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© 2012 FARIN & Associates Inc. 1 GSB Credit Track Effective Loan Pricing Session 3 Thomas Farin President
© 2012 FARIN & Associates Inc. Goals For This Session Review most important points from Sessions 1 and 2 at GSB Review assignment Walk you through software and model a loan 2
© 2012 FARIN & Associates Inc. Pricing Cash Flows When we price a loan –We are pricing a bundle of cash flows. –A good loan pricing model puts an A/L wrapper around a loan or a bundle of loans being priced. Approach and results should be consistent with. A/L model results Profitability system results Market results – Assuming loan is sold 3
© 2012 FARIN & Associates Inc. 4 Cash Flow and Repricing Characteristics Fixed or Variable –Origination Rate –First Reprice –Repricing Rate –Repricing Frequency Term or Revolving –Amortizing? –Term –Balloon? Amortization Term –Prepayment Speed 60 Month Bullet Loan You don’t control in LoanEdge
© 2012 FARIN & Associates Inc. 5 Loan Pricing – Cash Flows Rates Match Considers Interest Cash Flows 60 Month Bullet Loan
© 2012 FARIN & Associates Inc. 6 Loan Pricing – Cash Flows Match Considers Interest Cash Flows 60 Month Amortizing Loan with 25% annual prepayments
© 2012 FARIN & Associates Inc. 7 Loan Pricing – Interest Rate Risk Interest Rate Risk –When you are pricing loans you are pricing cash flows not maturities. –With fixed-rate loans, pieces reprice as cash flows come in. Few reprice at maturity. –Principal cash flows are often uncertain Prepayment options –Variable rate loans reprice When cash flow pieces come in When contractual repricing occurs, but … Variable rate loans may not respond immediately or completely at reset points Reset frequency Restrictions on adjustments (caps) To manage interest rate risk, institutions need to match funding to the repricing of the loans of loans. Two approaches: –Simplistic – match based on duration –More complex – Match fund individual repricing flows. –While in the real world you may not match, in making pricing decision, we should assume matching. x x X – Approach taken in this course
© 2012 FARIN & Associates Inc. 8 Market Curve Usage Curves Used for –Risk Free Curves –Investment Benchmarks –Wholesale Funding Curves Requirements –Broad range of benchmarks. –Updated very frequently You don’t control Market Curves or spreads in LoanEdge
© 2012 FARIN & Associates Inc. 9 Cash Flow Matching Example 60 Month Auto loan – 1 st 12 months of amortization Weighted average investment benchmarks and funding costs are calculated from these matches. You can view amortization schedules in LoanEdge
© 2012 FARIN & Associates Inc. 10 Loan Pricing – The Basics Interest Rate Risk – Conclusions Interest rate risk driven by the cash flow and repricing characteristics of the loan rather than the term of the loan To model most accurately, each cash flow and repricing point is matched The loan can be matched up to an appropriate point of: –A funding curve when matching funding Funds Transfer Pricing (FTP) –An investment curve when looking at investment alternatives. Pricing loans off investment alternatives Valuing loans
© 2012 FARIN & Associates Inc. 11 Loan Pricing – The Basics Credit Risk –Provision for Loan Loss? –Charge-Offs Problem with Using Provisions –1% Reserves –0.15% Charge-Offs 0% Growth 10% Growth 25% Growth RLL1.00% C/O0.15% PLL/ALL0.15%0.25%0.40% 0.15% C/O + (1% * 0%) Growth 0.15% C/O + (1% * 10%) Growth 0.15% C/O + (1% * 25%) Growth
© 2012 FARIN & Associates Inc. Which History to Use? Was history from a legitimate predictor of recent credit losses? Are losses a legitimate predictor of losses of newly originated loans in 2011? Do we even have legitimate loss history for loans originated today? –Changes in collateral coverage –Changes in underwriting standards –Changes in kinds of loans originated 12 You will be coming up with the credit risk adjustment for your loans
© 2012 FARIN & Associates Inc. 13 Loan Pricing – Servicing Servicing Cost –Marginal Origination Cost Cost of originating the next loan –Marginal Servicing Cost Cost of servicing the next loan –Direct Overhead Allocation Fixed costs directly related to loan production –General Overhead Allocation President’s salary, human resources, etc. Arguments –Economist – Continue to produce widgets until marginal revenue equals marginal cost. –Accountant – Without overhead allocation, you end up with profitable loans and an unprofitable institution. OTS Cost Assumptions –0.20% - FR Mortgages –0.38% - ARMs –0.20% - Multi & Non-Res –0.20% - Const & Land –0.20% - Second Mtg. –0.20% - Commercial –0.20% - Consumer –1.00% - Credit Card Is there a better source for generic servicing costs
© 2012 FARIN & Associates Inc. 14 Servicing Example Differential pricing on A, B, C credits should reflect both additional charge offs, and additional servicing costs due to legal and collection fees. In LoanEdge you can add servicing costs but you can’t delete what is there.
