Loan Profitability Report and Applications key words: return on investment, ALCO, RAROC, loan pricing

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1 , Loan Profitability Report and Applications key words: return on investment, ALCO, RAROC, loan pricing THC Asset-Liability Management (ALM) Insight Issue 8 Introduction Loan portfolio profitability is a key concern in ALCO meetings, particularly in our current rising interest rate environment, along with the introduction of CECL and the growing liquidity in the secondary loan market. This Insight #8 introduces a profitability measure that allows ALCO to compare the profitability of loans on the balance sheet, those being offered to customers, or offered in secondary market. Furthermore, ALCO can benchmark the loan profitability against prices offered by Fannie Mae, Freddie Mac prices and other investors. By making use of the secondary loan market, ALCO can enhance performance by employing multiple balance sheet strategies, such as reviewing concentrations, using 1 st and 2 nd mortgage lending by keeping one on the balance sheet and selling the other to meet customer s needs, and extending the traditional participation practice by accessing a broader network of bank participants. The purpose of this Insight #8 is to describe how ALCO can leverage the profitability measure to make actionable decisions. The Lending Profitability Model ( The Model ) is an integral part of a comprehensive ALM application. The Model determines the profitability of originating or transacting whole loans. It seamlessly interfaces with margin management and the loan secondary market. Using capital market best-practice valuation models, the Model analyzes the profitability of a broad range of loan types including 1-4 family residential 1 st and 2 nd mortgages, multi-family, commercial real estate (CRE), auto loans, agricultural loans, HELOCs, and consumer loans. Profitability models are important because they enable ALCO to make informed decisions about loan product offerings and secondary market transactions by addressing the following questions: Credit-based Internal Pricing for the Loan Rate Sheet: Which loan products have sufficient risk adjusted return on investment? ALCO Negotiation Guideline for Loan Officers: How much rate or floor rate concession can the loan officers accommodate customers demand? CECL Credit Box Pricing: How to use Current Expected Credit Loss (CECL) for loan pricing? Structuring Loans for Customers (A-B Structures): How to decide which loans to keep or sold to GSEs or secondary market? 1

2 The Model addresses these questions by determining the return on investment when purchasing or originating loans. The return consists of the lending and funding contributions to profit, whereby the funding is provided by retained earnings, deposits or borrowings. The return takes into account market realities, including the yield curve shape, option cost, expected and unexpected losses, capital allocation and the allocation of fixed and variable costs. The Model has comprehensive factors to specify loan profitability and the valuation method is consistent with capital market pricing. A federal bank regulator, Federal Housing Finance Agency (FHFA), has offered a guideline in Acquired Member Asset Price Risk Governance, Advisory Bulletin AB : 1. Should adopt an Option Adjusted Spread ( OAS ) approach to measure profitability when purchasing loans. Using the OAS approach is not because FHLBs have different loan types but because the OAS approach, as opposed to a static approach, is an appropriate methodology for the purpose of measuring profitability. [4] 2. The OAS can be determined as a spread off a liquid curve, such as LIBOR or Treasury, and then adjust the underlying curve for the differences between the CO* curve and the curve used. 3. Minimum Expected Spreads for Pricing Guidance acquisition prices to ensure the resulting expected spread to funding covers its costs and provides adequate compensation for the risks assumed, eg option, interest rate, credit, and model risks. *CO is the consolidated obligations, the funding rates. The Model follows the three salient features recommended by FHFA guidelines when analyzing loan purchase profitability: (1) use of Option Adjusted Spread ( OAS ) approach; (2) use Treasury or LIBOR as the Fund Transfer Pricing ( FTP ) curve to separate Lending Contribution and Funding Contribution in profitability; and (3) include expenses and adequate compensation for risks. By way of contrast, some of the commonly used methodologies, such as Net Interest Margin ( NIM ) and the Static Cash Flow Model, are inadequate to determine loan profitability under current competitive market conditions. NIM is defined as the spread between the loan rate and funding rate; however, NIM fails to include many items related to profitability, such as option cost sold to customers and credit risk premiums across loan types. These items vary significantly across loan types and must be modeled to ensure accuracy. The Static Cash Flow Model is another means of measuring profitability. The Static Cash Flow Model extends from an accounting approach by considering one proforma scenario to estimate NIM, as explained above, and then identifies the profits from the decomposition. The model does not incorporate the prevailing market conditions, market-determined credit risk premium, model-based prepayments or customers behaviors. For example, this method cannot compare the profitability of a 5-1 Adjustable Rate Mortgage ( ARM ) with caps and floors and a 15-year Fixed Rate Mortgage, as the complex cashflow characteristics of the ARM defies the use of a standard discount cashflow model. As a result, the estimated values of the components tend to depend significantly on the ALCO inputs and would not be consistent with the interest rate and credit models of the asset-liability management process in general. 2

