THC Asset-Liability Management (ALM) Insight Issue 6. Where Asset Liability Management and Transactions Meet. Overview

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1 , THC Asset-Liability Management (ALM) Insight Issue 6 Community banks serve their communities by focusing on customers needs based on each banks core competencies. But customers needs can be diverse. How can a community bank keep their customers when the loan s size, LTV, FICO or other characteristics exceeds the lending policy? This Insight #6 explains. In previous issues, I have discussed the measures of your Risk Capacity, which is then used to enhance profitability by applying the Fund Transfer Pricing (FTP) approach. As FTP illustrates, the profitability is driven primarily by your loan volume and pricing. My last Insight issue outlined an optimal strategy in selling loans to the Agencies. This issue continues this discussion by leveraging participations and 2nd mortgages to keep banks customers. Overview Our bank clients often receive mortgage applications for low FICO score borrowers and/or requests to originate high LTV loans. These customers may be turned away due to stringent underwriting standards as such loans cannot be kept in the loan portfolio or sold to the Agencies. When high LTV loans are originated, the bank will often times require the borrower to purchase expensive mortgage insurance. However, banks can split the loan into 1st and 2nd mortgages, called the A-B structure. The bank may: a) Keep the 1st mortgage which would meet the usual policy guidelines of the bank. The bank may then sell the remaining part of the loan as a 2nd mortgage to other investors. b) Sell the 1st mortgage and keep the 2nd mortgage. While the 2nd mortgage is used as credit enhancement of the 1st mortgage, community banks tend to have limited distribution of their loans. Fannie Mae (Federal National Mortgage Association), Freddie Mac (Federal Home Loan Mortgage Corp), and Federal Home Loan Banks (the Government-Sponsored Enterprises) tend to have strict investor guidelines. Capital market investors, such as hedge funds, tend to require assets with relatively high yields to compensate for credit risk. Today, community banks can gain access to a broad pool of potential buyers ranging from community banks, credit unions, and portfolio managers. The Loan Pricing Matrix provides a local market intelligence, suggesting the rate for different levels of risk (e.g. CLTV and FICO) offered by potential investors. This intelligence allows our bank clients to structure their 1st and 2nd loan packages accordingly. For example, based on the investor market rate, the bank may adjust the optimal credit enhancement ratio and the 2nd mortgage outstanding balance compared to that of the first position loan. (May be helpful to have a specific example, just a thought). A-B Structure a Description Using 2nd Mortgage to Serve Customers: A-B Structure key words: A-B Structure, Loan Pricing, conforming loans, Market Loan Pricing Matrix, 2nd Mortgage THC models can effectively value 1st and 2nd mortgages, using offer rates as inputs. The bank can work with other banks and the loan market to determine the credit enhancement ratio and disseminate the 1

2 investment opportunities to potential buyers. The bank can identify potential buyers, leveraging proprietary database intelligence, which include loan prices, historical loan rate trends, and risk measures. The issuing bank and potential buyers can utilize risk analysis reports to meet ALCO requirements. Loan transactions between buyers and sellers are straightforward single loan, 1st mortgage (the A component ), or 2nd mortgage loans (the B component ). Loan Pricing Matrix used in the A-B Structure To originate loans that exceed the loan policy limits to customers, ALCO may partner with another lender, work with correspondent banks, or with a loan market. In accessing available offer rates of different loan types, ALCO should monitor the market offer rates for a specific loan type from multiple sources of loan investors including Government-Sponsored Enterprises (GSE), correspondent banks, and investors. These rates can be monitored in the Loan Pricing Matrices, which are provided by the THC Loan Central where buyers and sellers negotiated loan transactions within the THC Network. An example is given below is based on Fannie Mae LLPA pricing of credit risk. As discussed in Insight 5, LLPA pricing of credit exposure may not be consistent with capital market pricing. Therefore, ALCO can use the appropriate Loan Pricing Matrix to determine the A-B Structure depending on the buyer of the loans. If ALCO is considering selling the A component to the Agency, then the Fannie Mae LLPA Loan Pricing Matrix should be used to determine the rate of the B component. 2

