13
Overview of Credit
Policy and Loan
Characteristics
1
Recent Trends in Loan Growth
and Quality
 Larger 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
2
Recent Trends in Loan Growth
and Quality
 Commercial and industrial loans
represent the second highest
concentration of loans at banks
 Loans to individuals are greatest for
banks with more than $1 billion in
assets
 Farmland and farm loans make up a
significant portion of the smallest
banks’ loans
3
4
Recent Trends in Loan Growth
and Quality
 Wholesale Bank
 Emphasizes
lending to businesses
 Retail Bank
 Emphasizes
lending to individuals
 Primary funding is from core deposits
5
Recent Trends in Loan Growth
and Quality
 FDIC Bank Categories
 Credit
Card Banks
 International Banks
 Agricultural Banks
 Commercial Lenders

Vast majority of FDIC-insured
institutions fall in this category
6
Recent Trends in Loan Growth
and Quality
 FDIC Bank Categories
 Mortgage
Lenders
 Consumer Lenders
 Other Specialized Banks (less than $1
billion)
 All Other Banks (less than $1 billion)
 All Other Banks (more than $1 billion)
7
8
9
10
Recent Trends in Loan Growth
and Quality
 Noncurrent Loans
 Loans and leases past due 90 days or
more and still accruing interest plus all
loans and leases in a nonaccrual status
 Nonaccrual loans and leases are those:
 that are maintained on a cash basis because of
deterioration in the financial position of the
borrower
 where full payment of interest and principal is
not expected
 where 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 collection
11
Recent Trends in Loan Growth
and Quality
 Net 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 off
12
13
14
15
Measuring Aggregate Asset
Quality
 It is extremely difficult to assess individual
asset quality using aggregate quality data
 Different types of assets and off-balance
sheet activities have different default
probabilities
 Loans typically exhibit the greatest credit
risk
 Historical charge-offs and past-due loans
might understate (or overstate) future losses
depending on the future economic and
operational conditions of the borrower
16
Measuring Aggregate Asset
Quality
 Concentration Risk
 Exists
when banks lend in a narrow
geographic area or concentrate their
loans in a certain industry
 Country Risk
 Refers
to the potential loss of interest
and principal on international loans
due to borrowers in a country refusing
to make timely payments
17
Trends in Competition for Loan
Business
 In 1984, there were nearly 14,500 banks
in the U.S.

This fell to fewer than 7,300 at the
beginning of 2007

Recently, the Treasury’s 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 sell
 This has forced consolidation
18
Trends in Competition for Loan
Business
 Banks still have the required expertise
and experience to make them the
preferred lender for many types of
loans
 Technology advances have meant that
more loans are becoming
“standardized,” making it easier for
market participants to offer loans in
direct competition to banks
19
Trends in Competition for Loan
Business
 Structured Note
 Loan
that is specifically designed to
meet the needs of one or a few
companies but has been packaged for
resale
20
The Credit Process
 Loan Policy
 Formalizes lending guidelines that
employees follow to conduct bank
business
 Credit Philosophy
 Management’s philosophy that
determines how much risk the bank will
take and in what form
 Credit Culture
 The fundamental principles that drive
lending activity and how management
analyzes risk
21
The Credit Process
22
The Credit Process
 Credit Culture
 The fundamental principles that drive
lending activity and how management
analyzes risk
 Values Driven
 Focus is on credit quality

Current-Profit Driven
 Focus is on short-term earnings

Market-Share Driven
 Focus is on having the highest market
share
23
24
The Credit Process
 Business Development and Credit
Analysis
Business Development
 Market research
 Train employees:

What products are available
 What products customers are likely to
need
 How they should communicate with
customers about those needs

Advertising and Public Relations
 Officer Call Programs

25
The Credit Process
 Business Development and Credit
Analysis

Credit Analysis
Evaluate a borrower’s ability and
willingness to repay
 Questions to address

 What 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?
26
The Credit Process
 Business Development and Credit
Analysis
 Credit

Analysis
Five C’s of Good Credit
 Character
 Capital
 Capacity
 Conditions
 Collateral
27
The Credit Process
 Business Development and Credit
Analysis
 Credit

Analysis
Five C’s of Bad Credit
 Complacency
 Carelessness
 Communication
 Contingencies
 Competition
28
The Credit Process
 Business Development and Credit
Analysis

Credit Analysis

Procedure
1. Collect information for the credit file
2. Evaluate management, the company, and the
industry in which it operates
3. Conduct a financial statement analysis
4. Project the borrower’s cash flow and its
ability to service the debt
5. Evaluate collateral or the secondary source
of repayment
6. Write a summary analysis and making a
recommendation
29
The Credit Process
 Credit Execution and Administration
 Loan
Decision
Individual officer decision
 Committee
 Centralized underwriting

30
The Credit Process
 Credit Execution and Administration
 Loan
Agreement
Formalizes the purpose of the loan
 Terms of the loan
 Repayment schedule
 Collateral required
 Any loan covenants
 States what conditions bring about a
default

31
The Credit Process
 Credit Execution and Administration
 Documentation:
Perfecting the
Security Interest

Perfected
 When the bank's claim is superior to that
of other creditors and the borrower
 Require the borrower to sign a security
agreement that assigns the qualifying
collateral to the bank
 Bank obtains title to equipment or
vehicles
32
The Credit Process
 Credit Execution and Administration
 Position

Maximum allowable credit exposures to
any single borrower, industry, or
geographic local
 Risk

Limits
Rating Loans
Evaluating characteristics of the
borrower and loan to assess the
likelihood of default and the amount of
loss in the event of default
33
The Credit Process
 Credit Execution and Administration
 Loan

Covenants
Positive (Affirmative)
 Indicate specific provisions to which the
borrower must adhere

Negative
 Indicate financial limitations and prohibited
events
34
35
The Credit Process
 Credit Execution and Administration
 Loan Review
 Monitoring the performance of existing
loans
 Handling problem loans
 Loan review should be kept separate from
credit analysis, execution, and
administration
 The loan review committee should act
independent of loan officers and report
directly to the CEO of the bank
36
The Credit Process
 Credit Execution and Administration
 Problem

