1. Copyright © 2000 by Harcourt, Inc. All rights reserved. 21-1 Chapter 21 Asset Management: Commercial, Consumer, and Mortgage Lending

2. Copyright © 2000 by Harcourt, Inc. All rights reserved. 21-2 Types of Commercial Bank Loans, October 1998 (As a Percent of Total Loans) Commercial Loans29% Consumer Loans 15% Real Estate Loans29% Other Loans17% Total Loans to Total Assets 63%

3. Copyright © 2000 by Harcourt, Inc. All rights reserved. 21-3 Trends As information about large borrowers has become readily available to investors, large corporations have accessed the capital markets, reducing reliance on bank loans. Banks have increased their lending to small and medium-sized firms where they retain an information and monitoring advantage. However, credit analysis and monitoring costs are relatively larger.

4. Copyright © 2000 by Harcourt, Inc. All rights reserved. 21-4 As a result of declining interest rates in the 1990’s, rising household income, and bank thrift acquisitions, mortgage lending by banks has increased rapidly. Diversification into residential mortgages is one factor contributing to the improvement in asset quality of U.S. commercial banks.

5. Copyright © 2000 by Harcourt, Inc. All rights reserved. 21-5 Suppliers of Consumer Credit, 1997 Source: Federal Reserve Bulletin, January 1999, A36

6. Copyright © 2000 by Harcourt, Inc. All rights reserved. 21-6 Holders of Mortgage Debt, Second Quarter 1998 Source: Federal Reserve Bulletin, January 1999, A35

7. Copyright © 2000 by Harcourt, Inc. All rights reserved. 21-7 The Credit Process Its function is to protect the bank from default risk and maximize the profitability of lending. It guides the bank’s business development plans. Issues to consider include: the identification of areas to be targeted for business; the forecast demand for bank services; and how employees will be trained regarding all bank products.

8. Copyright © 2000 by Harcourt, Inc. All rights reserved. 21-8 The credit process requires: a well written loan policy; loan request procedures and a process for credit analysis; a process for credit execution and administration; and a credit review process to identify problems for loans that have been made.

9. Copyright © 2000 by Harcourt, Inc. All rights reserved. 21-9 Loan Committee Review Loan officers are given some flexibility depending on their seniority and bank policies in determining whether loans should be granted. A loan committee reviews large loan applications to determine whether they should be granted.

10. Copyright © 2000 by Harcourt, Inc. All rights reserved. 21-10 Bank Written Loan Policies The policy reflects long-term strategic planning for the overall asset portfolio. The policy includes general guidelines for: the size of the loan portfolio; its composition; and maximum acceptable levels of default risk. The policy should influence decisions regarding among other things: how services are advertised; and whose loan applications will be given preference.

11. Copyright © 2000 by Harcourt, Inc. All rights reserved. 21-11 Consumer Lending Legislation and Compliance Policies The Equal Credit Opportunity Act (Reg B) The Fair Housing Act The Fair Credit Reporting Act of 1970 Truth in Lending Reg Z A Uniform Residential Loan Application (FNMA)

12. Copyright © 2000 by Harcourt, Inc. All rights reserved. 21-12 The Real Estate Settlement Procedures Act The Home Mortgage Disclosure Act The Community Reinvestment Act Loans to Insiders Act (Reg O) Limits on lending to one party as a percentage of total capital

13. Copyright © 2000 by Harcourt, Inc. All rights reserved. 21-13 Credit Execution Policies They should be written in terms of: loan committee reviews; collateral and documentation required; and follow-up procedures for loans once they have been made. From these policies specific procedures should be developed and put in place for: credit analysis; credit execution; and the credit review process.

14. Copyright © 2000 by Harcourt, Inc. All rights reserved. 21-14 Loan Request Procedures They are the implementation of the bank’s overall lending policy. Loan procedures focus on: the risk inherent in the business of the loan applicant; how risks have been mitigated; the use and amount of the loan; and the ability of the borrower to repay the loan in terms of cash flows, as well as secondary sources of repayment such as collateral.

15. Copyright © 2000 by Harcourt, Inc. All rights reserved. 21-15 5 C’s of Credit Loan presentations to the loan committee members use the framework of the 5 C’s of Credit. Character (the willingness of the customer to repay). Capacity (the ability of a customer to pay in terms of cash flows). Capital (the soundness of the borrower’s position in terms of equity).

