Bank Management and Commercial Lending
Exam II Guidelines – Class Discussion and Chapters 13 – 15
From Chapter 13 – Credit Policy and Loan Characteristics
With these topics, be familiar with recent banking trends (we reviewed loan delinquency rates by
loan type from 2000 – 2010 in class), and loan exposures. Recall that loan delinquencies seemed
to peak in 2009 or early 2010. For commercial banks, the total reach a peak of around $60 billion
in late 2009 or early 2010, but the data we examined did not include the exposure of Fannie Mae
and Freddie Mac, or the exposure of a number of banking houses (like the dissolved Bear Stearns
or the failed Lehman Brothers) that later became commercial banks.
The highest delinquency rate among loans was with residential loans, followed by commercial
loans and credit cards. Agricultural loans (with a number of unmentioned government support
programs) are historically the least delinquent of all loan types. Recall also that the gravest
exposure of community banks to CRE loans was in 2008, about the time of the peak of the
financial crisis in the fall of 2008.
Exhibits 13.1, 2 and 3 are dated.
Exhibits 13.4 and 5 tell a rich story of the increasing exposure of commercial banks by 2008 and
2009 to non-current loans (loans at least 90 days past due). Between 1951 and 2008, bank
exposure to real estate increased from around 25% to over 50%.
Most FDIC-insured banks are commercial lenders. And banks, given the collapse and failure of
much of the thrift industry between 1987 and 1992 following the Tax Reform Act of 1986, were
not as exposed to commercial loans with the financial crisis, but were gravely exposed to
residential loans.
The Tax Reform Act (TRA) of 1986 had several features:
1.
Depreciation schedules of investment real estate (15 years with the Economic Recovery
Tax Act of 1981) were changed to 27.5 years and 39 years for residential and commercial
investment real estate, reducing after-tax cash flows for those investments, and lowering
their values.
2.
Individual tax rates were lowered at the highest brackets from 50% to 28%.
3.
A number of individual and corporate tax “loopholes” were closed.
4.
The option of “income-averaging” for individuals was removed.
5.
All interest deductions, except for interest on a primary or secondary residence, were
disallowed. Interest deductions on residences are limited to a total outstanding mortgage
balance of $1.1 million, for the purchase and improvement of the home(s). The limit is $1
million for the purchase alone, AND the mortgage balance valid for interest deductions
can never exceed the amount the homeowner actually has invested in the home(s). For
example, if a home bought and improved for $300,000 in the 1990’s has a mortgage of
$700,000 attaching to it (even if it is worth over $1 million) is eligible for deductions on
loan balances equal to or less than ONLY the $300,000 the homeowner has invested in
the residence.
6.
The TRA caused many homeowners to use equity lines and second mortgages to finance
expenses previously covered with traditional credit cards. This contributed to the real
estate bubble (“buy more house, take more deductions!”) of 2006 or 2007 -present.
The current credit environment is characterized by low interest rates for four main reasons:
1.
2.
3.
4.
Credit scoring standardization among banks.
Securitization of consumer and small business loans. This has allowed banks to become
loan originators, not keeping the loans on their own balance sheets, and excusing
themselves from the long term risk of those loans failing.
FED loose-money policies.
Low-growth economic environment.
The credit process is pretty straightforward. Loan policies formalize lending guidelines. A credit
philosophy (establishing risk tolerance) and credit culture (establishing actual lending principles)
are used to drive the three differing lending foci:
1.
A values-driven focus leading to lower profits, but fewer losses; small rural banks come
to mind with this focus.
2.
A current-profit driven focus characterizes high-beta banks (think Lehman Brothers),
providing large profits when times are good, but risking failure as in 2007-2010.
3.
A market-share driven focus (think Bank of America or Citibank) might provide certain
synergies or cost savings in the short term, but becomes cumbersome and less
manageable long term. Banks often suffer with this focus.
Decisions to lend are based on the 5-c’s:
1. Character
2. Capital (borrower’s wealth)
3. Capacity (income and ability to repay)
4. Conditions (macro concerns)
5. Collateral (secondary source of repayment – security)
The 5-c’s of bad credit?
1. Complacency
2. Carelessness
3. (poor) Communication and follow-through
4. Contingencies
5. (poor response to) Competitors
In the commercial lending process, the bank collects information, conducts varied spreadsheet
analyses on cash flows and collateral values, prepares a summary and makes a recommendation
to the bank on accepting or rejecting the loan application.
