Week 033

1
Week 03-3

• FIRST TOPIC METRICS FOR ASSESSING WHAT AN FSF
  EARNS IN DEALS DONE BY ONE OF ITS COMPONENT
  BUSINESS UNITS

• Other Topics
• Lending Process Duty of Due Diligence
• Use of Scoring Software
• Credit-Risk Issues
• Book-Cooking opportunities in Loan Accounting
  (cont. into Week 4)

2
The Text Offers Two Alternative Internal
Profitability Metrics

• Risk-Adjusted Return on Capital RAROC
• Chapter 4 finesses the risk adjustment, an
  idea which is introduced along with loan-loss
  reserving in chapter 8. RAROC ROC risk
  allowance
• Economic Value Added EVA
• The first concept is measured as a percentage
  rate of return the second is expressed in
  currency units ( in the U.S.)

3
To calculate either figure, managers must first
use balance sheets to allocate or distribute
total FSF profit and equity capital across the
firms individual units.

• ROC allocated profit/allocated capital.
• If a unit earns 2 mil and absorbs 10 mil of the
  firms equity capital to support its activities,
  ROC 2/10 20.
• A unit creates value for the FSF if and only if
• ROC COE of firm.
• Is value created if COE 15? What if COE is
  25?

4
EVA seeks to answer the valuation-creation
question in a metric

• EVA allocated profit after tax cost of
  allocated equity where cost of allocated
  equity allocated equity x COE.
• In example, if COE 15
• EVA 2 10(.15) 2 1.5 .5
• But if COE 25, EVA 2 10(.25) .5
• ALLOCATION is a black box accomplished by using
  so-called internal models.

5
Suppose we want to measure the EVA (in mil.)
one of a banks n branch offices.

• We must first draw up the balance sheet for that
  branch. Text uses the following example for a
  downtown branch

Consumer Loans 60 Term Deposits 70 Corporate
Loans 40 Fixed Assets 10 110 Funding
Deficit 40
N.B. In principle, the funding deposit ? the
allocated equity of the branch. It is merely an
algebraic amount that may be understood to be
transferred virtually to the branch from the
head office.
6
To evaluate branch performance, Chap. 5 of text
treats all balance-sheet amounts as if they were
transferred into or out of the branch from the
head office at an implicit interest rate
determined in the interbank market.

• EVA of branch EVA from its activities
• EVA of its loans
• EVA of its deposits
• EVA of amounts transferred.

7
On the grounds that interest-rate risk ought to
be handled at the head office on an
enterprisewide basis, the transfer price the
Text uses to cost out the services of the
amounts transferred is the matched-maturity
interbank rate, i.

• The interbank rate i is often calculated as the
  average of the bid and asked rates quoted in a
  particular interbank market (federal funds vs.
  London interbank market).
• The Text represents the transfer rate by the more
  general term the matched-maturity marginal value
  of funds MMMVF.

8
Chapter 5 emphasizes that the EVA of deposits
must take into account the burden of liquidity
requirements that the head office has to meet.
Chapters 7 8 add two further burdens Capital
Requirements and Credit Risk

• The text assumes that liquidity requirements are
  the same as r, the reserve requirement set by the
  central bank. It is likely that in practice the
  relevant r comes from customer benefits and costs
  that a bank generates from the banks mix of cash
  and deposits at the central bank.

9
Chapter 5 of Text Calculates Interest Margins
(in ) on Deposits and Loans

• Input Needed to Calculate Interest Margin on any
  Category of Deposits
• D amount of Deposits (in mil)
• d deposit interest rate
• r reserve requirement on deposits
• R liquidity reserves
• IA Hypothetical transfer to head office for
  deployment in the Interbank Market
• i transfer interest rate

10
Two Accounting Identities Used

• 1) R IA D
• 2) Interest Margin on Deposit Side
• Implicit Revenue Explicit Expenses
• i x (D R) d x (D)

11
DATA USED IN PAGE 33 EXAMPLE

• r 10
• D are issued at two maturities
• 100 in one-year D1 at d1 1.7
• 200 in two-year D2 at d2 2.15
• i1 3 i2 3.5.
• Net interest margin on D1 (.03)(.9)100
  (.017)100 1
• Net interest margin on D2 (.035)(.9)200
  (.025)100 2
• Total net interest margin on deposits NIMD 1
  2 3

12
Input Needed to Calculate Net Interest Margin on
Any Category of Loans

• Loan rate in category rL
• Loan amount in category L
• Appropriate transfer interest rate i
• Hypothetical transfer into branch from head
  office IA
• Net Interest Margin Explicit Revenue Implicit
  Revenue
• rL x (L) i x (IA)

13
DATA Used in Page 33 Example

• Two types of loans
• L3 200 in 3-year loans _at_ 6
• L5 300 in 5-year loans _at_ 8
• i3 4 i5 5
• Net Interest Margin on Loan Portfolio (NIML)
• (.06 .04)200 (.08 .05)300
• .02(200) .03(300) 49 13.