© 2012 FARIN & Associates Inc. 15 Option Risk – What Is It 15 year FRM example showing remaining principal under different rate environments –Falling – 25% CPR – 2.75 year duration –Flat – 8% CPR – 4.64 Year duration –Rising – 5% CPR – 5.21 Year Duration
© 2012 FARIN & Associates Inc. 16 Consider Option Risk in Pricing Loans? Against –Not a true cost like charge offs, servicing costs, or costs of matching funding. –Considering option risk will cause loans to be unprofitable. –Not the loan officer’s problem. –Very difficult to calculate –May be inherently hedged in balance sheet of retail financial institution. For –Option risk can damage the performance of un-hedged institutions. It costs money to hedge option risk –Price/yield of securities reflects option risk. Securities are securitized loans –If loan officers are not ‘charged’ for options, they will give away options in exchange for rate –Can be derived from securities market. Source –Securities Markets
© 2012 FARIN & Associates Inc. Adding Option Risk 17 Applied to internal profitability calculations You can’t control the option risk adjustments in LoanEDGE
© 2012 FARIN & Associates Inc. 18 Sample Loan – 72 Month New Auto Cash Flows Pricing Expenses Risk Assum Benchmarks
© 2012 FARIN & Associates Inc. 19 Investment Benchmark Market rather than internal benchmark Compares performance of loan to closest investment benchmark after adjusting for risk and cost differences. Most relevant when –You are trying to decide how to invest cash already raised. –Anytime investing in a security is an alternative to making a loan –You are trying to derive market adjustments for Interest rate risk Option risk Required inputs –Cash flow characteristics –Risk free curve –Investment benchmark curve –Pricing – Rates and fees –Operating expenses –Credit risk adjustment –Additional option risk adjustments Calculated adjustments –Interest rate risk adjustment –Option risk adjustment –Loan’s spread to investment benchmark after adjustments –Test – Is spread positive (good) or negative (bad)? Not considered –Funding cost curve –Capital requirement –RAROC Goal –Institution Tax Rate
© 2012 FARIN & Associates Inc. 20 Investment Benchmark - Steps 1 Month Agency IRR Adjustment Agency Match Investment Benchmark Credit Risk Adjustment Servicing Cost Adj Option Adjustment Retail Benchmark Loan Rate Spread to Benchmark You can view the detailed Investment Benchmark analysis in LoanEdge
© 2012 FARIN & Associates Inc. 21 Valuation Market rather than internal benchmark Compares market value of loan as compared to book at time of origination. Most relevant when –You are going to sell loan after origination. –When you are trying to improve the franchise value of your institution by holding well priced loans Required inputs –Cash flow characteristics –Risk free curve –Investment benchmark curve –Discount rate curve –Pricing – Rates and fees –Operating expenses –Credit risk adjustment –Additional option risk adjustments Calculated outputs –Market value vs book value of loan –Price –With and without origination fees –Test – Is price at or above 100 (good) or below 100 (bad)? Not considered –Funding cost curve –Capital requirement –RAROC Goal –Institution Tax Rate
© 2012 FARIN & Associates Inc. 22 Valuation - Steps Value Cash flows –Project amount and timing of cash flows –Use discount rates to mark cash flows to market. nPVFVi PV 1 = FV 1 / (1+i) n = / (1 + (1.22%/12)) 1 = Note: Cash flows continue for an additional 60 months Discount Rate = Investment Benchmark + Adjustments (not including expense) The sum of the market values of individual cash flows is the market value of the instrument. You can view the market value cash flows in LoanEdge
© 2012 FARIN & Associates Inc. 23 Valuation - Steps Book Amount of Loan With Fees Sum of Cash Flow Market Values 100 * MV / BV Without Fees Sum of Cash Flow Market Values 100 * MV / BV Note: By Valuation standards, this is a well priced loan as its market value exceeds book at the time of origination. You can view the market value analysis in LoanEdge
© 2012 FARIN & Associates Inc. 24 FTP Analysis - RAROC Balance weighted costs Decision – Don’t make the loan !!! RAROC Goal RAROC (ROE) Assumed tax rate of 40% Horizon Lifetime You can view the RAROC analysis in LoanEdge
© 2012 FARIN & Associates Inc. 25 FTP Analysis - Income Decision Tool Make the loan !!! Note: The net income figure is converted into ROA Ratio analysis restated in dollars You can view the income analysis in LoanEdge
© 2012 FARIN & Associates Inc. 26 Decision Tree
© 2012 FARIN & Associates Inc. Intersession Assignment 27 Note: This is the 1st of 4 criteria
© 2012 FARIN & Associates Inc. Intersession Assignment 28 Note: This is the 2nd of 4 criteria
© 2012 FARIN & Associates Inc. Intersession Assignment 29 Note: This is the 3rd of 4 criteria Note: In your first loan you will model an individual loan. In the second you will model a relationship.
