in “AAA” guarantees supported by six monolines with less
than $20 bil in equity (0.8%)(1)
 In June 2007, financials made up 20.9% of S&P 500
 Implies that approximately 30% of every dollar earned by an S&P 500
company was earned by a financial services firm
 Total assets of the top 5 brokerage houses in the U.S. equaled
approximately 35% of the total U.S. annualGDP. Balance sheets were
levered on average 30:1(3)
 In 1998, failure of LongTerm Capital brought markets to their
knees, based on a loss of $4.6 bil.(4) To-date system has incurred
approximately 75x(5) this amount. Industry’s capital base increased by
only 2.5x that during this time(6)
(1) Pershing Square Capital Management. “How to Save the Bond Insurers,” 11/07
(2) Company Reports. Data as of Q4 2007
(3) SNL Financial. Data as of Q4 2007
(4) Financial Times. “Bank bailout shows need to intervene,” 6/08
(5) Loss estimate to-date of $460 bil provided by Goldman Sachs. Data provided on 8/28/08.
Inflation data provided by the U.S. department of Labor.
(6) SNL Financial. As measured by tangible capital base of top 25 U.S.
financial institutions (excluding insurance companies, from 1998 to Q2 2008)

60. Mortgages
Mortgages
Mortgages
Cash
Cash
Cash & Fees
AAACash
Cash
AA
Below
Notes Cash
10 to 1
50 to 1
(Warehouse)
50 to 1
15 to 1
30 to 1
Consumer
Loan Origination
Wall Street
Structured ABS
Ratings Agencies
70%
FNMA
FHLMC
30% Bank
Insurance
Companies
CDOs
AAA’s, AA, A, B
BB, BB
Equity
Wall Street
Source: Wachovia Securities, “Lifestyles of the Rich and Living Rich,
A Tale of Two Consumers,” 2005
400 to 1
Leverage
The Leverage Game
Notwithstanding the existing underlying leverage, banks
could lever AAA securities by over 100:1!

61. Risk vs. Information
Originator
Warehouse
Provider
Senior Bonds
Mezzanine
Bonds
Sub Bonds
Residual
Notes
CDO Equity
Performance Risk
UnderlyingCollateral
Knowledge
Least Most
LeastMost
Source: Wachovia Securities, “Lifestyles of the Rich and Living Rich,
A Tale of Two Consumers,” 2005
Those who knew the most held the least amount of the risk…
…while those who knew the least ended up holding the most risk

62. Hedging, Insuring, Mitigating Risk
Credit Derivatives

63. What is securitization?

64. What is a Collateralized
Loan Obligation?

65. What is a Total Return Swap?

66. What is the role of options
in the credit markets?
intrinsic value of an in-the-money American call option is determined by the difference between the current
market price of the underlying instrument and the option strike price. Let F denote the underlying futures
price and K the option strike price. Then, the intrinsic value of a futures call option is F - K if F > K and zero if
F < K, which can be written as
max(0, F - K).
Figure 4a illustrates the payoff to a long call option held to expiration. Let C0 denote the call premium
paid at the time the option was first purchased. If F < K, the option will expire out-of-the-money and the
buyer will lose the call premium. But the call premium is the most the option holder can lose, so that the
payoff diagram has a floor at -C0 on the vertical axis. When the underlying futures price is above the option
strike price, the call holder can earn a marginal profit of F - K by exercising the option, so the payoff line is
kinked at F = K, the point where the option goes in-the-money. The total net profit accruing to a long call
option position when the option expires in-the-money is F - K - C0. The payoff line intersects the horizontal
axis at the break-even price F = K + C0.
To illustrate, consider the payoff to a call option on September Treasury bill futures with a strike price of
96.00 bought at a premium of 30 basis points ($750). If the underlying futures contract is priced below 96.00
when the option expires, the option expires out-of-the-money and the buyer loses the entire $750 premium.
At any futures price above 96.00 the option is in-the-money, so a holder can exercise the option and
liquidate the resulting futures position to
FIGURE 4
Payoffs for Unhedged Call Options
Page 227
FIGURE 5
Payoffs for Unhedged Put Options
Principles of Option Pricing
The Time Value of an Option An out-of-the-money option typically will sell for a positive premium before
the contract expiration date because there is always some chance that the option will go in-the-money
before it expires. The excess of an option premium over its intrinsic value is termed its time value, or
speculative value. All other things equal, the time value of an option tends to increase with the time to
expiration because a longer-lived option has a greater chance of going deeper in-the-money before it
expires. At expiration time value is zero and the only value the option has is its intrinsic value. The rate at
which an option premium changes over time, with all other things held equal, is known as the "theta" of the
option. Option pricing theory predicts that theta should be negative, reflecting the fact that time value is
expected to fall as the expiration date draws nearer.

67. How are Interest Rate Swaps
traded?

68. How are Options priced?

69. How are Fixed Rate Notes
priced?

70. We hope you enjoyed the
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