14
Total Net Interest Margin (TNIM) for the Branch

• TNIM NIML NIMD
• 13 2.4 15.4
• N.B. This calculation tells us that the branch
  office creates more value on the lending side
  than on the funding side of its business.

15
A Look Ahead

• Chapter 7 introduces the critical course theme
  that all forms of dealmaking have to be funded in
  part by an appropriate allocation of FSF capital.
  In particular, the profit margin on a branchs
  loans should include an allowance for the
  implicit cost of the capital allocated over the
  life of the loan. As before
• Net Profit Margin Explicit Revenue Implicit
  Expenses
• But implicit expenses generated by the transfer
  price would include the costs of capital and loss
  reserves allocated to cover the risks the loan
  entails.

16
New Topic Due Diligence in LendingLending is
Banks Principal Product-Management Subchain
17
Loan Officers Must Collect Appropriate
Information to Make Four Decisions About Each
Customer

• 1. How much to lend?
• 2. In what form i.e., with what safeguards?
• 3. At what price? implicit explicit
  compensation
• 4. On what repayment schedule?

18
Historically, lending was an holistic process.
Computer Lending Deconstructs the Steps Traversed
in Making a Loan

• Allows FSFs either to specialize in-house or to
  outsource the subset of risks and skills needed
  at each particular stage.
• 1. Applications Generation
• 2. Processing
• 3. Underwriting
• 4. Closing
• 5. Servicing/Collection
• 6. Insuring risk of shortfalls in payments due
• 7. Funding
• 8. Postloan monitoring and risk transfer

Origination
19
Unbundled Parts of Lending Process are
Automating, Digitizing, and Globalizing

• Outsourcing intensifies Ethical Risk the
  problem of assuring due diligence is performed
  in individual functions
• with holistic loan-officer model, double-checking
  role is played by high-level committees who are
  subject to legal penalties for negligence and
  malfeasance. Good judgment comes from
  experience. Experience comes from exercising
  poor judgment.
• with outsourcing model, loan committee must rely
  on reputations, bonding agreements, and fraud
  negligence laws
• We explore these Issues in last 3 Weeks of the
  course

20
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21
First Link in Chain Generating Applications

• Referrals, Prospecting, and Prequalifications
  Computer cross-sell triggers
• Product Selection
• Application Completion
• Document Collection

22
Deal-Makingmust be Supported by 2 Kinds of
Informational Due Diligence
23
Due Diligence in Information Gathering uses 3d-
Party sources

• Application Verification
• Credit Investigation
• Collateral Valuation
• Blue-Book Values for Autos
• Repeat-Sales Data Base vs. Custom Appraisal for
  Houses

24
Underwriting What Constitutes Due Diligence in
Analysis?

• Credit Analysis standards, guidelines vs. credit
  scoring
• Pricing
• Mortgage Insurance Decision
• Commitment Issuance

25
Operational Links Closing and Postclosing
Activities

• Document Preparation
• Compliance with Commitment Conditions
• Packaging and Delivery
• Postclosing Document Tracking
• Set up Servicing System
• Collections/Monitoring/Dunning

26
Final Link Actual Funding

• Temporary warehousing prior to choosing how to
  permanently finance the deal.
• Three main alternatives for permanent funding
• Own debt (intermediation)
• Loan sales
• whole
• partial (syndication)
• Securitization (pooling pricing loan packages)
• with originator credit enhancement
• with external credit enhancement
• without credit enhancement

27
The funding decision also affects the allocation
of the Risks of Deals Retained

• Self-Insurance supporting with Loan-Loss
  reserves and Ownership Capital
• External Credit Enhancement (partial vs. complete
  risk transfer to borrower or third parties)
• Collateral
• Recourse to borrower or corporate officers
• Personal or Corporate Cosignors or Guarantors
• Private Mortgage Insurance (Mort. Guaranty Ins.
  Corp. GE Capital Mort. Ins. Corp. United
  Guaranty Corp.)