The loan is then processed, and the security interest is perfected (assuring the bank’s claim is
superior to the borrower and other lenders – like keeping the car title).
Loan covenants exist to assure borrower compliance with more than just principal and interest
payments. A homeowner’s need to keep taxes and insurance paid are examples of loan
covenants. Negative covenants and positive covenants require a borrower to avoid some things
(like dividend payouts) and achieve others (like a minimum cash balance at the bank).
Position limits and the risk-rating of individual loans limit the exposure of the lender to a single
type of loan (such as limiting the bank’s lending to farmers, for example, or car dealers) or to a
single risky borrower, respectively.
The Uniform Bank Performance Report (UBPR) includes six types of loans monitored by bank
regulators. All loans fall into one of these categories:
1. Real Estate (commercial RE, residential RE, home equity lines, mortgage-backed securities,
etc)
2. Commercial
3. Individual
4. Agricultural
5. Other domestic
6. Foreign
Practice questions and end-of-chapter assignments, including the RSM publishing problem we
completed in class (p. 584 of the 7th Edition of Bank Management) are good resources. Questions
1-9, 13 and 17 highlight important topics. Problems 1-4 and the RSM Publishing case are
helpful, as well.
From Chapter 14 – Commercial Loan Requests and Managing Credit Risk
Delinquencies on all loans and leases peaked in late 2009 and early 2010, evolving from the
credit crisis that cratered in the fall of 2008. In light of those delinquencies, and the financial
crisis, risk management for all lenders, especially commercial banks, is highlighted.
Borrower character and the accuracy of provided data are critical to appropriate and informed
loan decisions, and are cornerstones of bank risk management. Appropriate uses for commercial
loan proceeds by borrowers include most normal recurring business expenses, including the
funding of growth options (purchase of an entire company, expansion of existing facilities, etc).
Paying off a bad debt at another lender is never an appropriate use!
The use of the loan $, the loan amount, the source of repayment and secondary repayment
sources (collateral, other security, third-party guarantees) are also key, following the character
of the borrower.
Cash flow analysis is the centerpiece of the best lending decision.
Firms derive cash flows from 4 general sources:
1. Net Income
2. Asset Sales
3. Borrowing
4. Equity Issues
Firms use cash flows for 4 general uses:
1. Losses
2. Payoff of debt
3. Dividends or stock buybacks
4. Asset purchases, acquisitions
The credit request and loan evaluation follow a 4-step process
1. An overview of the firm, its management, and the firm’s industry. (JP Morgan Chase is now
the largest bank in the US, with Bank of America displaced earlier in the fall of 2011)
2. Financial Statement and Ratio Analysis using Common Size Financial Statements. Three types
of ratios interest the lender:
I.
Liquidity and activity ratios
1.
2.
3.
4.
The current ratio (current assets/current liabilities)
The quick ratio (current assets – inventory)/current liabilities
Days payable outstanding (accounts payable/average daily purchases on credit)
Total asset turnover (sales/total assets)
(Examples of the use of these ratios from your class notes, the chapter 14 notes on
the class website and Appendix I from chapter 14 in your text.
Familiarity
with all the ratios is required, memorization of them is not.)
II.
Leverage ratios
1.
2.
3.
4.
III.
Total debt ratio (total liabilities/total assets)
Times interest earned (EBITDA/annual interest expense)
EBITDA is used in the numerator as interest is tax deductible.
Fixed charge coverage ratio
= (EBITDA + lease payments)/(lease payments + interest expense)
Depreciation and amortization are added to EBIT in the text as depreciation and
amortization are non-cash expenses.
Equity multiplier (Total assets/owner’s equity)
Profitability ratios
1.
2.
3.
ROE = net income/owner’s equity = ROA x equity multiplier
ROA = Net income/total assets = Profit margin x total asset turnover
Profit margin = Net income/sales
The Dylan Enterprises example on the website, and the Chem-Co Holdings example in chapter
14 (problem II, page 645) are instructive.
3. The third part of the credit request evaluation is a cash-flow analysis. Exhibit 14.4 supports the
analysis. Sources and uses of cash are identified, as from the sources and uses of cash from the
list above.
