1. Copyright © 2004 by Thomson Southwestern All rights reserved. 13-1 Asset Management for Depository Institutions: Commercial, Consumer, and Mortgage Lending Chapter 13

2. Copyright © 2004 by Thomson Southwestern All rights reserved. 13-2 Trends Lending has become much more competitive Large corporations have capital market access Individuals have multiple sources of loans for ◦ Real estate ◦ Consumer credit Evaluation of credit quality still very important for small &medium-sized firms Is amount of consumer credit too large? Non-performing loans as a risk measure Growth in mortgage lending

3. Copyright © 2004 by Thomson Southwestern All rights reserved. 13-3 Trends in Types of Loans Total Loans, August 2003: $4,448 trillion Consumer Loans 13.0% Real Estate Loans 50.0% Commercial Loans 20.0% Other Loans 17.0% Source: Compiled by the authors from Federal Reserve Bulletin, November 2003, Table 1.26, A15.

4. Copyright © 2004 by Thomson Southwestern All rights reserved. 13-4 Consumer Credit & Mortgage Debt? Holders of Consumer CreditHolders of Mortgage Debt Individuals and Others 9% Mortgage Pools or Trusts 49% Life Insurance Companies 3% Commercial Banks 24% Savings Institutions 10% Federal and Related Agencies 5% Nonfinancial Firms 3% Savings Institutions 4% Finance Companies 13% Commercial Banks 33% Securitized Pools 35% Credit Unions 12% Source: Federal Reserve Bulletin, November 2003, A34

5. Copyright © 2004 by Thomson Southwestern All rights reserved. 13-5 Lending High return – high risk Default risk can be due to ◦ Mismanagement ◦ Economic conditions ◦ Uninsurable disasters ◦ Fraud Longer term is higher risk Risk of lending is managed, never eliminated

6. Copyright © 2004 by Thomson Southwestern All rights reserved. 13-6 The Credit Process: Managing & minimizing Credit Risk Lending is highly regulated including Types of loans & distribution across industries Collateral and documentation required Internal lending process A bank’s written loan policy details the specifics Loan committee review Monitoring & maintenance procedures Workout procedures Role of lending in business development

7. Copyright © 2004 by Thomson Southwestern All rights reserved. 13-7 Bank’s Written Loan Policy Major Components Include: Desired composition and size of loan portfolio Specification of loan approval process and the authority of individuals, committees, etc. Responsibilities of participants Operating procedures Documentation required Loan review & maintenance procedures & responsibilities Guidelines for management of loan collateral Policies and procedures for setting rates and repayment terms Statement of quality standards Description of bank's principal trade area Procedures for detecting and working out problem loans

8. Copyright © 2004 by Thomson Southwestern All rights reserved. 13-8 Regulations on Lending Purposes To protect consumers To minimize possibility of bailout with insurance To maintain stability of financial system To standardize procedures, instruments A business is assumed to be knowledgeable, a consumer is not and full disclosure is mandatory Discrimination against any member of a protected class is prohibited

9. Copyright © 2004 by Thomson Southwestern All rights reserved. 13-9 Major Consumer Lending Regulations The Equal Credit Opportunities Act The Fair Housing Act The Fair Credit Reporting Act of 1970 Truth in Lending Reg Z

10. Copyright © 2004 by Thomson Southwestern All rights reserved. 13-10 Mortgage Lending Regulations A Union Residential Loan Application The Real Estate Settlement Procedures Act The Home Mortgage Disclosure Act The Community Reinvestment Act

11. Copyright © 2004 by Thomson Southwestern All rights reserved. 13-11 Other Major Compliance Policies Loans to Insiders Act Limits on Lending to One Party as a Percentage of Total Capital Credit Execution Policies Lender Compensation Policies

12. Copyright © 2004 by Thomson Southwestern All rights reserved. 13-12 Commercial Loan Application Process I Acquire information Business description and principal contacts Amount & purpose of loan History and operations of firm, industry Profile of management, experience and expertise Full financial statements, credit analysis Verification of assets, liabilities, income