28
Many Business Loans and All Household Mortgage
and Auto Loans pledge property to lender as
security for a loan.

• What is a mortgage loan? Who is the Mortgagor?
  ANS. The borrower. Who is the Mortgagee?
• First Mortgages vs. Second Mortgages
• Lender must assess prospects of borrower default
  and the possible correlation of default events
  with changes in collateral value

29
New Topic Computer Scoring Technology

• Tortures Data to make them sing Uncover
  Recognizable Patterns and Convert them into Point
  scores that classify customers in terms of
  probability of some targeted form of behavior
• Credit scores can be fed directly into an
  implicit and explicit interest matrix.
• In use at all large U.S. banks most small ones.
  33 of small banks by early 2001.
• Targeted behavior can be anything. AI Expert
  Systems can identify loan leads, slow payers,
  deadbeats, profitable customers, volatility of
  collateral value, etc.
• Scoring is Driving Automation of all links in the
  lending chain

30
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31
Use of Scoring Presupposes and Shapes the
Collection and Verification of Databases

• Individual Application input
• External Credit Bureau Input (will score for and
  sell credit directly to customers)
• KnowX.com and Lexis-Nexus input data on arrests,
  scandals
• Internal Credit Information File (CIF) from data
  warehouse (FSF base of information by which it
  manages)
• Must address customer and legal concerns about
  privacy and accuracy

32
Computer credit-scoring models objectify credit
standards. They input multiple proxies for
each of the Five Cs of Credit.

• The 5 Cs of Credit a checklist of informational
  items that track a customers unobservable
  repayment speed and repayment probability. Scores
  should be tracked both before and after making a
  loan.
• Scores on proxy items can be used also to size
  and price a customers serviceable demand for
  borrowed funds.
• Increasingly, computer credit-scoring models
  re-estimate the rate outstanding loan portfolios
  should carry and business loan contracts reset
  the loan rate when and as a borrowers score
  changes.

33

• Character customers reputation for probity and
  fairness (past willingness to pay bills can be
  checked with credit agencies)
• Capacity projected future income of customer
  payment coverage.
• Capital strength of customers balance sheet
• Collateral any credit enhancement offered
  --consists of implicit and explicit guarantees,
  including right of recourse
• Conditions re economic cycles how changing
  economic environment affects the customers other
  Cs vulnerability
• Modern financial economists add 3 more Cs
  Regulatory Compliance Costs, Customer
  Relationships, and Costs of a borrowers
  opportunities for hidden actions and hidden
  information disadvantage a lender.

34
Major External Vendors of Online Scoring Services

• Fair Isaac (Grandaddy of scoring)
• Fiserv
• Credit Bureaus
• Global national
• Local
• Credit Grades (2002 joint venture of Deutsche
  Bank, JPM, and Goldman Sachs) derives a
  companys default probability from behavior of
  its equity.
• Mark-It Partners credit database (UK venture that
  may absorb Credit Grades)

35
About Fair Isaacs ScoresThe formula for the
Fair Isaac creditworthiness score deals only with
financial information about a borrower and
doesnt consider such factors as place of
residence, age, race, sex, or nationality.

• Factors in determining the credit score and the
  weight they are given

36
How the Fair Isaac Score Works

• Fair Isaac licenses its software to credit
  bureaus.
• Based on the credit information on file, the
  credit bureau uses Fair Isaacs formula to
  generate a credit score, also known as a FICO
  score. Scores are on a 900-point scale.
  Generally, a score of 640 or higher results in a
  mortgage on favorable terms subprime (prime, superprime ratings (720)
• Lenders acquire from a credit bureau a borrowers
  credit report and FICO score to evaluate the
  applicants creditworthiness.
• High Score High Probability of complete and
  timely performance by borower.
• Fair Isaac traditionally limited the information
  passed to borrower. Now, loan applicants can
  purchase their scores.

37
Another Scoring Model (Freddy Mac)
38
DISCUSSION QUESTIONS ON SCORINGPlease indicate
in one paragraph whether you agree or disagree
with the following statements and why

• 1. Credit-scoring software should make human
  loan officers obsolete. Software can identify
  several times as many potential losses as most
  institutions best human underwriters can.
• 2. Credit-scoring is a new and untested idea.
• 3. Scoring software is useful only in
  originating loans.
• 4. Once an institution switches to
  credit-scoring software, its approval rates
  usually decrease.

