GSB Credit Track Effective Loan Pricing Session 3

© 2012 FARIN & Associates Inc. 1

GSB Credit TrackEffective Loan Pricing

Session 3

Thomas FarinPresident

[email protected]

mailto:[email protected]

© 2012 FARIN & Associates Inc.

Goals For This Session• Review most important points from Sessions 1

and 2 at GSB• Review assignment• Walk you through software and model a loan

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Pricing Cash Flows• When we price a loan

– We are pricing a bundle of cash flows.– A good loan pricing model puts an A/L wrapper around

a loan or a bundle of loans being priced. Approach and results should be consistent with.• A/L model results• Profitability system results• Market results – Assuming loan is sold

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Cash Flow and Repricing Characteristics

• Fixed or Variable– Origination Rate– First Reprice– Repricing Rate– Repricing Frequency

• Term or Revolving– Amortizing?– Term– Balloon?

• Amortization Term– Prepayment Speed

60 Month Bullet Loan

You don’t control in LoanEdge


Loan Pricing – Cash Flows

1 2 3 4 50

0.5

1

1.5

2

2.5

3

3.5

Funding Cost

RatesMatch

60 Month Bullet

$0

$20,000

$40,000

$60,000

$80,000

$100,000

$120,000

1 6 11 16 21 26 31 36 41 46 51 56

Cum Prin CF

Series1Series2

Considers Interest Cash Flows

60 Month Bullet Loan


Loan Pricing – Cash Flows

Match

Considers Interest Cash Flows

60 Month New Car - 20% PP

$0

$20,000

$40,000

$60,000

$80,000

$100,000

$120,000

1 6 11 16 21 26 31 36 41 46 51 56

Cum Prin CF

60 Month Amortizing Loanwith 25% annual prepayments


Loan Pricing – Interest Rate Risk• Interest Rate Risk

– When you are pricing loans you are pricing cash flows not maturities.– With fixed-rate loans, pieces reprice as cash flows come in. Few reprice at

maturity. – Principal cash flows are often uncertain

• Prepayment options– Variable rate loans reprice

• When cash flow pieces come in• When contractual repricing occurs, but …• Variable rate loans may not respond immediately or completely at reset points• Reset frequency• Restrictions on adjustments (caps)

• To manage interest rate risk, institutions need to match funding to the repricing of the loans of loans. Two approaches:– Simplistic – match based on duration– More complex – Match fund individual repricing flows.– While in the real world you may not match, in making pricing decision, we should

assume matching.

xx

X – Approach taken in this course


Market Curve UsageCurveNo CurveName

1 US Treasury5 Prime6 Fed Funds9 Balloon MBS

10 Libor14 FHLMC FR MBS16 UST Strip20 FNMA FR MBS21 GNMA FR MBS29 Interest Rate Swap37 Indexed AAA Corporate Bond40 AAA Auto Index66 11th District COFI84 Average FHLB ADV87 Cost of Savings Index90 Indexed AAA MUNI Bond91 Indexed Agency Bond95 National COFI98 REPO (Overnight)99 Retail CD Avg

100 US CMT (H.15)119 AAA Commercial Equipment126 Indexed A Corporate Bond127 Indexed B Corporate Bond128 Indexed A- MUNI Bond134 FR MBS137 Balloon MBS Synthetic138 GNMA II ARMS

• Curves Used for– Risk Free Curves– Investment Benchmarks– Wholesale Funding Curves

• Requirements– Broad range of benchmarks.– Updated very frequently

You don’t control Market Curves or spreads in LoanEdge


Cash Flow Matching Example

60 Month Auto loan – 1st 12 months of amortization

Weighted averageinvestment benchmarksand funding costs arecalculated from thesematches.

You can view amortization schedules in LoanEdge


Loan Pricing – The Basics

Interest Rate Risk – Conclusions• Interest rate risk driven by the cash flow and repricing

characteristics of the loan rather than the term of the loan

• To model most accurately, each cash flow and repricing point is matched

• The loan can be matched up to an appropriate point of:– A funding curve when matching funding

• Funds Transfer Pricing (FTP)– An investment curve when looking at investment alternatives.