13. Copyright © 2004 by Thomson Southwestern All rights reserved. 13-13 Commercial Loan Application Process II Analyze information received Spread financial statements and compare to industry data (Robert Morris Associates, Dun & Bradstreet) Collect external information on the firm Develop recommendation on application Present application to loan committee If no, determine what and how to present it If yes, determine final terms, conditions and participation, and perfect all documentation Present decision to applicant

14. Copyright © 2004 by Thomson Southwestern All rights reserved. 13-14 Five Cs of Credit Character -the willingness of a customer to pay Capacity - the ability of a customer to pay in terms of cash flow Capital - the soundness of a borrower's financial position in terms of equity Conditions - the industry and economic conditions that may affect a firm’s ability to repay a loan Collateral - secondary sources of repayment

15. Copyright © 2004 by Thomson Southwestern All rights reserved. 13-15 Commercial Loan Credit Scoring Model Purpose To minimize credit risk (minimize defaults while making good loans) To process financial information in a timely and less expensive way Models are developed from historical data to discriminate between “good” firms and firms more likely to default Generally used in conjunction with other analysis

16. Copyright © 2004 by Thomson Southwestern All rights reserved. 13-16 Consumer Credit Scoring Model Created to standardize consumer loan decisions ◦ consistent evaluation ◦ minimize discrimination claims reduce cost of loan application evaluation ◦ reduce time required ◦ reduce experience level of evaluator Based on discriminant analysis of past loans and variables affecting them Used by major corporations as well as banks Consists of a scoring system and a decision function

17. Copyright © 2004 by Thomson Southwestern All rights reserved. 13-17 1. Occupation l professional (Executive)12 l skilled worker 8 l clerical worker 7 l student 5 l unskilled worker 4 l part-time employee 2 2. Housing status l owns home 6 l rents home or apartment 4 l lives with friend or relative 2 3.Credit rating l excellent10 l average 5 l no record 2 l poor 0 4. Length of time on current job l more than one year 5 l one year or less 2 5. Length of time at current address l more than one year2 l one year or less1 6. Telephone in residence l yes2 l no0 7. Number of dependents l none3 l one3 l two4 l three4 l more than three2 8. Bank accounts held l both checking & savings4 l savings account only3 l checking account only2 l none0 8. Bank credit card l yes6 l no0 Consumer Credit Scoring System An Example

18. Copyright © 2004 by Thomson Southwestern All rights reserved. 13-18 Consumer Credit Scoring System Decision Function Total ScoreCredit Decision 28 or lessReject application 29-30Extend credit up to $500 31-33Extend credit up to $1,500 34-36Extend credit up to $2,500 37-38Extend credit up to $3,500 39-40Extend credit up to $5,000 41-45Extend credit up to $8,000 over 45Extend credit up to $12,000

19. Copyright © 2004 by Thomson Southwestern All rights reserved. 13-19 Other Credit Risk Management Methods Credit risk is evaluated By customer By type of loan (commercial, consumer, etc) Overall for the firm Managing overall firm credit risk Value at risk (VAR) CreditMetrics

20. Copyright © 2004 by Thomson Southwestern All rights reserved. 13-20 Commercial Lending: Financial Statement Analysis Types of Information Required Past financial statements Personal financial information from the owner Projection of the future financial position A credit report Financial performance measures for similar firms as a basis of comparison Economic projections External Sources of Information Evaluating Risk

