Funding the Bank 10

The Relationship Between Liquidity Requirements, Cash, and Funding Sources The amount of cash that a bank holds is influenced by the bank’s liquidity requirements The size and volatility of cash requirements affect the liquidity position of the bank Deposits, withdrawals, loan disbursements, and loan payments affect the bank’s cash balance and liquidity position

The Relationship Between Liquidity Requirements, Cash, and Funding Sources Recent Trends in Bank Funding Sources Bank customers have become more rate conscious Many customers have demonstrated a a strong preference for shorter-term deposits Core deposits are viewed as increasingly valuable Bank often issue hybrid CDs to appeal to rate sensitive depositors

The Relationship Between Liquidity Requirements, Cash, and Funding Sources Recent Trends in Bank Funding Sources Retail Funding Deposit Accounts Transaction accounts Money market deposit accounts Savings accounts Small time deposits

The Relationship Between Liquidity Requirements, Cash, and Funding Sources Recent Trends in Bank Funding Sources Borrowed Funding Federal Funds purchased Repurchase agreements Federal Home Loan Bank borrowings

The Relationship Between Liquidity Requirements, Cash, and Funding Sources Recent Trends in Bank Funding Sources Wholesale Funding Includes borrowed funds plus large CDs Equity Funding Common stock Preferred stock Retained earnings

The Relationship Between Liquidity Requirements, Cash, and Funding Sources Recent Trends in Bank Funding Sources Volatile (Managed) Liabilities Funds purchased from rate-sensitive investors Federal Funds purchased Repurchase agreements Jumbo CDs Eurodollar time deposits Foreign Deposits Investors will move their funds if other institutions are paying higher rates

The Relationship Between Liquidity Requirements, Cash, and Funding Sources Recent Trends in Bank Funding Sources Core Deposits Stable deposits that customers are less likely to withdraw when interest rates on competing investments rise Includes: Transactions accounts MMDAs Savings accounts Small CDs

Characteristics of Retail-Type Deposits Retail Deposits Small denomination (under $100,000, now $250,000) liabilities Normally held by individual investors Not actively traded in the secondary market

Characteristics of Retail-Type Deposits Transaction Accounts Most banks offer three different transaction accounts Demand Deposits DDAs Negotiable Order of Withdrawal NOWs Automatic Transfers from Savings ATS

Characteristics of Retail-Type Deposits Transaction Accounts Demand Deposits Checking accounts that do not pay interest Held by individuals, business, and governmental units Most are held by businesses since Regulation Q prohibits banks from paying explicit interest on for-profit corporate checking accounts

Characteristics of Retail-Type Deposits Transaction Accounts NOW Accounts Checking accounts that pay interest ATS Accounts Customer has both a DDA and savings account The bank transfers enough from savings to DDA each day to force a zero balance in the DDA account For-profit corporations are prohibited from owning NOW and ATS accounts

Characteristics of Retail-Type Deposits Transaction Accounts Although the interest cost of transaction accounts is very low, the non-interest costs can be quite high Generally, low balance checking accounts are not profitable for banks due to the high cost of processing checks

Characteristics of Retail-Type Deposits Nontransactional Accounts Non-transaction accounts are interest-bearing with limited or no check-writing privileges

Characteristics of Retail-Type Deposits Nontransactional Accounts Money Market Deposit Accounts Pay interest but holders are limited to 6 transactions per month, of which only three can be checks Attractive to banks because they are not required to hold reserves against MMDAs

Characteristics of Retail-Type Deposits Nontransactional Accounts Savings Accounts Have no fixed maturity Small Time Deposits (Retail CDs) Have a specified maturity ranging from 7 days on up Large Time Deposits (Jumbo CDs) Negotiable CDs of $100,000 or more Typically can be traded in the secondary market

Characteristics of Retail-Type Deposits Estimating the Cost of Deposit Accounts Interest Costs Legal Reserve Requirements Check Processing Costs Account Charges NSF fees Monthly fees Per check fees

Characteristics of Retail-Type Deposits Estimating the Cost of Deposit Accounts Transaction Account Cost Analysis Classifies check-processing as: Deposits Electronic Non-Electronic Withdrawals

Characteristics of Retail-Type Deposits Estimating the Cost of Deposit Accounts Transaction Account Cost Analysis Classifies check-processing as: Transit Checks Deposited Cashed Account Opened or Closed On-Us checks cashed General account maintenance Truncated Non-Truncated

Characteristics of Retail-Type Deposits Estimating the Cost of Deposit Accounts Transaction Account Cost Analysis Electronic Transactions Conducted through automatic deposits, Internet, and telephone bill payment Non-Electronic Transactions Conducted in person or by mail Transit Checks Checks drawn on any bank other than the bank it was deposited into

Characteristics of Retail-Type Deposits Estimating the Cost of Deposit Accounts Transaction Account Cost Analysis On-Us Checks Cashed Checks drawn on the bank’s own customer’s accounts Deposits Checks or currency directly deposited in the customer's account Account Maintenance General record maintenance and preparing & mailing a periodic statement

Characteristics of Retail-Type Deposits Estimating the Cost of Deposit Accounts Transaction Account Cost Analysis Truncated Account A checking account in which the physical check is ‘truncated’ at the bank and the checks are not returned to the customer Official Check Issued A check for certified funds. Net Indirect Costs Those costs not directly related to the product such as management salaries or general overhead costs

Characteristics of Retail-Type Deposits Calculating the Average Net Cost of Deposit Accounts Average Historical Cost of Funds Measure of average unit borrowing costs for existing funds Average Interest Cost Calculated by dividing total interest expense by the average dollar amount of liabilities outstanding

Characteristics of Retail-Type Deposits Calculating the Average Net Cost of Deposit Accounts

Characteristics of Retail-Type Deposits Calculating the Average Net Cost of Deposit Accounts Example: If a demand deposit account does not pay interest, has $20.69 in transaction costs charges, $7.75 in fees, an average balance of $5,515, and 5% float, what is the net cost of the deposit?

Characteristics of Large Wholesale Deposits Wholesale Liabilities Customers move these investments on the basis of small rate differentials, so these funds are labeled: Hot Money Volatile Liabilities Short-Term Non-Core funding

Characteristics of Large Wholesale Deposits Wholesale Liabilities Jumbo CDs $100,000 (now $250,000) or more Negotiable Can be traded on the secondary market Minimum maturity of 7 days Interest rates quoted on a 360-day year basis Insured up to $100,000 (now $250,000) per investor per institution Issued directly or indirectly through a dealer or broker (Brokered Deposits)

Characteristics of Large Wholesale Deposits Wholesale Liabilities Jumbo CDs Fixed-Rate Variable-Rate Jump Rate (Bump-up) CD Depositor has a one-time option until maturity to change the rate to the prevailing market rate

Characteristics of Large Wholesale Deposits Wholesale Liabilities Jumbo CDs Callable Zero Coupon Stock Market Indexed Rate tied to stock market index performance Rate Boards Represent venues for selling non-brokered CDs via the Internet to institutional investors Rate boards help raise funds quickly and represent a virtual branch for a bank

Characteristics of Large Wholesale Deposits Individual Retirement Accounts Each year, a wage earner can make a tax-deferred investment up to $8,000 of earned income Funds withdrawn before age 59 ½ are subject to a 10% IRS penalty This makes IRAs an attractive source of long-term funding for banks

Characteristics of Large Wholesale Deposits Foreign Office Deposits Eurocurrency Financial claim denominated in a currency other than that of the country where the issuing bank is located Eurodollar Dollar-denominated financial claim at a bank outside the U.S. Eurodollar deposits Dollar-denominated deposits in banks outside the U.S.