Loans
Often require special treatment
 Modify terms of the loan agreement to
increases the probability of full repayment
 Modifications might include:
 Deferring interest and principal
payments
 Lengthening maturities
 Liquidating unnecessary assets
37
Characteristics of Different Types
of Loans
 UBPR Classifications
 Real
Estate Loans
 Commercial Loans
 Individual Loans
 Agricultural Loans
 Other Loans and Leases in Domestic
Offices
 Loans and Leases in Foreign Offices
38
Characteristics of Different Types
of Loans
 Real Estate Loans
 Construction
and Development Loans
 Commercial Real Estate
 Multi-Family Residential Real Estate
 1-4 Family Residential
 Home Equity
 Farmland
 Other Real Estate Loans
39
Characteristics of Different Types
of Loans
 Real Estate Loans
 Commercial

Real Estate Loans
Typically short-term loans consisting
of:
 Construction and Real Estate Development
Loans
 Land Development Loans
 Commercial Building Construction and
Land Development Loans
40
Characteristics of Different Types
of Loans
 Real Estate Loans
 Commercial Real Estate Loans
 Construction Loans
 Interim financing on commercial, industrial,
and multi-family residential property

Interim Loans
 Provide financing for a limited time until
permanent financing is arranged

Land Development Loans
 Finance the construction of road and public
utilities in areas where developers plan to
build houses
 Developers typically repay loans as lots or
homes are sold
41
Characteristics of Different Types
of Loans
 Real Estate Loans
 Commercial

Real Estate Loans
Takeout Commitment
 An agreement whereby a different lender
agrees to provide long-term financing after
construction is finished
42
Characteristics of Different Types
of Loans
 Real Estate Loans
 Residential

Mortgage Loans
Mortgage
 Legal document through which a borrower
gives a lender a lien on real property as
collateral against a debt

Most are amortized with monthly
payments, including principal and
interest
43
Characteristics of Different Types
of Loans
 Real Estate Loans
 Residential Mortgage Loans
 1-4 Family Residential Mortgage Loans
 Holding long-term fixed-rate mortgages can
create interest rate risk for banks with loss
potential if rates increase
 To avoid this, many mortgages now provide
for:
 Periodic adjustments in the interest rate
 Adjustments in periodic principal payments
 The lender sharing in any price
appreciation of the underlying asset at sale
 All of these can increase cash flows to the
lender when interest rates rise
44
Characteristics of Different Types
of Loans
 Real Estate Loans
 The

Secondary Mortgage Market
Involves the trading of previously
originated residential mortgages
 Can be sold directly to investors or
packaged into mortgage pools
45
Characteristics of Different Types
of Loans
 Real Estate Loans
 Home

Equity Loans
Second Mortgage Loans
 Typically shorter term than first mortgages
 Subordinated to first mortgage

Home Equity Lines of Credit (HELOC)
46
Characteristics of Different Types
of Loans
 Real Estate Loans
 Equity Investments in Real Estate
 Historically, commercial banks have been
prevented from owning real estate except
for their corporate offices or property
involved in foreclosure
 Regulators want banks to engage in
speculative real estate activities only
through separate subsidiaries
 The Gramm-Leach-Bliley Act of 1999
allowed for commercial banks and savings
institutions to enter into the merchant
banking business
47
Characteristics of Different Types
of Loans
 Commercial Loans
 Loan
Commitment/Line of Credit
Formal agreement between a bank and
borrower to provide a fixed amount of
credit for a specified period
 The customer determines the timing of
actual borrowing

48
Characteristics of Different Types
of Loans
 Commercial Loans
 Working

Capital Requirements
Net Working Capital
 Current assets – Current liabilities
 For most firms, net working capital is
positive, indicating that some current
assets are not financed with current
liabilities
49
Characteristics of Different Types
of Loans
 Commercial Loans
 Working

Capital Requirements
Days Cash
 Cash/(Sales/365)

Days Receivables
 AR/(Sales/365)

Days Inventory
 Inventory/(COGS/365)
50
Characteristics of Different Types
of Loans
 Commercial Loans
 Working

Capital Requirements
Days Payable
 AP/(Purchases/365)

Days Accruals
 Accruals/(Operating Expenses/365)
51
Characteristics of Different Types
of Loans
 Commercial Loans
 Working

Capital Requirements
Cash-to-Cash Asset Cycle
 How long the firm must finance operating
cash, inventory and accounts receivables
from the day of first sale

Cash-to-Cash Liability Cycle
 How long a firm obtains interest-free
financing from suppliers in the form of
accounts payable and accrued expenses to
help finance the asset cycle
52
53
Characteristics of Different Types
of Loans
 Commercial Loans
 Working
Capital Requirements
54
Characteristics of Different Types
of Loans
 Commercial Loans
 Seasonal
versus Permanent Working
Capital Needs
All firms need some minimum level of
current assets and current liabilities
 The amount of current assets and
current liabilities will vary with
seasonal patterns

55
Characteristics of Different Types
of Loans
 Commercial Loans
 Seasonal
versus Permanent Working
Capital Needs

Permanent Working Capital
 The minimum level of current assets minus
the minimum level of adjusted current
liabilities
 Adjusted Current Liabilities
 Current liabilities net of short-term
bank credit and current maturities of
long-term debt
56
Characteristics of Different Types
of Loans
 Commercial Loans
 Seasonal
versus Permanent Working
Capital Needs

Seasonal Working Capital
 Difference in total current assets and
adjusted current liabilities
57
Characteristics of Different Types
of Loans
 Commercial Loans
 Seasonal Working Capital Loans
 Finance a temporary increase in net
current assets above the permanent
requirement
 Loan is seasonal if the need arises on a
regular basis and if the cycle completes
itself within one year
 Loan is self-liquidating if repayment
derives from sales of the finished
goods that are financed
58
59
Characteristics of Different Types
of Loans
 Commercial Loans
 Short-Term

