FINANCIAL SERVICES
LECTURE 3
Chara Charalambous
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Learning Goals:
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What is the main source of income for Banks?
What is a loan and what is an advance.
Loan Agreements: Legal and Equitable.
Principles of lending.
Types of loans
What is a credit analysis.
What is a collateral.
What is a mortgage.
Land Registry.
What is a secondary mortgage market?
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Lending services:
Making loans is the principal economic function
of banks. For most banks, loans account for half
or more of their total assets and about half to
two-thirds of their revenues.
Risk in banking tends to be concentrated in the
loan portfolio. Uncollectable loans can cause
serious financial problems for banks.
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Loan Vs Advance
• Many people think that loan and advance is almost same .
Both means when a person borrows the money from other , it
is called loan or advance . Both Loan and Advance are to be
repaid in installments for example: monthly installments of
equal amounts. But , In true sense, it has many differences.
• Loan is against a security but advance is not against any
security but based on relationship, for example vehicle loan
given to employees is against the security of the vehicle and if
advance is given for travel then it is not against any security.
• There is a sense of debt in loan, whereas an advance is a
facility being availed to the borrower.
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• Regarding loans there is a further classification of
lending agreements. The legal or equitable
agreements.
• A legal agreement is usually based on a contractual
relationship drawn up between lender and borrower
and it is more secured than the equitable agreements.
• An equitable agreement does not always require a
formal written contract. A borrower might offer an
asset of some value in return for funds and have this
confirmed by a letter, note of memorandum to the
effect that the asset will be retained until the debt is
repaid.
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Banks lend for many purposes:
Overdrafts
Personal loans
Business loans
Mortgages
 Banks grant advances largely for short-term purposes, such as
purchase of goods traded in and meeting other short-term
trading liabilities. But loan could be for any period.
• Interest terms and structure is different regarding loan and
regarding advance.
• Example of Advance: Consumer loan(Car, Refrigerator), Personal loan, Staff
loan.
a. Advances to Directors
b. Advances to Chief Executive
c. Advances to Other Senior Executives
d. Advances to Customer's Group:
Agriculture loan
Commercial lending Consumer credit scheme Staff loan
Export financing
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Principles of Lending
Parties
• In every lending transaction there is a lender and a borrower
who form the basis of the creditor-debtor relationship. In a
mortgage the lender is called mortgagee and the borrower is
called mortgagor.
When the lender requires some additional back up
(reinforcement) of the borrower’s ability to pay, there
may also be:
• A guarantor or
• A surety
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• A guarantor’s role is to assurance repayment of the
loan if the primary debtor fails to do so. A surety puts
forward some form of collateral, such as cash or life
policy with a surrender value, to secure the debt
being paid. However is prudent to seek independent
legal advice before entering into guarantor
agreements. In the words of one writer ‘ the easiest
thing to sign, the hardest to enforce’.
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Types of Loans Made By Banks:
Bank loans can be grouped according to their
purpose.
1. Real Estate Loans: secured by real property (land
,building, and other properties).can be both short term (land
development & construction) long term ( for purchase of
farmland, homes, apartments, commercial structures)
2. Financial Institution Loans: credit to banks, insurance
company, finance company and other FI
3. Agricultural Loans: planting and harvesting crops and to
support feeding and care of livestock (harvest=collect=gather)
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• 4.
Commercial
and
Industrial
Loans:
Purchasing inventories, paying tax, meeting payrolls,
factory infrastructure
• 5. Loans to Individuals: consumer loan, auto
mobile, home loan, medical expense, other personal
expenses
• 6. Miscellaneous Loans: (various, mixed)
Securities loan, other loan which is not categories
here including
• 7. Lease Financing Receivables: buy
equipment/ vehicle and lease them
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Credit Analysis:
The division of the bank responsible for analyzing and
making recommendations about loan applications is the
credit department.
Is the Borrower Creditworthy?
