Chapter 13

Funding the Bank110The Relationship Between Liquidity Requirements, Cash, and Funding SourcesThe amount of cash that a bank holds is influenced by the banks liquidity requirementsThe size and volatility of cash requirements affect the liquidity position of the bankDeposits, withdrawals, loan disbursements, and loan payments affect the banks cash balance and liquidity position223

The Relationship Between Liquidity Requirements, Cash, and Funding SourcesRecent Trends in Bank Funding SourcesBank customers have become more rate consciousMany customers have demonstrated a a strong preference for shorter-term depositsCore deposits are viewed as increasingly valuableBank often issue hybrid CDs to appeal to rate sensitive depositors44The Relationship Between Liquidity Requirements, Cash, and Funding SourcesRecent Trends in Bank Funding SourcesRetail FundingDeposit AccountsTransaction accountsMoney market deposit accountsSavings accountsSmall time deposits5The Relationship Between Liquidity Requirements, Cash, and Funding SourcesRecent Trends in Bank Funding SourcesBorrowed FundingFederal Funds purchasedRepurchase agreementsFederal Home Loan Bank borrowings

6The Relationship Between Liquidity Requirements, Cash, and Funding SourcesRecent Trends in Bank Funding SourcesWholesale FundingIncludes borrowed funds plus large CDsEquity FundingCommon stockPreferred stockRetained earnings

77The Relationship Between Liquidity Requirements, Cash, and Funding SourcesRecent Trends in Bank Funding SourcesVolatile (Managed) LiabilitiesFunds purchased from rate-sensitive investorsFederal Funds purchasedRepurchase agreementsJumbo CDsEurodollar time depositsForeign DepositsInvestors will move their funds if other institutions are paying higher rates88The Relationship Between Liquidity Requirements, Cash, and Funding SourcesRecent Trends in Bank Funding SourcesCore DepositsStable deposits that customers are less likely to withdraw when interest rates on competing investments riseIncludes:Transactions accountsMMDAsSavings accountsSmall CDs9910

11

12

Characteristics of Retail-Type DepositsRetail DepositsSmall denomination (under $100,000, now $250,000) liabilitiesNormally held by individual investorsNot actively traded in the secondary market13Characteristics of Retail-Type DepositsTransaction AccountsMost banks offer three different transaction accountsDemand DepositsDDAsNegotiable Order of Withdrawal NOWsAutomatic Transfers from SavingsATS

14Characteristics of Retail-Type DepositsTransaction AccountsDemand DepositsChecking accounts that do not pay interestHeld by individuals, business, and governmental unitsMost are held by businesses since Regulation Q prohibits banks from paying explicit interest on for-profit corporate checking accounts

15Characteristics of Retail-Type DepositsTransaction AccountsNOW AccountsChecking accounts that pay interestATS AccountsCustomer has both a DDA and savings accountThe bank transfers enough from savings to DDA each day to force a zero balance in the DDA accountFor-profit corporations are prohibited from owning NOW and ATS accounts

16Characteristics of Retail-Type DepositsTransaction AccountsAlthough the interest cost of transaction accounts is very low, the non-interest costs can be quite highGenerally, low balance checking accounts are not profitable for banks due to the high cost of processing checks

17Characteristics of Retail-Type DepositsNontransactional AccountsNon-transaction accounts are interest-bearing with limited or no check-writing privileges

18Characteristics of Retail-Type DepositsNontransactional AccountsMoney Market Deposit AccountsPay interest but holders are limited to 6 transactions per month, of which only three can be checksAttractive to banks because they are not required to hold reserves against MMDAs

19Characteristics of Retail-Type DepositsNontransactional AccountsSavings AccountsHave no fixed maturitySmall Time Deposits (Retail CDs)Have a specified maturity ranging from 7 days on upLarge Time Deposits (Jumbo CDs)Negotiable CDs of $100,000 or moreTypically can be traded in the secondary market

20Characteristics of Retail-Type DepositsEstimating the Cost of Deposit AccountsInterest CostsLegal Reserve RequirementsCheck Processing CostsAccount ChargesNSF feesMonthly feesPer check fees

21Characteristics of Retail-Type DepositsEstimating the Cost of Deposit AccountsTransaction Account Cost AnalysisClassifies check-processing as:DepositsElectronicNon-ElectronicWithdrawalsElectronicNon-Electronic

22Characteristics of Retail-Type DepositsEstimating the Cost of Deposit AccountsTransaction Account Cost AnalysisClassifies check-processing as:Transit ChecksDepositedCashedAccount Opened or ClosedOn-Us checks cashedGeneral account maintenanceTruncatedNon-Truncated

23Characteristics of Retail-Type DepositsEstimating the Cost of Deposit AccountsTransaction Account Cost AnalysisElectronic TransactionsConducted through automatic deposits, Internet, and telephone bill paymentNon-Electronic TransactionsConducted in person or by mailTransit ChecksChecks drawn on any bank other than the bank it was deposited into24Characteristics of Retail-Type DepositsEstimating the Cost of Deposit AccountsTransaction Account Cost AnalysisOn-Us Checks CashedChecks drawn on the banks own customers accountsDepositsChecks or currency directly deposited in the customer's account Account MaintenanceGeneral record maintenance and preparing & mailing a periodic statement 25Characteristics of Retail-Type DepositsEstimating the Cost of Deposit AccountsTransaction Account Cost AnalysisTruncated AccountA checking account in which the physical check is truncated at the bank and the checks are not returned to the customerOfficial Check IssuedA check for certified funds. Net Indirect CostsThose costs not directly related to the product such as management salaries or general overhead costs2627

Characteristics of Retail-Type DepositsCalculating the Average Net Cost of Deposit AccountsAverage Historical Cost of FundsMeasure of average unit borrowing costs for existing fundsAverage Interest CostCalculated by dividing total interest expense by the average dollar amount of liabilities outstanding28Characteristics of Retail-Type DepositsCalculating the Average Net Cost of Deposit Accounts29

Characteristics of Retail-Type DepositsCalculating the Average Net Cost of Deposit AccountsExample: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?

30

31

Characteristics of Large Wholesale DepositsWholesale LiabilitiesCustomers move these investments on the basis of small rate differentials, so these funds are labeled:Hot MoneyVolatile LiabilitiesShort-Term Non-Core funding32Characteristics of Large Wholesale DepositsWholesale LiabilitiesJumbo CDs$100,000 (now $250,000) or moreNegotiableCan be traded on the secondary marketMinimum maturity of 7 daysInterest rates quoted on a 360-day year basisInsured up to $100,000 (now $250,000) per investor per institutionIssued directly or indirectly through a dealer or broker (Brokered Deposits)33Characteristics of Large Wholesale DepositsWholesale LiabilitiesJumbo CDsFixed-RateVariable-RateJump Rate (Bump-up) CDDepositor has a one-time option until maturity to change the rate to the prevailing market rate