Commercial Loans
Short-term funding needs are financed
by short-term loans, while long-term
needs are financed by term loans with
longer maturities
60
Characteristics of Different Types
of Loans
 Commercial Loans
 Open Credit Lines
 Used to meet many types of temporary
needs in addition to seasonal needs
 Informal Credit Line
 Not legally binding but represent a promise
that the lender will advance credit

Formal Credit Line
 Legally binding even though no written
agreement is signed
 A commitment fee is charged for making credit
available, regardless of whether the customer
actually uses the line
61
Characteristics of Different Types
of Loans
 Commercial Loans
 Asset-Based

Loans
Loans Secured by Accounts Receivable
 The security consists of paper assets that
presumably represent sales
 The quality of the collateral depends on the
borrower’s integrity in reporting actual
sales and the credibility of billings
62
Characteristics of Different Types
of Loans
 Commercial Loans
 Asset-Based Loans
 Loans Secured by Accounts Receivable
 Accounts Receivable Aging Schedule
 List of A/Rs grouped according to the
month in which the invoice is dated
 Lockbox
 Customer’s mail payments go directly to a
P.O. Box controlled by the bank
 The bank processes the payments and
reduces the borrower’s balance but
charges the borrower for handling the
items
63
Characteristics of Different Types
of Loans
 Commercial Loans
 Highly

Levered Transactions
Leveraged 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 debt
 Target companies are generally those
with undervalued hard assets
64
Characteristics of Different Types
of Loans
 Commercial Loans
 Highly Levered Transactions
 Leveraged Buyout (LBO)
 The investors often sell specific assets or
subsidiaries to pay down much of the debt
quickly
 If key assets have been undervalued, the
investors may own a downsized company
whose earnings prospects have improved
and whose stock has increased in value
 The investors sell the company or take it
public once the market perceives its
greater value
65
Characteristics of Different Types
of Loans
 Commercial Loans
 Highly

Levered Transactions
Arise from three types of transactions
 LBOs in which debt is substituted for
privately held equity
 Leveraged recapitalizations in which
borrowers use loan proceeds to pay large
dividends to shareholders
 Leveraged acquisitions in which a cash
purchase of another related company
produces an increase in the buyer’s debt
structure
66
Characteristics of Different Types
of Loans
 Commercial Loans
 Highly Levered Transactions
 An HLT must involve the buyout,
recapitalization, or acquisition of a firm
in which either:
1. The firm’s subsequent leverage ratio
exceeds 75 percent
2. The transaction more than doubles the
borrower’s liabilities and produces a
leverage ratio over 50 percent
3. The regulators or firm that syndicates the
loans declares the transaction an HLT
67
Characteristics of Different Types
of Loans
 Commercial Loans
 Term

Commercial Loans
Original maturity greater than 1 year
 Typically finance:
 Depreciable assets
 Start-up costs for a new venture
 Permanent increase in the level of
working capital
68
Characteristics of Different Types
of Loans
 Commercial Loans
 Term

Commercial Loans
Lenders focus more on the borrower’s
periodic income and cash flow rather
than the balance sheet
 Term loans often require collateral, but this
represents a secondary source of
repayment in case the borrower defaults
69
Characteristics of Different Types
of Loans
 Commercial Loans
 Term

Commercial Loans
Balloon Payments
 Most of the principal is due at maturity

Bullet Payments
 All of the principal is due at maturity
70
Characteristics of Different Types
of Loans
 Commercial Loans
 Revolving Credits
 A hybrid of short-term working capital
loans and term loans
 Typically involves the commitment of
funds for 1 – 5 years
 At the end of some interim period, the
outstanding principal converts to a term
loan
 During the interim period, the borrower
determines how much credit to use
 Mandatory principal payments begin once
the revolver is converted to a term loan
71
Characteristics of Different Types
of Loans
 Agricultural Loans
 Proceeds are used to purchase seed,
fertilizer and pesticides and to pay other
production costs
 Farmers expect to repay the debt with the
crops are harvested and sold
 Long-term loans finance livestock,
equipment, and land purchases
 The primary source of repayment is cash
flow from the sale of livestock and
harvested crops in excess of operating
expenses
72
Characteristics of Different Types
of Loans
 Consumer Loans
 Installment

Require periodic payments of principal
and interest
 Credit
Card
 Non-Installment

For special purposes
 Example: Bridge loan for the down
payment on a house that is repaid from the
sale of the previous house
73
Characteristics of Different Types
of Loans
 Venture Capital

A broad term use to describe funding
acquired in the earlier stages of a firm’s
economic life
Due to the high leverage and risk involved
banks generally do not participate directly
in venture capital deals
 Some banks have subsidiaries that
finance certain types of equity
participations and venture capital deals,
but their participation is limited

74
Characteristics of Different Types
of Loans
 Venture Capital
 Venture
capital firms attempt to add
value to the firm without taking
majority control

Often, venture capital firms not only
provide financing but experience,
expertise, contacts, and advice when
required
75
Characteristics of Different Types
of Loans
 Venture Capital
 Types

of Venture Financing
Seed or Start-up Capital
 Early stages of financing
 Highly levered transactions in which the
venture capital firm will lend money for a
percentage stake in the firm
 Rarely, if ever, do banks participate at
this stage
76
Characteristics of Different Types
of Loans
 Venture Capital
 Types of Venture Financing
 Later-Stage Development Financing:





Expansion and replacement financing
Recapitalization or turnaround financing
Buy-out or buy-in financing
Mezzanine financing
Banks 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 financing
77
14
Evaluating Commercial
Loan Requests and
Managing Credit Risk
78
Evaluating Commercial Loan
Requests and Managing Credit Risk
 Important Questions Regarding Commercial Loan
Requests
1.
2.
3.
4.
5.
What 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?
79
Fundamental Credit Issues
 There are two types of loan errors
 Type

Making a loan to a customer who will
ultimately default
 Type

I Error
II Error
Denying a loan to a customer who
would ultimately repay the debt
80
Fundamental Credit Issues
 Character of the Borrower and Quality
of Data Provided
 The
most important issue in assessing
credit risk is determining a borrower’s
commitment and ability to repay debts
in accordance with the terms of a loan
agreement