16. Copyright © 2000 by Harcourt, Inc. All rights reserved. 21-16 Condition (the industry and economic conditions that may affect a firm’s ability to pay). Collateral (secondary resources of repayment). –Collateral is generally matched with the use for the loan. –For consumer and mortgage loans the value of the property at the time of the application should exceed the loan amount.

17. Copyright © 2000 by Harcourt, Inc. All rights reserved. 21-17 Quantitative Scoring Models They are used to integrate information from a variety of sources. Data on an applicant is weighted according to predetermined standards. A score for credit worthiness is calculated. Applicants falling below a predetermined minimum acceptable score are rejected or given more attention in the loan application process before loans can be made.

18. Copyright © 2000 by Harcourt, Inc. All rights reserved. 21-18 Commercial and consumer credit scoring models focus on identifying the characteristics of individuals or firms that will make them likely candidates for loan default. Models help institutions evaluate applicants by the same standards to comply with Reg B. However, the model focuses on default risk and may ignore such information as deposit or other service relationships with the customer. The model must be carefully structured to comply with Reg B.

19. Copyright © 2000 by Harcourt, Inc. All rights reserved. 21-19 Commercial Lending: Financial Statement Analysis The analysis serves two purposes: deciding whether a loan should be granted; and determining the proper structure for the loan. Financial statements analyzed include: common size income statements (put as a % of revenues); common size balance sheets (put as a % of assets); cash flow statements; and pro forma statements.

20. Copyright © 2000 by Harcourt, Inc. All rights reserved. 21-20 FINANCIAL RATIOS PERCEIVED AS IMPORTANT BY LOAN OFFICERS Although many ratios can be calculated, loan officers believe that some are more important then others. One survey showed that a firm’s debt/equity ratio was viewed as the most useful ratio, followed by the current ratio. RatioSignificance Rating Primary Measure Debt/Equity8.71Debt Current ratio8.25Liquidity Cash flows/current maturities of long-term debt8.08Debt Fixed charge coverage7.58Debt Net profit margin after tax7.56Profitability Times interest earned7.50Debt Net profit margin before taxes7.43Profitability Degree of financial leverage7.33Debt Inventory turnover (days)7.25Liquidity Accounts receivable turnover (days)7.08Liquidity Quick ratio6.79Liquidity Cash flow/total debt6.71Debt Return on assets after tax6.69Profitability Accounts receivable turnover (times)6.58Liquidity Return on equity after tax6.30Profitability Significance: 0-2 Low Importance; 7-9 High Importance. Source: Charles Gibson “Financial Ratios as Perceived by Commercial Loan Officers,” Akron Business & Economic Review, Vol. 14, No. 2, Summer, 1983, pp. 23-27.

21. Copyright © 2000 by Harcourt, Inc. All rights reserved. 21-21 Loan Terms Base lending rate Noninterest terms and fees for the loan Maturity and timing of payment Loan amount Collateral or other secondary sources of payment Restrictive Covenants associated with the loan

22. Copyright © 2000 by Harcourt, Inc. All rights reserved. 21-22 Base Lending Rate A base lending rate is established after considering an institution’s: target NIM; target return on equity; and asset mix. The base rate is the starting point from which loan terms for individual borrowers are established. Competitive conditions will also affect lending rates.

23. Copyright © 2000 by Harcourt, Inc. All rights reserved. 21-23 where: r i = the interest earn on asset category i A i = total dollar investment in asset category i c = average interest cost of financial liabilities TL = total liabilities

24. Copyright © 2000 by Harcourt, Inc. All rights reserved. 21-24 Suppose an institution has nonearning assets equal to 10% of total assets. Also, suppose that it has 30% of its assets invested in securities on which the before- tax average rate of return is 10.5%. The remaining 60% of total assets are invested in loans. The average cost of liabilities is 9% and liabilities total $92 million. What should be the base loan rate if the institution’s target NIM is 3.2%?

25. Copyright © 2000 by Harcourt, Inc. All rights reserved. 21-25 NIM = (IR-IE)/Total Asset Spread = NIM × Total assets = 0.032 × $100 m = $3.2 million $3.2m = (0 × $10m) + (0.105×$30m) + (r L ×$60m) - (0.09×$92m) r L = $8.33/$60 = 0.1388 or 13.88% Because nonearning assets and securities contribute to the target NIM at a lower rate than do loans, interest earned on loans must provide a higher than average return for the financial objective to be met.