34Characteristics of Large Wholesale DepositsWholesale LiabilitiesJumbo CDsCallableZero CouponStock Market IndexedRate tied to stock market index performanceRate BoardsRepresent venues for selling non-brokered CDs via the Internet to institutional investorsRate boards help raise funds quickly and represent a virtual branch for a bank35Characteristics of Large Wholesale DepositsIndividual Retirement AccountsEach year, a wage earner can make a tax-deferred investment up to $8,000 of earned incomeFunds withdrawn before age 59 are subject to a 10% IRS penaltyThis makes IRAs an attractive source of long-term funding for banks36Characteristics of Large Wholesale DepositsForeign Office DepositsEurocurrencyFinancial claim denominated in a currency other than that of the country where the issuing bank is locatedEurodollarDollar-denominated financial claim at a bank outside the U.S. Eurodollar depositsDollar-denominated deposits in banks outside the U.S.3738

Characteristics of Large Wholesale DepositsBorrowing Immediately Available FundsFederal Funds PurchasedThe term Fed Funds is often used to refer to excess reserve balances traded between banksThis is grossly inaccurate, given reserves averaging as a method of computing reserves, different non-bank players in the market, and the motivation behind many tradesMost transactions are overnight loans, although maturities are negotiated and can extend up to several weeksInterest rates are negotiated between trading partners and are quoted on a 360-day basis39Characteristics of Large Wholesale DepositsBorrowing Immediately Available FundsSecurity Repurchase Agreements (RPs or Repos)Short-term loans secured by government securities that are settled in immediately available fundsIdentical to Fed Funds except they are collateralizedTechnically, the RPs entail the sale of securities with a simultaneous agreement to buy them back later at a fixed price plus accrued interest40Characteristics of Large Wholesale DepositsBorrowing Immediately Available FundsSecurity Repurchase Agreements (RPs or Repos)Most transactions are overnightIn most cases, the market value of the collateral is set above the loan amount when the contract is negotiated. This difference is labeled the marginThe lenders transaction is referred to as a Reverse Repo41Characteristics of Large Wholesale DepositsBorrowing Immediately Available FundsStructured Repurchase AgreementsEmbeds 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 investmentFlipper RepoCarries a floating rate that will convert, or flip, to a fixed rate after some lock-out period42Characteristics of Large Wholesale DepositsBorrowing From the Federal ReserveDiscount WindowDiscount RatePolicy is to set discount rate 1% (1.5%) over the Fed Funds target for primary (secondary) credit loansTo borrow from the Federal Reserve, banks must apply and provide acceptable collateral before the loan is grantedEligible collateral includes U.S. government securities, bankers acceptances, and qualifying short-term commercial or government paper43Characteristics of Large Wholesale DepositsBorrowing From the Federal ReserveDiscount Rate

44Current Interest Rates in effect since 2/19/2010Primary Credit0.75%Secondary Credit1.25%Seasonal Credit0.20%Fed Funds Target0 - 0.25%Characteristics of Large Wholesale DepositsBorrowing From the Federal ReservePrimary CreditAvailable to sound depository institutions on a short-term basis to meet short-term funding needs45Characteristics of Large Wholesale DepositsBorrowing From the Federal ReserveSecondary CreditAvailable to depository institutions that are not eligible for primary creditAvailable 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 institution46Characteristics of Large Wholesale DepositsBorrowing From the Federal ReserveSeasonal CreditDesigned to assist small depository institutions in managing significant seasonal swings in their loans and deposits47Characteristics of Large Wholesale DepositsBorrowing From the Federal ReserveEmergency CreditMay be authorized in unusual and exigent circumstances by the Board of Governors to individuals, partnerships, and corporations that are not depository institutions48Characteristics of Large Wholesale DepositsOther Borrowing from the Federal ReserveTerm Auction FacilityAllows banks to bid for an advance that will generally have a 28-day maturityBanks must post collateral against the borrowings and cannot prepay the loan4949Characteristics of Large Wholesale DepositsOther Borrowing from the Federal ReserveTerm Securities Lending FacilityA facility in which the Open Market Trading Desk of the Federal Reserve Bank of New York makes loans to primary securities dealers50Characteristics of Large Wholesale DepositsFederal Home Loan Bank AdvancesThe FHLB system is a government-sponsored enterprise created to assist in home buyingThe FHLB system is one of the largest U.S. financial institutions, rated AAA because of the government sponsorshipAny bank can become a member of the FHLB system by buying FHLB stockIf it has the available collateral, primarily real estate related loans, it can borrow from the FHLBFHLB advances have maturities from 1 day to as long as 20 years

5152

Electronic MoneyIntelligent CardContains a microchip with the ability to store and secure informationMemory CardSimply store information

53Electronic MoneyDebit CardOnlinePIN basedTransaction goes through the ATM systemOfflineSignature based transactionsTransaction goes through the credit card system

54Electronic MoneyElectronic Funds Transfer (EFT)An electronic movement of financial data, designed to eliminate the paper instruments normally associated with such funds movementTypes of EFTACH: Automated Clearing HousePOS: Point of SaleATMDirect DepositTelephone Bill PayingAutomated Merchant Authorization SystemsPreauthorized Payments

5556

Check 21Check Clearing for the 21st Century Act Facilitates check truncation by reducing some of the legal impedimentsFoster innovation in the payments and check collection system without mandating receipt of check in electronic formImprove the overall efficiency of the nations payment system

57Check 21Check TruncationConversion 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 bankFacilitates check truncation by creating a new negotiable instrument called a substitute check

58Check 21Substitute CheckThe legal equivalent of the original check and includes all the information contained on the originalCheck 21 does NOT require banks to accept checks in electronic form nor does it require banks to create substitute checksIt does allow banks to handle checks electronically instead of physically moving paper checks

5960

Check 21Check Clearing ProcessBanks typically place a hold on a check until it verifies that the check is goodExpedited Funds Availability ActUnder Reg CC, it states that:Local check must clear in no more than two business daysNon-local checks must clear in no more than five business daysGovernment, certified, and cashiers checks must be available by 9 a.m. the next business day

6162

Measuring the Cost of FundsAverage Historical Cost of FundsMany banks incorrectly use the average historical costs in their pricing decisionsThe 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

63Measuring the Cost of FundsThe Marginal Cost of FundsMarginal Cost of DebtMeasure of the borrowing cost paid to acquire one additional unit of investable fundsMarginal Cost of EquityMeasure of the minimum acceptable rate of return required by shareholdersMarginal Cost of FundsThe marginal costs of debt and equity

64Measuring the Cost of FundsThe Marginal Cost of FundsCosts of Independent Sources of FundsIt is difficult to measure marginal costs preciselyManagement 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

65Measuring the Cost of FundsThe Marginal Cost of FundsCosts of Independent Sources of FundsMarginal costs may be defined as :

66

Measuring the Cost of FundsThe Marginal Cost of FundsCosts of Independent Sources of FundsExample:Market interest rate is 2.5%Servicing costs are 4.1% of balancesAcquisition costs are 1.0% of balancesDeposit insurance costs are 0.25% of balancesNet investable balance is 85% of the balance (10% required reserves and 5% float)

67Measuring the Cost of FundsThe Marginal Cost of FundsCosts of Independent Sources of FundsExample:

68

Measuring the Cost of FundsThe Marginal Cost of FundsCosts of Independent Sources of FundsCost of DebtEquals the effective cost of borrowing from each source, including interest expense and transactions costsThis 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

69Measuring the Cost of FundsThe Marginal Cost of FundsCosts of Independent Sources of FundsCost of DebtExample:Assume the bank will issue:$10 million in par value subordinated notes paying $700,000 in annual interest and a 7-year maturityIt must pay $100,000 in flotation costs to an underwriterThe effective cost of borrowing (kd) is 7.19%