Characteristics of Large Wholesale Deposits Borrowing Immediately Available Funds Federal Funds Purchased The term Fed Funds is often used to refer to excess reserve balances traded between banks This is grossly inaccurate, given reserves averaging as a method of computing reserves, different non-bank players in the market, and the motivation behind many trades Most transactions are overnight loans, although maturities are negotiated and can extend up to several weeks Interest rates are negotiated between trading partners and are quoted on a 360-day basis

Characteristics of Large Wholesale Deposits Borrowing Immediately Available Funds Security Repurchase Agreements (RPs or Repos) Short-term loans secured by government securities that are settled in immediately available funds Identical to Fed Funds except they are collateralized Technically, the RPs entail the sale of securities with a simultaneous agreement to buy them back later at a fixed price plus accrued interest

Characteristics of Large Wholesale Deposits Borrowing Immediately Available Funds Security Repurchase Agreements (RPs or Repos) Most transactions are overnight In most cases, the market value of the collateral is set above the loan amount when the contract is negotiated. This difference is labeled the margin The lender’s transaction is referred to as a Reverse Repo

Characteristics of Large Wholesale Deposits Borrowing Immediately Available Funds Structured Repurchase Agreements Embeds an option (call, put, swap, cap, floor, etc.) in the instrument to either lower its initial cost to the borrower or better help the borrower match the risk and return profile of an investment Flipper Repo Carries a floating rate that will convert, or flip, to a fixed rate after some lock-out period

Characteristics of Large Wholesale Deposits Borrowing From the Federal Reserve Discount Window Discount Rate Policy is to set discount rate 1% (1.5%) over the Fed Funds target for primary (secondary) credit loans To borrow from the Federal Reserve, banks must apply and provide acceptable collateral before the loan is granted Eligible collateral includes U.S. government securities, bankers acceptances, and qualifying short-term commercial or government paper

Characteristics of Large Wholesale Deposits Borrowing From the Federal Reserve Discount Rate Current Interest Rates in effect since 2/19/2010 Primary Credit 0.75% Secondary Credit 1.25% Seasonal Credit 0.20% Fed Funds Target 0 - 0.25%

Characteristics of Large Wholesale Deposits Borrowing From the Federal Reserve Primary Credit Available to sound depository institutions on a short-term basis to meet short-term funding needs

Characteristics of Large Wholesale Deposits Borrowing From the Federal Reserve Secondary Credit Available to depository institutions that are not eligible for primary credit Available to meet backup liquidity needs when its use is consistent with a timely return to a reliance on market sources of funding or the orderly resolution of a troubled institution

Characteristics of Large Wholesale Deposits Borrowing From the Federal Reserve Seasonal Credit Designed to assist small depository institutions in managing significant seasonal swings in their loans and deposits

Characteristics of Large Wholesale Deposits Borrowing From the Federal Reserve Emergency Credit May be authorized in unusual and exigent circumstances by the Board of Governors to individuals, partnerships, and corporations that are not depository institutions

Characteristics of Large Wholesale Deposits Other Borrowing from the Federal Reserve Term Auction Facility Allows banks to bid for an advance that will generally have a 28-day maturity Banks must post collateral against the borrowings and cannot prepay the loan

Characteristics of Large Wholesale Deposits Other Borrowing from the Federal Reserve Term Securities Lending Facility A facility in which the Open Market Trading Desk of the Federal Reserve Bank of New York makes loans to primary securities dealers

Characteristics of Large Wholesale Deposits Federal Home Loan Bank Advances The FHLB system is a government-sponsored enterprise created to assist in home buying The FHLB system is one of the largest U.S. financial institutions, rated AAA because of the government sponsorship Any bank can become a member of the FHLB system by buying FHLB stock If it has the available collateral, primarily real estate related loans, it can borrow from the FHLB FHLB advances have maturities from 1 day to as long as 20 years

Electronic Money Intelligent Card Memory Card Contains a microchip with the ability to store and secure information Memory Card Simply store information

Electronic Money Debit Card Online Offline PIN based Transaction goes through the ATM system Offline Signature based transactions Transaction goes through the credit card system

Electronic Money Electronic Funds Transfer (EFT) An electronic movement of financial data, designed to eliminate the paper instruments normally associated with such funds movement Types of EFT ACH: Automated Clearing House POS: Point of Sale ATM Direct Deposit Telephone Bill Paying Automated Merchant Authorization Systems Preauthorized Payments

Check 21 Check Clearing for the 21st Century Act Facilitates check truncation by reducing some of the legal impediments Foster innovation in the payments and check collection system without mandating receipt of check in electronic form Improve the overall efficiency of the nation’s payment system

Check 21 Check Truncation Conversion of a paper check into an electronic debit or image of the check by a third party in the payment system other than the paying bank Facilitates check truncation by creating a new negotiable instrument called a substitute check

Check 21 Substitute Check The legal equivalent of the original check and includes all the information contained on the original Check 21 does NOT require banks to accept checks in electronic form nor does it require banks to create substitute checks It does allow banks to handle checks electronically instead of physically moving paper checks

Check 21 Check Clearing Process Banks typically place a hold on a check until it verifies that the check is “good” Expedited Funds Availability Act Under Reg CC, it states that: Local check must clear in no more than two business days Non-local checks must clear in no more than five business days Government, certified, and cashiers checks must be available by 9 a.m. the next business day

Measuring the Cost of Funds Average Historical Cost of Funds Many banks incorrectly use the average historical costs in their pricing decisions The primary problem with historical costs is that they provide no information as to whether future interest costs will rise or fall. Pricing decisions should be based on marginal costs compared with marginal revenues

Measuring the Cost of Funds The Marginal Cost of Funds Marginal Cost of Debt Measure of the borrowing cost paid to acquire one additional unit of investable funds Marginal Cost of Equity Measure of the minimum acceptable rate of return required by shareholders Marginal Cost of Funds The marginal costs of debt and equity

Measuring the Cost of Funds The Marginal Cost of Funds Costs of Independent Sources of Funds It is difficult to measure marginal costs precisely Management must include both the interest and noninterest costs it expects to pay and identify which portion of the acquired funds can be invested in earning assets

Measuring the Cost of Funds The Marginal Cost of Funds Costs of Independent Sources of Funds Marginal costs may be defined as :

Measuring the Cost of Funds The Marginal Cost of Funds Costs of Independent Sources of Funds Example: Market interest rate is 2.5% Servicing costs are 4.1% of balances Acquisition costs are 1.0% of balances Deposit insurance costs are 0.25% of balances Net investable balance is 85% of the balance (10% required reserves and 5% float)

Measuring the Cost of Funds The Marginal Cost of Funds Costs of Independent Sources of Funds Example:

Measuring the Cost of Funds The Marginal Cost of Funds Costs of Independent Sources of Funds Cost of Debt Equals the effective cost of borrowing from each source, including interest expense and transactions costs This cost is the discount rate, which equates the present value of expected interest and principal payments with the net proceeds to the bank from the issue

Measuring the Cost of Funds The Marginal Cost of Funds Costs of Independent Sources of Funds Cost of Debt Example: Assume the bank will issue: $10 million in par value subordinated notes paying $700,000 in annual interest and a 7-year maturity It must pay $100,000 in flotation costs to an underwriter The effective cost of borrowing (kd) is 7.19%

Measuring the Cost of Funds The Marginal Cost of Funds Costs of Independent Sources of Funds Cost of Debt Example:

Measuring the Cost of Funds The Marginal Cost of Funds Costs of Independent Sources of Funds Cost of Equity The marginal cost of equity equals the required return to shareholders It is not directly measurable because dividend payments are not mandatory

Measuring the Cost of Funds The Marginal Cost of Funds Costs of Independent Sources of Funds Cost of Equity Several methods are commonly used to approximate this required return: Dividend Valuation Model Capital Asset Pricing Model (CAPM) Targeted Return on Equity Model Cost of Debt + Risk Premium

Measuring the Cost of Funds The Marginal Cost of Funds Costs of Independent Sources of Funds Cost of Preferred Stock Preferred stock acts as a hybrid of debt and common equity Claims are superior to those of common stockholders but subordinated to those of debt holders Preferred stock pays dividends that may be deferred when management determines that earnings are too low. The marginal cost of preferred stock can be approximated in the same manner as the Dividend Valuation Model however, dividend growth is zero