21. Copyright © 2004 by Thomson Southwestern All rights reserved. 13-21 Important Financial Ratios Overall Profitability:Return on Equity = Net Income/Equity Return on Assets = Net Income/Assets Cost Efficiency:Net Profit Margin = Net Income/Revenues Operating Profit Margin = Operating income/Revenues Gross Profit Margin = Gross Income/Revenues Revenue Generation:Total Asset Turnover = Revenue/Sales Fixed Asset Turnover = Fixed Asset/Revenues Inventory Turnover = Cost of Goods Sold/Inventory Accounts Receivables Turnover = Revenues/Accounts Receivables Days Cash CycleInventory Days = 365/Inventory Turnover Average Collection Period = 364/AR Turnover Accounts Payable Days = 365/(CGS/Accounts Payable) Days Cash to Cash Cycle=Average Collection Period+Days Inventory - Days Accounts Payable Debt and Coverage RatiosDebt to Assets =Total Debt/Total Assets Interest Coverage = EBIT/Interest Expense Fixed Charge Coverage = (EBIT + Fixed Charges)/(Int Exp + Fixed Ch) Cash Flow to Total Debt = Operating Cash Flow/Total Debt Liquidity RatiosCurrent Ratio = Current Assets/Current Liabilities Quick Ratio = (Current Assets - Inventory)/Current Liabilities Net Working Capital Ratio = Net Working Capital/Total Assets

22. Copyright © 2004 by Thomson Southwestern All rights reserved. 13-22 Commercial Lending Sample Loan Presentation Background and Request Repayment Analysis Secondary and Tertiary Sources of Repayment Financial Analysis Summary Balance Sheet Income Statement Guarantor and Collateral Risk Analysis and Recommendation Proposed Loan Structure

23. Copyright © 2004 by Thomson Southwestern All rights reserved. 13-23 Establishing Loan Terms Loan amount Lending rate Maturity and timing of payments Non-interest terms and fees Collateral, guarantees, other sources of repayment Restrictive covenants

24. Copyright © 2004 by Thomson Southwestern All rights reserved. 13-24 Lending Rate Lending rate must include Base lending rate Default risk premium Administrative cost premium Desired profit margin May be Fixed (usually for short-term or small loans) Variable (for longer-term or larger loans)

25. Copyright © 2004 by Thomson Southwestern All rights reserved. 13-25 Base Lending Rate Established at institutional level Total spread = IR – IE where IR – IE = [∑ r i X A i ] – (c X TL) and r i = the interest rate earned on asset category i A i = total dollar investment in asset category i c = average interest cost of financial liabilities TL = total liabilities IR = [∑ r i X A i ] = (r S X S) + (r L X L) where S is securities, r S is return on securities, L is loans, and r L is the base lending rate

26. Copyright © 2004 by Thomson Southwestern All rights reserved. 13-26 The cost to the borrower and the yield to the lender can be significantly affected by noninterest loan terms. The table illustrates how a commitment fee on a line of credit can increase an institution’s rate of return. Stated interest rate11.5% (base rate plus risk premium) Commitment fee0.25% on unused portion of the commitment Term 1 year Compensating balances8% of commitment plus 4% on borrowed funds Estimated average loan balance60% of commitment Maximum line of credit$2,000,000 Loan Interest and Noninterest Revenue Interest [$2,000,000(0.6)(0.115)]$138,000 Fees [$2,000,000(0.4)(0.0025) 2,000 Total Revenues$140,000 EFFECT OF NONINTEREST LOAN TERMS ON THE LENDER’S EXPECTED RETURN

27. Copyright © 2004 by Thomson Southwestern All rights reserved. 13-27 Net Funds Invested Average loan balance $1,200,000 Portion offset by compensating bal. $2,000,000(0.08) $ (160,000) $1,200,000(0.04) ( 48,000) Deduct reserve requirements [10% ×($160,000 + $40,000) ( 20,800) Total offsetting funds (187,200) Net Invested funds $1,012,800 Total Expected Return (Interest and Noninterest Revenues ) ÷ Net invested funds $140,000 ÷ $1,012,800 = 13.82%

28. Copyright © 2004 by Thomson Southwestern All rights reserved. 13-28 Noninterest Terms and Conditions These increase bank’s expected return Compensating Balance Requirements Lines of credit fees Commitment fees Discounted loans Fees for other banking services Customer Pricing Using Profitability Analysis

29. Copyright © 2004 by Thomson Southwestern All rights reserved. 13-29 Noninterest Terms & Conditions (continued) Collateral assigned by a security agreement Provides secondary source of repayment Value must be secure and documentation proper ◦ At outset ◦ During the term of the loan Arrangements include Floating liens Warehouse receipts Floor planning factoring