70Measuring the Cost of FundsThe Marginal Cost of FundsCosts of Independent Sources of FundsCost of DebtExample:

71

Measuring the Cost of FundsThe Marginal Cost of FundsCosts of Independent Sources of FundsCost of EquityThe marginal cost of equity equals the required return to shareholdersIt is not directly measurable because dividend payments are not mandatory72Measuring the Cost of FundsThe Marginal Cost of FundsCosts of Independent Sources of FundsCost of EquitySeveral methods are commonly used to approximate this required return:Dividend Valuation ModelCapital Asset Pricing Model (CAPM)Targeted Return on Equity ModelCost of Debt + Risk Premium

73Measuring the Cost of FundsThe Marginal Cost of FundsCosts of Independent Sources of FundsCost of Preferred StockPreferred stock acts as a hybrid of debt and common equityClaims are superior to those of common stockholders but subordinated to those of debt holdersPreferred 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

74Measuring the Cost of FundsThe Marginal Cost of FundsCosts of Independent Sources of FundsTrust Preferred StockTrust preferred stock is attractive because it effectively pays dividends that are tax deductibleThis loan interest is tax deductible such that the bank effectively gets to deduct dividend payments as the preferred stock

75Measuring the Cost of FundsWeighted Marginal Cost of Total FundsThis is the best cost measure for asset-pricing purposesIt recognizes both explicit and implicit costs associated with any single source of funds

76Measuring the Cost of FundsWeighted Marginal Cost of Total FundsIt 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

77

78

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

79Funding Sources and Banking RisksFunding Sources: Liquidity RiskThe liquidity risk associated with a banks deposit base is a function of:The competitive environmentNumber of depositorsAverage size of accountsLocation of the depositorSpecific maturity and rate characteristics of each account80Funding Sources and Banking RisksFunding Sources: Liquidity RiskInterest ElasticityHow 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 bank81Funding Sources and Banking RisksFunding Sources: Interest Rate RiskMany depositors and investors prefer short-term instruments that can be rolled over quickly as interest rates changeBanks must offer a substantial premium to induce depositors to lengthen maturitiesThose banks that choose not to pay this premium will typically have a negative one-year GAP 82Funding Sources and Banking RisksFunding Sources: Interest Rate RiskOne strategy is to aggressively compete for retail core depositsIndividual 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

83Funding Sources and Banking RisksFunding Sources: Credit and Capital RiskChanges in the composition and cost of bank funds can indirectly affect a banks 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 quality84Overview of Credit Policy and Loan Characteristics8513Recent Trends in Loan Growth and QualityLarger 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

86Recent Trends in Loan Growth and QualityCommercial and industrial loans represent the second highest concentration of loans at banksLoans to individuals are greatest for banks with more than $1 billion in assetsFarmland and farm loans make up a significant portion of the smallest banks loans8788

Recent Trends in Loan Growth and QualityWholesale BankEmphasizes lending to businessesRetail BankEmphasizes lending to individualsPrimary funding is from core deposits89Recent Trends in Loan Growth and QualityFDIC Bank CategoriesCredit Card BanksInternational BanksAgricultural BanksCommercial LendersVast majority of FDIC-insured institutions fall in this category90Recent Trends in Loan Growth and QualityFDIC Bank CategoriesMortgage LendersConsumer LendersOther Specialized Banks (less than $1 billion)All Other Banks (less than $1 billion)All Other Banks (more than $1 billion)9192

93

94

Recent Trends in Loan Growth and QualityNoncurrent LoansLoans and leases past due 90 days or more and still accruing interest plus all loans and leases in a nonaccrual statusNonaccrual loans and leases are those: that are maintained on a cash basis because of deterioration in the financial position of the borrowerwhere full payment of interest and principal is not expectedwhere 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 collection95Recent Trends in Loan Growth and QualityNet 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 off9697

98

99

Measuring Aggregate Asset QualityIt is extremely difficult to assess individual asset quality using aggregate quality dataDifferent types of assets and off-balance sheet activities have different default probabilitiesLoans typically exhibit the greatest credit riskHistorical charge-offs and past-due loans might understate (or overstate) future losses depending on the future economic and operational conditions of the borrower100Measuring Aggregate Asset QualityConcentration RiskExists when banks lend in a narrow geographic area or concentrate their loans in a certain industryCountry RiskRefers to the potential loss of interest and principal on international loans due to borrowers in a country refusing to make timely payments101Trends in Competition for Loan BusinessIn 1984, there were nearly 14,500 banks in the U.S.This fell to fewer than 7,300 at the beginning of 2007Recently, the Treasurys 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 sellThis has forced consolidation102Trends in Competition for Loan BusinessBanks still have the required expertise and experience to make them the preferred lender for many types of loansTechnology advances have meant that more loans are becoming standardized, making it easier for market participants to offer loans in direct competition to banks103Trends in Competition for Loan BusinessStructured NoteLoan that is specifically designed to meet the needs of one or a few companies but has been packaged for resale

104The Credit ProcessLoan PolicyFormalizes lending guidelines that employees follow to conduct bank businessCredit PhilosophyManagements philosophy that determines how much risk the bank will take and in what formCredit CultureThe fundamental principles that drive lending activity and how management analyzes risk

105The Credit Process106

The Credit ProcessCredit CultureThe fundamental principles that drive lending activity and how management analyzes riskValues DrivenFocus is on credit qualityCurrent-Profit DrivenFocus is on short-term earningsMarket-Share DrivenFocus is on having the highest market share

107108

The Credit ProcessBusiness Development and Credit AnalysisBusiness DevelopmentMarket researchTrain employees:What products are availableWhat products customers are likely to needHow they should communicate with customers about those needsAdvertising and Public RelationsOfficer Call Programs

109The Credit ProcessBusiness Development and Credit AnalysisCredit AnalysisEvaluate a borrowers ability and willingness to repayQuestions to addressWhat 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?

110The Credit ProcessBusiness Development and Credit AnalysisCredit AnalysisFive Cs of Good CreditCharacterCapitalCapacityConditionsCollateral

111The Credit ProcessBusiness Development and Credit AnalysisCredit AnalysisFive Cs of Bad CreditComplacencyCarelessnessCommunicationContingenciesCompetition

112The Credit ProcessBusiness Development and Credit AnalysisCredit AnalysisProcedureCollect information for the credit fileEvaluate management, the company, and the industry in which it operatesConduct a financial statement analysisProject the borrowers cash flow and its ability to service the debtEvaluate collateral or the secondary source of repaymentWrite a summary analysis and making a recommendation

113The Credit ProcessCredit Execution and AdministrationLoan DecisionIndividual officer decisionCommitteeCentralized underwriting

114The Credit ProcessCredit Execution and AdministrationLoan AgreementFormalizes the purpose of the loanTerms of the loanRepayment scheduleCollateral requiredAny loan covenantsStates what conditions bring about a default

115The Credit ProcessCredit Execution and AdministrationDocumentation: Perfecting the Security InterestPerfectedWhen the bank's claim is superior to that of other creditors and the borrowerRequire the borrower to sign a security agreement that assigns the qualifying collateral to the bankBank obtains title to equipment or vehicles