3 Source: THC Loan Central ALCO and loan officers can use indicative rates to determine the optimal sizes and rates of the 1st mortgage and 2nd mortgage, the A-B Structure. A loan valuation model is used to ensure that the combined interest cost and principal payments are equal to the loan that the customer initially sought. Case 1. Low Credit Borrower The numerical example below uses a range of FICO scores to illustrate the risk and return of the 1st and 2nd mortgages. A customer comes into the office and applies for a loan. The loan is a 30-year fixed rate 1-4 family mortgage. The owner s property is located in a reasonably priced neighborhood and the customer is a longtime resident in the community. The property has recently appraised at $137,500. He is looking to finance $110,000, with an LTV just meeting the loan policy guideline. However, for lack of sufficient credit history, the FICO sore is below 700. The bank considers the borrower a good customer that can develop a long-term relationship and does not want the customer to borrow from another bank, two blocks away. The bank is considering originating a 1st mortgage with a lower LTV to compensate for the lower FICO score. ALCO would buy a loan with a lower LTV to compensate for the lower credit score. The bank can then sell the 2nd mortgage to investors that seek higher yields. The rate can be obtained from the Market Loan Pricing Matrix, as explained above. The table below illustrates how yields are affected by risk-based pricing of second mortgages, providing investors with a higher return opportunity. The 2nd mortgage may be appropriate for investors looking for high yielding assets, or the 1st mortgage can be sold at a price acceptable to buyers and sellers. The credit 3

4 enhancement ratio can be adjusted to fit both the buyer and seller requirements to determine the appropriate level efficiently. In the event the FICO score does not correctly reflect the borrower s credit quality, with compensating factors in the borrowers file (i.e., contesting letter as a result of a divorce, identity theft, etc.), the bank s CFO may simulate multiple credit score scenarios, 650, 680 and 690. The CFO may subsequently estimate the appropriate loan rate for the 1st and 2nd mortgages. The results are provided below FICO Scores Balance Borrower s need $110, % 4.260% 4.040% 1st Mortgage $ 66, % 3.640% 3.640% 2nd Mortgage $ 44, % 5.190% 4.640% The CFO proceeds to originate the 1st mortgage of $66,000 at 3.64% and the 2nd mortgage of $44,000 at 4.640% (690 FICO). The 1st mortgage is kept on the balance sheet and the 2nd mortgage is sold to an investor. The customer receives a loan of $110,000 in total at an average loan rate of 4.040%. Most important of all, the bank keeps the customer. Case 2. A Borrower with High LTV Example Bank is a $500 million total asset community bank in a 200,000-population town in Iowa. The bank has served the community for over 80 years and is an important institution of the community. Today, a longtime customer would like to finance an investment property in the amount of $250,000. The appraised value is $278,000, and the borrower would like to lock in a rate, as he is concerned with the rising interest rates. He is looking for a 30-year fixed rate mortgage loan. The CFO knows the customer well and strongly believes that the customer has good credit. However, considering the high LTV ratio along with the significant size, ALCO is hesitant to keep such a loan on the balance sheet. The CFO then considers two scenarios. The bank can originate a 1st mortgage of $200,000 or $175,000 in scenarios 1 and 2, respectively. Based on the market rates and the Loan Pricing Matrix, illustrated above, and the A-B Structuring calculation, the 1st mortgage rates would be 5.516% and 5.125% respectively. Given the 1st Mortgage rate, the 2nd Mortgage rates would be 8.762% and 8.593% for the two scenarios. By lowering the LTV, he can sell the 1st mortgage to a correspondent bank, while the bank can keep the 2nd mortgage on the balance sheet. 4