26. Copyright © 2000 by Harcourt, Inc. All rights reserved. 21-26 Common Base Rates Prime rate Institution’s cost of funds LIBOR T-bill rate

27. Copyright © 2000 by Harcourt, Inc. All rights reserved. 21-27 Premiums are added to the base rate for... default risk; maturity risk; and collateral risk.

28. Copyright © 2000 by Harcourt, Inc. All rights reserved. 21-28 Customer Profitability Analysis It involves examining the funds received from and the nonlending services provided to a customer as well as a specific loan application. Loan rates to individual borrowers are often based on the total net income brought by the relationship. The relationship will affect the noninterest terms and conditions of a loan.

29. Copyright © 2000 by Harcourt, Inc. All rights reserved. 21-29 Noninterest Terms and Conditions Compensating balances Borrower is required to keep noninterest earning deposit balances with the institution. Gives lenders access to inexpensive funds and liquidity. The borrower has a higher effective cost of funds equal to interest expense/(loan minus compensating balances).

30. Copyright © 2000 by Harcourt, Inc. All rights reserved. 21-30 Commitment fees Commitments are arrangements with a legal guarantee that funds will be available at a given rate, amount, and maturity. A commitment fee compensates the lender for the liquidity that must be provided. Discounting The first interest payment is paid at the beginning of the loan period by being deducted before loan funds are made available to the borrower.

31. Copyright © 2000 by Harcourt, Inc. All rights reserved. 21-31 The borrower’s effective rate is the interest expense based on the entire loan/(the actual amount borrowed less the first interest payment). Collateral It requires determining the value of the assets to be pledged as collateral. It requires ensuring that all legal requirements are met for securing those assets. It requires monitoring the condition of the collateral during the loan period.

32. Copyright © 2000 by Harcourt, Inc. All rights reserved. 21-32 EFFECT OF NONINTEREST LOAN TERMS ON THE LENDER’S EXPECTED RETURN 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

33. Copyright © 2000 by Harcourt, Inc. All rights reserved. 21-33 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%

34. Copyright © 2000 by Harcourt, Inc. All rights reserved. 21-34 Types of Loans Seasonal Working Capital Loans Generally repaid within a year. Collateralized by accounts receivable or inventories. Term Loans Used to purchase depreciable assets with maturities of one to seven years. Amount lent is based on the purchase price of the asset. Often amortized but can be structured as a either a balloon or bullet loan.

35. Copyright © 2000 by Harcourt, Inc. All rights reserved. 21-35 Commercial Real Estate Loans Use real estate property as collateral. Often involve interim financing by a bank with a takeout commitment by a long-term lender. Projected vacancy rates on the project are important to reduce the risk of a project failing. Often priced at 1 to 1.5% above the typical commercial loan. Agricultural Loans They are collateralized by land and equipment. Are very cyclical and seasonal. After the problems of the 1980’s, loan approvals are based on cash flow rather than real estate values.

36. Copyright © 2000 by Harcourt, Inc. All rights reserved. 21-36 Consumer Loans - Credit Cards Annual fees paid are analogous to commitment fees in commercial lending. Institutions receive fee income from credit cards. Institutions that process credit transactions and bill customers for other depository institutions are able to earn additional revenues. The credit card card issuing bank earns merchant fees. Competition among issuers is narrowing margins. Tiered pricing schemes and affinity card programs have been developed.

37. Copyright © 2000 by Harcourt, Inc. All rights reserved. 21-37 Consumer Loans - Installment Loans Sometimes institutions use the add-on-interest method. The add-on-interest method requires that the interest on the full amount borrowed be paid each year of the loan term, even though the entire balance is not outstanding for the full term. With add-on-interest, the effective rate is a little less than double the quoted rate.

38. Copyright © 2000 by Harcourt, Inc. All rights reserved. 21-38 The Rule of 78 is sometimes used by lenders to calculate the remaining principal on the loan. The Rule of 78 works as a prepayment penalty for installment loans. –Lenders argue that it is justified because it helps them recover fixed lending costs. Home Equity Loans (Hels) Interest paid on Hels is tax-deductible. Can borrow 70% to 85% of the equity in a home. Hels are variable rate loans tied to movements in the prime rate or T-bill rate.