© 2012 FARIN & Associates Inc. Intersession Assignment 30 Note: This is the 4th of 4 criteria You are probably thinking, “But Farin, you haven’t showed me how to use the model.”
© 2012 FARIN & Associates Inc. In Order to Follow Along … Register – click registration link on resource page and follow instructions Download Getting Started Guide – click download link on registration page Have the loan you wish to model selected and have the information to model the loan assembled Have this window open as well as the software. You can pause the recording, switch windows, and model your loan as I walk you through. 31
© 2012 FARIN & Associates Inc. Logging Onto iPrice 32 Process 1.URL ipriceweb.farin.com 2.Click here to begin log on LoanEDGE is Web based …
© 2012 FARIN & Associates Inc. Logging Onto iPrice 33 Process 1.Click Logon link 2.Enter User Name and Password 3.Click OK Resource pages have information on user name and password. Each attendee can have his or her own logon.
© 2012 FARIN & Associates Inc. Creating New Relationship 34 Process 1.Click here 2.Give Relationship a name 3. Click Add Note: You won’t have these. Will say LoanEDGE for GSB School 2012
© 2012 FARIN & Associates Inc. Add Product to Relationship 35 Process 1.Click category of loan you wish to add 2.Then click select to get to next screen. Note: pick the loan from the list that most closely matches the loan you wish to model
© 2012 FARIN & Associates Inc. Select Product to Add 36 Process 1.Select product to be added 2.Click Select
© 2012 FARIN & Associates Inc. Product Modeling Screen 37 Product characteristics preset 1.Structure 2.Fees/Expenses 3.Credit Risk Note: You will be able to edit some characteristics but not others depending on account type selected in previous step.
© 2012 FARIN & Associates Inc. Entering Product Data 38 Enter 1.Rate 2.Balance 3.Credit adjustment 4.Review product results To see: Amort Schedule Details
© 2012 FARIN & Associates Inc. Amortization Schedule 39 Process 1.Review 2.Done Note: if you scroll right you will be able to see market value cash flows
© 2012 FARIN & Associates Inc. Detailed Results 40 Process 1.Investment benchmark 2.Characteristics 3.Scroll down to see other methods 4.Done to close
© 2012 FARIN & Associates Inc. Detailed Results 41 Duration More Characteristics RAROC Summary
© 2012 FARIN & Associates Inc. Detailed Results 42 Full Summary Horizon Income
© 2012 FARIN & Associates Inc. Exporting Details 43 If you find it helpful, you can use the Save As button to export this information to an Excel file for comparison and printing.
© 2012 FARIN & Associates Inc. Notes Everything you have done persists on our server. If you want to modify a deal later you can: –Log onto LoanEDGE –Open (View) a relationship –Modify or enhance –In Session 4 you will be either modifying an existing relationship or creating a new one. Our support people will be able to view the loan you have been working on. Feel free to model additional loans if you wish. 44
© 2012 FARIN & Associates Inc. Notes Limits – You accept our management assumptions Resource Page –Self-registration link –Getting started guide –Links to the two recorded Webinars –Links to the PowerPoints as PDFs –Support number should you need help Model two situations –Two separate loans –Comparison –Sensitivity testing –A loan and a relationship Session 4 focuses on last three 45
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