The best indicators are the borrower’s
financial history and personal
references
81
Fundamental Credit Issues
 Character of the Borrower and Quality of
Data Provided

Audited 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 entries

But just because a company has audited
financial statements, however, does not
mean the reported data are not
manipulated
82
Fundamental Credit Issues
 Use of Loan Proceeds
 Loan 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 expenses
 Speculative asset purchases and debt
substitutions should be avoided
83
Fundamental Credit Issues
 How Much Does the Borrower Need?
The Loan Amount
 Borrowers
often request a loan before
they clearly understand how much
external financing is actually needed
and how much is available internally

The amount of credit required depends
on the use of the proceeds and the
availability of internal sources of funds
84
Fundamental Credit Issues
 How Much Does the Borrower Need? The
Loan Amount
For a shorter-term loan, the amount might
equal the temporary seasonal increase in
receivables and inventory net of that
supported by increased accounts payable
 With term loans, the amount can be
determined via pro forma analysis which
is the projecting or forecasting of a
company’s financial statements into the
future

85
Fundamental Credit Issues
 The Primary Source and Timing of
Repayment
 Loans
are repaid from cash flows:
Liquidation of assets
 Cash flow from normal operations
 New debt issues
 New equity issues

86
Fundamental Credit Issues
 The Primary Source and Timing of
Repayment
 Specific
sources of cash are generally
associated with certain types of loans

Short-term, seasonal working capital
loans are normally repaid from the
liquidation of receivables or reductions
in inventory
87
Fundamental Credit Issues
 The Primary Source and Timing of
Repayment
 Specific
sources of cash are generally
associated with certain types of loans

Term 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 base
88
Fundamental Credit Issues
 The Primary Source and Timing of
Repayment
 The
primary source of repayment on
the loan can also determine the risk of
the loan

The general rule is not to rely on the
acquired asset or underlying collateral
as the primary source of repayment
89
Fundamental Credit Issues
 Secondary Source of Repayment:
Collateral
 Collateral
1.
must exhibit three features
Its value should always exceed the
outstanding principal on a loan
 The 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 loses
 Borrowers are “upside-down” on a loan if
the value of the collateral is less than the
outstanding loan balance
90
Fundamental Credit Issues
 Secondary Source of Repayment:
Collateral

Collateral must exhibit three features
2.
3.
The lender should be able to easily take
possession of the collateral and have a
ready market for its sale
A lender must be able to clearly mark the
collateral as its own


Careful loan documentation is required to
“perfect” the bank’s interest in the collateral
If collateral is not readily available, a
personal guarantee may be required
91
Fundamental Credit Issues
 Secondary Source of Repayment:
Collateral
The borrower’s cash flow is the preferred
source of loan repayments
 Liquidating collateral is secondary

There are significant transactions costs
associated with foreclosure
 Bankruptcy laws allow borrowers to retain
possession of the collateral long after they
have defaulted
 When the bank takes possession of the
collateral, it deprives the borrower of the
opportunity to salvage the company

92
Evaluating Credit Requests: A
Four-Part Process
1. Overview of management, operations,
and the firm’s industry
2. Common size and financial ratio
analysis
3. Analysis of cash flow
4. Projections and analysis of the
borrower’s financial condition
93
Evaluating Credit Requests: A
Four-Part Process
 Overview of Management, Operations,
and the Firm’s Industry
 Gather
background information on the
firm’s operations
 Write a Business and Industry Outlook
report
 Examine the nature of the borrower’s
loan request and the quality of the
financial data provided
94
Evaluating Credit Requests: A
Four-Part Process
 Common Size and Financial Ratio
Analysis
 Common
size ratio comparisons are
valuable because they adjust for size
and thus enable comparisons across
firms in the same industry or line of
business
95
96
Evaluating Credit Requests: A
Four-Part Process
 Common Size and Financial Ratio
Analysis
 Most
analysts differentiate between at
least four categories of ratios:

Liquidity ratios
 Indicate a firm’s ability to meet its shortterm obligations and continue operations.

Activity ratios
 Signal how efficiently a firm uses assets to
generate sales
97
Evaluating Credit Requests: A
Four-Part Process
 Common Size and Financial Ratio
Analysis
 Most
analysts differentiate between at
least four categories of ratios:

Leverage ratios
 Indicate the mix of the firm’s financing
between debt and equity and potential
earnings volatility

Profitability ratios
 Provide evidence of the firm’s sales and
earnings performance
98
99
Evaluating Credit Requests: A
Four-Part Process
 Common Size and Financial Ratio
Analysis
 Liquidity

Ratios
Current Ratio
 CA / CL

Quick Ratio
 (Cash + A/R) / CL
100
Evaluating Credit Requests: A
Four-Part Process
 Common Size and Financial Ratio
Analysis
 Activity

Ratios
Days Cash
 Cash/Average Daily Sales

Days Inventory on Hand
 Inventory/Average Daily Cost of Goods
Sold

Inventory Turnover
 COGS / Average Inventory
101
Evaluating Credit Requests: A
Four-Part Process
 Common Size and Financial Ratio
Analysis
 Activity

Ratios
Days Accounts Receivable Collection
Period
 A/R / Average Daily Sales

Days Cash-to-Cash Cycle
 Days Cash + Days A/R + Days Inventory on
Hand
102
Evaluating Credit Requests: A
Four-Part Process
 Common Size and Financial Ratio
Analysis
 Activity

Ratios
Days Accounts Payable Outstanding
 A/P / Average Daily Purchases
 Purchases COGS + ΔInventory

Sales-to-Asset Ratio
 Sales/Net Fixed Assets
103
Evaluating Credit Requests: A
Four-Part Process
 Common Size and Financial Ratio
Analysis

Leverage Ratios

Debt to Tangible Net Worth
 Total Liabilities/Tangible Net Worth

Debt to Total Assets
 Total Debt/Total Assets

Times Interest Earned
 EBIT/Interest Expense

EBIT
 Earnings Before Taxes + Interest Expense
104
Evaluating Credit Requests: A
Four-Part Process
 Common Size and Financial Ratio
Analysis
 Leverage