116The Credit ProcessCredit Execution and AdministrationPosition LimitsMaximum allowable credit exposures to any single borrower, industry, or geographic localRisk Rating LoansEvaluating characteristics of the borrower and loan to assess the likelihood of default and the amount of loss in the event of default

117The Credit ProcessCredit Execution and AdministrationLoan CovenantsPositive (Affirmative)Indicate specific provisions to which the borrower must adhereNegativeIndicate financial limitations and prohibited events

118119

The Credit ProcessCredit Execution and AdministrationLoan ReviewMonitoring the performance of existing loansHandling problem loansLoan review should be kept separate from credit analysis, execution, and administrationThe loan review committee should act independent of loan officers and report directly to the CEO of the bank

120The Credit ProcessCredit Execution and AdministrationProblem LoansOften require special treatmentModify terms of the loan agreement to increases the probability of full repaymentModifications might include:Deferring interest and principal paymentsLengthening maturitiesLiquidating unnecessary assets

121Characteristics of Different Types of LoansUBPR ClassificationsReal Estate LoansCommercial LoansIndividual LoansAgricultural LoansOther Loans and Leases in Domestic OfficesLoans and Leases in Foreign Offices

122Characteristics of Different Types of LoansReal Estate LoansConstruction and Development LoansCommercial Real EstateMulti-Family Residential Real Estate1-4 Family ResidentialHome EquityFarmlandOther Real Estate Loans

123Characteristics of Different Types of LoansReal Estate LoansCommercial Real Estate LoansTypically short-term loans consisting of:Construction and Real Estate Development LoansLand Development LoansCommercial Building Construction and Land Development Loans

124Characteristics of Different Types of LoansReal Estate LoansCommercial Real Estate LoansConstruction LoansInterim financing on commercial, industrial, and multi-family residential propertyInterim LoansProvide financing for a limited time until permanent financing is arrangedLand Development LoansFinance the construction of road and public utilities in areas where developers plan to build housesDevelopers typically repay loans as lots or homes are sold

125Characteristics of Different Types of LoansReal Estate LoansCommercial Real Estate LoansTakeout CommitmentAn agreement whereby a different lender agrees to provide long-term financing after construction is finished

126Characteristics of Different Types of LoansReal Estate LoansResidential Mortgage LoansMortgageLegal document through which a borrower gives a lender a lien on real property as collateral against a debtMost are amortized with monthly payments, including principal and interest

127Characteristics of Different Types of LoansReal Estate LoansResidential Mortgage Loans1-4 Family Residential Mortgage LoansHolding long-term fixed-rate mortgages can create interest rate risk for banks with loss potential if rates increaseTo avoid this, many mortgages now provide for:Periodic adjustments in the interest rateAdjustments in periodic principal paymentsThe lender sharing in any price appreciation of the underlying asset at saleAll of these can increase cash flows to the lender when interest rates rise

128Characteristics of Different Types of LoansReal Estate LoansThe Secondary Mortgage MarketInvolves the trading of previously originated residential mortgagesCan be sold directly to investors or packaged into mortgage pools

129Characteristics of Different Types of LoansReal Estate LoansHome Equity LoansSecond Mortgage LoansTypically shorter term than first mortgagesSubordinated to first mortgageHome Equity Lines of Credit (HELOC)

130Characteristics of Different Types of LoansReal Estate LoansEquity Investments in Real EstateHistorically, commercial banks have been prevented from owning real estate except for their corporate offices or property involved in foreclosureRegulators want banks to engage in speculative real estate activities only through separate subsidiariesThe Gramm-Leach-Bliley Act of 1999 allowed for commercial banks and savings institutions to enter into the merchant banking business

131Characteristics of Different Types of LoansCommercial LoansLoan Commitment/Line of CreditFormal agreement between a bank and borrower to provide a fixed amount of credit for a specified periodThe customer determines the timing of actual borrowing132Characteristics of Different Types of LoansCommercial LoansWorking Capital RequirementsNet Working CapitalCurrent assets Current liabilitiesFor most firms, net working capital is positive, indicating that some current assets are not financed with current liabilities133Characteristics of Different Types of LoansCommercial LoansWorking Capital RequirementsDays CashCash/(Sales/365)Days ReceivablesAR/(Sales/365)Days InventoryInventory/(COGS/365)134Characteristics of Different Types of LoansCommercial LoansWorking Capital RequirementsDays PayableAP/(Purchases/365)Days AccrualsAccruals/(Operating Expenses/365)135Characteristics of Different Types of LoansCommercial LoansWorking Capital RequirementsCash-to-Cash Asset CycleHow long the firm must finance operating cash, inventory and accounts receivables from the day of first saleCash-to-Cash Liability CycleHow long a firm obtains interest-free financing from suppliers in the form of accounts payable and accrued expenses to help finance the asset cycle136137

Characteristics of Different Types of LoansCommercial LoansWorking Capital Requirements138

Characteristics of Different Types of LoansCommercial LoansSeasonal versus Permanent Working Capital NeedsAll firms need some minimum level of current assets and current liabilitiesThe amount of current assets and current liabilities will vary with seasonal patterns139Characteristics of Different Types of LoansCommercial LoansSeasonal versus Permanent Working Capital NeedsPermanent Working CapitalThe minimum level of current assets minus the minimum level of adjusted current liabilities Adjusted Current LiabilitiesCurrent liabilities net of short-term bank credit and current maturities of long-term debt140Characteristics of Different Types of LoansCommercial LoansSeasonal versus Permanent Working Capital NeedsSeasonal Working CapitalDifference in total current assets and adjusted current liabilities

141Characteristics of Different Types of LoansCommercial LoansSeasonal Working Capital LoansFinance a temporary increase in net current assets above the permanent requirementLoan is seasonal if the need arises on a regular basis and if the cycle completes itself within one yearLoan is self-liquidating if repayment derives from sales of the finished goods that are financed

142143

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

144Characteristics of Different Types of LoansCommercial LoansOpen Credit LinesUsed to meet many types of temporary needs in addition to seasonal needsInformal Credit LineNot legally binding but represent a promise that the lender will advance creditFormal Credit LineLegally binding even though no written agreement is signedA commitment fee is charged for making credit available, regardless of whether the customer actually uses the line

145Characteristics of Different Types of LoansCommercial LoansAsset-Based LoansLoans Secured by Accounts ReceivableThe security consists of paper assets that presumably represent salesThe quality of the collateral depends on the borrowers integrity in reporting actual sales and the credibility of billings146Characteristics of Different Types of LoansCommercial LoansAsset-Based LoansLoans Secured by Accounts ReceivableAccounts Receivable Aging ScheduleList of A/Rs grouped according to the month in which the invoice is datedLockboxCustomers mail payments go directly to a P.O. Box controlled by the bankThe bank processes the payments and reduces the borrowers balance but charges the borrower for handling the items147Characteristics of Different Types of LoansCommercial LoansHighly Levered TransactionsLeveraged 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 debtTarget companies are generally those with undervalued hard assets148Characteristics of Different Types of LoansCommercial LoansHighly Levered TransactionsLeveraged Buyout (LBO)The investors often sell specific assets or subsidiaries to pay down much of the debt quicklyIf key assets have been undervalued, the investors may own a downsized company whose earnings prospects have improved and whose stock has increased in valueThe investors sell the company or take it public once the market perceives its greater value149Characteristics of Different Types of LoansCommercial LoansHighly Levered TransactionsArise from three types of transactionsLBOs in which debt is substituted for privately held equityLeveraged recapitalizations in which borrowers use loan proceeds to pay large dividends to shareholdersLeveraged acquisitions in which a cash purchase of another related company produces an increase in the buyers debt structure150Characteristics of Different Types of LoansCommercial LoansHighly Levered TransactionsAn HLT must involve the buyout, recapitalization, or acquisition of a firm in which either:The firms subsequent leverage ratio exceeds 75 percentThe transaction more than doubles the borrowers liabilities and produces a leverage ratio over 50 percentThe regulators or firm that syndicates the loans declares the transaction an HLT151Characteristics of Different Types of LoansCommercial LoansTerm Commercial LoansOriginal maturity greater than 1 yearTypically finance:Depreciable assetsStart-up costs for a new venturePermanent increase in the level of working capital

