First American Bank

Kittal has to decide whether to take on the risk of CapEX Unlimited’s (CEU) loan of $50 million or offload the risk from First American Bank’s (FAB) balance sheet to another FI. The decision to keep the credit risk or to pass it along depends, in large part, on FAB’s risk-tolerance and the premium it would receive on taking on the risk.

Credit Risk Analysis

CEU’s credit rating is now B2 and 5-yr B2 corporate bonds have a cumulative default probability of 28.24% (Exhibit 10b).

Assuming that the default probability in each six-month period is the same, the six-month default probability can be estimated using the equation:

Cp = 1 – p^10, p = probability of repayment in six-months = 96.74%, thus the probability of default in six-months is 3.26%

The recovery rate in case of default for CEU is assumed to be 82% (from Exhibit 14).

Because we are valuing the loan as a risk-neutral transaction, we’ll use the risk-free rate (4.5%) to discount the cash flows.

Assuming the semiannual fixed fee charged on the swap is x, then the total fee charged over 2 years is

(96.74%x+93.48%x+90.24%x+86.98%x)=3.67x.

The fair fee level to charge is when the expected loss equals to the total fee payment, that is when 3.67x= 1.112 million.

Thus the semiannual fee = 1112000/3.67= $302941.

Credit Risk Options

FAB could choose to take on the credit risk in which case it would earn a semiannual fee over the 2-year period of the loan (see Table 1). FAB would need to review its current capital position and decide whether or not to increase that amount to cover payouts to CBI in the event of a default by CEU. This is the riskiest option, but has the highest potential return.

Option 2, FAB could choose to take on some risk and package this transaction as a security, such as a Credit Linked Note (CLN) and sell it off to investors. This would have two key benefits: (1) It would allow FAB to collect money up front for the loan preventing them from having to...