39. Copyright © 2000 by Harcourt, Inc. All rights reserved. 21-39 Mortgages ARMS National banks have only three index choices: indexes of long-term mortgage rates; T-bills; or T-bond rates. Thrifts may use any interest rate series that is widely published, verifiable by the borrower, and not in the direct control of the lender. Banks have caps on periodic rate adjustments. Federal law requires an overall rate cap and prohibits prepayment penalties.

40. Copyright © 2000 by Harcourt, Inc. All rights reserved. 21-40 A due-on-sale clause in a mortgage allows the lender to require the borrower to repay the outstanding loan balance when the mortgage property is sold. Clause protects lenders by allowing the lender to evaluate the financial position of the new owner. Assumable mortgages do not have due-on-sale clauses. Innovative Mortgages Graduate payment mortgages. Reverse annuity mortgages. Growing equity mortgages. Price-level adjusted mortgages.

41. Copyright © 2000 by Harcourt, Inc. All rights reserved. 21-41 Small Business Loans Banks often become designated as small business lenders, with the ability to make SBA loans. Borrowers who are denied conventional loans qualify to apply for SBA loans through the designated lender. The SBA guarantees a portion of the loan, reducing the lender’s default risk. The SBA guaranteed portions of SBA loans are securities with yields close to those of government-issued securities.

42. Copyright © 2000 by Harcourt, Inc. All rights reserved. 21-42 Types of Higher Risk Lending Leveraged Buyouts (LBOs) Transactions in which a group of investors, often a firm’s managers, buys a firm by using huge amounts of debt capital and relatively little net worth. Mezzanine Lending They are long-term, unsecured loans in which a firm’s cash flow is the major source of repayment. In addition, the financial contract contains an option through which the lender can share in the increased value of the business if the venture is successful.

43. Copyright © 2000 by Harcourt, Inc. All rights reserved. 21-43 Loan Monitoring and Review The procedures are designed to identify problems early enough to circumvent a need for legal action later. The procedures provide incentives for loan officers to make good decisions initially.

44. Copyright © 2000 by Harcourt, Inc. All rights reserved. 21-44 Loan Monitoring Financial Reporting and Regulation Problems loans are often classified as: past due for 30 to 89 days; nonperforming if they are past due 90 days or more; or nonaccruing when payments are not received. Regulators classify problem loans into: substandard; doubtful; or loss.

45. Copyright © 2000 by Harcourt, Inc. All rights reserved. 21-45 Regulators may require an institution to write down capital for loans that are likely to be losses and for a portion of likely losses on substandard and doubtful loans. Regulators may also ask for an increase in an institution’s loan loss reserves. Delinquent loans are transferred to collections which will first attempt to arrange a workout before instituting legal action.

46. Copyright © 2000 by Harcourt, Inc. All rights reserved. 21-46 Loan Participations and Syndications A participation is an arrangement by two or more lenders to share a loan in some agreed on proportions. In a syndication, several lenders simultaneously lend to a single borrower and all lenders have a direct relationship with the borrower. They are often necessary for large loans because of the lending limits placed on lending to a single borrower.

47. Copyright © 2000 by Harcourt, Inc. All rights reserved. 21-47 Syndications and participations allow small institutions to: expand their loan portfolios; and diversify geographically. However, small institutions may not perform their own credit analysis. Market flex is a new pricing strategy for syndicated loans. Pricing of syndicated loans switched from fixed upfront pricing to flexible pricing at the time of closing in 1998. The policy puts price uncertainty to corporate borrowers.

48. Copyright © 2000 by Harcourt, Inc. All rights reserved. 21-48 Lender Liability Lenders are often sued by borrowers in financial distress. Lenders are often cited 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.

49. Copyright © 2000 by Harcourt, Inc. All rights reserved. 21-49 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.

50. Copyright © 2000 by Harcourt, Inc. All rights reserved. 21-50 New CRA Regulation The lending test measures lending activities across different types of loans including small business loans and small farm loans. The investment test considers an institution’s involvement with qualified investments. The service test considers an institution’s availability and responsiveness for delivering retail banking services and judges the degree of its community development services and their degree of innovation.