152Characteristics of Different Types of LoansCommercial LoansTerm Commercial LoansLenders focus more on the borrowers periodic income and cash flow rather than the balance sheetTerm loans often require collateral, but this represents a secondary source of repayment in case the borrower defaults

153Characteristics of Different Types of LoansCommercial LoansTerm Commercial LoansBalloon PaymentsMost of the principal is due at maturityBullet PaymentsAll of the principal is due at maturity154Characteristics of Different Types of LoansCommercial LoansRevolving CreditsA hybrid of short-term working capital loans and term loansTypically involves the commitment of funds for 1 5 yearsAt the end of some interim period, the outstanding principal converts to a term loanDuring the interim period, the borrower determines how much credit to useMandatory principal payments begin once the revolver is converted to a term loan155Characteristics of Different Types of LoansAgricultural LoansProceeds are used to purchase seed, fertilizer and pesticides and to pay other production costsFarmers expect to repay the debt with the crops are harvested and soldLong-term loans finance livestock, equipment, and land purchasesThe primary source of repayment is cash flow from the sale of livestock and harvested crops in excess of operating expenses156Characteristics of Different Types of LoansConsumer LoansInstallmentRequire periodic payments of principal and interestCredit CardNon-InstallmentFor special purposesExample: Bridge loan for the down payment on a house that is repaid from the sale of the previous house157Characteristics of Different Types of LoansVenture CapitalA broad term use to describe funding acquired in the earlier stages of a firms economic lifeDue to the high leverage and risk involved banks generally do not participate directly in venture capital dealsSome banks have subsidiaries that finance certain types of equity participations and venture capital deals, but their participation is limited158Characteristics of Different Types of LoansVenture CapitalVenture capital firms attempt to add value to the firm without taking majority controlOften, venture capital firms not only provide financing but experience, expertise, contacts, and advice when required159Characteristics of Different Types of LoansVenture CapitalTypes of Venture FinancingSeed or Start-up CapitalEarly stages of financingHighly levered transactions in which the venture capital firm will lend money for a percentage stake in the firmRarely, if ever, do banks participate at this stage160Characteristics of Different Types of LoansVenture CapitalTypes of Venture FinancingLater-Stage Development Financing:Expansion and replacement financingRecapitalization or turnaround financingBuy-out or buy-in financingMezzanine financingBanks 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 financing161Evaluating Commercial Loan Requests and Managing Credit Risk16214Evaluating Commercial Loan Requests and Managing Credit RiskImportant Questions Regarding Commercial Loan RequestsWhat 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?163Fundamental Credit IssuesThere are two types of loan errorsType I ErrorMaking a loan to a customer who will ultimately default Type II ErrorDenying a loan to a customer who would ultimately repay the debt

164Fundamental Credit IssuesCharacter of the Borrower and Quality of Data ProvidedThe most important issue in assessing credit risk is determining a borrowers commitment and ability to repay debts in accordance with the terms of a loan agreementThe best indicators are the borrowers financial history and personal references

165Fundamental Credit IssuesCharacter of the Borrower and Quality of Data ProvidedAudited 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 entriesBut just because a company has audited financial statements, however, does not mean the reported data are not manipulated

166Fundamental Credit IssuesUse of Loan ProceedsLoan 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 expensesSpeculative asset purchases and debt substitutions should be avoided

167Fundamental Credit IssuesHow Much Does the Borrower Need? The Loan AmountBorrowers often request a loan before they clearly understand how much external financing is actually needed and how much is available internallyThe amount of credit required depends on the use of the proceeds and the availability of internal sources of funds

168Fundamental Credit IssuesHow Much Does the Borrower Need? The Loan AmountFor a shorter-term loan, the amount might equal the temporary seasonal increase in receivables and inventory net of that supported by increased accounts payableWith term loans, the amount can be determined via pro forma analysis which is the projecting or forecasting of a companys financial statements into the future169Fundamental Credit IssuesThe Primary Source and Timing of RepaymentLoans are repaid from cash flows:Liquidation of assetsCash flow from normal operationsNew debt issuesNew equity issues170Fundamental Credit IssuesThe Primary Source and Timing of RepaymentSpecific sources of cash are generally associated with certain types of loansShort-term, seasonal working capital loans are normally repaid from the liquidation of receivables or reductions in inventory171Fundamental Credit IssuesThe Primary Source and Timing of RepaymentSpecific sources of cash are generally associated with certain types of loansTerm 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 base172Fundamental Credit IssuesThe Primary Source and Timing of RepaymentThe primary source of repayment on the loan can also determine the risk of the loanThe general rule is not to rely on the acquired asset or underlying collateral as the primary source of repayment173Fundamental Credit IssuesSecondary Source of Repayment: CollateralCollateral must exhibit three featuresIts value should always exceed the outstanding principal on a loanThe 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 losesBorrowers are upside-down on a loan if the value of the collateral is less than the outstanding loan balance174Fundamental Credit IssuesSecondary Source of Repayment: CollateralCollateral must exhibit three featuresThe lender should be able to easily take possession of the collateral and have a ready market for its saleA lender must be able to clearly mark the collateral as its ownCareful loan documentation is required to perfect the banks interest in the collateralIf collateral is not readily available, a personal guarantee may be required175Fundamental Credit IssuesSecondary Source of Repayment: CollateralThe borrowers cash flow is the preferred source of loan repaymentsLiquidating collateral is secondaryThere are significant transactions costs associated with foreclosureBankruptcy laws allow borrowers to retain possession of the collateral long after they have defaultedWhen the bank takes possession of the collateral, it deprives the borrower of the opportunity to salvage the company

176Evaluating Credit Requests: A Four-Part ProcessOverview of management, operations, and the firms industryCommon size and financial ratio analysisAnalysis of cash flowProjections and analysis of the borrowers financial condition177Evaluating Credit Requests: A Four-Part ProcessOverview of Management, Operations, and the Firms IndustryGather background information on the firms operationsWrite a Business and Industry Outlook reportExamine the nature of the borrowers loan request and the quality of the financial data provided178Evaluating Credit Requests: A Four-Part ProcessCommon Size and Financial Ratio AnalysisCommon size ratio comparisons are valuable because they adjust for size and thus enable comparisons across firms in the same industry or line of business179180