Ratios
Fixed Charge Coverage
 (EBIT + Lease Payments)/(Interest Expense
+ Lease Payments)

Net Fixed Assets to Tangible Net Worth
 Net Fixed Assets/Tangible Net Worth

Dividend Payout
 Cash Dividends Paid/Net Income
105
Evaluating Credit Requests: A
Four-Part Process
 Common Size and Financial Ratio
Analysis
 Profitability

Analysis
Profit Margin (PM)
 Net Income/Sales
 1 – Expenses/Sales
 1 – (COGS/Sales) – (Operating
Expenses/Sales) – (Other Expenses/Sales)
– (Taxes/Sales)
106
Evaluating Credit Requests: A
Four-Part Process
 Common Size and Financial Ratio
Analysis
 Profitability

Analysis
Asset Utilization (AU)
 Sales/Total Assets

Return on Assets
 Net Income/Total Assets
 PM × AU
107
Evaluating Credit Requests: A
Four-Part Process
 Common Size and Financial Ratio
Analysis
 Profitability

Analysis
Equity Multiplier (EM)
 Total Assets/Equity

Return on Equity (ROE)
 Net Income/Equity
 ROA × EM

Sales Growth
 Demonstrates whether a firm is expanding
or contracting
108
109
Evaluating Credit Requests: A
Four-Part Process
 Cash-Flow Analysis
 Cash-Based

Income Statement
Modified form of a direct statement of
cash flows
110
111
112
113
Evaluating Credit Requests: A
Four-Part Process
 Cash-Flow Analysis
 Cash-Flow

Statement Format
Operations Section
 Income statement items and the change in
current assets and current liabilities
(except bank debt)

Investments Section
 The change in all long-term assets
114
Evaluating Credit Requests: A
Four-Part Process
 Cash-Flow Analysis
 Cash-Flow

Statement Format
Financing Section
 Payments for debt and dividends, the
change in all long-term liabilities, the
change in short-term bank debt, and any
new stock issues

Cash Section
 The change in cash and marketable
securities
115
Evaluating Credit Requests: A
Four-Part Process
 Cash-Flow Analysis
 Cash-Flow
n
Statement Format
m
 A   L
i 1
i
j1
j
 NW
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

116
Evaluating Credit Requests: A
Four-Part Process
 Cash-Flow Analysis
 Cash-Flow

Statement Format
Cash Flow From Operations is defined
as:
m
n
j1
i 1
A1   L j   Ai  Stock + Surplus + NI - DIV
where:
 ΔA1 = ΔCash

117
Evaluating Credit Requests: A
Four-Part Process
 Cash-Flow Analysis
 Cash-Flow
m
n
j1
i 1
Statement Format
A1   L j   A i  Stock + Surplus
+ Revenue  Expenses  Taxes - DIV
118
Evaluating Credit Requests: A
Four-Part Process
 Cash-Flow Analysis
 Cash-Flow

Statement Format
Sources of Cash
 Increase in any liability
 Decrease in a non-cash asset
 New issue of stock
 Additions to surplus
 Revenues
119
Evaluating Credit Requests: A
Four-Part Process
 Cash-Flow Analysis
 Cash-Flow

Statement Format
Uses of Cash
 Decrease in any liability
 Increase in a non-cash asset
 Repayments/Buy back stock
 Deductions from surplus
 Cash Expenses
 Taxes
 Cash Dividends
120
Evaluating Credit Requests: A
Four-Part Process
 Cash-Flow Analysis For Prism
Industries
 Cash
Flow From Operations
Recall Exhibits 14.1, 14.2, & 14.3
 Cash Purchases for 2008:

 Cash Purchases = -(COGS + ΔInventory –
ΔAccounts Payable)
121
Evaluating Credit Requests: A FourPart Process
 Cash-Flow Analysis For Prism
Industries
 Cash

Flow From Investing Activities
ΔNet Fixed Assets = ΔGross Fixed Assets
– ΔAccumulated Depreciation
 Or

ΔNet Fixed Assets = Capital
Expenditures – Depreciation
 where:
 Capital Expenditures = ΔNet Fixed Assets
122
+ Depreciation
Evaluating Credit Requests: A
Four-Part Process
 Cash-Flow Analysis For Prism
Industries
 Cash

Flow From Financing Activities
Although 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
123
Evaluating Credit Requests: A
Four-Part Process
 Cash-Flow Analysis For Prism
Industries
 Change

in Cash
Equals cash flow from operations
adjusted for discretionary
expenditures, cash used for
investments, payments for financing,
and external financing
124
125
126
127
128
Evaluating Credit Requests: A
Four-Part Process
 Financial Projections
 Pro
Forma projections of the
borrower’s condition reveal:
How much financing is required
 When the loan will be repaid
 Use of the loan

129
Evaluating Credit Requests: A
Four-Part Process
 Financial Projections
 Pro

Forma Assumptions
Salest+1 = Salest × (1 + gSales)
 where:
 gSales = Projected Sales Growth
COGSt+1 = Salest+1 × COGS % of Sales
 Accounts Receivablet+1 = Days A/R
Outstanding × Average Daily Salest+1
 Inventoryt+1 = COGSt+1/Inventory
Turnover

130
Evaluating Credit Requests: A
Four-Part Process
 Financial Projections
 Pro

Forma Assumptions
Accounts Payablet+1 = Days A/P
Outstanding × Average Daily
Purchasest+1
 Or

Accounts Payablet+1 = Days A/P
Outstanding × [(COGSt+1 +
ΔInventoryt+1)/365]
131
Evaluating Credit Requests: A
Four-Part Process
 Financial Projections
 Projecting

Notes Payable to Banks
Rarely will the balance sheet “balance”
in the initial round of pro forma
forecasts
 To reconcile this, there must be a
balancing item or “plug” figure
132
Evaluating Credit Requests: A
Four-Part Process
 Financial Projections
 Projecting
Notes Payable to Banks
When projected assets exceed
projected liabilities plus equity,
additional debt (assumed to be in the
form of notes payable) is required
 When 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