Measuring the Cost of Funds The Marginal Cost of Funds Costs of Independent Sources of Funds Trust Preferred Stock Trust preferred stock is attractive because it effectively pays dividends that are tax deductible This loan interest is tax deductible such that the bank effectively gets to deduct dividend payments as the preferred stock

Measuring the Cost of Funds Weighted Marginal Cost of Total Funds This is the best cost measure for asset-pricing purposes It recognizes both explicit and implicit costs associated with any single source of funds

Measuring the Cost of Funds Weighted Marginal Cost of Total Funds It assumes that all assets are financed from a pool of funds and that specific sources of funds are not tied directly to specific uses of funds

Funding Sources and Banking Risks Banks face two fundamental problems in managing liabilities. Uncertainty over: What rates they must pay to retain and attract funds The likelihood that customers will withdraw their money regardless of rates

Funding Sources and Banking Risks Funding Sources: Liquidity Risk The liquidity risk associated with a bank’s deposit base is a function of: The competitive environment Number of depositors Average size of accounts Location of the depositor Specific maturity and rate characteristics of each account

Funding Sources and Banking Risks Funding Sources: Liquidity Risk Interest Elasticity How much can market interest rates change before the bank experiences deposit outflows? If a bank raises its rates, how many new funds will it attract? Depositors often compare rates and move their funds between investment vehicles to earn the highest yields It is important to note the liquidity advantage that stable core deposits provide a bank

Funding Sources and Banking Risks Funding Sources: Interest Rate Risk Many depositors and investors prefer short-term instruments that can be rolled over quickly as interest rates change Banks must offer a substantial premium to induce depositors to lengthen maturities Those banks that choose not to pay this premium will typically have a negative one-year GAP

Funding Sources and Banking Risks Funding Sources: Interest Rate Risk One strategy is to aggressively compete for retail core deposits Individual are not as rate sensitive as corporate depositors and will often maintain their balances through rate cycles as long as the bank provides good service

Funding Sources and Banking Risks Funding Sources: Credit and Capital Risk Changes in the composition and cost of bank funds can indirectly affect a bank’s credit risk by forcing it to reduce asset quality For example, banks that substitute purchased funds for lost demand deposits will often see their cost of funds rise Rather than let their interest margins deteriorate, many banks make riskier loans at higher promised yields While they might maintain their margins in the near-term, later loan losses typically rise with the decline in asset quality

Overview of Credit Policy and Loan Characteristics 13

Recent Trends in Loan Growth and Quality Larger banks have, on average, recently reduced their dependence on loans relative to smaller banks. Real estate loans represent the largest single loan category for banks. Residential 1-4 family homes contribute the largest amount of real estate loans for banks. Commercial real estate is highest for banks with $100 million to $1 billion in assets

Recent Trends in Loan Growth and Quality Commercial and industrial loans represent the second highest concentration of loans at banks Loans to individuals are greatest for banks with more than $1 billion in assets Farmland and farm loans make up a significant portion of the smallest banks’ loans

Recent Trends in Loan Growth and Quality Wholesale Bank Emphasizes lending to businesses Retail Bank Emphasizes lending to individuals Primary funding is from core deposits

Recent Trends in Loan Growth and Quality FDIC Bank Categories Credit Card Banks International Banks Agricultural Banks Commercial Lenders Vast majority of FDIC-insured institutions fall in this category

Recent Trends in Loan Growth and Quality FDIC Bank Categories Mortgage Lenders Consumer Lenders Other Specialized Banks (less than $1 billion) All Other Banks (less than $1 billion) All Other Banks (more than $1 billion)

Recent Trends in Loan Growth and Quality Noncurrent Loans Loans and leases past due 90 days or more and still accruing interest plus all loans and leases in a nonaccrual status Nonaccrual loans and leases are those: that are maintained on a cash basis because of deterioration in the financial position of the borrower where full payment of interest and principal is not expected where principal or interest has been in default for a period of 90 days or more, unless the obligation is both well secured and in the process of collection

Recent Trends in Loan Growth and Quality Net Losses (Net Charge-offs) The dollar amount of loans that are formally charged off as uncollectible minus the dollar value of recoveries on loans previously charged off

Measuring Aggregate Asset Quality It is extremely difficult to assess individual asset quality using aggregate quality data Different types of assets and off-balance sheet activities have different default probabilities Loans typically exhibit the greatest credit risk Historical charge-offs and past-due loans might understate (or overstate) future losses depending on the future economic and operational conditions of the borrower

Measuring Aggregate Asset Quality Concentration Risk Exists when banks lend in a narrow geographic area or concentrate their loans in a certain industry Country Risk Refers to the potential loss of interest and principal on international loans due to borrowers in a country refusing to make timely payments

Trends in Competition for Loan Business In 1984, there were nearly 14,500 banks in the U.S. This fell to fewer than 7,300 at the beginning of 2007 Recently, the Treasury’s efforts to provide capital to banks via TARP further differentiated between strong and weaker banks, as those in the worst condition did not qualify for the capital and ultimately either failed or were forced to sell This has forced consolidation

Trends in Competition for Loan Business Banks still have the required expertise and experience to make them the preferred lender for many types of loans Technology advances have meant that more loans are becoming “standardized,” making it easier for market participants to offer loans in direct competition to banks

Trends in Competition for Loan Business Structured Note Loan that is specifically designed to meet the needs of one or a few companies but has been packaged for resale

The Credit Process Loan Policy Credit Philosophy Credit Culture Formalizes lending guidelines that employees follow to conduct bank business Credit Philosophy Management’s philosophy that determines how much risk the bank will take and in what form Credit Culture The fundamental principles that drive lending activity and how management analyzes risk

The Credit Process

The Credit Process Credit Culture The fundamental principles that drive lending activity and how management analyzes risk Values Driven Focus is on credit quality Current-Profit Driven Focus is on short-term earnings Market-Share Driven Focus is on having the highest market share

The Credit Process Business Development and Credit Analysis Market research Train employees: What products are available What products customers are likely to need How they should communicate with customers about those needs Advertising and Public Relations Officer Call Programs

The Credit Process Business Development and Credit Analysis Evaluate a borrower’s ability and willingness to repay Questions to address What risks are inherent in the operations of the business? What have managers done or failed to do in mitigating those risks? How can a lender structure and control its own risks in supplying funds?

The Credit Process Business Development and Credit Analysis Five C’s of Good Credit Character Capital Capacity Conditions Collateral

The Credit Process Business Development and Credit Analysis Five C’s of Bad Credit Complacency Carelessness Communication Contingencies Competition

The Credit Process Business Development and Credit Analysis Procedure Collect information for the credit file Evaluate management, the company, and the industry in which it operates Conduct a financial statement analysis Project the borrower’s cash flow and its ability to service the debt Evaluate collateral or the secondary source of repayment Write a summary analysis and making a recommendation

The Credit Process Credit Execution and Administration Loan Decision Individual officer decision Committee Centralized underwriting

The Credit Process Credit Execution and Administration Loan Agreement Formalizes the purpose of the loan Terms of the loan Repayment schedule Collateral required Any loan covenants States what conditions bring about a default

The Credit Process Credit Execution and Administration Documentation: Perfecting the Security Interest Perfected When the bank's claim is superior to that of other creditors and the borrower Require the borrower to sign a security agreement that assigns the qualifying collateral to the bank Bank obtains title to equipment or vehicles

The Credit Process Credit Execution and Administration Position Limits Maximum allowable credit exposures to any single borrower, industry, or geographic local Risk Rating Loans Evaluating characteristics of the borrower and loan to assess the likelihood of default and the amount of loss in the event of default

The Credit Process Credit Execution and Administration Loan Covenants Positive (Affirmative) Indicate specific provisions to which the borrower must adhere Negative Indicate financial limitations and prohibited events

The Credit Process Credit Execution and Administration Loan Review Monitoring the performance of existing loans Handling problem loans Loan review should be kept separate from credit analysis, execution, and administration The loan review committee should act independent of loan officers and report directly to the CEO of the bank