Evaluating Credit Requests: A Four-Part ProcessCommon Size and Financial Ratio AnalysisMost analysts differentiate between at least four categories of ratios: Liquidity ratios Indicate a firms ability to meet its short-term obligations and continue operations. Activity ratiosSignal how efficiently a firm uses assets to generate sales181Evaluating Credit Requests: A Four-Part ProcessCommon Size and Financial Ratio AnalysisMost analysts differentiate between at least four categories of ratios: Leverage ratiosIndicate the mix of the firms financing between debt and equity and potential earnings volatilityProfitability ratios Provide evidence of the firms sales and earnings performance182183

Evaluating Credit Requests: A Four-Part ProcessCommon Size and Financial Ratio AnalysisLiquidity RatiosCurrent RatioCA / CLQuick Ratio(Cash + A/R) / CL

184Evaluating Credit Requests: A Four-Part ProcessCommon Size and Financial Ratio AnalysisActivity RatiosDays CashCash/Average Daily SalesDays Inventory on HandInventory/Average Daily Cost of Goods SoldInventory TurnoverCOGS / Average Inventory

185Evaluating Credit Requests: A Four-Part ProcessCommon Size and Financial Ratio AnalysisActivity RatiosDays Accounts Receivable Collection PeriodA/R / Average Daily SalesDays Cash-to-Cash CycleDays Cash + Days A/R + Days Inventory on Hand186Evaluating Credit Requests: A Four-Part ProcessCommon Size and Financial Ratio AnalysisActivity RatiosDays Accounts Payable OutstandingA/P / Average Daily PurchasesPurchases COGS + InventorySales-to-Asset RatioSales/Net Fixed Assets

187Evaluating Credit Requests: A Four-Part ProcessCommon Size and Financial Ratio AnalysisLeverage RatiosDebt to Tangible Net WorthTotal Liabilities/Tangible Net WorthDebt to Total AssetsTotal Debt/Total AssetsTimes Interest EarnedEBIT/Interest ExpenseEBITEarnings Before Taxes + Interest Expense188Evaluating Credit Requests: A Four-Part ProcessCommon Size and Financial Ratio AnalysisLeverage RatiosFixed Charge Coverage(EBIT + Lease Payments)/(Interest Expense + Lease Payments)Net Fixed Assets to Tangible Net WorthNet Fixed Assets/Tangible Net WorthDividend Payout Cash Dividends Paid/Net Income189Evaluating Credit Requests: A Four-Part ProcessCommon Size and Financial Ratio AnalysisProfitability AnalysisProfit Margin (PM)Net Income/Sales1 Expenses/Sales1 (COGS/Sales) (Operating Expenses/Sales) (Other Expenses/Sales) (Taxes/Sales)190Evaluating Credit Requests: A Four-Part ProcessCommon Size and Financial Ratio AnalysisProfitability AnalysisAsset Utilization (AU)Sales/Total AssetsReturn on AssetsNet Income/Total AssetsPM AU191Evaluating Credit Requests: A Four-Part ProcessCommon Size and Financial Ratio AnalysisProfitability Analysis Equity Multiplier (EM)Total Assets/EquityReturn on Equity (ROE)Net Income/EquityROA EMSales GrowthDemonstrates whether a firm is expanding or contracting

192193

Evaluating Credit Requests: A Four-Part ProcessCash-Flow AnalysisCash-Based Income StatementModified form of a direct statement of cash flows

194195

196

197

Evaluating Credit Requests: A Four-Part ProcessCash-Flow AnalysisCash-Flow Statement FormatOperations SectionIncome statement items and the change in current assets and current liabilities (except bank debt)Investments SectionThe change in all long-term assets

198Evaluating Credit Requests: A Four-Part ProcessCash-Flow AnalysisCash-Flow Statement FormatFinancing SectionPayments for debt and dividends, the change in all long-term liabilities, the change in short-term bank debt, and any new stock issuesCash SectionThe change in cash and marketable securities

199Evaluating Credit Requests: A Four-Part ProcessCash-Flow AnalysisCash-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

200

Evaluating Credit Requests: A Four-Part ProcessCash-Flow AnalysisCash-Flow Statement FormatCash Flow From Operations is defined as:

where:A1 = Cash

201

Evaluating Credit Requests: A Four-Part ProcessCash-Flow AnalysisCash-Flow Statement Format

202

Evaluating Credit Requests: A Four-Part ProcessCash-Flow AnalysisCash-Flow Statement FormatSources of CashIncrease in any liabilityDecrease in a non-cash assetNew issue of stockAdditions to surplusRevenues

203Evaluating Credit Requests: A Four-Part ProcessCash-Flow AnalysisCash-Flow Statement FormatUses of CashDecrease in any liabilityIncrease in a non-cash assetRepayments/Buy back stockDeductions from surplusCash ExpensesTaxes Cash Dividends

204Evaluating Credit Requests: A Four-Part ProcessCash-Flow Analysis For Prism IndustriesCash Flow From OperationsRecall Exhibits 14.1, 14.2, & 14.3Cash Purchases for 2008:Cash Purchases = -(COGS + Inventory Accounts Payable)

205

Evaluating Credit Requests: A Four-Part ProcessCash-Flow Analysis For Prism IndustriesCash Flow From Investing ActivitiesNet Fixed Assets = Gross Fixed Assets Accumulated DepreciationOrNet Fixed Assets = Capital Expenditures Depreciationwhere:Capital Expenditures = Net Fixed Assets + Depreciation

206Evaluating Credit Requests: A Four-Part ProcessCash-Flow Analysis For Prism IndustriesCash Flow From Financing ActivitiesAlthough 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

207Evaluating Credit Requests: A Four-Part ProcessCash-Flow Analysis For Prism IndustriesChange in CashEquals cash flow from operations adjusted for discretionary expenditures, cash used for investments, payments for financing, and external financing

208209

210

211

212

Evaluating Credit Requests: A Four-Part ProcessFinancial ProjectionsPro Forma projections of the borrowers condition reveal:How much financing is requiredWhen the loan will be repaidUse of the loan

213Evaluating Credit Requests: A Four-Part ProcessFinancial ProjectionsPro Forma AssumptionsSalest+1 = Salest (1 + gSales)where:gSales = Projected Sales GrowthCOGSt+1 = Salest+1 COGS % of SalesAccounts Receivablet+1 = Days A/R Outstanding Average Daily Salest+1Inventoryt+1 = COGSt+1/Inventory Turnover

214Evaluating Credit Requests: A Four-Part ProcessFinancial ProjectionsPro Forma AssumptionsAccounts Payablet+1 = Days A/P Outstanding Average Daily Purchasest+1OrAccounts Payablet+1 = Days A/P Outstanding [(COGSt+1 + Inventoryt+1)/365]

215Evaluating Credit Requests: A Four-Part ProcessFinancial ProjectionsProjecting Notes Payable to BanksRarely will the balance sheet balance in the initial round of pro forma forecastsTo reconcile this, there must be a balancing item or plug figure

216Evaluating Credit Requests: A Four-Part ProcessFinancial ProjectionsProjecting Notes Payable to BanksWhen projected assets exceed projected liabilities plus equity, additional debt (assumed to be in the form of notes payable) is requiredWhen 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

217Evaluating Credit Requests: A Four-Part ProcessFinancial ProjectionsSensitivity AnalysisBest Case ScenarioAssumes optimistic improvements in planned performance and the economy are realizedWorst Case ScenarioAssumes the environment with the greatest potential negative impact on sales, earnings, and the balance sheetMost Likely ScenarioAssumes the most reasonable sequence of economic events and performance trends

