GSB Credit Track
Effective Loan Pricing
Session 3
Thomas Farin
President
tfarin@farin.com
© 2012 FARIN & Associates Inc.
1
Goals For This Session
• Review most important points from Sessions 1
and 2 at GSB
• Review assignment
• Walk you through software and model a loan
© 2012 FARIN & Associates Inc.
2
Pricing Cash Flows
• When we price a loan
– We are pricing a bundle of cash flows.
– A good loan pricing model puts an A/L wrapper around
a loan or a bundle of loans being priced. Approach
and results should be consistent with.
• A/L model results
• Profitability system results
• Market results – Assuming loan is sold
© 2012 FARIN & Associates Inc.
3
Cash Flow and Repricing
Characteristics
60 Month Bullet Loan
• Term or Revolving
– Amortizing?
– Term
– Balloon?
• Amortization Term
• Fixed or Variable
–
–
–
–
Origination Rate
First Reprice
Repricing Rate
Repricing Frequency
– Prepayment Speed
You don’t control in LoanEdge
© 2012 FARIN & Associates Inc.
4
Loan Pricing – Cash Flows
60 Month Bullet
$120,000
$100,000
$80,000
Series1
$60,000
Series2
$40,000
$20,000
56
51
46
41
36
31
26
21
16
11
6
1
$0
Cum Prin CF
60 Month Bullet Loan
3.5
Match
3
Rates
Considers Interest Cash Flows
2.5
2
1.5
1
0.5
0
1
2
3
4
5
Funding Cost
© 2012 FARIN & Associates Inc.
5
Loan Pricing – Cash Flows
60 Month New Car - 20% PP
$120,000
$100,000
$80,000
$60,000
$40,000
$20,000
56
51
46
41
36
31
26
21
16
11
6
1
$0
Cum Prin CF
Considers Interest Cash Flows
Match
60 Month Amortizing Loan
with 25% annual prepayments
© 2012 FARIN & Associates Inc.
6
Loan Pricing – Interest Rate Risk
•
•
Interest Rate Risk
– When you are pricing loans you
are pricing cash flows not
maturities.
– With fixed-rate loans, pieces
reprice as cash flows come in.
Few reprice at maturity.
– Principal cash flows are often
uncertain
• Prepayment options
– Variable rate loans reprice
To manage interest rate risk,
institutions need to match funding
to the repricing of the loans of
loans. Two approaches:
– Simplistic – match based on
duration
complex – Match fund
x– More
individual repricing flows.
– While in the real world you may not
x match, in making pricing decision,
we should assume matching.
• When cash flow pieces come in
• When contractual repricing occurs,
but …
• Variable rate loans may not
respond immediately or completely
at reset points
• Reset frequency
• Restrictions on adjustments (caps)
X – Approach taken in this course
© 2012 FARIN & Associates Inc.
7
Market Curve Usage
CurveNo
1
5
6
9
10
14
16
20
21
29
37
40
66
84
87
90
91
95
98
99
100
119
126
127
128
134
137
138
CurveName
US Treasury
Prime
Fed Funds
Balloon MBS
Libor
FHLMC FR MBS
UST Strip
FNMA FR MBS
GNMA FR MBS
Interest Rate Swap
Indexed AAA Corporate Bond
AAA Auto Index
11th District COFI
Average FHLB ADV
Cost of Savings Index
Indexed AAA MUNI Bond
Indexed Agency Bond
National COFI
REPO (Overnight)
Retail CD Avg
US CMT (H.15)
AAA Commercial Equipment
Indexed A Corporate Bond
Indexed B Corporate Bond
Indexed A- MUNI Bond
FR MBS
Balloon MBS Synthetic
GNMA II ARMS
• Curves Used for
– Risk Free Curves
– Investment Benchmarks
– Wholesale Funding Curves
• Requirements
– Broad range of benchmarks.