39
DISCUSSION QUESTIONS ON SCORING (continued)

• 5. Credit-scoring software can be used only on
  loan applicants that have a prior credit history.
• 6. Cellular Services could eventually be the
  largest providers of credit information in the
  U.S.s
• 7. Mortgage-Loan automation can consolidate the
  many steps on mortgage lending into a single
  virtual back office that can bid on (but not
  seal) a deal in a matter of minutes.
• 8. It is perfectly safe to explain their credit
  scores to rejected customers.
• 9. It should be a source of pride to some
  bankers that they dont use credit scoring.

40
Reshaping of Job Opportunities and Branch
Architecture by New Lending Technologies

• 1. Calling Officers (Salespersons or Drummers).
• 2. Credit Analysts
• 3. Loan Review Committee
• 4. Workout Specialists

41
Business-Loan Officers Going the Way of the Dodo?
MINICASE
42
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43
New Topic Credit-Risk Issues

• What is risk? The downside of a deal caused by
  its negatives.
• What is a loans credit risk? Obverse of Asset
  Quality
• Danger that an individual counterparty wont
  perform as promised in a contract a priceable
  chance of suffering default losses - e.g., in
  loans to customers who go bankrupt.
• Delinquent vs. truly nonperforming loans
• workouts on partial vs. complete defaults show
  some chargeoff against bank loan reserves or
  net worth

An obverse is the positive quality that can be
obtained from a negative or the negative quality
corresponding to a positive.
44
A parents loan officer learns about credit risk
45
Managing Risk in Loan Origination

• Adage Every debt is paid, if not by the
  borrower, by the lender.
• How does a lender pay for borrower defaults?
• Lending officers may be disciplined for defaults
  on loans they originate.
• Computer scoring cannot capture every negative
  Jürgen Schneider Warning Signal CEOs gilding an
  iron fence in 1994

46
Recognizing Loan ScamstersTop Ten Warning
Signs (Paul Nadler, American Banker, March
1996)Beware of Customers who

• 10. Soft-soap you.
• 9. Seem too dumb to fool you.
• 8. Pride themselves on breaking rules.
• 7. Focus on what your firm will do in the event
  of delinquency.
• 6. Seem unusually charming.
• 5. Seem unusually optimistic.
• 4. Challenge your policy on overdrafts or on the
  use of uncollected funds.
• 3. Always want to meet you on your premises.
• 2. Whose buildings and equipment show signs of
  neglect.
• 1. Who appeal to your greed.
• 0. Seem unconcerned about payments Schedules
  and Interest Costs.

47
Concept of Pricing a Loan

• Concept of a loans price as an opportunity cost
  value of all implicit and explicit compensation
  received for extending this credit.
• Every contractual requirement is a potential
  burden. Nonprice terms is an oxymoron.
• In practice, rates are set as spreads above a
  low-risk benchmark interest rate.
• a. Libor
• b. Treasury yields
• c. Own CD or prime rate
• d. Spreads on interest-rate swaps (week 9)

48
Why do the following items Constitute Implicit
Interest on a Business Loan?
Explicit Interest is Not the Full Price of a Loan

• 1. Compensating-Balance Requirements (a legal
  tying of use of deposit and loan products).
• Does it ever make sense to pay interest on ones
  own money? Credit repairs/ money laundering
• 2. Collateral Requirements.
• 3. Covenant Rights.
• 4. Monitoring requirements.
• 5. Tie-in arrangements (mostly unwritten) though
  illegal, these are alleged to exist

49
Besides Adjusting for Elements of a contract that
generate Implicit Interest and Capital Costs,
Yield Spreads price risk factors associated
with Differences in Delinquency Rates
50
Some Vocabulary Priceable Differences in Loan
Contracts

• Fees for loan commitments (e.g., a credit line a
  revolver) vs. fees for drawdowns or
  disbursements
• Overdraft loans vs. signature loans vs.
  collateralized loans
• overdraft permission to initiate loans up to an
  agreed limit by writing checks in excess of a
  customers deposit balance
• signature loan unsecured promissory note

51
In theory, what is the least compensation an FSF
should accept on a Standalone Risk?

• RF amount to cover risk must correspond to at
  least a breakeven rate relative to benchmark
  return on a risk-free loan.
• But Chapters 78 of Text stress that all risks
  must be managed and priced using a long-run and
  enterprise-wide perspective.
• Relationship effects
• cost of capital that supports risk
• diversification/concentration effects

52
Risk Management ? Risk Avoidance. Ways an
institution can price, support, diversify or
shift credit risk introduce the concept of
financial engineering.