218Evaluating Credit Requests: A Four-Part ProcessRisk-Classification SchemeAfter evaluating the borrowers risk profile along all dimensions, a loan is placed in a rating category ranked according to the degree of risk

219220

Credit Analysis Application: Wades Office FurnitureSee Exhibits 14.5- 14.11221222

223

224

225

226

227

228

229

230

231

232

233

234

Managing Risk with Loan Sales and Credit DerivativesMany financial institutions have changed their business models, switching to the originate-to-distribute (OTD) modelUnder 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 marketplace235Managing Risk with Loan Sales and Credit DerivativesLarger 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 riskLead BankThe institution that actually underwrites the original loan and sells the participation236Managing Risk with Loan Sales and Credit DerivativesThere are several inherent risk in loan participations or loan salesGeneral credit risksThere is an inherent potential conflict between the originating institution and the investorThe 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 portfolio237Managing Risk with Loan Sales and Credit DerivativesUnderwriting Loan Sales, Participations, and SyndicationsThe 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 books238Managing Risk with Loan Sales and Credit DerivativesShared 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 agreementThe various regulatory agencies established the SNC program in 1977 to monitor and review the risk structure of large syndicated loans239Managing Risk with Loan Sales and Credit DerivativesShared National Credits (SNC)240

Managing Risk with Loan Sales and Credit DerivativesCredit EnhancementsCan take many formsKey terms of credit enhancements potentially include:Excess cash flowMany securitized assets are placed in pools in which the required payments to investors are less than the contractual payments of borrowersThus, even if some borrowers do not make the required payments, there is sufficient cash flow to continue to pay investors241Managing Risk with Loan Sales and Credit DerivativesCredit EnhancementsKey terms of credit enhancements potentially include:Reserve accountsThe 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 borrowersCollateralizationOne or more parties pledge collateral against the loan242Managing Risk with Loan Sales and Credit DerivativesCredit EnhancementsKey terms of credit enhancements potentially include:Loan guaranteesOne or more parties pledge personal or business assets or are contractually bound to meet the obligations of the borrower if that party defaultsCredit insuranceAny party can purchase credit insurance, provided either privately or by a governmental unit, for loans that provide payments for losses stemming from default243Managing Risk with Loan Sales and Credit DerivativesCredit EnhancementsKey terms of credit enhancements potentially include:Credit derivativesInstruments or contracts that derive their value from the underlying credit risk of a loan or bond244Managing Risk with Loan Sales and Credit DerivativesCredit 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 markets245Managing Risk with Loan Sales and Credit DerivativesCredit Default Swaps (CDS)The buyer pays a premium and thus the CDS is similar to an insurance contractThe buyer often owns the underlying debt and uses the CDS as a hedgeThe seller of the CDS plays a role similar to that of the insurance companySellers generally do not own the debt and provide longer-term protectionIf an adverse event occurs the seller pays the buyer the change in value of the underlying asset246Managing Risk with Loan Sales and Credit DerivativesCredit Default Swaps (CDS)247

Managing Risk with Loan Sales and Credit DerivativesCredit 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 mannerRestructuring of the debt in such a way that the lender (investor in the debt) is negatively affectedBankruptcy or insolvency in which the debt is not paidAcceleration 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 debt248Managing Risk with Loan Sales and Credit DerivativesCredit Default Swaps (CDS)The credit crisis of 20072008 caused many sellers of credit default swaps to make large and unexpected payments for default249Evaluating Consumer Loans15250Evaluating Consumer LoansToday, many banks target individuals as the primary source of growth in attracting new businessConsumer loans differ from commercial loansQuality of financial data is lowerPrimary source of repayment is current income

Types of Consumer LoansEvaluating Consumer LoansAn analyst should addresses the same issues discussed with commercial loans: The use of loan proceedsThe amount neededThe primary and secondary source of repaymentTypes of Consumer LoansEvaluating Consumer LoansConsumer loans differ so much in design that no comprehensive analytical format applies to all loansTypes of Consumer LoansInstallment LoansRequire the periodic payment of principal and interestTypes of Consumer LoansInstallment LoansDirectNegotiated between the bank and the ultimate user of the fundsIndirect Funded by a bank through a separate retailer that sells merchandise to a customerTypes of Consumer LoansInstallment LoansRevenues and Costs from Installment LoansConsumer installment loans can be extremely profitableCosts $100 - $250 to originate loanTypically yield over 5% (loan income minus loan acquisition costs, collections costs and net charge-offs)

Types of Consumer LoansCredit Cards and Other Revolving CreditCredit cards and overlines tied to checking accounts are the two most popular forms of revolving credit agreementsIn 2007, over 92% of households had credit cards (average of 13 cards)Types of Consumer LoansCredit Cards and Other Revolving CreditMost banks operate as franchises of MasterCard and/or VisaBank pays a one-time membership fee plus an annual charge determined by the number of its customers actively using the cardsTypes of Consumer LoansDebit Cards, Smart Cards, and Prepaid CardsDebit CardsWidely availableWhen an individual uses the card, their balance is immediately debitedBanks prefer debit card use over checks because debit cards have lower processing costs

Types of Consumer LoansDebit Cards, Smart Cards, and Prepaid CardsSmart CardContains a memory chip which can store information and valueProgrammable such that users can store information and add or transfer value to another smart cardOnly modest usage in the U.S.

Types of Consumer LoansDebit Cards, Smart Cards, and Prepaid CardsPrepaid CardA hybrid of a debit cardCustomers prepay for services to be rendered and receive a card against which purchases are chargedUse of phone cards, prepaid cellular, toll tags, subway, etc. are growing rapidly

Types of Consumer LoansCredit Card Systems and ProfitabilityCard issuers earn income from three sources:Cardholders annual feesInterest on outstanding loan balancesDiscounting the charges that merchants accept on purchases

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

Types of Consumer LoansOverdraft Protection and Open Credit LinesOverdraft Protection Against Checking AccountsA type of revolving creditA 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 LoansOverdraft Protection and Open Credit LinesOpen Credit LinesThe bank provides customers with special checks that activate a loan when presented for payment

Types of Consumer LoansHome Equity LoansGrew from virtually nothing in the mid-1980s to over $350 billion in 2008They 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 LoansHome Equity LoansSome allow access to credit line by using a credit cardBorrowers 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 LoansNon-Installment Loansaka Bridge LoanRequires a single principal and interest paymentTypically, the individuals borrowing needs are temporary and repayment is from a well-defined future cash inflow

Subprime LoansOne of the hottest growth areas during the early 2000sSubprime loans are higher-risk loans labeled B, C, and D creditsThey have been especially popular in auto, home equity, and mortgage lendingTypically have the same risk as loans originated through consumer finance companiesSubprime LoansMany subprime lenders make loans to individuals that a bank would not traditionally make and keep on-balance sheetSubprime lenders charge higher rates and have more restrictive covenantsSubprime LoansWhat Happens When Housing Prices FallSubprime loans can be attractive when housing values are risingIndividuals 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 highThe opposite occurs when housing prices fallSubprime LoansWhat Happens When Housing Prices FallDuring 20072008, banks were forced to charge-off historically high amounts of mortgage loans as delinquencies and foreclosures skyrocketed