– Updated very frequently
You don’t control Market Curves or spreads in LoanEdge
© 2012 FARIN & Associates Inc.
8
Cash Flow Matching Example
60 Month Auto loan – 1st 12 months of amortization
Weighted average
investment benchmarks
and funding costs are
calculated from these
matches.
You can view amortization schedules in LoanEdge
© 2012 FARIN & Associates Inc.
9
Loan Pricing – The Basics
Interest Rate Risk – Conclusions
• Interest rate risk driven by the cash flow and repricing
characteristics of the loan rather than the term of the
loan
• To model most accurately, each cash flow and repricing
point is matched
• The loan can be matched up to an appropriate point of:
– A funding curve when matching funding
• Funds Transfer Pricing (FTP)
– An investment curve when looking at investment alternatives.
• Pricing loans off investment alternatives
• Valuing loans
© 2012 FARIN & Associates Inc.
10
Loan Pricing – The Basics
Credit Risk
– Provision for Loan Loss?
– Charge-Offs
• Problem with Using
Provisions
– 1% Reserves
– 0.15% Charge-Offs
0%
Growth
10%
Growth
25%
Growth
RLL
1.00%
C/O
0.15%
PLL/ALL 0.15%
1.00%
0.15%
0.25%
1.00%
0.15%
0.40%
0.15% C/O + (1% * 0%) Growth
0.15% C/O + (1% * 25%) Growth
0.15% C/O + (1% * 10%) Growth
© 2012 FARIN & Associates Inc.
11
Which History to Use?
• Was history from 2005-2007 a legitimate
predictor of recent credit losses?
• Are 2008-2010 losses a legitimate predictor of
losses of newly originated loans in 2011?
• Do we even have legitimate loss history for loans
originated today?
– Changes in collateral coverage
– Changes in underwriting standards
– Changes in kinds of loans originated
You will be coming up with the credit risk adjustment for your loans
© 2012 FARIN & Associates Inc.
12
Loan Pricing – Servicing
Arguments
Servicing Cost
– Marginal Origination Cost
• Cost of originating the next
loan
– Marginal Servicing Cost
• Cost of servicing the next
loan
– Direct Overhead Allocation
• Fixed costs directly related to
loan production
– General Overhead Allocation
• President’s salary, human
resources, etc.
– Economist – Continue to
produce widgets until marginal
revenue equals marginal cost.
– Accountant – Without overhead
allocation, you end up with
profitable loans and an
unprofitable institution.
OTS Cost Assumptions
–
–
–
–
–
–
–
–
0.20% - FR Mortgages
0.38% - ARMs
0.20% - Multi & Non-Res
0.20% - Const & Land
0.20% - Second Mtg.
0.20% - Commercial
0.20% - Consumer
1.00% - Credit Card
• Is there a better source for
generic servicing costs
© 2012 FARIN & Associates Inc.
13
Servicing Example
• Differential pricing on A, B, C credits should reflect both
additional charge offs, and additional servicing costs due
to legal and collection fees.
In LoanEdge you can add servicing costs but you can’t delete what is there.
© 2012 FARIN & Associates Inc.
14
Option Risk – What Is It
• 15 year FRM example showing remaining principal under different
rate environments
– Falling – 25% CPR – 2.75 year duration
– Flat – 8% CPR – 4.64 Year duration
– Rising – 5% CPR – 5.21 Year Duration
15 Year FRM
Remaining Principal
120,000.00
100,000.00
80,000.00
5% CPR
8% CPR
60,000.00
25% CPR
40,000.00
20,000.00
1
14
27
40
53
66
79
92 105 118 131 144 157 170
Month
© 2012 FARIN & Associates Inc.
15
Consider Option Risk
in Pricing Loans?
• Against
– Not a true cost like charge offs,
servicing costs, or costs of
matching funding.
– Considering option risk will
cause loans to be unprofitable.
– Not the loan officer’s problem.