The Credit Process Credit Execution and Administration Problem Loans Often require special treatment Modify terms of the loan agreement to increases the probability of full repayment Modifications might include: Deferring interest and principal payments Lengthening maturities Liquidating unnecessary assets

Characteristics of Different Types of Loans UBPR Classifications Real Estate Loans Commercial Loans Individual Loans Agricultural Loans Other Loans and Leases in Domestic Offices Loans and Leases in Foreign Offices

Characteristics of Different Types of Loans Real Estate Loans Construction and Development Loans Commercial Real Estate Multi-Family Residential Real Estate 1-4 Family Residential Home Equity Farmland Other Real Estate Loans

Characteristics of Different Types of Loans Real Estate Loans Commercial Real Estate Loans Typically short-term loans consisting of: Construction and Real Estate Development Loans Land Development Loans Commercial Building Construction and Land Development Loans

Characteristics of Different Types of Loans Real Estate Loans Commercial Real Estate Loans Construction Loans Interim financing on commercial, industrial, and multi-family residential property Interim Loans Provide financing for a limited time until permanent financing is arranged Land Development Loans Finance the construction of road and public utilities in areas where developers plan to build houses Developers typically repay loans as lots or homes are sold

Characteristics of Different Types of Loans Real Estate Loans Commercial Real Estate Loans Takeout Commitment An agreement whereby a different lender agrees to provide long-term financing after construction is finished

Characteristics of Different Types of Loans Real Estate Loans Residential Mortgage Loans Mortgage Legal document through which a borrower gives a lender a lien on real property as collateral against a debt Most are amortized with monthly payments, including principal and interest

Characteristics of Different Types of Loans Real Estate Loans Residential Mortgage Loans 1-4 Family Residential Mortgage Loans Holding long-term fixed-rate mortgages can create interest rate risk for banks with loss potential if rates increase To avoid this, many mortgages now provide for: Periodic adjustments in the interest rate Adjustments in periodic principal payments The lender sharing in any price appreciation of the underlying asset at sale All of these can increase cash flows to the lender when interest rates rise

Characteristics of Different Types of Loans Real Estate Loans The Secondary Mortgage Market Involves the trading of previously originated residential mortgages Can be sold directly to investors or packaged into mortgage pools

Characteristics of Different Types of Loans Real Estate Loans Home Equity Loans Second Mortgage Loans Typically shorter term than first mortgages Subordinated to first mortgage Home Equity Lines of Credit (HELOC)

Characteristics of Different Types of Loans Real Estate Loans Equity Investments in Real Estate Historically, commercial banks have been prevented from owning real estate except for their corporate offices or property involved in foreclosure Regulators want banks to engage in speculative real estate activities only through separate subsidiaries The Gramm-Leach-Bliley Act of 1999 allowed for commercial banks and savings institutions to enter into the merchant banking business

Characteristics of Different Types of Loans Commercial Loans Loan Commitment/Line of Credit Formal agreement between a bank and borrower to provide a fixed amount of credit for a specified period The customer determines the timing of actual borrowing

Characteristics of Different Types of Loans Commercial Loans Working Capital Requirements Net Working Capital Current assets – Current liabilities For most firms, net working capital is positive, indicating that some current assets are not financed with current liabilities

Characteristics of Different Types of Loans Commercial Loans Working Capital Requirements Days Cash Cash/(Sales/365) Days Receivables AR/(Sales/365) Days Inventory Inventory/(COGS/365)

Characteristics of Different Types of Loans Commercial Loans Working Capital Requirements Days Payable AP/(Purchases/365) Days Accruals Accruals/(Operating Expenses/365)

Characteristics of Different Types of Loans Commercial Loans Working Capital Requirements Cash-to-Cash Asset Cycle How long the firm must finance operating cash, inventory and accounts receivables from the day of first sale Cash-to-Cash Liability Cycle How long a firm obtains interest-free financing from suppliers in the form of accounts payable and accrued expenses to help finance the asset cycle

Characteristics of Different Types of Loans Commercial Loans Working Capital Requirements

Characteristics of Different Types of Loans Commercial Loans Seasonal versus Permanent Working Capital Needs All firms need some minimum level of current assets and current liabilities The amount of current assets and current liabilities will vary with seasonal patterns

Characteristics of Different Types of Loans Commercial Loans Seasonal versus Permanent Working Capital Needs Permanent Working Capital The minimum level of current assets minus the minimum level of adjusted current liabilities Adjusted Current Liabilities Current liabilities net of short-term bank credit and current maturities of long-term debt

Characteristics of Different Types of Loans Commercial Loans Seasonal versus Permanent Working Capital Needs Seasonal Working Capital Difference in total current assets and adjusted current liabilities

Characteristics of Different Types of Loans Commercial Loans Seasonal Working Capital Loans Finance a temporary increase in net current assets above the permanent requirement Loan is seasonal if the need arises on a regular basis and if the cycle completes itself within one year Loan is self-liquidating if repayment derives from sales of the finished goods that are financed

Characteristics of Different Types of Loans Commercial Loans Short-Term Commercial Loans Short-term funding needs are financed by short-term loans, while long-term needs are financed by term loans with longer maturities

Characteristics of Different Types of Loans Commercial Loans Open Credit Lines Used to meet many types of temporary needs in addition to seasonal needs Informal Credit Line Not legally binding but represent a promise that the lender will advance credit Formal Credit Line Legally binding even though no written agreement is signed A commitment fee is charged for making credit available, regardless of whether the customer actually uses the line

Characteristics of Different Types of Loans Commercial Loans Asset-Based Loans Loans Secured by Accounts Receivable The security consists of paper assets that presumably represent sales The quality of the collateral depends on the borrower’s integrity in reporting actual sales and the credibility of billings

Characteristics of Different Types of Loans Commercial Loans Asset-Based Loans Loans Secured by Accounts Receivable Accounts Receivable Aging Schedule List of A/Rs grouped according to the month in which the invoice is dated Lockbox Customer’s mail payments go directly to a P.O. Box controlled by the bank The bank processes the payments and reduces the borrower’s balance but charges the borrower for handling the items

Characteristics of Different Types of Loans Commercial Loans Highly Levered Transactions Leveraged Buyout (LBO) Involves a group of investors, often part of the management team, buying a target company and taking it private with a minimum amount of equity and a large amount of debt Target companies are generally those with undervalued hard assets

Characteristics of Different Types of Loans Commercial Loans Highly Levered Transactions Leveraged Buyout (LBO) The investors often sell specific assets or subsidiaries to pay down much of the debt quickly If key assets have been undervalued, the investors may own a downsized company whose earnings prospects have improved and whose stock has increased in value The investors sell the company or take it public once the market perceives its greater value

Characteristics of Different Types of Loans Commercial Loans Highly Levered Transactions Arise from three types of transactions LBOs in which debt is substituted for privately held equity Leveraged recapitalizations in which borrowers use loan proceeds to pay large dividends to shareholders Leveraged acquisitions in which a cash purchase of another related company produces an increase in the buyer’s debt structure

Characteristics of Different Types of Loans Commercial Loans Highly Levered Transactions An HLT must involve the buyout, recapitalization, or acquisition of a firm in which either: The firm’s subsequent leverage ratio exceeds 75 percent The transaction more than doubles the borrower’s liabilities and produces a leverage ratio over 50 percent The regulators or firm that syndicates the loans declares the transaction an HLT

Characteristics of Different Types of Loans Commercial Loans Term Commercial Loans Original maturity greater than 1 year Typically finance: Depreciable assets Start-up costs for a new venture Permanent increase in the level of working capital

Characteristics of Different Types of Loans Commercial Loans Term Commercial Loans Lenders focus more on the borrower’s periodic income and cash flow rather than the balance sheet Term loans often require collateral, but this represents a secondary source of repayment in case the borrower defaults

Characteristics of Different Types of Loans Commercial Loans Term Commercial Loans Balloon Payments Most of the principal is due at maturity Bullet Payments All of the principal is due at maturity