5 Example Bank uses the 2nd mortgage methodology, assisted with a risk-adjusted margin approach, to keep the customer and at the same time, receive the yields that compensate for higher credit risk. Benefits of the A-B Loan Strategy Avoid Turning Customers Away This pricing/structuring model can be very useful to banks, particularly if they knew upfront that the 2nd mortgage could be sold. Many banks are reluctant to make high LTV loans due to regulatory capital requirements and exam scrutiny, as well as the higher default risk. Retaining only the 1st mortgage is desirable for risk adverse banks seeking to preserve capital. Minimize regulatory risks with current market practices Splitting the loan request into a first and a second mortgage to avoid mortgage insurance is a common practice in the origination industry. Often a lender will originate a conforming first and a second, sell the first to Fannie/Freddie and keep the second on their balance sheet. The borrower would receive two loans. A-B Structure simply extends this concept to using a flexible credit enhancement ratio, 2nd mortgage to the combined mortgage, such that the bank can retain the 1st mortgage and sell the 2nd mortgage to achieve optimality by seeking potential buyers from more diverse investor pool. (long sentence). Impose minimal operational changes CFOs, chief lending officers and legal counsel often work together in determining optimal product offerings. This includes implementing a A-B Structure. Leveraging current ALM risk models and technologies, the bank would only have to decide whether they want to service the loan or not. Skin in the Game One benefit of the bank servicing both the 1st and 2nd liens is that a default on the 2nd may be an early warning sign of impending trouble for the 1st mortgage. Arrangements can also be made so that the originator shares part of the credit risk. Flexible Strategies Retaining servicing on a 2nd mortgage that has been sold would require the bank to set up a servicing asset, and properly account for the servicing asset over time. Some banks may simply prefer to sell it servicing released. The Market Loan Rate Matrix can assist in structuring the transaction with servicing released or retained. 5

6 Transparency Where Asset Liability Management and Transactions Meet A bank may ask if the 2nd mortgage could be sold individually as they are originated or if they need to be sold as a package of loans. The investor may impose requirements such as minimum loan size and geography restrictions as well as posting price levels they are willing to pay. A bank would want to know such requirements in advance to avoid being required to hold the 2nd mortgage. The Market Loan Rate Matrix can indicate such transactional information, offering transparency for participants. Increase Product Offerings A-B Structure can be useful for both residential and commercial real estate loans. The model can be extended to jumbo loans, which is common in a loan participation. Conclusions Using 2nd mortgage, banks can expand the offerings of loans to customers by leveraging the GSEs and other investors willing to participate. This A-B structure enables ALCO to originate loans and keep customers. I welcome your comments. Regards, Tom Ho PhD President Thomas Ho Company Ltd Tom.ho@thomasho.com About THC THC is a financial technology company founded by Dr. Thomas Ho, a former professor at New York University, who introduced the first balance sheet valuation (Ho-Lee model 1986) called "option model" by regulators and key rate durations (1992), one of the most popular interest rate risk measures. THC was selected as the sole provider of the risk reporting to all regulated institutions under a federal bank regulator. THC continues to dedicate its research and resources to supporting community banks. THE THC CONTENT IS PROVIDED AS IS, WITHOUT REPRESENTATIONS OR WARRANTIES OF ANY KIND. TO THE MAXIMUM EXTENT PERMISSIBLE UNDER APPLICABLE LAW THC HEREBY DISCLAIMS ANY AND ALL WARRANTIES, EXPRESS AND IMPLIED, RELATING TO THE THC CONTENT, AND NEITHER THC NOR ANY OF ITS AFFILIATES SHALL IN ANY EVENT BE LIABLE FOR ANY DAMAGES OF ANY NATURE WHATSOEVER, INCLUDING, BUT NOT LIMITED TO, DIRECT, INDIRECT, CONSEQUENTIAL, SPECIAL AND PUNITIVE DAMAGES, LOSS OF PROFITS AND TRADING LOSSES, RESULTING FROM ANY PERSON S USE OR RELIANCE UPON, OR INABILITY TO USE, ANY THC CONTENT, EVEN IF THC IS ADVISED OF THE POSSIBILITY OF SUCH DAMAGES OR IF SUCH DAMAGES WERE FORESEEABLE 6