– Very difficult to calculate
– May be inherently hedged in
balance sheet of retail financial
institution.
• For
– Option risk can damage the
performance of un-hedged
institutions. It costs money to
hedge option risk
– Price/yield of securities
reflects option risk. Securities
are securitized loans
– If loan officers are not
‘charged’ for options, they will
give away options in exchange
for rate
– Can be derived from securities
market.
• Source
– Securities Markets
© 2012 FARIN & Associates Inc.
16
Adding Option Risk
Applied to internal profitability calculations
You can’t control the option risk adjustments in LoanEDGE
© 2012 FARIN & Associates Inc.
17
Sample Loan – 72 Month New Auto
•Cash Flows
•Pricing
•Expenses
•Risk Assum
•Benchmarks
© 2012 FARIN & Associates Inc.
18
Investment Benchmark
•
•
•
Market rather than internal
benchmark
Compares performance of loan to
closest investment benchmark
after adjusting for risk and cost
differences.
Most relevant when
– You are trying to decide how to
invest cash already raised.
– Anytime investing in a security is
an alternative to making a loan
– You are trying to derive market
adjustments for
•
Required inputs
–
–
–
–
–
–
–
•
Cash flow characteristics
Risk free curve
Investment benchmark curve
Pricing – Rates and fees
Operating expenses
Credit risk adjustment
Additional option risk adjustments
Calculated adjustments
– Interest rate risk adjustment
– Option risk adjustment
– Loan’s spread to investment
benchmark after adjustments
– Test – Is spread positive (good) or
negative (bad)?
• Interest rate risk
• Option risk
•
Not considered
–
–
–
–
Funding cost curve
Capital requirement
RAROC Goal
Institution Tax Rate
© 2012 FARIN & Associates Inc.
19
Investment Benchmark - Steps
Investment Benchmarks
Risk Free Rate
+ Int Rate Risk Adjust
0.620%
1.107%
=
+
=
+
1.727%
0.000%
1.727%
0.350%
Risk Free Match
Option Risk Adjust
Investment Benchmark
Credit Risk Adjust
+ Expense Adjust
0.682%
+ Add'l Option Risk Adjust
= Retail Equiv Benchmark
Wtd Loan Yield
0.250%
3.009%
4.500%
Spread to Benchmark
1.491%
1 Month Agency
IRR Adjustment
Agency Match
Investment Benchmark
Credit Risk Adjustment
Servicing Cost Adj
Option Adjustment
Retail Benchmark
Loan Rate
20
Spread to Benchmark
You can view the detailed Investment Benchmark analysis in LoanEdge
© 2012 FARIN & Associates Inc.
Valuation
•
•
•
Market rather than internal
benchmark
Compares market value of loan as
compared to book at time of
origination.
Most relevant when
– You are going to sell loan after
origination.
– When you are trying to improve
the franchise value of your
institution by holding well priced
loans
•
Required inputs
–
–
–
–
–
–
–
–
•
Cash flow characteristics
Risk free curve
Investment benchmark curve
Discount rate curve
Pricing – Rates and fees
Operating expenses
Credit risk adjustment
Additional option risk adjustments
Calculated outputs
– Market value vs book value of
loan
– Price
– With and without origination fees
– Test – Is price at or above 100
(good) or below 100 (bad)?
•
Not considered
–
–
–
–
Funding cost curve
Capital requirement
RAROC Goal
Institution Tax Rate
© 2012 FARIN & Associates Inc.
21
Valuation - Steps
• Value Cash flows
– Project amount and timing of cash flows
– Use discount rates to mark cash flows to market.