3 The Model does not have the deficiencies of these models described above. The Model maintains consistency in measuring profitability across a broad range of loan types and can appropriately compare loan profitability with those loans transacted in the secondary market, such as the Government Sponsored Enterprises ( GSE ) loan purchase programs and other loans offered by market participants. Furthermore, the profitability measure compares a loan s return to the bank s target Return on Equity ( ROE ). For these reasons, the Profitability Model results are used within many ALM functions. ALCO Loan Profitability Report The Model first determines the profitability of a loan by aggregating the profit contributions from lending and from funding separately and subsequently netting the variable costs and taxes. Then, the investment return is calculated based on the bank s economic capital. This return is referred to as the Loan Risk Adjusted Return on Capital ( RAROC ). This methodology enables ALCO to evaluate the RAROC of loans, ensuring that the purchased loans can enhance the bank s Return on Equity ( ROE ), optimize loan pricing, secondary loan transactions, meet customers requirements and augment fixed and variable cost allocations. Figure 1 presents a sample of the Profitability Report, showing the Loan RAROC and the components of the returns. The report enables ALCO to compare profitability of their products with competitors and secondary market loans and examine the underlying assumptions in pricing the loan. The left-hand side axis is yield (%) of each component of the loan profitability. The right-hand side is the Risk Adjusted Return on Capital (RAROC%). Figure 1. Profitability Report 3

4 Referring to Figure 1, the blue line shows the the loan return, adjusting for the servicing costs of both fundings and loans and for the indirect cost borne by business units to support the products. Also included is the cost of managing the interest rate risk gap between the loans and funding. The Loan RAROC is the return on the economic capital that reflects the risk appetite of the bank and the credit risk of the loans. For example, the results show that the direct new auto loans have the highest returns even after adjusting for their relatively high credit risk. The Lending Contribution has isolated the expected credit losses using the valuation model. It is worth noting that funding is an important contributor of returns for all the loans. If the hurdle rate of the bank is 6%, then all the loans are profitable in this example, as all the loans have RAROC exceeding the hurdle rate. When applicable, ROE can be used as the hurdle rate. The following examples illustrate the importance of using an accurate profitability model. Without an accurate profitability model, the use of a profitability measure would be limited and may even systematically adversely bias the bank s ALM strategies. Credit-based Internal Pricing for the Loan Sheet ALCO can use the profitability model to optimize the offer rate/volume tradeoff of each loan product based on the risk adjusted returns. The Profitability Report shows the Loan Risk Adjusted Return on Capital with relative profitability for each loan type, enabling ALCO to decide on the most profitable loan types given the credit risk characteristics. When the profitability model does not measure credit risk accurately, the portfolio concentration risk can be biased. For example, an accurate profitability model would be able to allocate the relative volume growth between Commercial Real Estate ( CRE ) and 1-4 Family residential loans with customers options taken into account, even though CRE typically has higher yields than conforming residential mortgages. Without an accurate model, allocation to CRE may become sub-optimal. ALCO Negotiation Guideline for Loan Officers When pricing each product, ALCO must take the bank s risk appetite into consideration. The Profitability Report provides transparency, identifying the yields allocated to compensate for the credit risk at the loan level. The results enable ALCO to simulate alternative loan rate concessions that loan officers can offer to meet customer requests. The tradeoff between customer relationships and pricing is complex and multi-faceted. However, a transparent and accurate reasoning behind the loan pricing can provide invaluable inputs to the discussion and decision-making process. Trade-offs in meeting customer demands and the bank s profitability would more readily exist. CECL Credit Box in Loan Pricing Many banks provide a prespecified loan rate based on a credit box. This can be based on the borrower s credit, LTV, term, and other characteristics. Without a systematic methodology, the impact of changing market sentiments could not be correctly modeled across the loan types. For example, the loan rates across the product line should respond to a rate rising or economic cycle down turn scenario in a correlated way; the profitability model should be able to capture this complex correlation relationship. 4