• Develop and maintain an accurate and consistent
  risk-grading system.
• Establish a credit culture that reflects the risk
  appetite of your institution.
• Use a loan approval process, by committee or
  otherwise, that provides a formal, systematic
  review of total exposure to a borrower in
  different products.
• Implement credit scoring, though it need not be
  the sole factor in lending decisions.
• Establish a credit database with heavy emphasis
  on the collection and retention of risk ratings.
• Develop a process to review and control
  exceptions to credit policy.
• Introduce a pricing model, even a rudimentary
  one, to bring disciplined risk-based pricing into
  the underwriting and review process. Even
  better, use a pricing model, either internally or
  vendor purchased, to price your credits to
  reflect risk, relationship, and capital
  allocation.
• Manage your loans as portfolio investments.
  Quantify the return relative to the risk and
  manage portfolio diversification.

53
The credit risk bankers must Price and Manage
is a Portfolio Concept

• Measures of this risk must identify and account
  for
• 1. Correlations in underlying risk factors
  that cause individual-customer default events
• 2. Correlations in the size of the losses driven
  by different events and risk factors
• 3. Last half of course will introduce the
  effects of hedging transactions that mitigate
  or transfer particular categories of loss
  exposures (hedging will be the focus of the
  middle weeks of this course).

54
Some Factors that Affect Enterprisewide Risk

• Regional or industry portfolio concentrations
• Decisions about the maturity of loans and funding
  instruments
• Actuarially unpredictable risks
• especially extreme events and catastrophic risks
  (e.g. Terrorist acts)

55
Important Slide To Assure Due Diligence at the
staff level, a Loan-Review Committee Should Ask
Deal-Making Staff to Report Three Features of
Every Deal

• 1. What are the risks?
• 2. What is the firm being offered for bearing
  these risks?
• 3. Allowing for differences in risk, how does the
  risk-adjusted return line up with other deals
  that we are or might be making?

56
Modern FSFs Can Rely on Outside Expertise to Help
Answer These Questions
57
New Topic Introduction to the Discipline and Art
of Loan Accounting

• GAAP Allows Considerable Leeway for timing
  reported changes in economic value
• TRANSPARENCY of Accounting Reports of Bank Income
  and Net Worth is deliberately weak (opacity)
• Book Value (usually par) and Market Value (PDV
  of cash flows) of Loans can Diverge Greatly after
  a loan is made
• late payments
• changes in credit quality of borrowers
• changes in market risk premia
• changes in level of riskless rate

58

• On average, borrowers are slow. Why?
• Expect to extract leniency
• Many plan to move in and out of delinquency
• Banks employ accrual accounting rather than cash
  accounting for yet-to-be-received receipts on
  slow, but performing loans.
• They are obliged to shift to cash accounting only
  for loans on which payments are so far overdue
  that they must be classified as nonperforming
  (90 days in U.S.).

59
Examiner Criticism May Sometimes Force a Loan
into Nonaccrual Status

• A four-way categorization of criticized loans
  is used by examiners special mention,
  substandard, doubtful, loss.
• Rising value of criticized loans in annual
  midyear Shared National Credit Exam for Large
  Syndicated Loans

1998 45 B 1999 69 B 2000 100B 2001
193 B
60
Exercise in Booking Accruals, Provisions, and
Chargeoffs
1. Eagle Bank lends 200,000 to BC Company on
January 1 at 7 percent simple interest to be paid
quarterly on the unpaid balance. Payments of
50,000 plus quarterly interest are due on March
30, June 30, September 29, and December 30. a.
Calculate the payments due at each payment date
(in thousands).
March 30 June 30 September 29 December 30
61
b. Suppose the first payment is made on time and
no further payments are received until the
following year. Assuming a 180-day threshold for
putting a slow loan into nonaccrual status, what
would the bank initially report as current
revenue on the loan in each quarter of the
current year ( thousands)?
1Q 2Q 3Q 4Q
3.5
2.625 (Credited but not received)
152.625(.07/4)2.671 (Credited but not received)
-5.296 (2Q 3Q Accruals must be reversed at year
end)
62
1Q 4Q
3.5 - 1 (in provisioned funds on Jan. 1) 2.5
-5.25 1 (in chargeoffs) -4.25
63
3. Suppose in February of year 2 federal bank
examiners forced Eagle Bank to restructure the
loan and write off 10 percent of the principal
still due on the loan against its net worth
account. Suppose also that the new contract
structure required the BC Company to make only a
single payment of 155,000 on June 15 of year
two. How would these events affect the banks
income in the first quarter and how would the
timely receipt of the settlement payment affect
the income in the second quarter of year two?
Year 2, 1Q -15.496 end-of-year
principle accrued interest 154.961 Year 2,
2Q 155 139.465 15.535