Characteristics of Different Types of Loans Commercial Loans Revolving Credits A hybrid of short-term working capital loans and term loans Typically involves the commitment of funds for 1 – 5 years At the end of some interim period, the outstanding principal converts to a term loan During the interim period, the borrower determines how much credit to use Mandatory principal payments begin once the revolver is converted to a term loan

Characteristics of Different Types of Loans Agricultural Loans Proceeds are used to purchase seed, fertilizer and pesticides and to pay other production costs Farmers expect to repay the debt with the crops are harvested and sold Long-term loans finance livestock, equipment, and land purchases The primary source of repayment is cash flow from the sale of livestock and harvested crops in excess of operating expenses

Characteristics of Different Types of Loans Consumer Loans Installment Require periodic payments of principal and interest Credit Card Non-Installment For special purposes Example: Bridge loan for the down payment on a house that is repaid from the sale of the previous house

Characteristics of Different Types of Loans Venture Capital A broad term use to describe funding acquired in the earlier stages of a firm’s economic life Due to the high leverage and risk involved banks generally do not participate directly in venture capital deals Some banks have subsidiaries that finance certain types of equity participations and venture capital deals, but their participation is limited

Characteristics of Different Types of Loans Venture Capital Venture capital firms attempt to add value to the firm without taking majority control Often, venture capital firms not only provide financing but experience, expertise, contacts, and advice when required

Characteristics of Different Types of Loans Venture Capital Types of Venture Financing Seed or Start-up Capital Early stages of financing Highly levered transactions in which the venture capital firm will lend money for a percentage stake in the firm Rarely, if ever, do banks participate at this stage

Characteristics of Different Types of Loans Venture Capital Types of Venture Financing Later-Stage Development Financing: Expansion and replacement financing Recapitalization or turnaround financing Buy-out or buy-in financing Mezzanine financing Banks do participate in these rounds of financing, but if the company is overleveraged at the onset, the banks will be effectively excluded from these later rounds of financing

Evaluating Commercial Loan Requests and Managing Credit Risk 14

Evaluating Commercial Loan Requests and Managing Credit Risk Important Questions Regarding Commercial Loan Requests What is the character of the borrower and quality of information provided? What are the loan proceeds going to be used for? How much does the customer need to borrow? What is the primary source of repayment, and when will the loan be repaid? What is the secondary source of repayment; that is, what collateral, guarantees, or other cash inflows are available?

Fundamental Credit Issues There are two types of loan errors Type I Error Making a loan to a customer who will ultimately default Type II Error Denying a loan to a customer who would ultimately repay the debt

Fundamental Credit Issues Character of the Borrower and Quality of Data Provided The most important issue in assessing credit risk is determining a borrower’s commitment and ability to repay debts in accordance with the terms of a loan agreement The best indicators are the borrower’s financial history and personal references

Fundamental Credit Issues Character of the Borrower and Quality of Data Provided Audited financial statements are preferred in determining the quality of the data because accounting rules are well established so that an analyst can better understand the underlying factors that affect the entries But just because a company has audited financial statements, however, does not mean the reported data are not manipulated

Fundamental Credit Issues Use of Loan Proceeds Loan proceeds should be used for legitimate business operating purposes, including seasonal and permanent working capital needs, the purchase of depreciable assets, physical plant expansion, acquisition of other firms, and extraordinary operating expenses Speculative asset purchases and debt substitutions should be avoided

Fundamental Credit Issues How Much Does the Borrower Need? The Loan Amount Borrowers often request a loan before they clearly understand how much external financing is actually needed and how much is available internally The amount of credit required depends on the use of the proceeds and the availability of internal sources of funds

Fundamental Credit Issues How Much Does the Borrower Need? The Loan Amount For a shorter-term loan, the amount might equal the temporary seasonal increase in receivables and inventory net of that supported by increased accounts payable With term loans, the amount can be determined via pro forma analysis which is the projecting or forecasting of a company’s financial statements into the future

Fundamental Credit Issues The Primary Source and Timing of Repayment Loans are repaid from cash flows: Liquidation of assets Cash flow from normal operations New debt issues New equity issues

Fundamental Credit Issues The Primary Source and Timing of Repayment Specific sources of cash are generally associated with certain types of loans Short-term, seasonal working capital loans are normally repaid from the liquidation of receivables or reductions in inventory

Fundamental Credit Issues The Primary Source and Timing of Repayment Specific sources of cash are generally associated with certain types of loans Term loans are typically repaid out of cash flows from operations, specifically earnings and noncash charges in excess of net working capital needs and capital expenditures needed to maintain the existing fixed asset base

Fundamental Credit Issues The Primary Source and Timing of Repayment The primary source of repayment on the loan can also determine the risk of the loan The general rule is not to rely on the acquired asset or underlying collateral as the primary source of repayment

Fundamental Credit Issues Secondary Source of Repayment: Collateral Collateral must exhibit three features Its value should always exceed the outstanding principal on a loan The lower the loan-to-value (LTV) ratio, the more likely a the lender can sell the collateral for more than the balance due and reduce loses Borrowers are “upside-down” on a loan if the value of the collateral is less than the outstanding loan balance

Fundamental Credit Issues Secondary Source of Repayment: Collateral Collateral must exhibit three features The lender should be able to easily take possession of the collateral and have a ready market for its sale A lender must be able to clearly mark the collateral as its own Careful loan documentation is required to “perfect” the bank’s interest in the collateral If collateral is not readily available, a personal guarantee may be required

Fundamental Credit Issues Secondary Source of Repayment: Collateral The borrower’s cash flow is the preferred source of loan repayments Liquidating collateral is secondary There are significant transactions costs associated with foreclosure Bankruptcy laws allow borrowers to retain possession of the collateral long after they have defaulted When the bank takes possession of the collateral, it deprives the borrower of the opportunity to salvage the company

Evaluating Credit Requests: A Four-Part Process Overview of management, operations, and the firm’s industry Common size and financial ratio analysis Analysis of cash flow Projections and analysis of the borrower’s financial condition

Evaluating Credit Requests: A Four-Part Process Overview of Management, Operations, and the Firm’s Industry Gather background information on the firm’s operations Write a Business and Industry Outlook report Examine the nature of the borrower’s loan request and the quality of the financial data provided

Evaluating Credit Requests: A Four-Part Process Common Size and Financial Ratio Analysis Common size ratio comparisons are valuable because they adjust for size and thus enable comparisons across firms in the same industry or line of business

Evaluating Credit Requests: A Four-Part Process Common Size and Financial Ratio Analysis Most analysts differentiate between at least four categories of ratios: Liquidity ratios Indicate a firm’s ability to meet its short-term obligations and continue operations. Activity ratios Signal how efficiently a firm uses assets to generate sales

Evaluating Credit Requests: A Four-Part Process Common Size and Financial Ratio Analysis Most analysts differentiate between at least four categories of ratios: Leverage ratios Indicate the mix of the firm’s financing between debt and equity and potential earnings volatility Profitability ratios Provide evidence of the firm’s sales and earnings performance

Evaluating Credit Requests: A Four-Part Process Common Size and Financial Ratio Analysis Liquidity Ratios Current Ratio CA / CL Quick Ratio (Cash + A/R) / CL

Evaluating Credit Requests: A Four-Part Process Common Size and Financial Ratio Analysis Activity Ratios Days Cash Cash/Average Daily Sales Days Inventory on Hand Inventory/Average Daily Cost of Goods Sold Inventory Turnover COGS / Average Inventory

Evaluating Credit Requests: A Four-Part Process Common Size and Financial Ratio Analysis Activity Ratios Days Accounts Receivable Collection Period A/R / Average Daily Sales Days Cash-to-Cash Cycle Days Cash + Days A/R + Days Inventory on Hand

Evaluating Credit Requests: A Four-Part Process Common Size and Financial Ratio Analysis Activity Ratios Days Accounts Payable Outstanding A/P / Average Daily Purchases Purchases COGS + ΔInventory Sales-to-Asset Ratio Sales/Net Fixed Assets

