Quantifying credit risk.

The five C's of credit help us to identify and analyze the risk inherent in a loan. Now the ball is in the court of the lender to determine if that risk can be mitigated, so that it is acceptable to the lending institution. The tools of the bank has in its arsenal to mitigate the riskiness of the loan are pricing, which is encapsulated by risk versus return. This is also driven by supply and demand however. The covenants, which enable the lender to monitor the loan and the performance of the borrower, they also provide the early warning signs for the lender. Seniority. In a liquidation scenario, senior lenders are paid back first. Therefore, a careful lender will ensure that their loans have the highest priority. Security, this is essentially the collateral of the loan. Ring fenced assets are paid to lenders with security first. The maturity, the longer loans are outstanding the greater the risk of default or capital loss. Also, there's a refinance risk with loans that have balloon payments or payments that are only made at the end of the loan term. Amortizing loans therefore reduce capital risk early on but they can also drive up default risk because they require the borrower to have a certain amount of cash flow to repay principle throughout the life of the loan. Those tools are invaluable to the lender as we will see in the documentation section of the course and much attention is given to the structure of the loan. However, those tools are of the greatest value when the risk has not just been identified but rather properly quantified. Credit risk is therefore broken down into two categories. The first is default risk. This is the likelihood of a borrower being unable to pay principle and interest. It is based on an issuer's financial condition otherwise known as financial risk as well as the industry segment and condition also known as the business risk as well as intangibles such as management. The second is loss given default risk, it is the severity of loss the lender is likely to incur in the event of a default that is based on things like collateral covenants in the term sheet and the seniority of the debt issuance.