133
Evaluating Credit Requests: A
Four-Part Process
 Financial Projections
 Sensitivity Analysis
 Best Case Scenario
 Assumes optimistic improvements in planned
performance and the economy are realized

Worst Case Scenario
 Assumes the environment with the greatest
potential negative impact on sales, earnings,
and the balance sheet

Most Likely Scenario
 Assumes the most reasonable sequence of
economic events and performance trends
134
Evaluating Credit Requests: A
Four-Part Process
 Risk-Classification Scheme
 After
evaluating the borrower’s risk
profile along all dimensions, a loan is
placed in a rating category ranked
according to the degree of risk
135
136
Credit Analysis Application:
Wade’s Office Furniture
 See Exhibits 14.5- 14.11
137
138
139
140
141
142
143
144
145
146
147
148
149
150
Managing Risk with Loan Sales
and Credit Derivatives
 Many financial institutions have
changed their business models,
switching to the originate-to-distribute
(OTD) model
 Under
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
marketplace
151
Managing Risk with Loan Sales
and Credit Derivatives
 Larger 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
risk
 Lead Bank

The institution that actually underwrites
the original loan and sells the
participation
152
Managing Risk with Loan Sales
and Credit Derivatives
 There are several inherent risk in loan
participations or loan sales
General credit risks
 There is an inherent potential conflict
between the originating institution and
the investor


The 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 portfolio
153
Managing Risk with Loan Sales
and Credit Derivatives
 Underwriting Loan Sales,
Participations, and Syndications
 The
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 books
154
Managing Risk with Loan Sales
and Credit Derivatives
 Shared 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
agreement

The various regulatory agencies
established the SNC program in 1977 to
monitor and review the risk structure of
large syndicated loans
155
Managing Risk with Loan Sales
and Credit Derivatives
 Shared National Credits (SNC)
156
Managing Risk with Loan Sales
and Credit Derivatives
 Credit Enhancements
 Can take many forms
 Key terms of credit enhancements
potentially include:
 Excess cash flow
 Many securitized assets are placed in pools in
which the required payments to investors are
less than the contractual payments of
borrowers
 Thus, even if some borrowers do not make
the required payments, there is sufficient
cash flow to continue to pay investors
157
Managing Risk with Loan Sales
and Credit Derivatives
 Credit Enhancements
 Key
terms of credit enhancements
potentially include:

Reserve accounts
 The 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 borrowers

Collateralization
 One or more parties pledge collateral
against the loan
158
Managing Risk with Loan Sales
and Credit Derivatives
 Credit Enhancements
 Key terms of credit enhancements
potentially include:
 Loan guarantees
 One or more parties pledge personal or
business assets or are contractually bound to
meet the obligations of the borrower if that
party defaults

Credit insurance
 Any party can purchase credit insurance,
provided either privately or by a governmental
unit, for loans that provide payments for
losses stemming from default
159
Managing Risk with Loan Sales
and Credit Derivatives
 Credit Enhancements
 Key
terms of credit enhancements
potentially include:

Credit derivatives
 Instruments or contracts that derive their
value from the underlying credit risk of a
loan or bond
160
Managing Risk with Loan Sales
and Credit Derivatives
 Credit 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 markets
161
Managing Risk with Loan Sales
and Credit Derivatives
 Credit Default Swaps (CDS)
 The buyer pays a premium and thus the
CDS is similar to an insurance contract
 The buyer often owns the underlying debt
and uses the CDS as a hedge
 The seller of the CDS plays a role similar
to that of the insurance company
 Sellers generally do not own the debt and
provide longer-term protection
 If an adverse event occurs the seller pays
the buyer the change in value of the
underlying asset
162
Managing Risk with Loan Sales
and Credit Derivatives
 Credit Default Swaps (CDS)
163
Managing Risk with Loan Sales
and Credit Derivatives
 Credit 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 manner
 Restructuring of the debt in such a way that the
lender (investor in the debt) is negatively affected
 Bankruptcy or insolvency in which the debt is not
paid
 Acceleration 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 debt
164
Managing Risk with Loan Sales
and Credit Derivatives
 Credit Default Swaps (CDS)
 The
credit crisis of 2007–2008 caused
many sellers of credit default swaps to
make large and unexpected payments
for default
165
15
Evaluating Consumer
Loans
Evaluating Consumer Loans
 Today, many banks target individuals
as the primary source of growth in
attracting new business
 Consumer loans differ from
commercial loans
 Quality
of financial data is lower
 Primary source of repayment is current
income
Types of Consumer Loans
 Evaluating Consumer Loans
 An
analyst should addresses the same
issues discussed with commercial
loans:
The use of loan proceeds
 The amount needed
 The primary and secondary source of
repayment

Types of Consumer Loans
 Evaluating Consumer Loans
 Consumer
loans differ so much in
design that no comprehensive
analytical format applies to all loans
Types of Consumer Loans
 Installment Loans
 Require
the periodic payment of
principal and interest
Types of Consumer Loans
 Installment Loans
 Direct

Negotiated between the bank and the
ultimate user of the funds
 Indirect

Funded by a bank through a separate
retailer that sells merchandise to a
customer
Types of Consumer Loans
 Installment Loans
 Revenues
and Costs from Installment
Loans
Consumer installment loans can be
extremely profitable
 Costs $100 - $250 to originate loan
 Typically yield over 5% (loan income
minus loan acquisition costs,
collections costs and net charge-offs)

Types of Consumer Loans
 Credit Cards and Other Revolving
Credit
 Credit
cards and overlines tied to
checking accounts are the two most
popular forms of revolving credit
agreements
 In 2007, over 92% of households had
credit cards (average of 13 cards)
Types of Consumer Loans
 Credit Cards and Other Revolving
Credit
 Most
banks operate as franchises of
MasterCard and/or Visa

Bank pays a one-time membership fee
plus an annual charge determined by
the number of its customers actively
using the cards
Types of Consumer Loans
 Debit Cards, Smart Cards, and Prepaid
Cards
 Debit
Cards
Widely available
 When an individual uses the card, their
balance is immediately debited
 Banks prefer debit card use over
checks because debit cards have lower
processing costs

Types of Consumer Loans
 Debit Cards, Smart Cards, and Prepaid
Cards
 Smart
Card
Contains a memory chip which can
store information and value
 Programmable such that users can
store information and add or transfer
value to another smart card
 Only modest usage in the U.S.