• Pricing loans off investment alternatives• Valuing loans


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Loan Pricing – The Basics

Credit Risk– Provision for Loan

Loss?– Charge-Offs

• Problem with Using Provisions– 1% Reserves– 0.15% Charge-Offs

0% Growth

10% Growth

25% Growth

RLL 1.00% 1.00% 1.00%C/O 0.15% 0.15% 0.15%PLL/ALL 0.15% 0.25% 0.40%

0.15% C/O + (1% * 0%) Growth

0.15% C/O + (1% * 10%) Growth

0.15% C/O + (1% * 25%) Growth


Which History to Use?• Was history from 2005-2007 a legitimate

predictor of recent credit losses?• Are 2008-2010 losses a legitimate predictor of

losses of newly originated loans in 2011?• Do we even have legitimate loss history for loans

originated today?– Changes in collateral coverage– Changes in underwriting standards– Changes in kinds of loans originated

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You will be coming up with the credit risk adjustment for your loans


Loan Pricing – ServicingServicing Cost

– Marginal Origination Cost• Cost of originating the next

loan– Marginal Servicing Cost

• Cost of servicing the next loan

– Direct Overhead Allocation• Fixed costs directly related to

loan production– General Overhead Allocation

• President’s salary, human resources, etc.

Arguments– Economist – Continue to produce widgets until marginal revenue equals

marginal cost.– Accountant – Without overhead allocation, you end up with profitable

loans and an unprofitable institution. OTS Cost Assumptions

– 0.20% - FR Mortgages– 0.38% - ARMs– 0.20% - Multi & Non-Res– 0.20% - Const & Land– 0.20% - Second Mtg.– 0.20% - Commercial– 0.20% - Consumer– 1.00% - Credit Card

• Is there a better source for generic servicing costs


Servicing Example

• Differential pricing on A, B, C credits should reflect both additional charge offs, and additional servicing costs due to legal and collection fees.

In LoanEdge you can add servicing costs but you can’t delete what is there.


Option Risk – What Is It• 15 year FRM example showing remaining principal under different

rate environments– Falling – 25% CPR – 2.75 year duration– Flat – 8% CPR – 4.64 Year duration– Rising – 5% CPR – 5.21 Year Duration

15 Year FRM

-

20,000.00

40,000.00

60,000.00

80,000.00

100,000.00

120,000.00

1 14 27 40 53 66 79 92 105 118 131 144 157 170

Month

Rem

aini

ng P

rinci

pal

5% CPR8% CPR25% CPR


Consider Option Risk in Pricing Loans?

• Against– Not a true cost like charge offs, servicing costs, or costs of matching

funding.– Considering option risk will cause loans to be unprofitable.– Not the loan officer’s problem.– Very difficult to calculate– May be inherently hedged in balance sheet of retail financial institution.

• For– Option risk can damage the

performance of un-hedged institutions. It costs money to hedge option risk

– Price/yield of securities reflects option risk. Securities are securitized loans

– If loan officers are not ‘charged’ for options, they will give away options in exchange for rate

– Can be derived from securities market.

• Source– Securities Markets


Adding Option Risk

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Applied to internal profitability calculations

You can’t control the option risk adjustments in LoanEDGE


Sample Loan – 72 Month New Auto

• Cash Flows• Pricing• Expenses• Risk Assum• Benchmarks


Investment Benchmark• Market rather than internal

benchmark• Compares performance of loan to

closest investment benchmark after adjusting for risk and cost differences.

• Most relevant when– You are trying to decide how to

invest cash already raised.– Anytime investing in a security is

an alternative to making a loan– You are trying to derive market

adjustments for• Interest rate risk• Option risk

• Required inputs– Cash flow characteristics– Risk free curve– Investment benchmark curve– Pricing – Rates and fees– Operating expenses– Credit risk adjustment– Additional option risk adjustments

• Calculated adjustments– Interest rate risk adjustment– Option risk adjustment– Loan’s spread to investment

benchmark after adjustments– Test – Is spread positive (good) or

negative (bad)?• Not considered

– Funding cost curve– Capital requirement– RAROC Goal– Institution Tax Rate


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Investment Benchmark - Steps