Consumer Credit RegulationsEqual Credit OpportunityMakes it illegal for lenders to discriminate on the basis of race, religion, sex, marital status, age, or national originConsumer Credit RegulationsProhibited Information RequestsThe applicant's marital statusWhether alimony, child support, and public assistance are included in reported incomeA woman's childbearing capability and plansWhether an applicant has a telephone

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

Consumer Credit RegulationsCredit ReportingLenders must report credit extended jointly to married couples in both spouses' namesWhenever 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 RegulationsTruth In LendingRegulations apply to all individual loans up to $25,000 where the borrower's primary residence does not serve as collateralConsumer Credit RegulationsTruth In LendingRequires 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 RatesDiscount RatesSimple Interest Rates

Consumer Credit RegulationsFair Credit ReportingFair Credit Reporting ActEnables individuals to examine their credit reports provided by credit bureausIf any information is incorrect, the individual can have the bureau make changes and notify all lenders who obtained the inaccurate dataConsumer Credit RegulationsFair Credit ReportingThere are three primary credit reporting agencies:EquifaxExperianTrans UnionUnfortunately, the credit reports that they produce are quite often wrong

Consumer Credit RegulationsFair Credit ReportingCredit ScoreLike a bond rating for individualsBased on several factorsPayment HistoryAmounts OwedLength of Credit HistoryTypes of CreditNew Credit

Consumer Credit RegulationsCommunity Reinvestment ActCRA prohibits redlining and encourages lenders to extend credit within their immediate trade area and the markets where they collect depositsConsumer Credit RegulationsCommunity Reinvestment ActFinancial 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 complianceConsumer Credit RegulationsCommunity Reinvestment ActRegulators 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 RegulationsBankruptcy ReformIndividuals who cannot repay their debts on time can file for bankruptcy and receive court protection against creditorsConsumer Credit RegulationsBankruptcy ReformIndividuals can file for bankruptcy under:Chapter 7Individuals liquidate qualified assets and distribute the proceeds to creditorsChapter 13An individual works out a repayment plan with court supervisionConsumer Credit RegulationsBankruptcy ReformIn 2005, Congress passed bankruptcy reform legislation that made it more difficult for individuals to completely avoid repaying their debtsIn 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 debtsCredit AnalysisObjective of consumer credit analysis is to assess the risks associated with lending to individuals

Credit AnalysisWhen evaluating loans, bankers cite the Cs of credit: CharacterCapitalCapacityConditionsCollateralCredit AnalysisTwo additional CsCustomer RelationshipA banks prior relationship with a customer reveals information about past credit experienceCompetition Lenders periodically react to competitive pressuresCompetition should not affect the accept/reject decision

Credit AnalysisPolicy GuidelinesAcceptable LoansAutomobileBoatHome ImprovementPersonal-UnsecuredSingle PaymentCosigned

Credit AnalysisPolicy GuidelinesUnacceptable LoansLoans for speculative purposesLoans secured by a second lienOther than home improvement or home equity loansAny participation with a correspondent bank in a loan that the bank would not normally approveCredit AnalysisPolicy GuidelinesUnacceptable LoansLoans to a poor credit risk based on the strength of the cosignerSingle payment automobile or boat loansLoans secured by existing home furnishingsLoans for skydiving equipment and hang gliders

Credit AnalysisEvaluation Procedures: Judgmental and Credit ScoringJudgmentalSubjectively interpret the information in light of the banks lending guidelines and accepts or rejects the loanAssessment can be completed shortly after receiving the loan application and visiting with the applicant

Credit AnalysisEvaluation Procedures: Judgmental and Credit ScoringCredit ScoringGrades the loan request according to a statistically sound model that assigns points to selected characteristics of the prospective borrowerCredit AnalysisEvaluation Procedures: Judgmental and Credit ScoringCredit ScoringIf the total points exceeds the accept threshold, the officer approves the loanIf the total is below the reject threshold, the officer denies the loan

Credit AnalysisEvaluation Procedures: Judgmental and Credit ScoringIn both cases, judgmental and quantitative, a lending officer collects information regarding the borrowers character, capacity, and collateralCredit AnalysisAn Application: Credit Scoring a Consumer LoanYou receive an application for a customer to purchase a 2007 Jeep CherokeeDo you make the loan?

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

Credit AnalysisAn Application: Credit Scoring a Consumer LoanThe Credit DecisionThe credit decision rests on the loan officers evaluation of the applicants character and capacity to repay the debt

Credit AnalysisAn Application: Credit Scoring a Consumer LoanThe Credit DecisionThe loan officer has numerous grounds for denying creditLimited credit historyLocal residence was established too recentlyEmployed too recentlyCredit AnalysisAn Application: Credit Scoring a Consumer LoanThe Credit DecisionThe loan officer sees some positive thingsApplicant appears to be a hard worker who is the victim of circumstances resulting from her husbands deathIt is unlikely that anyone who puts almost 30 percent down on a new model is going to walk away from a debtCredit AnalysisAn Application: Credit Scoring a Consumer LoanThe Credit DecisionThe loan officer sees some positive thingsThe bank will likely lose Groome as a depositor if it denies the application

What would you recommend?Credit AnalysisYour FICO Credit ScoreSummarizes in one number an individuals credit historyLenders often use this number when evaluating whether to approve a consumer loan or mortgageMany insurance companies consider the score when determining whether to offer insurance coverage and how to price the insuranceCredit AnalysisYour FICO Credit ScoreSummarizes in one number an individuals credit historyThe scores range from 300 to 850 with a higher figure indicating a better credit historyThe national average is 670The 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 AnalysisYour FICO Credit ScoreAn individuals 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 AnalysisAn Application: Indirect LendingA retailer sells merchandise and takes the credit applicationBecause many firms do not have the resources to carry their receivables, they sell the loans to banks or other financial institutions

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

Credit AnalysisAn Application: Indirect LendingDealers negotiate finance charges directly with their customersA 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 loanCredit AnalysisAn Application: Indirect LendingA dealer normally negotiates a higher rate with the car buyer than the determined rate charged by the bankThis differential varies with competitive conditions but potentially represents a significant source of dealer profit

Credit AnalysisAn Application: Indirect LendingMost 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 LoansRevenues from Consumer LoansThe attraction is two-fold:Competition for commercial customers narrowed commercial loan yields so that returns fell relative to potential risksDeveloping loan and deposit relationships with individuals presumably represents a strategic response to deregulation

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

Recent Risk and Return Characteristics of Consumer LoansRevenues from Consumer LoansWith 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 LoansConsumer Loan LossesLosses on consumer loans are normally the highest among all categories of bank creditLosses are anticipated because of mass marketing efforts pursued by many lenders, particularly with credit cardsCredit card losses and fraud amounted to more than $12 billion in 2005Recent Risk and Return Characteristics of Consumer LoansInterest Rate and Liquidity Risk with Consumer CreditThe majority of consumer loans are priced at fixed ratesNew auto loans typically carry 4-year maturities, and credit card loans exhibit an average 15- to 18-month maturityRecent Risk and Return Characteristics of Consumer LoansInterest Rate and Liquidity Risk with Consumer CreditBankers have responded in two ways to deal with the interest rate risk:Price more consumer loans on a floating-rate basisCommercial and investment banks have created a secondary market in consumer loans, allowing loan originators to sell a package of loansEvaluating Consumer Loans330