Types of Consumer Loans
 Debit Cards, Smart Cards, and Prepaid
Cards
 Prepaid
Card
A hybrid of a debit card
 Customers prepay for services to be
rendered and receive a card against
which purchases are charged
 Use of phone cards, prepaid cellular,
toll tags, subway, etc. are growing
rapidly

Types of Consumer Loans
 Credit Card Systems and Profitability
 Card
issuers earn income from three
sources:
Cardholders’ annual fees
 Interest on outstanding loan balances
 Discounting the charges that
merchants accept on purchases

Types of Consumer Loans
 Credit Card Systems and Profitability
 Despite
high charge-offs, credit cards
are attractive because they provide
higher risk-adjusted returns than do
other types of loans
Types of Consumer Loans
 Overdraft Protection and Open Credit
Lines
 Overdraft
Protection Against Checking
Accounts

A type of revolving credit
 A bank authorizes qualifying individuals to
write checks in excess of actual balances
held in a checking account up to a prespecified limit
Types of Consumer Loans
 Overdraft Protection and Open Credit
Lines
 Open

Credit Lines
The bank provides customers with
special checks that activate a loan
when presented for payment
Types of Consumer Loans
 Home Equity Loans
 Grew
from virtually nothing in the mid1980s to over $350 billion in 2008
 They 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 Loans
 Home Equity Loans
 Some
allow access to credit line by
using a credit card
 Borrowers 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 Loans
 Non-Installment Loans
 aka
Bridge Loan
Requires a single principal and interest
payment
 Typically, the individual’s borrowing
needs are temporary and repayment is
from a well-defined future cash inflow

Subprime Loans
 One of the hottest growth areas during
the early 2000s
 Subprime
loans are higher-risk loans
labeled “B,” “C,” and “D” credits
 They have been especially popular in
auto, home equity, and mortgage
lending
 Typically have the same risk as loans
originated through consumer finance
companies
Subprime Loans
 Many subprime lenders make loans to
individuals that a bank would not
traditionally make and keep onbalance sheet
 Subprime lenders charge higher rates
and have more restrictive covenants
Subprime Loans
 What Happens When Housing Prices
Fall
 Subprime
loans can be attractive when
housing values are rising
Individuals 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 high
 The opposite occurs when housing
prices fall

Subprime Loans
 What Happens When Housing Prices
Fall
 During
2007–2008, banks were forced
to charge-off historically high amounts
of mortgage loans as delinquencies
and foreclosures skyrocketed
Consumer Credit Regulations
 Equal Credit Opportunity
 Makes
it illegal for lenders to
discriminate on the basis of race,
religion, sex, marital status, age, or
national origin
Consumer Credit Regulations
 Prohibited Information Requests
 The
applicant's marital status
 Whether alimony, child support, and
public assistance are included in
reported income
 A woman's childbearing capability and
plans
 Whether an applicant has a telephone
Consumer Credit Regulations
 Credit Scoring Systems
 Acceptable
if they do not require
prohibited information and are
statistically justified
 Can use information about age, sex,
and marital status as long as these
factors contribute positively to the
applicant's creditworthiness
Consumer Credit Regulations
 Credit Reporting
 Lenders
must report credit extended
jointly to married couples in both
spouses' names
 Whenever 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 Regulations
 Truth In Lending
 Regulations
apply to all individual
loans up to $25,000 where the
borrower's primary residence does not
serve as collateral
Consumer Credit Regulations
 Truth In Lending
 Requires
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 Rates
 Discount Rates
 Simple Interest Rates

Consumer Credit Regulations
 Fair Credit Reporting
 Fair
Credit Reporting Act
Enables individuals to examine their
credit reports provided by credit
bureaus
 If any information is incorrect, the
individual can have the bureau make
changes and notify all lenders who
obtained the inaccurate data

Consumer Credit Regulations
 Fair Credit Reporting
 There
are three primary credit
reporting agencies:
Equifax
 Experian
 Trans Union

 Unfortunately,
the credit reports that
they produce are quite often wrong
Consumer Credit Regulations
 Fair Credit Reporting
 Credit
Score
Like a bond rating for individuals
 Based on several factors

 Payment History
 Amounts Owed
 Length of Credit History
 Types of Credit
 New Credit
Consumer Credit Regulations
 Community Reinvestment Act
 CRA
prohibits redlining and
encourages lenders to extend credit
within their immediate trade area and
the markets where they collect
deposits
Consumer Credit Regulations
 Community Reinvestment Act
 Financial
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
compliance
Consumer Credit Regulations
 Community Reinvestment Act
 Regulators
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 Regulations
 Bankruptcy Reform
 Individuals
who cannot repay their
debts on time can file for bankruptcy
and receive court protection against
creditors
Consumer Credit Regulations
 Bankruptcy Reform
 Individuals
can file for bankruptcy
under:

Chapter 7
 Individuals liquidate qualified assets and
distribute the proceeds to creditors

Chapter 13
 An individual works out a repayment plan
with court supervision
Consumer Credit Regulations
 Bankruptcy Reform
 In
2005, Congress passed bankruptcy
reform legislation that made it more
difficult for individuals to completely
avoid repaying their debts

In 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 debts
Credit Analysis
 Objective of consumer credit analysis
is to assess the risks associated with
lending to individuals
Credit Analysis
 When evaluating loans, bankers cite
the Cs of credit:
 Character
 Capital
 Capacity
 Conditions
 Collateral
Credit Analysis
 Two additional Cs
 Customer

Relationship
A bank’s prior relationship with a
customer reveals information about
past credit experience
 Competition
Lenders periodically react to
competitive pressures
 Competition should not affect the
accept/reject decision