Evaluating Credit Requests: A Four-Part Process Common Size and Financial Ratio Analysis Leverage Ratios Debt to Tangible Net Worth Total Liabilities/Tangible Net Worth Debt to Total Assets Total Debt/Total Assets Times Interest Earned EBIT/Interest Expense EBIT Earnings Before Taxes + Interest Expense

Evaluating Credit Requests: A Four-Part Process Common Size and Financial Ratio Analysis Leverage Ratios Fixed Charge Coverage (EBIT + Lease Payments)/(Interest Expense + Lease Payments) Net Fixed Assets to Tangible Net Worth Net Fixed Assets/Tangible Net Worth Dividend Payout Cash Dividends Paid/Net Income

Evaluating Credit Requests: A Four-Part Process Common Size and Financial Ratio Analysis Profitability Analysis Profit Margin (PM) Net Income/Sales 1 – Expenses/Sales 1 – (COGS/Sales) – (Operating Expenses/Sales) – (Other Expenses/Sales) – (Taxes/Sales)

Evaluating Credit Requests: A Four-Part Process Common Size and Financial Ratio Analysis Profitability Analysis Asset Utilization (AU) Sales/Total Assets Return on Assets Net Income/Total Assets PM × AU

Evaluating Credit Requests: A Four-Part Process Common Size and Financial Ratio Analysis Profitability Analysis Equity Multiplier (EM) Total Assets/Equity Return on Equity (ROE) Net Income/Equity ROA × EM Sales Growth Demonstrates whether a firm is expanding or contracting

Evaluating Credit Requests: A Four-Part Process Cash-Flow Analysis Cash-Based Income Statement Modified form of a direct statement of cash flows

Evaluating Credit Requests: A Four-Part Process Cash-Flow Analysis Cash-Flow Statement Format Operations Section Income statement items and the change in current assets and current liabilities (except bank debt) Investments Section The change in all long-term assets

Evaluating Credit Requests: A Four-Part Process Cash-Flow Analysis Cash-Flow Statement Format Financing Section Payments for debt and dividends, the change in all long-term liabilities, the change in short-term bank debt, and any new stock issues Cash Section The change in cash and marketable securities

Evaluating Credit Requests: A Four-Part Process Cash-Flow Analysis Cash-Flow Statement Format where: Ai = the dollar value of the ith type of asset (A) Lj = the dollar value of the jth type of liability (L) NW = the dollar value of net worth

Evaluating Credit Requests: A Four-Part Process Cash-Flow Analysis Cash-Flow Statement Format Cash Flow From Operations is defined as: where: ΔA1 = ΔCash

Evaluating Credit Requests: A Four-Part Process Cash-Flow Analysis Cash-Flow Statement Format

Evaluating Credit Requests: A Four-Part Process Cash-Flow Analysis Cash-Flow Statement Format Sources of Cash Increase in any liability Decrease in a non-cash asset New issue of stock Additions to surplus Revenues

Evaluating Credit Requests: A Four-Part Process Cash-Flow Analysis Cash-Flow Statement Format Uses of Cash Decrease in any liability Increase in a non-cash asset Repayments/Buy back stock Deductions from surplus Cash Expenses Taxes Cash Dividends

Evaluating Credit Requests: A Four-Part Process Cash-Flow Analysis For Prism Industries Cash Flow From Operations Recall Exhibits 14.1, 14.2, & 14.3 Cash Purchases for 2008: Cash Purchases = -(COGS + ΔInventory – ΔAccounts Payable)

Evaluating Credit Requests: A Four-Part Process Cash-Flow Analysis For Prism Industries Cash Flow From Investing Activities ΔNet Fixed Assets = ΔGross Fixed Assets – ΔAccumulated Depreciation Or ΔNet Fixed Assets = Capital Expenditures – Depreciation where: Capital Expenditures = ΔNet Fixed Assets + Depreciation

Evaluating Credit Requests: A Four-Part Process Cash-Flow Analysis For Prism Industries Cash Flow From Financing Activities Although cash-flow statements group payments for financing below the investment section, this is somewhat misleading because payments for financing generally take precedence over capital expenditures and increases in long-term investments

Evaluating Credit Requests: A Four-Part Process Cash-Flow Analysis For Prism Industries Change in Cash Equals cash flow from operations adjusted for discretionary expenditures, cash used for investments, payments for financing, and external financing

Evaluating Credit Requests: A Four-Part Process Financial Projections Pro Forma projections of the borrower’s condition reveal: How much financing is required When the loan will be repaid Use of the loan

Evaluating Credit Requests: A Four-Part Process Financial Projections Pro Forma Assumptions Salest+1 = Salest × (1 + gSales) where: gSales = Projected Sales Growth COGSt+1 = Salest+1 × COGS % of Sales Accounts Receivablet+1 = Days A/R Outstanding × Average Daily Salest+1 Inventoryt+1 = COGSt+1/Inventory Turnover

Evaluating Credit Requests: A Four-Part Process Financial Projections Pro Forma Assumptions Accounts Payablet+1 = Days A/P Outstanding × Average Daily Purchasest+1 Or Accounts Payablet+1 = Days A/P Outstanding × [(COGSt+1 + ΔInventoryt+1)/365]

Evaluating Credit Requests: A Four-Part Process Financial Projections Projecting Notes Payable to Banks Rarely will the balance sheet “balance” in the initial round of pro forma forecasts To reconcile this, there must be a balancing item or “plug” figure

Evaluating Credit Requests: A Four-Part Process Financial Projections Projecting Notes Payable to Banks When projected assets exceed projected liabilities plus equity, additional debt (assumed to be in the form of notes payable) is required When projected assets are less than projected liabilities plus equity, no new debt is required and existing debt could be reduced or excess funds invested in marketable securities

Evaluating Credit Requests: A Four-Part Process Financial Projections Sensitivity Analysis Best Case Scenario Assumes optimistic improvements in planned performance and the economy are realized Worst Case Scenario Assumes the environment with the greatest potential negative impact on sales, earnings, and the balance sheet Most Likely Scenario Assumes the most reasonable sequence of economic events and performance trends

Evaluating Credit Requests: A Four-Part Process Risk-Classification Scheme After evaluating the borrower’s risk profile along all dimensions, a loan is placed in a rating category ranked according to the degree of risk

Credit Analysis Application: Wade’s Office Furniture See Exhibits 14.5- 14.11

Managing Risk with Loan Sales and Credit Derivatives Many financial institutions have changed their business models, switching to the originate-to-distribute (OTD) model Under the OTD model, firms make loans and thereby collect fees, then either sell parts of the loan through participations or package the loans into pools and sell them in the marketplace

Managing Risk with Loan Sales and Credit Derivatives Larger institutions also form loan syndicates in which one firm serves as a principal in negotiating terms with a borrower who has significant credit needs, but then engages other firms to take part of the credit and thus share the risk Lead Bank The institution that actually underwrites the original loan and sells the participation

Managing Risk with Loan Sales and Credit Derivatives There are several inherent risk in loan participations or loan sales General credit risks There is an inherent potential conflict between the originating institution and the investor The loan originator might see the up-front fees and premium to the loan value as an excellent source of revenue that might not be as attractive if these loans were subsequently held in portfolio

Managing Risk with Loan Sales and Credit Derivatives Underwriting Loan Sales, Participations, and Syndications The lead lending institution and the participating investor are required to underwrite the loans as if they were making the loans themselves and placing them on their own books

Managing Risk with Loan Sales and Credit Derivatives Shared National Credits (SNC) Loan or loan commitment of $20 million or more made generally by three or more unaffiliated supervised institutions under a formal lending agreement The various regulatory agencies established the SNC program in 1977 to monitor and review the risk structure of large syndicated loans

Managing Risk with Loan Sales and Credit Derivatives Shared National Credits (SNC)

Managing Risk with Loan Sales and Credit Derivatives Credit Enhancements Can take many forms Key terms of credit enhancements potentially include: Excess cash flow Many securitized assets are placed in pools in which the required payments to investors are less than the contractual payments of borrowers Thus, even if some borrowers do not make the required payments, there is sufficient cash flow to continue to pay investors