1 Month AgencyIRR AdjustmentAgency Match

Investment BenchmarkCredit Risk AdjustmentServicing Cost AdjOption AdjustmentRetail BenchmarkLoan RateSpread to Benchmark

Investment BenchmarksRisk Free Rate 0.620%+ Int Rate Risk Adjust 1.107%

= Risk Free Match 1.727%+ Option Risk Adjust 0.000%= Investment Benchmark 1.727%+ Credit Risk Adjust 0.350%

+ Expense Adjust 0.682%

+ Add'l Option Risk Adjust 0.250%= Retail Equiv Benchmark 3.009%Wtd Loan Yield 4.500%

Spread to Benchmark 1.491%

You can view the detailed Investment Benchmark analysis in LoanEdge


Valuation• Market rather than internal

benchmark• Compares market value of loan as

compared to book at time of origination.

• Most relevant when– You are going to sell loan after

origination.– When you are trying to improve

the franchise value of your institution by holding well priced loans

• Required inputs– Cash flow characteristics– Risk free curve– Investment benchmark curve– Discount rate curve– Pricing – Rates and fees– Operating expenses– Credit risk adjustment– Additional option risk adjustments

• Calculated outputs– Market value vs book value of

loan– Price– With and without origination fees– Test – Is price at or above 100

(good) or below 100 (bad)?• Not considered

– Funding cost curve– Capital requirement– RAROC Goal– Institution Tax Rate


Valuation - Steps• Value Cash flows

– Project amount and timing of cash flows– Use discount rates to mark cash flows to market.

n PVFViPV1 = FV1 / (1+i)n = 1086.14 / (1 + (1.22%/12))1 = 1085.05

Note: Cash flows continue for an additional 60 months

Discount Rate = InvestmentBenchmark + Adjustments(not including expense)

The sum of the market valuesof individual cash flows is the market value of the instrument.

Period0123456789

101112

discRates ttlCashFlowmktValue0.00% -230.00 -230.001.22% 1,086.14 1,085.051.22% 1,056.16 1,054.021.22% 1,026.92 1,023.811.22% 998.42 994.391.22% 970.63 965.741.24% 943.55 937.751.24% 917.14 910.571.24% 891.40 884.111.24% 866.31 858.341.24% 841.86 833.251.24% 818.02 808.831.36% 794.79 784.11 You can view the

market value cash flows in LoanEdge


Valuation - Steps

Book Amount of LoanWith FeesSum of Cash Flow Market Values100 * MV / BVWithout FeesSum of Cash Flow Market Values100 * MV / BV

Note: By Valuation standards, this is a well priced loan as its market value exceeds book at the time of origination.

Market ValueBook Value $30,000.00With Initial FeesMarket Value $30,910.43Price 103.03Without Initial Fees

Market Value $30,910.43Price 103.03

You can view the market value analysis in LoanEdge


RAROC (Lifetime)Wtd Loan Yield 4.500%+Wtd Fees 0.000%- Wtd Fund Bench 1.539%- Option Risk 0.125%- Credit Risk 0.350%- Expense 0.682%

= Spread 1.804%- Tax Adjust 0.722%= After Tax Spread 1.082%/ Capital Req. 10.000%= ROE (RAROC) 10.825%ROE Target 15.000%ROE Spread -4.175%

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FTP Analysis - RAROCBalance weighted costs

Decision – Don’t make the loan !!!

RAROC GoalRAROC (ROE)

Assumed tax rate of 40%

Horizon

Lifetime ROE 11.37%ROE Target 15.00%

You can view the RAROC analysis in LoanEdge


ROA 2.27%Avg Annual Horizon Income (ROA numer.) $195Avg Net Principal (ROA denom.) $8,582

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FTP Analysis - Income

Decision ToolMake the loan !!! Note: The net incomefigure is converted into ROA

Ratio analysisrestated indollars

Horizon Incom eH or izon P eriod (yrs) 3 .0In tere st Incom e $2,31 7+ F ee s $0- F und E xpense $ 71 2- O p tion R isk $64- C red it R isk $ 18 0- O per . E xpe nse $ 38 4= N et Inco m e B 4 Tax $ 97 6- Ta xes $ 39 0= A fter Ta x Net In com e $ 58 6