Cash flow from operations (CFO) = NI + Depreciation + Δ accounts receivable + Δ inventory +
Δ pre-paid items + Δ accounts payable
In words? CFO is net income plus depreciation minus increases in short term assets supporting
operations, plus increases in short term liabilities supporting operations. The Dylan Enterprises
example on the web is, again, instructive.
CFO should also cover dividends paid and mandatory principal payments on debt in the
operating period being examined. These are cf’s from normal business operations, while
dividends are a cash flow from financing activities. We just need to live with that contrast!
4. The last part of the credit evaluation is a pro-forma projection and analysis of the borrower’s
financial condition, supplemented with common-size financial statements and financial ratios for
the firm and its industry.
Exhibit 14.7 is instructive, as well, but it gets bogged down in far too many details. Question 13
at chapter’s end is illustrative, as is Problem II. Questions 1 - 4, 7, 9, and 12 – 15 are good study
tools.
Do not worry at all about pages 629-638 in your text.
Finally, credit enhancements (numbers 2 and 3 below are considered above) for loans being
considered include:
1.
2.
3.
4.
Reserve accounts or sinking funds
Security, collateral
Third party guarantees
Credit insurance, credit default swaps, and credit derivatives. (These are
considered further in the closing classes of this course, and in more advanced
academic environments. )
From Chapter 15 – Evaluating Consumer Loans
Consumer loans, dollar-for-dollar, require more management, but credit card lenders, in
particular, generate the greatest interest margin of all lenders.
Consumer loans include direct lending from the bank to the borrower, or indirect lending (as
with many auto, furniture or appliance loans) from the bank to the borrower by way of a retailer.
The Kirby Vacuum Cleaner salesperson comes to mind.
Credit card lending is attractive as it provides three cash flows – annual fees, late charges and
interest on outstanding balances; the credit card provider may also have the chance to collect
additional income from the sales of travel packages or other services.
Installment loans (typically less than $10,000 with maturities of from 1 – 7 years) are small, with
higher risk attaching to them, but provide higher interest margins; recall the interest margin is
simply the spread between the lender’s cost of capital (in this case perhaps simply the average
cost of savings, checking, certificate of deposits and money market accounts) and the interest
charged on the loaned funds. Marketing, administrative and default costs with these loans are
high.
Most consumer loans are secured. Smaller loans lead to high dollar-for-dollar management costs,
as noted above, but far higher returns.
Among new product offerings by banks (in addition to services mentioned in chapters 1 and 12)
are debit cards, another type of consumer “loan.” (Though no funds are actually loaned~!) The
debit card suffers from a lack of float, and greater difficulty in resolving errant charges, such as
those committed fraudulently.
With the TRA in 1986, credit cards based on a home-equity line of credit became popular, as the
only interest (besides business or investment interest) deductible by the individual is interest on
home loans. That interest, in turn, is limited according to the terms outlined in the chapter 13
notes for this course. $1.1 million gross limit on primary and secondary residences, mortgage
balance limited to the funds the homeowner has invested, etc. The amount the homeowner
actually has invested in the home is the limit of deductibility: Cannot deduct interest on a
$500,000 mortgage for a home for which the homeowner paid only $200,000. Interest only on
the first $200,000 is allowed. (Sidebar: the homeowner’s second home can be a boat or an RV,
provided the boat or RV has indoor plumbing).
The housing bubble, the financial crisis, the recession of 2007-2009 – all these contributed to
homes being under water, with negative equity, belly up, or upside down. Many less honorable
homeowners, with the ability to pay (but not the willingness) on a home whose value has
collapsed, just walked away.
Fair Isaac Corporation Credit Ratings (FICO scores) are used to numerically rank the
creditworthiness of borrowers. FICO scores range between 300 and 850.
Subprime loans, made to the poorest credit risks with the lowest FICO scores, contributed to the
loan crisis. From least to most risky:
1.
2.
3.
4.
Prime loans (credit rating of around 720 or higher)
Alt – A’s (credit rating of 660 – 720, or otherwise “non-conforming” loans)
– a non-conforming loan is one over the Fannie Mae or Freddie Mac or FHA limit of
$417,500 [this amount will likely be raised later in 2011], one for over 80% of the
purchase price or one designed to meet some unusual lending requirement by the
borrower – like no payments for 6 months or something.
B (FICO of 600 to 660)
C (FICO of 500 to 600)
5.
D (FICO of less than 500)
By 2011, close to half of all subprime loans (the ones rated B, C or D) had gone into delinquency
or arrears, in some markets like Las Vegas.