Managing Risk with Loan Sales and Credit Derivatives Credit Enhancements Key terms of credit enhancements potentially include: Reserve accounts The originating institution creates a trust for losses up to an amount allocated for a reserve which is used to make up any deficits in payments by borrowers Collateralization One or more parties pledge collateral against the loan

Managing Risk with Loan Sales and Credit Derivatives Credit Enhancements Key terms of credit enhancements potentially include: Loan guarantees One or more parties pledge personal or business assets or are contractually bound to meet the obligations of the borrower if that party defaults Credit insurance Any party can purchase credit insurance, provided either privately or by a governmental unit, for loans that provide payments for losses stemming from default

Managing Risk with Loan Sales and Credit Derivatives Credit Enhancements Key terms of credit enhancements potentially include: Credit derivatives Instruments or contracts that derive their value from the underlying credit risk of a loan or bond

Managing Risk with Loan Sales and Credit Derivatives Credit Default Swaps (CDS) CDS contracts are relatively unregulated derivative instruments based on the underlying payments and values of fixed-income securities These contracts are privately negotiated instruments between a buyer and a seller and are traded in over-the-counter markets

Managing Risk with Loan Sales and Credit Derivatives Credit Default Swaps (CDS) The buyer pays a premium and thus the CDS is similar to an insurance contract The buyer often owns the underlying debt and uses the CDS as a hedge The seller of the CDS plays a role similar to that of the insurance company Sellers generally do not own the debt and provide longer-term protection If an adverse event occurs the seller pays the buyer the change in value of the underlying asset

Managing Risk with Loan Sales and Credit Derivatives Credit Default Swaps (CDS)

Managing Risk with Loan Sales and Credit Derivatives Credit Default Swaps (CDS) There are several credit events that potentially trigger a payment from the seller of a CDS to the buyer: Failure to pay principal and interest payments in a timely manner Restructuring of the debt in such a way that the lender (investor in the debt) is negatively affected Bankruptcy or insolvency in which the debt is not paid Acceleration of the principal and interest payments prior to the scheduled date(s) Repudiation or moratorium in which the debt issuer rejects or refuses to pay the debt

Managing Risk with Loan Sales and Credit Derivatives Credit Default Swaps (CDS) The credit crisis of 2007–2008 caused many sellers of credit default swaps to make large and unexpected payments for default

Evaluating Consumer Loans 15

Evaluating Consumer Loans Today, many banks target individuals as the primary source of growth in attracting new business Consumer loans differ from commercial loans Quality of financial data is lower Primary source of repayment is current income

Types of Consumer Loans Evaluating Consumer Loans An analyst should addresses the same issues discussed with commercial loans: The use of loan proceeds The amount needed The primary and secondary source of repayment

Types of Consumer Loans Evaluating Consumer Loans Consumer loans differ so much in design that no comprehensive analytical format applies to all loans

Types of Consumer Loans Installment Loans Require the periodic payment of principal and interest

Types of Consumer Loans Installment Loans Direct Negotiated between the bank and the ultimate user of the funds Indirect Funded by a bank through a separate retailer that sells merchandise to a customer

Types of Consumer Loans Installment Loans Revenues and Costs from Installment Loans Consumer installment loans can be extremely profitable Costs $100 - $250 to originate loan Typically yield over 5% (loan income minus loan acquisition costs, collections costs and net charge-offs)

Types of Consumer Loans Credit Cards and Other Revolving Credit Credit cards and overlines tied to checking accounts are the two most popular forms of revolving credit agreements In 2007, over 92% of households had credit cards (average of 13 cards)

Types of Consumer Loans Credit Cards and Other Revolving Credit Most banks operate as franchises of MasterCard and/or Visa Bank pays a one-time membership fee plus an annual charge determined by the number of its customers actively using the cards

Types of Consumer Loans Debit Cards, Smart Cards, and Prepaid Cards Debit Cards Widely available When an individual uses the card, their balance is immediately debited Banks prefer debit card use over checks because debit cards have lower processing costs

Types of Consumer Loans Debit Cards, Smart Cards, and Prepaid Cards Smart Card Contains a memory chip which can store information and value Programmable such that users can store information and add or transfer value to another smart card Only modest usage in the U.S.

Types of Consumer Loans Debit Cards, Smart Cards, and Prepaid Cards Prepaid Card A hybrid of a debit card Customers prepay for services to be rendered and receive a card against which purchases are charged Use of phone cards, prepaid cellular, toll tags, subway, etc. are growing rapidly

Types of Consumer Loans Credit Card Systems and Profitability Card issuers earn income from three sources: Cardholders’ annual fees Interest on outstanding loan balances Discounting the charges that merchants accept on purchases

Types of Consumer Loans Credit Card Systems and Profitability Despite high charge-offs, credit cards are attractive because they provide higher risk-adjusted returns than do other types of loans

Types of Consumer Loans Overdraft Protection and Open Credit Lines Overdraft Protection Against Checking Accounts A type of revolving credit A bank authorizes qualifying individuals to write checks in excess of actual balances held in a checking account up to a pre-specified limit

Types of Consumer Loans Overdraft Protection and Open Credit Lines Open Credit Lines The bank provides customers with special checks that activate a loan when presented for payment

Types of Consumer Loans Home Equity Loans Grew from virtually nothing in the mid-1980s to over $350 billion in 2008 They meet the tax deductibility requirements of the Tax Reform Act of 1986, which limits deductions for consumer loan interest paid by individuals, because they are secured by equity in an individual's home

Types of Consumer Loans Home Equity Loans Some allow access to credit line by using a credit card Borrowers pay interest only on the amount borrowed, pay 1 to 2 percent of the outstanding principal each month, and can repay the remaining principal at their discretion

Types of Consumer Loans Non-Installment Loans aka Bridge Loan Requires a single principal and interest payment Typically, the individual’s borrowing needs are temporary and repayment is from a well-defined future cash inflow

Subprime Loans One of the hottest growth areas during the early 2000s Subprime loans are higher-risk loans labeled “B,” “C,” and “D” credits They have been especially popular in auto, home equity, and mortgage lending Typically have the same risk as loans originated through consumer finance companies

Subprime Loans Many subprime lenders make loans to individuals that a bank would not traditionally make and keep on-balance sheet Subprime lenders charge higher rates and have more restrictive covenants

Subprime Loans What Happens When Housing Prices Fall Subprime loans can be attractive when housing values are rising Individuals who are overextended and cannot make their monthly payments, can often sell the home or refinance and withdraw equity to pay the debts if the price increases are sufficiently high The opposite occurs when housing prices fall

Subprime Loans What Happens When Housing Prices Fall During 2007–2008, banks were forced to charge-off historically high amounts of mortgage loans as delinquencies and foreclosures skyrocketed

Consumer Credit Regulations Equal Credit Opportunity Makes it illegal for lenders to discriminate on the basis of race, religion, sex, marital status, age, or national origin

Consumer Credit Regulations Prohibited Information Requests The applicant's marital status Whether alimony, child support, and public assistance are included in reported income A woman's childbearing capability and plans Whether an applicant has a telephone

Consumer Credit Regulations Credit Scoring Systems Acceptable if they do not require prohibited information and are statistically justified Can use information about age, sex, and marital status as long as these factors contribute positively to the applicant's creditworthiness

Consumer Credit Regulations Credit Reporting Lenders must report credit extended jointly to married couples in both spouses' names Whenever lenders reject a loan, they must notify applicants of the credit denial within 30 days and indicate why the request was turned down

Consumer Credit Regulations Truth In Lending Regulations apply to all individual loans up to $25,000 where the borrower's primary residence does not serve as collateral

Consumer Credit Regulations Truth In Lending Requires that lenders disclose to potential borrowers both the total finance charge and an annual percentage rate (APR) Historically, consumer loan rates were quoted as: Add-On Rates Discount Rates Simple Interest Rates

