Loan Pricing Deals & Relationships Session 1. Agenda

Transcription

1 Loan Pricing Deals & Relationships Session 1 Thomas Farin President Farin & Associates, Inc tfarin@farin.com 1 Agenda Session 1 Inputs What We Need to Know Role of Benchmarks Four Models to Look at Profitability Spread to Benchmark Economic Value FTP ROE (RAROC) FTP ROA Adjusting loan pricing for risk and cost factors Session 2 Commercial R/E Case Commodity CRE Pricing Modifying Structure to Meet Customer Needs Valuing Deposit Relationships Effect of Deposit Relationship on Profitability Consumer Relationship Pricing Loan and Deposit Deposit and Deposit 2 1

2 Use of Pricing Models Given others set market rates Identify well priced loans and deposits Identify poorly priced loans and deposits Aggressively compete for well priced loans and deposits Do not aggressively compete for poorly priced loans and deposits Pricing models Market View Investment benchmarks Valuation Balance sheet view RAROC Risk Adjusted Return on Capital (ROE) ROA - Net income produced 3 THE INPUTS AND ASSUMPTIONS 4 2

3 Evaluating Profitability of Cash Flows When we price a loan or deposit We are pricing a bundle of cash flows. A good 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 5 Understanding Cash Flows Interest Prepayments Fees and Expenses Contractual Flows Credit Losses Note: Current market example 6 3

4 Loan Cash Flow Matching Example Only the first 12 of 60 cash flows are shown 60 month A Credit Auto Loan Weighted average investment benchmarks and funding costs are calculated from these matches. 7 Credit Risk - Which History to Use? There are plenty of guidelines for establishing ALL for loans already in the portfolio. But what about the loans you are pricing today? Was history from a legitimate predictor of recent credit losses? Are losses a legitimate predictor of losses of newly originated loans in 2013? 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 8 4

5 Credit Risk - Comparative Loss Experience Do you have loss experience at the same level of detail at which you are making pricing decisions? Important in determining whether loans are well or poorly priced. Also important in justifying your pricing actions in a compliance exam. 9 Servicing 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. Arguments Economist Continue to produce widgets until marginal revenue equals marginal cost. Accountant Without overhead allocation, you end up with profitable loans and an unprofitable institution. Sources of Servicing Cost Adjustments Survey data Activity based cost analysis Key issue is where you get the data Internal study activity based cost analysis Peer group data source? 10 5

6 Comparative Servicing Cost Adjusts for Credit Risk Servicing cost: Can vary by credit grade Can also make smaller loans less profitable origination and servicing costs are spread across smaller volumes Forms of cost in this example Origination Servicing Risk Adjusted 11 Loan Pricing The Basics Option Risk Dealing with uncertain cash flows We imbed options in loan contracts that allow customers to modify cash flow characteristics of loans when they consider it to their advantage to do so. Prepayments Basic prepayment levels death, divorce, transfer, upgrades, etc. Incentive driven prepayments Customer prepays to refinance at a lower rate Customer can t afford to move or upgrade because of interest rate jump. Up to the customer to execute the option In some cases, subject to penalty primarily commercial contracts Adjustable rate mortgage caps Annual caps, lifetime caps Automatically executed by the institution. Loan floors Ideally the institution is compensated with rate for making the option available. Note that option risk is not a cash flow. It is a risk that costs money to hedge. 12 6

7 Remaining Principal 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 120, , , , , % CPR 8% CPR 25% CPR 20, Month 13 Accounting for Option Risk Cash Flow Items Cost of Hedging Option Risk 14 7

8 DECISION TOOLS 15 Investment Benchmark Market rather than internal benchmark Compares performance of loan or deposit to closest benchmark after adjusting for risk and cost differences. Most relevant when You are trying to decide how to invest cash being raised raised. Anytime investing in a security is an alternative to making a loan or borrowing funds is an alternative to raising deposits You are trying to derive market adjustments for Interest rate risk Option risk Required inputs Cash flow characteristics Risk free curve Investment or funding benchmark curve Pricing Rates and fees Operating expenses Credit risk adjustment - Loans Additional option risk adjustments Calculated adjustments Interest rate risk adjustment Option risk adjustment Spread to investment or funding benchmark after adjustments Test Is spread good or bad? Not considered Funding cost curve Capital requirement RAROC Goal (Loans) Institution Tax Rate 16 8

9 Investment Benchmark Steps (Loan) 1 Month Agency IRR Adjustment Investment Benchmark (weighted average of matches from amortization slide) Credit Risk Adjustment Servicing Cost Adj Option Adjustment Retail Benchmark Loan Yield Spread to Benchmark Month A Credit Auto Loan Rate is 4%, No Fees Valuation Market rather than internal benchmark Compares market value of loan or deposit 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 Benchmark curve Discount rate curve Pricing Rates and fees Operating expenses Credit risk adjustment (loans) Additional option risk adjustments Calculated outputs Market value vs book value of loan or deposit Price Test Is price good or bad? Not considered Funding cost curve Capital requirement RAROC Goal Institution Tax Rate Note: Valuation technique used here is same as that used in EVE and NEV (Economic Value) Calculations 18 9