30. Copyright © 2004 by Thomson Southwestern All rights reserved. 13-30 Restrictive Covenants Protect bank’s interest during term of loan Positive covenant examples Borrower will provide current financial statements every quarter Borrower will have key person insurance payable to bank Negative covenant examples Borrower will maintain certain minimum ratios for liquidity and debt coverage No significant assets will be sold or debt acquired without prior permission of the bank

31. Copyright © 2004 by Thomson Southwestern All rights reserved. 13-31 Special Consideration for Different Types of Loans Seasonal Working Capital Loans Term Loans Commercial Real Estate Loans Agricultural Loans

32. Copyright © 2004 by Thomson Southwestern All rights reserved. 13-32 Consumer Loans Credit card loans Unsecured cards Secured cards Installment loans Different ways to calculate interest rates & returns The rule of 78s as a prepayment penalty Home equity loans (hels) Second mortgage loans

33. Copyright © 2004 by Thomson Southwestern All rights reserved. 13-33 Special Consideration of Mortgage Loans ARMS Due on Sale Clauses Innovative Mortgages Graduated payment mortgages Reverse annuity mortgages Growing equity mortgagees Price-level adjusted mortgages

34. Copyright © 2004 by Thomson Southwestern All rights reserved. 13-34 Small Business Loans Are more risky than large business loans Small Business Administration loans SBA Guarantees loans which do not qualify for a conventional loan Does not make loan, but guarantees repayment of most of the loan SBA guarantee reduces default cost to bank but not default probability

35. Copyright © 2004 by Thomson Southwestern All rights reserved. 13-35 Types of Higher Risk Lending Sub prime Lending Leveraged Buyouts Mezzanine Lending

36. Copyright © 2004 by Thomson Southwestern All rights reserved. 13-36 Loan Monitoring & Maintenance Goals To keep good loans from going bad Uncover problems while they are small Accurately estimate quality of loan portfolio Noncurrent loans can be described as Past due Nonperforming Nonaccruing

37. Copyright © 2004 by Thomson Southwestern All rights reserved. 13-37 Loan Classification Good Loans Potential Problems Criticized Loans - minor weaknesses ◦ deviation from loan policy, improper documentation Scheduled Loans - significant weaknesses ◦ serious deviations from policy or in documentation, overly-concentrated in a borrower or industry Adversely Classified Loans Substandard Loans - may result in loss Doubtful Loans - probably will result in some loss Loss Loans - uncollectible

38. Copyright © 2004 by Thomson Southwestern All rights reserved. 13-38 Loan Participations & Syndications Ways in which multiple lenders can meet the credit needs of a single borrower Loan participation – lead lender initiates loan and has all contact with borrower Loan syndication - every lender is in directly contact with the borrower Allows small banks to diversify loan portfolio and participate loans larger than they could make alone

39. Copyright © 2004 by Thomson Southwestern All rights reserved. 13-39 Lender Liability Lenders are sometimes sued by borrowers in financial distress because They refused to advance funds Attempted to take position of collateral Lenders are named in environmental liability suits if collateral used for loans is associated with environmental hazards. To protect themselves, banks conduct environmental audits on land and buildings used for collateral. The best way to prevent lawsuits is to: follow institutional monitoring procedures scrupulously; give ample notice to borrowers if credit is not to be extended; and keep excellent records.

40. Copyright © 2004 by Thomson Southwestern All rights reserved. 13-40 CRA Revisions Lending test Measures lending activities across different types of loans Includes small business loans and small farm loans. Investment test considers an institution’s involvement with qualified investments Includes investments, deposits, grants providing benefits Service test Considers retail banking services delivered Judges the degree of its community development services and their degree of innovation

41. Copyright © 2004 by Thomson Southwestern All rights reserved. 13-41 Other Loan Related Actions Securitization and sale of loan packages Expanding business contact from lending to include other bank services & product Incorporating better measures of risk Value at risk (VAR) Risk adjusted return on capital (RAROC)