This usually involves a detailed study
of six aspects of the loan application:
character, capacity, cash, Collateral (security,
guarantee), conditions, and control.
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The Six Basic C’s of Lending
1. Character—Specific Purpose For Loan and Serious
Intent to Repay Loan
2. Capacity—Customer Has Legal Authority to Sign
Binding ( the compulsory) Contract or he/she is a
bankrupt person?
3. Cash—Does the Borrower Have the Ability to
generate Enough Cash to Repay the Loan
4. Collateral—Does the Borrower Have Adequate
Assets to Support the Loan (security of the loan)
5. Conditions—Must Look At the Industry and
Changing Economic Conditions to Assess ability to Repay
6. Control—Does Loan Meet Written Loan Policy and
how Would Changing Laws and regulations Affect Loan
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COLLATERAL
Security: Loans are either: secured or unsecured
• With a secured loan the borrower offers something of
value so that in the event of default the lender can take
this asset, sell it (realize the security) and be repaid out of
the proceeds.
• By contrast an unsecured loan relies on the personal
promise (covenant) of the borrower to repay. In the even
of default, the lender must hope that the borrower has
sufficient financial resources to be able to repay the debt.
• Generally secured loans are less risky business and
therefore offer: lower interest rates and longer available
terms for repayment. Thus mortgages secured on land are
often available for 25-30 year terms of repayment, it is
unusual to be offered an unsecured loan for terms in
excess of five to seven years.
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Common Types of Collateral/Security
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Accounts Receivable
Factoring
Inventory
Real Property-mortgage
Personal Property
Personal Guarantees
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What is a Mortgage?
• A loan that is secured by the collateral
(security/guarantee) of specified real estate
property, which obliges the borrower to make a
predetermined series of payments. Over a period
of many years, the borrower repays the loan, plus
interest, until he/she eventually owns the
property free and clear. Mortgages are also
known as "liens against property" or "claims on
property."
• In the event of default by the borrower, the
lender can sell off the property
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When a house is bought with the assistance of a mortgage two
conveyances – transfers- take place:
The first transfers the ownership of the interest in land from vendor to
purchaser.
The second creates rights for the lender if the borrower break the
conditions of the loan.
These take place at the same time
Once a mortgage is created, the lender is said to have first charge. In
due course, the borrower may see the value of the property increase
and it may therefore be possible to take out ‘top up’ loans by way of:
A further loan from the same lender , usually secured by the original
legal agreement.
A second mortgage whereby a different lender creates an additional
agreement over the same property.
It is of course possible to create third and even subsequent charges.
But the first agreement holder usually holds the title deeds and this
gives him stronger enforcement power in the event of failure to pay.
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• Mortgages come in many forms. With a fixed-rate mortgage, the
borrower pays the same interest rate for the life of the loan. Her
monthly principal and interest payment never change from the first
mortgage payment to the last. Most fixed-rate mortgages have a
15- or 30-year term. If market interest rates rise, the borrower’s
payment does not change. If market interest rates drop
significantly, the borrower may be able to secure that lower rate by
refinancing the mortgage. A fixed-rate mortgage is also called a
“traditional" mortgage.
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With an adjustable-rate mortgage (ARM), the interest rate is fixed
for an initial term, but then it fluctuates with market interest rates.
The initial interest rate is often a below-market rate, which can
make a mortgage seem more affordable than it really is. If interest
rates increase later, the borrower may not be able to afford the
higher monthly payments. Interest rates could also decrease,
making an ARM less expensive. In either case, the monthly
payments are unpredictable after the initial term.
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DEFINITION of 'Refinance'
• 1. When a business or person revises a payment schedule for
repaying debt.
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2. Replacing an older loan with a new loan offering better terms.
• When a business refinances, it typically extends the maturity date.
When individuals change their monthly payments or modify the
rate of interest on their loans, it usually involves a penalty fee.