Credit Analysis
 Policy Guidelines
 Acceptable
Loans
Automobile
 Boat
 Home Improvement
 Personal-Unsecured
 Single Payment
 Cosigned

Credit Analysis
 Policy Guidelines
 Unacceptable
Loans
Loans for speculative purposes
 Loans secured by a second lien
 Other than home improvement or home
equity loans
 Any participation with a correspondent
bank in a loan that the bank would not
normally approve

Credit Analysis
 Policy Guidelines
 Unacceptable
Loans
Loans to a poor credit risk based on
the strength of the cosigner
 Single payment automobile or boat
loans
 Loans secured by existing home
furnishings
 Loans for skydiving equipment and
hang gliders

Credit Analysis
 Evaluation Procedures: Judgmental
and Credit Scoring
 Judgmental
Subjectively interpret the information in
light of the bank’s lending guidelines
and accepts or rejects the loan
 Assessment can be completed shortly
after receiving the loan application and
visiting with the applicant

Credit Analysis
 Evaluation Procedures: Judgmental
and Credit Scoring
 Credit

Scoring
Grades the loan request according to a
statistically sound model that assigns
points to selected characteristics of the
prospective borrower
Credit Analysis
 Evaluation Procedures: Judgmental
and Credit Scoring
 Credit
Scoring
If the total points exceeds the accept
threshold, the officer approves the loan
 If the total is below the reject threshold,
the officer denies the loan

Credit Analysis
 Evaluation Procedures: Judgmental
and Credit Scoring
 In
both cases, judgmental and
quantitative, a lending officer collects
information regarding the borrower’s
character, capacity, and collateral
Credit Analysis
 An Application: Credit Scoring a
Consumer Loan
 You
receive an application for a
customer to purchase a 2007 Jeep
Cherokee

Do you make the loan?
Credit Analysis
 An Application: Credit Scoring a
Consumer Loan
 The
Credit Score
At this bank, the loan is automatically
approved if the total score equals at
least 200
 The loan is automatically denied if the
total score is below 150
 Accept/Reject is indeterminate for
scores between 150 & 200

Credit Analysis
 An Application: Credit Scoring a
Consumer Loan
 The

Credit Decision
The credit decision rests on the loan
officer’s evaluation of the applicant’s
character and capacity to repay the
debt
Credit Analysis
 An Application: Credit Scoring a
Consumer Loan
 The

Credit Decision
The loan officer has numerous grounds
for denying credit
 Limited credit history
 Local residence was established too
recently
 Employed too recently
Credit Analysis
 An Application: Credit Scoring a
Consumer Loan
 The

Credit Decision
The loan officer sees some positive
things
 Applicant appears to be a hard worker who
is the victim of circumstances resulting
from her husband’s death
 It is unlikely that anyone who puts almost
30 percent down on a new model is going
to walk away from a debt
Credit Analysis
 An Application: Credit Scoring a
Consumer Loan
 The

Credit Decision
The loan officer sees some positive
things
 The bank will likely lose Groome as a
depositor if it denies the application

What would you recommend?
Credit Analysis
 Your FICO Credit Score
 Summarizes
in one number an
individual’s credit history
Lenders often use this number when
evaluating whether to approve a
consumer loan or mortgage
 Many insurance companies consider
the score when determining whether to
offer insurance coverage and how to
price the insurance

Credit Analysis
 Your FICO Credit Score
 Summarizes
in one number an
individual’s credit history

The scores range from 300 to 850 with
a higher figure indicating a better credit
history
 The national average is 670
 The 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 Analysis
 Your FICO Credit Score
 An
individual’s 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 Analysis
 An Application: Indirect Lending
A
retailer sells merchandise and takes
the credit application

Because many firms do not have the
resources to carry their receivables,
they sell the loans to banks or other
financial institutions
Credit Analysis
 An Application: Indirect Lending
 These
loans are collectively referred to
as dealer paper
 Banks aggressively compete for paper
originated by well-established
automobile, mobile home, and
furniture dealers
Credit Analysis
 An Application: Indirect Lending
 Dealers
negotiate finance charges
directly with their customers

A 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 loan
Credit Analysis
 An Application: Indirect Lending
A
dealer normally negotiates a higher
rate with the car buyer than the
determined rate charged by the bank
 This differential varies with competitive
conditions but potentially represents a
significant source of dealer profit
Credit Analysis
 An Application: Indirect Lending
 Most
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 Loans
 Revenues from Consumer Loans
 The
attraction is two-fold:
Competition for commercial customers
narrowed commercial loan yields so
that returns fell relative to potential
risks
 Developing loan and deposit
relationships with individuals
presumably represents a strategic
response to deregulation

Recent Risk and Return
Characteristics of Consumer Loans
 Revenues from Consumer Loans
 Consumer
loan rates have been among
the highest rates quoted at banks in
recent years
 In addition to interest income, banks
generate substantial non-interest
revenues from consumer loans
Recent Risk and Return
Characteristics of Consumer Loans
 Revenues from Consumer Loans
 With
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 Loans
 Consumer Loan Losses
 Losses
on consumer loans are
normally the highest among all
categories of bank credit
 Losses are anticipated because of
mass marketing efforts pursued by
many lenders, particularly with credit
cards
 Credit card losses and fraud amounted
to more than $12 billion in 2005
Recent Risk and Return
Characteristics of Consumer Loans
 Interest Rate and Liquidity Risk with
Consumer Credit
 The
majority of consumer loans are
priced at fixed rates
 New auto loans typically carry 4-year
maturities, and credit card loans
exhibit an average 15- to 18-month
maturity
Recent Risk and Return
Characteristics of Consumer Loans
 Interest Rate and Liquidity Risk with
Consumer Credit
 Bankers
have responded in two ways
to deal with the interest rate risk:
Price more consumer loans on a
floating-rate basis
 Commercial and investment banks
have created a secondary market in
consumer loans, allowing loan
originators to sell a package of loans

Evaluating Consumer
Loans