Like the Equal Employment Opportunity Act, the Truth in Lending Act of 1968 and the Equal
Credit Opportunity Act of 1974 (followed by the Community Reinvestment Act of 1977), were
passed to criminalize any lending decision made on the basis of age, race, religion, national
origin, gender, marital status or family circumstances. Alimony and child support can only enter
a lending decision if the borrower agrees. The CRA, mandating lending by any bank in every
market in which it is active (it cannot only get deposits from one struggling area, and lend only
to a growing area, for example), has continued to be a point of contention among those looking
for “causes” of the financial crisis.
The CRA purportedly “forces” lenders to loan to the less-creditworthy, but its intent was merely
to assure banks loaned fairly, to creditworthy borrowers, in all of its markets. It has been used,
however, as a sounding board by groups claiming discrimination on the part of lenders, whereas
the lenders claim merely to have been adhering to a consistent set of lending criteria. The
handout in class also discussed redlining and reverse redlining. Redlining was the practice by
the FHA to delineate areas off-limits to FHA financing in the period from the start of the FHA in
the 1930’s until the Civil Rights Act of 1964, the ECOA of 1974, the Truth in Lending Act of
1968 and the CRA of 1977. Areas within redlined neighborhoods could not be collateral for FHA
loans. Reverse redlining purportedly occurred in the late 90’s and early 2000’s where lowercredit and lower-income areas experienced a preponderance of sub-prime lending and, since
2007, an inordinate number of mortgage delinquencies and foreclosures.
Truth in Lending was designed to standardize the reporting platform used by lenders in telling
borrowers the interest rate or cost of a loan.
Three general types of loans exist:
1.
2.
3.
The add-on rate
The discount rate
Simple interest rate
Examples in class, and in the text, describe the manner with which the APR or annual percentage
rate, is calculated with each of these types of loans. The proceeds provided the borrower varies
with each type of loan, as does the APR.
Following the TRA and the collapse of the thrift industry between 1987 and 1992, the Financial
Institution Reform, Recovery and Enforcement Act (FIRREA) of 1989 was passed and it
underscored the need for transparency among lenders for their reported lending activities. A
FIRREA-type piece of legislation, along with the Resolution Trust Corporation (RTC) – it was
designed to implement FIRREA and dispose of the real estate collateral (primarily commercial)
of failed commercial mortgages left over from the 1980’s – is sometimes suggested to address
the mounting seized assets in banks hands as a result of the financial crisis of 2007-present.
Acceptable consumer loans include ones for the home, car, boat, RV, home improvements or the
personal business. Unacceptable loans include those for the payoff of gambling debts, the payoff
of other bad loans, or ones based solely upon a co-signer or valuable collateral. (It makes no
sense to lend to someone who does not have the ability of pay off a loan, no matter that the
collateral is valuable or the co-signer creditworthy.)
In the event the borrower cannot meet loan terms, bankruptcy is an option.
With chapter 7, the personal bankrupt liquidates all of his assets under court supervision,
and distributes the monies to creditors based on the court’s guidelines. Most courts allow the
bankrupt to retain ownership of purely personal assets (clothing, electronics, one older car, etc)
and some allow retention of home equity, even under chapter 7.
With chapter 13, a repayment plan is agreed to between a debtor and his creditors (with
court approval) and the debtor gets his life back, provided he abides by the debt repayment
guidelines of the court.
Some states allow the debtor to retain ownership of the home, a car and other assets
(retirement accounts are generally immune to bankruptcy, but not to divorce). The abuse of this
option (the bankrupt moving to Florida and buying an expensive home with cash before filing for
bankruptcy is common) has led to it being used less and less, except by genuine residents of
those states. Mortgage holders still have valid claim to the bankrupt’s home, unless he has been
making all his mortgage payments. Thus, the “game” played by many bankrupts in Florida is to
pay cash for a home, owning it free and clear, and THEN declare bankruptcy. Pretty cheesy.
Finally, neither chapter 7 nor chapter 13 discharge liabilities for:
1. Child support
2. Past due income taxes
3. Student loans
4. Debt incurred by fraud.
Each of these topics concerning consumer lending is expanded with the assigned problems at
chapter’s end: numbers 1-6, 8, 11, 13 and 14 highlight important topics. The website provides
solutions to each of these.