Refinancing may refer to the replacement of an existing debt
obligation with another debt obligation under different terms. The
terms and conditions of refinancing may vary widely by country,
province, or state, based on several economic factors such as,
inherent risk, projected risk, political stability of a nation, currency
stability, banking regulations, borrower's credit worthiness, and
credit rating of a nation. In many industrialized nations, a common
form of refinancing is for a place of primary residency mortgage.
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Fixed Rate Mortgages
• Fixed rate loans have a constant, unchanging rate
– Interest rate risk can hurt lender rate of return
• If interest rates rise in the market, lender’s cost of funds
increases
• No matching increase in fixed-rate mortgage return
– Borrowers lock in their cost and have to refinance to
benefit from lower market rates
• Fixed monthly payment includes
– Interest owed first
– Balance to principal
• Interest on the declining principal balance
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Calculating monthly payment
• The fixed monthly payment for a fixed rate mortgage is the amount
paid by the borrower every month that ensures that the loan is paid
off in full with interest at the end of its term. The monthly payment
formula is based on the annuity formula. The monthly payment c
depends upon:
• r - the monthly interest rate, expressed as a decimal, not a
percentage. Since the quoted yearly percentage rate is not a
compounded rate, the monthly percentage rate is simply the yearly
percentage rate divided by 12; dividing the monthly percentage rate
by 100 gives r, the monthly rate expressed as a decimal.
• N - the number of monthly payments, called the loan's term, and
• P - the amount borrowed, known as the loan's principal.
• In the standardized calculations used in the United States, c is given
by the formula:
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For example, for a home loan for $200,000 with a
fixed yearly interest rate of 6.5% for 30 years, the
principal is P=200,000, the monthly interest rate is
R=(6.5/12)/100, the number of monthly payments is
N=30*12=360, the fixed monthly payment equals C=
$1,264.14. This formula is provided using the financial
function PMT in a spreadsheet such as Excel.
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Example 2:
Calculate the monthly payment for a
$330,000 new home. The new owner has
made a $70,000 down payment and plans to
finance for 30 years at the current fixed rate
of 7%.
$330,000 – $70,000 = $260,000 PV (original
investment of the financial institution)
30  12 = 360 N; 7/12 = I; Calculate PMT
PMT = $1,729.79
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Adjustable Rate Mortgages
• Adjustable-rate mortgages
– Rates and the size of payments can change
• Maximum allowable fluctuation over year and life of loan
• Upper and lower boundaries for rate changes
– Lenders stabilize profits (make profits stable) as yields
move with cost of funds
– Uncertainty for borrowers whose mortgage payments can
change over time
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LAND REGISTRY
In England and Wales ( and much of Scotland) it is
compulsory to register the land when a transfer takes
place. The purpose here is to create an ultimate
register of all land who owns it. A government body
the H.M Land Registry exist for this purpose. It has 3
registers:
• PROPERTY REGISTER: what each property consists of
and its boundaries
• PROPRIETORSHIP REGISTER: details of legal owner
• CHARGES REGISTER: details of rights of others
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Secondary Mortgage Market
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The secondary market refers in particular to the purchasing of
loans and mortgages from finance lenders. The secondary
mortgage market allows banks to sell mortgages, giving them
new funds to offer more mortgages to new borrowers.
• A mortgage lender, commercial banks, or specialized firm will
group together many loans (from the "primary mortgage
market") and sell grouped loans known as collateralized
mortgage obligations (CMOs) or mortgage-backed securities
(MBS) to investors such as: pension funds, insurance
companies and hedge funds. The mortgage must have
originated from a regulated and authorized financial
institution.
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Definitions
Primary Mortgage Market
• The market where borrowers and mortgage originators
come together to negotiate terms and effectuate
mortgage transaction. Mortgage brokers, mortgage
bankers, credit unions and banks are all part of the
primary mortgage market.
