Loan Pricing Fundamentals

Transcription

1 Loan Pricing Fundamentals Session 2 Thomas Farin President tfarin@farin.com 2015 FARIN & Associates Inc. 1 Loan Pricing Fundamentals Two Part Series Session 1: Inputs and Investment Benchmark Four potential models for pricing loans Session 2: Pricing commodity loans Pricing deals and relationships 2015 FARIN & Associates Inc. 2 1

2 Definition Commodity Loans Appears on Rate Sheet Pricing Decisions affect Multiple Loans Generally Conforms to Secondary Standard 2015 FARIN & Associates Inc. 3 Inputs Rate & Fees Cash Flows Credit and Option Risk Origination and Servicing Expenses If a dollar amount, typical balance is important Benchmarks Investments Funding ROE ROA Discount Rates Mkt Value 2015 FARIN & Associates Inc. 4 2

3 Outputs Am I better off with loan or a security? Green Light How does ROE compare to goal? Red Light What is the loan s ROA? Green Light What is the market value immediately after origination? Green Light 2015 FARIN & Associates Inc. 5 The Problem with Rate Sheets Most loan rate sheets are multipage documents If implemented with spread sheets, key relationships are often hard wired Large vs Small New vs. Used Short-term vs. Long-term A vs. B vs. C Direct vs. Indirect Changes in the economic environment should cause changes in these relationships Yield curve Loss experience in changing economic cycles Collateral based pricing as compared to risk based pricing Hard wired spreads can cause anomalies 2015 FARIN & Associates Inc. 6 3

4 Effect of Loan Size $ Orig Cost $30,000 $20,000 $10,000 Adds 38 bp Adds 57.5 bp Adds 116 bp To hit 12% ROE Note: Effect would be even greater if servicing was specified in dollars Question: Does it make sense to tier price loans in much the same way as we tier price deposits? 2015 FARIN & Associates Inc. 7 Effect of Term 72 Month New Auto Loan is well priced under all four measures FARIN & Associates Inc. 8 4

5 Term 60 Month New Auto -20bp +5bp -15bp Loan is well priced under all four measures FARIN & Associates Inc. 9 Term 48 Month New Auto -20bp +8bp -15bp Loan is well priced under all four measures FARIN & Associates Inc. 10 5

6 Indirect A Credit Auto 48 Months Adjustments to credit risk and servicing cost. Loan is less well priced under all four measures & fails ROE test. Would require 4.70% rate to produce 15% ROE FARIN & Associates Inc. 11 Lessons from these Examples Reacting to the Curve Relationships between different term loans should not be hard wired. Rather they should adjust along with the yield curve. It is more accurate to price based on matching cash flows than it is to price based on duration Dealer Loans Dealer loans can be evaluated by adjusting servicing costs for fees paid Options for improving profitability of dealer loans Charge a higher rate Introduce relationship pricing 2015 FARIN & Associates Inc. 12 6

7 Adjusting for Credit Risk You need loss experience by product and by credit grade. In reviewing loss experience you need to ask yourself: Have the economic factors that caused the losses changed? Have my underwriting standards changed? Has my collateral coverage changed? Am I offering the same products I did in the past? ALLL reserves for the risk in the loans you have already made. Loss experience in pricing is an adjustment for the credit risk you are taking on today. Loss experience needs to look back far enough that you can see the good years and the bad years. In RAROC calculations credit risk for high risk loans may be higher than low risk loans FARIN & Associates Inc. 13 A Credit Auto 48 Months Which credit risk adjustment do we use? Capital requirement - Basel III Loan is well priced under all four measures 2015 FARIN & Associates Inc. 14 7

8 B Credit Auto 48 Months +50bp from A +30bp from A +20bp from A Capital requirement - Basel III Loan is as well priced under 3 Measures FARIN & Associates Inc. 15 C Credit Auto 48 Months +100bp from A +65bp from A +40bp from A Capital requirement - Basel III Loan is as well priced under 3 measures FARIN & Associates Inc. 16 8

9 C Credit Auto 48 Months Internal Cap Model Note change in capital requirement to internal capital Model 2015 FARIN & Associates Inc. 17 C Credit Auto 48 Months Basel II +300 bp from A Note change in capital requirement (Basel III -> Internal In order for the internal model ROE to match the A, a 200 bp rate increase is required. Note that all other measures improve 2015 FARIN & Associates Inc. 18 9

10 Lessons from these Examples Situation A, B, & C loans all priced to approximately the same spread to benchmark given credit risk and servicing cost. Market values, spreads, and net incomes are nearly the same for all three loans as would be expected. Because of same Basel III capital requirements, RAROCs are roughly the same. Credit union situation under the proposed risk based regulations is similar to banks. Capital requirements are the same under Basel III for all credit grades Lessons Assume the institution switches to an internal capital model that increases the capital requirements for C credits The institution will need to increase spreads between A s B s and C s to equalize RAROC FARIN & Associates Inc Year FRM Conforming Profitability measure (ROE) indicates we can t afford to hold this mortgage (if we fully account for option risk) but we can sell it and make money FARIN & Associates Inc

11 So How Do You Make Money on Portfolio Mortgages? Step outside the commodity box Non-conforming loans Non-portfolio lender funding has dried up As a result spreads to conforming loans have opened up Example: Jumbo mortgage 2015 FARIN & Associates Inc. 21 Relationship Pricing Multiple Loans New Customer - Same Origination Dates Existing Customer Different Origination Dates Old loans current or past FTP rates? Multiple Deposits New Customer Same Origination Dates Existing Customer Different Origination Dates Old Deposits current or past FTP rates 2015 FARIN & Associates Inc

12 Commercial R/E Becoming More Commodity Like Common term commercial R/E (5 balloon, 20 ammo) is becoming a commodity. Hard to make money on this product in many markets. Beating the Commodity Game Extend terms Point buy downs Risk based pricing Later: Relationship pricing 2015 FARIN & Associates Inc. 23 Commercial R/E Loan 2015 FARIN & Associates Inc

13 Commercial R/E Loan Pricing needed to hit 15% ROE. No Sale! 2015 FARIN & Associates Inc. 25 Commercial R/E Loan Add Fee 2015 FARIN & Associates Inc

14 Commercial R/E Loan Add Fee 5/20 FA FARIN & Associates Inc. 27 Commercial R/E Loan Add Fee 2015 FARIN & Associates Inc

15 Session Summary Institutions able to evaluate relationship profitability have an advantage over those focusing on loan only. Relationship profitability can still use all relevant market and balance sheet measures. Primary focus is on a single goal ROA or ROE. Can be used for: Pricing individual deals Evaluating relationship pricing strategies on commodity products FARIN & Associates Inc