Period
0
1
2
3
4
5
6
7
8
9
10
11
12
discRates ttlCashFlowmktValue
0.00%
-230.00
-230.00
1.22% 1,086.14 1,085.05
1.22% 1,056.16 1,054.02
1.22% 1,026.92 1,023.81
1.22%
998.42
994.39
1.22%
970.63
965.74
1.24%
943.55
937.75
1.24%
917.14
910.57
1.24%
891.40
884.11
1.24%
866.31
858.34
1.24%
841.86
833.25
1.24%
818.02
808.83
1.36%
794.79
784.11
n
i
FV
Discount Rate = Investment
Benchmark + Adjustments
(not including expense)
The sum of the market values
of individual cash flows is the
market value of the instrument.
PV
PV1 = FV1 / (1+i)n = 1086.14 / (1 + (1.22%/12))1 = 1085.05
You can view the
market value
cash flows in LoanEdge
Note: Cash flows continue for an additional 60 months
© 2012 FARIN & Associates Inc.
22
Valuation - Steps
Market Value
Book Value
With Initial Fees
Market Value
Price
Without Initial Fees
$30,000.00
Market Value
Price
$30,910.43
103.03
$30,910.43
103.03
Book Amount of Loan
With Fees
Sum of Cash Flow Market Values
100 * MV / BV
Without Fees
Sum of Cash Flow Market Values
100 * MV / BV
Note: By Valuation standards, this is a well priced loan
as its market value exceeds book at the time of
origination.
You can view the market value analysis in LoanEdge
© 2012 FARIN & Associates Inc.
23
FTP Analysis - RAROC
RAROC (Lifetime)
Wtd Loan Yield
+Wtd Fees
- Wtd Fund Bench
- Option Risk
- Credit Risk
- Expense
4.500%
0.000%
1.539%
0.125%
0.350%
0.682%
= Spread
- Tax Adjust
= After Tax Spread
/ Capital Req.
= ROE (RAROC)
ROE Target
ROE Spread
1.804%
0.722%
1.082%
10.000%
10.825%
15.000%
-4.175%
Lifetime
ROE
ROE Target
11.37%
15.00%
Horizon
Balance weighted costs
Assumed tax rate of 40%
RAROC (ROE)
RAROC Goal
Decision – Don’t make the
loan !!!
You can view the RAROC analysis in LoanEdge
© 2012 FARIN & Associates Inc.
24
FTP Analysis - Income
Horizon Inc om e
H or izo n P e rio d (yrs)
In tere st In com e
+ F ee s
- F u n d E xp e n se
- O p tion R isk
- C red it R isk
- O p er . E xp e n se
= N et In co m e B 4 Ta x
- Ta xe s
= A fter Ta x N e t In com e
A vg N et Pr in cip al
3 .0
$ 2 ,3 1 7
$0
$ 712
$64
$ 180
$ 384
$ 976
$ 390
$ 586
$ 1 7 ,1 6 4
ROA
Avg Annual Horizon Income (ROA numer.)
Avg Net Principal (ROA denom.)
Ratio analysis
restated in
dollars
You can view the income
analysis in LoanEdge
2.27%
$195
$8,582
Decision Tool
Make the loan !!!
Note: The net income
figure is converted into ROA
© 2012 FARIN & Associates Inc.
25
Decision Tree
Loan
New A 48 Mo
Initial
Reprice
Rate
6.500% 0.000%
Reprice
0
0
Amortize
Mature
Is the spread to Investment
Benchmark positive?
0.851%
Better off putting money
Yes
in investments.
48
Balance
Option
Credit
1,000
0.00%
0.15%
Servicing
0.15%
Capital
Constraint?
No
Decision based on
income contribution
Is the FTP loan profit
adequate?
No
Decision based on ROE (RAROC)
Don't make the
Yes
loan.
4.82
Yes
No
Does the FTP ROE beat
the target?
-7.70%
No
Yes
Originate for
portfolio.
Is the loan price sufficiently
above book?
101.82
No
Don't make the
loan.
© 2012 FARIN & Associates Inc.
Yes
Originate and
Sell.
26
Intersession Assignment
Note: This is the 1st of 4 criteria
© 2012 FARIN & Associates Inc.