A mortgage-backed security (MBS):
• Is a type of asset-backed security that is secured by a
mortgage, or more commonly a collection ("pool") of
sometimes hundreds of mortgages. The mortgages are
sold to a financial institution (a government agency or
investment bank) that "securitizes", or packages, the
loans together into a security that can be sold to
investors. The mortgages of a MBS may be residential or
commercial.
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Securitization
• The financial practice of pooling various types of debts such as
residential mortgages, commercial mortgages, auto loans or
credit card debt obligations and selling these debts as passthrough securities to various investors. The cash collected
from the financial instruments underlying the security (the
instalments that the borrowers pay for their loan-mortgage) is paid to
the various investors who had advance money for that right.
• By combining mortgages into one large pool, the issuer can
divide the large pool into smaller pieces based on each
individual mortgage's inherent risk of default and then sell
those
smaller
pieces
to
investors.
The process creates liquidity by enabling smaller investors to
purchase shares in a larger asset pool. Using the mortgagebacked security example, individual retail investors are able to
purchase portions of a mortgage as a type of bond. Without
the securitization of mortgages, retail investors may not be
able to afford to buy into a large pool of mortgages.
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Why lending institutions sell loan portfolio? And why
investors buy them?
• If banks had to keep these mortgages the full 15 or
30 years, they would soon use up all their funds, and
potential homebuyers would have a more difficult
time to find mortgage lenders.
• On the funding side institutional investors will not be
particularly enthusiastic to get involved in direct
lending. It is costly to set up administration centers to
deal with loan applications and with the loans
themselves once repayments start being made upon
them. Also the institutional investor will have both
the advantage of liquidity and the security that these
instruments issued by housing finance institutions
are backed by residential property.
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• Also the two sides have come together because they
see this way of investment profitable since interest
rates in the mortgage market are higher.
• Furthermore there is a risk of overexposure to one
particular sector of the market but by securitizing the
loans, this risk is reduced. The lenders can continue
to originate and service new loans, the funds raised
are not shown on the balance sheet and the investor
has insurance of safety of the mortgage backed
securities.
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What is a CMO?
• Collateralized Mortgage Obligation
1. Mortgages are pooled
2. The ‘pool’ is split into various installments with
varying degrees of risk, cash flows, and time
frames.
3. Investors purchase securities
4. Mortgages are used as collateral for mortgage
pass-through securities
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The Risks Of Mortgage-Backed Securities
• Mortgage-backed securities (MBS), while attractive for a number of
reasons, have some unique features which add risk . MBS are
collateralized by a pool of residential mortgages.
• Monthly payments "pass through" the originating bank on to a
third-party investor.
• Besides monthly interest payments, mortgages amortize over their
life, meaning some amount of principal is paid off with every monthly
payment, unlike a bond, which generally pays all principal at maturity.
• In addition to scheduled amortizations, investors receive, on a prorata basis, unscheduled prepayments of principal due to refinancing,
foreclosure and house sales. While a typical mortgage may have a
term of 30 years, quite often mortgages are paid off much sooner.
Because of these unscheduled prepayments, predicting the
maturity of the MBS is problematic.
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• Prepayment is the process of paying principal on a debt before the
due date. In the case of an amortized loan that has fixed periodic
payments, prepayment means that the lender will receive fewer of
the fixed periodic payments, one or more payments of extra principal,
and the final payment will be made before the final payment due
date. The two primary factors that cause prepayment are (1) the
refinancing of the loan by the borrower because of better interest rates
and (2) the economic reality of having the cash to repay before
maturity. In the case of residential mortgages, this economic reality
usually occurs with the sale of a house because of relocation. In the
first case, investors must reinvest at lower rates and thus realize lower
rates of return over their entire investment horizon. Advantage:
Housing turnover risk may or may not translate into losses for passthrough holders because interest rates could remain the same,
allowing them to reinvest the early payments in other instruments
paying similar rates.
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Thank you
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