Consumer Credit Regulations Fair Credit Reporting Fair Credit Reporting Act Enables individuals to examine their credit reports provided by credit bureaus If any information is incorrect, the individual can have the bureau make changes and notify all lenders who obtained the inaccurate data

Consumer Credit Regulations Fair Credit Reporting There are three primary credit reporting agencies: Equifax Experian Trans Union Unfortunately, the credit reports that they produce are quite often wrong

Consumer Credit Regulations Fair Credit Reporting Credit Score Like a bond rating for individuals Based on several factors Payment History Amounts Owed Length of Credit History Types of Credit New Credit

Consumer Credit Regulations Community Reinvestment Act CRA prohibits redlining and encourages lenders to extend credit within their immediate trade area and the markets where they collect deposits

Consumer Credit Regulations Community Reinvestment Act Financial Institutions Reform, Recover, and Enforcement Act of 1989 raised the profile of the CRA by mandating public disclosure of bank lending policies and regulatory ratings of bank compliance

Consumer Credit Regulations Community Reinvestment Act Regulators must also take CRA compliance into account when evaluating a bank's request to charter a new bank, acquire a bank, open a branch, or merge with another institution

Consumer Credit Regulations Bankruptcy Reform Individuals who cannot repay their debts on time can file for bankruptcy and receive court protection against creditors

Consumer Credit Regulations Bankruptcy Reform Individuals can file for bankruptcy under: Chapter 7 Individuals liquidate qualified assets and distribute the proceeds to creditors Chapter 13 An individual works out a repayment plan with court supervision

Consumer Credit Regulations Bankruptcy Reform In 2005, Congress passed bankruptcy reform legislation that made it more difficult for individuals to completely avoid repaying their debts In particular, an individual whose income exceeds the state median has to file for Chapter 13 and will repay at least a portion of his or her debts

Credit Analysis Objective of consumer credit analysis is to assess the risks associated with lending to individuals

Credit Analysis When evaluating loans, bankers cite the Cs of credit: Character Capital Capacity Conditions Collateral

Credit Analysis Two additional Cs Customer Relationship Competition A bank’s prior relationship with a customer reveals information about past credit experience Competition Lenders periodically react to competitive pressures Competition should not affect the accept/reject decision

Credit Analysis Policy Guidelines Acceptable Loans Automobile Boat Home Improvement Personal-Unsecured Single Payment Cosigned

Credit Analysis Policy Guidelines Unacceptable Loans Loans for speculative purposes Loans secured by a second lien Other than home improvement or home equity loans Any participation with a correspondent bank in a loan that the bank would not normally approve

Credit Analysis Policy Guidelines Unacceptable Loans Loans to a poor credit risk based on the strength of the cosigner Single payment automobile or boat loans Loans secured by existing home furnishings Loans for skydiving equipment and hang gliders

Credit Analysis Evaluation Procedures: Judgmental and Credit Scoring Subjectively interpret the information in light of the bank’s lending guidelines and accepts or rejects the loan Assessment can be completed shortly after receiving the loan application and visiting with the applicant

Credit Analysis Evaluation Procedures: Judgmental and Credit Scoring Grades the loan request according to a statistically sound model that assigns points to selected characteristics of the prospective borrower

Credit Analysis Evaluation Procedures: Judgmental and Credit Scoring If the total points exceeds the accept threshold, the officer approves the loan If the total is below the reject threshold, the officer denies the loan

Credit Analysis Evaluation Procedures: Judgmental and Credit Scoring In both cases, judgmental and quantitative, a lending officer collects information regarding the borrower’s character, capacity, and collateral

Credit Analysis An Application: Credit Scoring a Consumer Loan You receive an application for a customer to purchase a 2007 Jeep Cherokee Do you make the loan?

Credit Analysis An Application: Credit Scoring a Consumer Loan The Credit Score At this bank, the loan is automatically approved if the total score equals at least 200 The loan is automatically denied if the total score is below 150 Accept/Reject is indeterminate for scores between 150 & 200

Credit Analysis An Application: Credit Scoring a Consumer Loan The Credit Decision The credit decision rests on the loan officer’s evaluation of the applicant’s character and capacity to repay the debt

Credit Analysis An Application: Credit Scoring a Consumer Loan The Credit Decision The loan officer has numerous grounds for denying credit Limited credit history Local residence was established too recently Employed too recently

Credit Analysis An Application: Credit Scoring a Consumer Loan The Credit Decision The loan officer sees some positive things Applicant appears to be a hard worker who is the victim of circumstances resulting from her husband’s death It is unlikely that anyone who puts almost 30 percent down on a new model is going to walk away from a debt

Credit Analysis An Application: Credit Scoring a Consumer Loan The Credit Decision The loan officer sees some positive things The bank will likely lose Groome as a depositor if it denies the application What would you recommend?

Credit Analysis Your FICO Credit Score Summarizes in one number an individual’s credit history Lenders often use this number when evaluating whether to approve a consumer loan or mortgage Many insurance companies consider the score when determining whether to offer insurance coverage and how to price the insurance

Credit Analysis Your FICO Credit Score Summarizes in one number an individual’s credit history The scores range from 300 to 850 with a higher figure indicating a better credit history The national average is 670 The higher the score is, the more likely it is a lender will see the individual as making the promised payments in a timely manner

Credit Analysis Your FICO Credit Score An individual’s credit score is based on five broad factors: Payment history 35% Amounts owed 30% Length of credit history 15% New credit 10% Type of credit in use 10%

Credit Analysis An Application: Indirect Lending A retailer sells merchandise and takes the credit application Because many firms do not have the resources to carry their receivables, they sell the loans to banks or other financial institutions

Credit Analysis An Application: Indirect Lending These loans are collectively referred to as dealer paper Banks aggressively compete for paper originated by well-established automobile, mobile home, and furniture dealers

Credit Analysis An Application: Indirect Lending Dealers negotiate finance charges directly with their customers A bank, in turn, agrees to purchase the paper at predetermined rates that vary with the default risk assumed by the bank, the quality of the assets sold, and the maturity of the consumer loan

Credit Analysis An Application: Indirect Lending A dealer normally negotiates a higher rate with the car buyer than the determined rate charged by the bank This differential varies with competitive conditions but potentially represents a significant source of dealer profit

Credit Analysis An Application: Indirect Lending Most indirect loan arrangements provide for dealer reserves that reduce the risk in indirect lending The reserves are derived from the differential between the normal, or contract loan rate and the bank rate, and help protect the bank against customer defaults and refunds

Recent Risk and Return Characteristics of Consumer Loans Revenues from Consumer Loans The attraction is two-fold: Competition for commercial customers narrowed commercial loan yields so that returns fell relative to potential risks Developing loan and deposit relationships with individuals presumably represents a strategic response to deregulation

Recent Risk and Return Characteristics of Consumer Loans Revenues from Consumer Loans Consumer loan rates have been among the highest rates quoted at banks in recent years In addition to interest income, banks generate substantial non-interest revenues from consumer loans

Recent Risk and Return Characteristics of Consumer Loans Revenues from Consumer Loans With traditional installment credit, banks often encourage borrowers to purchase credit life insurance on which the bank may earn a premium

Recent Risk and Return Characteristics of Consumer Loans Consumer Loan Losses Losses on consumer loans are normally the highest among all categories of bank credit Losses are anticipated because of mass marketing efforts pursued by many lenders, particularly with credit cards Credit card losses and fraud amounted to more than $12 billion in 2005

Recent Risk and Return Characteristics of Consumer Loans Interest Rate and Liquidity Risk with Consumer Credit The majority of consumer loans are priced at fixed rates New auto loans typically carry 4-year maturities, and credit card loans exhibit an average 15- to 18-month maturity

Recent Risk and Return Characteristics of Consumer Loans Interest Rate and Liquidity Risk with Consumer Credit Bankers have responded in two ways to deal with the interest rate risk: Price more consumer loans on a floating-rate basis Commercial and investment banks have created a secondary market in consumer loans, allowing loan originators to sell a package of loans

Evaluating Consumer Loans