27
Intersession Assignment
Note: This is the 2nd of 4 criteria
© 2012 FARIN & Associates Inc.
28
Intersession Assignment
Note: In your first loan you will model an
individual loan. In the second you will model
a relationship.
Note: This is the 3rd of 4 criteria
© 2012 FARIN & Associates Inc.
29
Intersession Assignment
You are probably
thinking, “But Farin,
you haven’t showed
me how to use the
model.”
Note: This is the 4th of 4 criteria
© 2012 FARIN & Associates Inc.
30
In Order to Follow Along …
• Register – click registration link on resource page
and follow instructions
• Download Getting Started Guide – click download
link on registration page
• Have the loan you wish to model selected and
have the information to model the loan
assembled
• Have this window open as well as the software.
You can pause the recording, switch windows,
and model your loan as I walk you through.
© 2012 FARIN & Associates Inc.
31
Logging Onto iPrice
Process
1. URL
ipriceweb.farin.com
2. Click here to begin
log on
LoanEDGE is Web based …
© 2012 FARIN & Associates Inc.
32
Logging Onto iPrice
Process
1. Click Logon
link
2. Enter User
Name and
Password
3. Click OK
Resource pages have information on user name and password. Each attendee
can have his or her own logon.
© 2012 FARIN & Associates Inc.
33
Creating New Relationship
Will say LoanEDGE for GSB School 2012
Process
1. Click here
2. Give Relationship
a name
3. Click Add
Note: You won’t have these.
© 2012 FARIN & Associates Inc.
34
Add Product to Relationship
Process
1. Click category
of loan you
wish to add
2. Then click
select to get
to next
screen.
Note: pick the
loan from the
list that most
closely matches
the loan you
wish to model
© 2012 FARIN & Associates Inc.
35
Select Product to Add
Process
1. Select product
to be added
2. Click Select
© 2012 FARIN & Associates Inc.
36
Product Modeling Screen
Product
characteristics
preset
1. Structure
2. Fees/Expenses
3. Credit Risk
Note: You will be
able to edit some
characteristics
but not others
depending on
account type
selected in
previous step.
© 2012 FARIN & Associates Inc.
37
Entering Product Data
To see:
• Amort Schedule
• Details
Enter
1. Rate
2. Balance
3. Credit
adjustment
4. Review
product
results
© 2012 FARIN & Associates Inc.
38
Amortization Schedule
Process
1. Review
2. Done
Note: if you
scroll right
you will be
able to see
market value
cash flows
© 2012 FARIN & Associates Inc.
39
Detailed Results
Process
1. Investment
benchmark
2. Characteristics
3. Scroll down
to see other
methods
4. Done to
close
© 2012 FARIN & Associates Inc.
40
Detailed Results
Duration
More
Characteristics
RAROC
Summary
© 2012 FARIN & Associates Inc.
41
Detailed Results
Full Summary
Horizon Income
© 2012 FARIN & Associates Inc.
42
Exporting Details
If you find it
helpful, you can
use the Save As
button to export
this information
to an Excel file
for comparison
and printing.
© 2012 FARIN & Associates Inc.
43
Notes
• Everything you have done persists on our server.
• If you want to modify a deal later you can:
–
–
–
–
Log onto LoanEDGE
Open (View) a relationship
Modify or enhance
In Session 4 you will be either modifying an existing
relationship or creating a new one.
• Our support people will be able to view the loan
you have been working on.
• Feel free to model additional loans if you wish.
© 2012 FARIN & Associates Inc.
44
Notes
• Limits – You accept our
management assumptions
• Resource Page
– Self-registration link
– Getting started guide
– Links to the two recorded
Webinars
– Links to the PowerPoints as
PDFs
– Support number should you
need help
• Model two situations
–
–
–
–
Two separate loans
Comparison
Sensitivity testing
A loan and a relationship
• Session 4 focuses on last
three
© 2012 FARIN & Associates Inc.
45