A vg N et Pr inc ipal $ 17 ,16 4You can view the incomeanalysis in LoanEdge


Decision TreeLoan New A 48 Mo

Initial Reprice Is the spread to Investment Rate 6.500% 0.000% Benchmark positive? 0.851%Reprice 0 0 Better off putting moneyAmortize in investments.Mature 48Balance 1,000 CapitalOption 0.00% Constraint?Credit 0.15% Decision based on ROE (RAROC)Servicing 0.15% Don't make the

Decision based on loan. income contribution

Is the FTP loan profitadequate? 4.82

Does the FTP ROE beatthe target? -7.70%

Originate for Is the loan price sufficientlyportfolio. above book? 101.82

Don't make the Originate and loan. Sell.

No

NoYes

Yes

YesNo

No

No

Yes

Yes


Intersession Assignment

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Note: This is the 1st of 4 criteria



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Note: This is the 2nd of 4 criteria



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Note: This is the 3rd of 4 criteria

Note: In your first loan you will model anindividual loan. In the second you will modela relationship.



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Note: This is the 4th of 4 criteria

You are probablythinking, “But Farin,you haven’t showedme how to use the model.”


In Order to Follow Along …• Register – click registration link on resource page

and follow instructions• Download Getting Started Guide – click download

link on registration page• Have the loan you wish to model selected and

have the information to model the loan assembled

• Have this window open as well as the software. You can pause the recording, switch windows, and model your loan as I walk you through.

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Logging Onto iPrice

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Process1. URL

ipriceweb.farin.com2. Click here to begin

log on

LoanEDGE is Web based …


Logging Onto iPrice

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Process1. Click Logon

link2. Enter User

Name andPassword

3. Click OK

Resource pages have information on user name and password. Each attendeecan have his or her own logon.


Creating New Relationship

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Process1. Click here2. Give Relationship

a name3. Click Add

Note: You won’t have these.

Will say LoanEDGE for GSB School 2012


Add Product to Relationship

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Process1. Click category

of loan you wish to add

2. Then clickselect to getto nextscreen.

Note: pick theloan from thelist that mostclosely matchesthe loan youwish to model


Select Product to Add

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Process1. Select product

to be added2. Click Select


Product Modeling Screen

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Productcharacteristicspreset

1. Structure2. Fees/Expenses3. Credit Risk

Note: You will beable to edit some characteristicsbut not othersdepending onaccount typeselected inprevious step.


Entering Product Data

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Enter1. Rate2. Balance3. Credit

adjustment4. Review

productresults

To see: • Amort Schedule• Details


Amortization Schedule

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Process1. Review2. Done

Note: if youscroll rightyou will beable to seemarket valuecash flows


Detailed Results

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Process1. Investment

benchmark2. Characteristics3. Scroll down

to see othermethods

4. Done to close


Detailed Results

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Duration

MoreCharacteristics

RAROC

Summary


Detailed Results

42

Full Summary

Horizon Income


Exporting Details

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If you find ithelpful, you canuse the Save Asbutton to exportthis information to an Excel filefor comparison and printing.


Notes• Everything you have done persists on our server.• If you want to modify a deal later you can:

– Log onto LoanEDGE– Open (View) a relationship– Modify or enhance– In Session 4 you will be either modifying an existing

relationship or creating a new one.• Our support people will be able to view the loan

you have been working on.• Feel free to model additional loans if you wish.

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Notes• Limits – You accept our

management assumptions• Resource Page

– Self-registration link– Getting started guide– Links to the two recorded

Webinars– Links to the PowerPoints as

PDFs– Support number should you

need help

• Model two situations– Two separate loans– Comparison– Sensitivity testing– A loan and a relationship

• Session 4 focuses on last three

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GSB Credit Track Effective Loan Pricing Session 3

Documents

pricing loans

farin associates

pricing cash flowswhen

loans of loans

good loan pricing model

loan loss

matchedthe loan

bundle of cash flows