10 Valuation Steps (Loan) Value Cash flows Project amount and timing of cash flows Use discount rates to mark cash flows to market. 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. n i FV PV PV 1 = FV 1 / (1+i) n = 1, / (1 + (0.72%/12)) 1 = 1, Note: Cash flows continue for an additional 48 months 19 Funds Transfer Pricing Internal profitability benchmark Evaluates whether a loan is profitable within context of balance sheet Most relevant when You are trying to decide whether you can make money originating a loan Anytime you are trying to asses the profitability of a relationship, product or profit center Can focus on: Dollar contribution to profit (ROA) Return on required capital (RAROC) Required inputs Cash flow characteristics Cost Curve Pricing Rates and fees Operating expenses Credit risk adjustment Additional option risk adjustments Capital Requirement (RAROC) Capital Goal (RAROC) Institution Tax Rate Calculated adjustments Pretax Spread ($ or %) After tax spread ($ or %) RAROC Spread to RAROC Goal Test Is spread positive (good) or negative (bad)? Not considered Risk free curve Investment benchmark curve Capital Requirement (ROA) 20 10

11 Not Recommended - Your Cost of Funds Curve Penalizes loan function for inefficient funds gathering, rewards for efficient funds gathering. Could force you to price out of the market. Fails to reward and provide an incentive for funds providers to gather funds efficiently. History based curve is used to price newly originated instruments. Selecting a FTP Curve Recommended - Your true wholesale funding alternative FHLB Advance Jumbo/Brokered/I-net CD AAA corporate Swap Curve Use the one that comes closest to your true wholesale funding cost. Credits deposit gathering functions for sub-wholesale deposits. Levels the playing field for lending functions. 21 Capital Allocation Why assign a capital requirement to a loan? Relates profitability of an entity (loan) to a primary earnings measurement ratio. Allows for adjustments in return based on differential capital needs for different loans and investments. Should you bother with a capital allocation model? Will adding this level of complexity have a material effect on analysis or decisions? Is capital a constraint Regulatory requirements Self-imposed requirements What capital allocation model should I use? Leverage Requirement Core capital requirement Internal capital goals Risk Based Requirement Basel I Basel II Basel III Standardized Approach Internal Model 22 11

12 FTP Analysis - RAROC Note that in FTP analysis, funding cost is swapped in, investment bench is swapped out. Benchmark is weighted average cost from amortization schedule. Tax rate adjusted for as ROE is after tax RAROC (ROE) RAROC Goal Lifetime 3 Year Horizon 23 FTP Analysis Loan Income (ROA) Ratio analysis restated in dollars 24 12

13 Decision Rules Summary Which model do you use? In this case, all lights are green for both the loan and the deposit. But what if one was red? 25 Decision Tree Loan New A 48 Mo Initial Reprice Is the spread to Investment Rate 6.500% 0.000% Benchmark positive? 0.851% 2.306% Reprice 0 0 Better off putting money Amortize Yes in investments. Sometimes results Mature 48 Balance 1,000 Capital No Option are in conflict, 0.00% but Constraint? Credit 0.15% Decision based on ROE (RAROC) No Servicing not in this example. 0.15% Don't make the Yes Decision based on loan. income contribution Yes Yes Is the FTP loan profit adequate? 2.96% 4.82 Does the FTP ROE beat the target? -7.70% 14.80% No No Originate for Is the loan price sufficiently portfolio. above book? No Yes Don't make the loan. Originate and Sell

14 Effect of Risk/Cost Factors on Profitability Term Interest Rate Risk Loan Size Amortization of fixed origination cost Credit Grade Credit Risk Adjustment Loss Experience Servicing Cost Legal & collection Loan Size Fixed origination cost amortization Capital Requirement ROE or RAROC Direct vs. Indirect Effect of Fees Effect of Structure 27 Effect of Term on Profitability 28 14

15 60 Month Effect of Term on Profitability 72 Month 29 Effect of Loan Size on Profitability 30 15

16 Effect of Credit Grade on Profitability 31 Direct vs. Indirect 32 16

17 Effect of Fees and Structure on Profitability Typical Commercial Real Estate Structure 33 Effect of Fees 34 17

18 Effect of Structure on Profitability 35 Take Aways Effect of term will vary with slope in yield curve and amortization of fixed costs. It may make sense to tier loans Risk based pricing is a given. Make sure you consider all the factors. Also, make sure you document your credit grade differentials. Origination fees can considerably enhance loan profitability Giving the customer what he wants is often more profitable than attempting to push him into what we want to sell

19 Agenda Session 1 Inputs What We Need to Know Role of Benchmarks Four Models to Look at Profitability Spread to Benchmark Economic Value FTP ROE (RAROC) FTP ROA Adjusting loan pricing for risk and cost factors Session 2 Commercial R/E Case Commodity CRE Pricing Modifying Structure to Meet Customer Needs Valuing Deposit Relationships Effect of Deposit Relationship on Profitability Consumer Relationship Pricing Loan and Deposit Deposit and Deposit 37 19