5 The credit risk will soon be calculated by the FASB s Current Expected Credit Loss ( CECL ) requirement. The Profitability Report provides the credit spread of each loan type. The present value of the credit spreads for the life of the loan is CECL. Therefore, CECL should be appropriately included in the loan pricing and should also be consistent with financial accounting rules and ALCO risk analyses, including interest rate risk, prepayment risk, and callability of the loans. Structuring Loans for Customers (A-B Structures) The Profitability Report also provides the secondary market pricing of a sample (or pool ) of loans, such as FNMA offer prices for conforming loans. When the investor s offer price is lower than the bank s risk adjusted price, selling the loan to investors can be more profitable than holding the loan on the balance sheet. Using RAROC of secondary market loans, the bank can optimally structure 1st and 2nd mortgages for a borrower, such that one of the two loans can be sold to the secondary market while keeping the other loan on the balance sheet. When the profitability model is not consistent with the pricing in the secondary market, then ALCO will have difficulties in many secondary market activities. For example, swapping mortgage-backed securities to residential whole loan mortgages. Therefore, ALCO can use the Profitability Report in four aspects of loan pricing. (1) evaluate a risk-based loan pricing strategy; (2) formulate negotiation strategy in lending; (3) generate the credit box for non-negotiable loan rate sheet and ensure consistency with CECL FASB accounting and interest rate risk regulatory requirements; and (4) use the secondary loan market to meet customers needs. Model Methodology The Model differs from the standard approaches in three important ways. First, the Model uses the standard capital market interest rate yield curve generator, called the Arbitrage-Free interest rate model. The Model uses over 1,000 interest rate scenarios to determine the net interest income for all scenarios and the prevailing yield curve shape to capture the impact of rate movements on loans. This is important because banks portfolio optionality and credit risk are defined and separated out within the loan return, rather than using an approximation without basing on an option pricing model. Second, the Model calculates the loan profitability and funding cost separately, interest rate risk gap between the loans and funding. This approach can clearly identify the profitability attributed to the loan pricing, and have it isolated from funding strategies. Third, the Model is an integral part of a comprehensive ALM solution. The methodology follows a 3-step process: Step 1. Lending Contribution The Model utilizes the banks loan types and loan rates to calculate the Lending Contribution, which is the Risk Adjusted Margin ( RAM ) or commonly referred to as the Clean Option Adjusted Spread ( COAS ) in capital markets. RAM is the net interest margin that is isolated from servicing fees, the expected credit loss and embedded borrower s option cost. The RAM funding rate is calculated based on the ALCO s simulated 5

6 rate scenarios of the benchmark curve, the Treasury curve or the LIBOR/swap curve. For this Insight #8, this curve is called the FTP curve. Step 2. Funding Contribution The Model uses the Bank s deposits and borrowings to calculate the weighted average cost of funding and servicing cost. The Model then calculates the Funding Contribution, the contribution to the margin from funding in relation to the Fund Transfer Pricing Curve. Step 3. Operational Expenses and Provisions for Taxes Step 1 and 2 derive an accurate margin of a loan purchase. Step 3 derives the operating profit by taking operating expenses into account. The bank can use the Trial Balance and the Contribution Margin Ratio to specify the variable costs from the non-interest expense per dollar unit of loans. The two items are deducted from the lending and funding profits to derive the loan returns. The first term is the Indirect Cost, which is all the variable costs net of the direct servicing fees, because the direct servicing fees have been considered in the Lending and Funding Contributions. The second term is provision for taxes based on the marginal tax rate. This three-step process derives the return of a loan purchase. This return is then used to determine the Loan RAROC based on the equity ratio and the loan s CECL. RAROC is a commonly used methodology in determining profitability of business units for a bank. But this Insight #8 focuses on the profitability of loans. Therefore, the RAROC methodology is adapted for the loan profitability purpose by defining the Economic Capital differently, namely as the sum of equity ratio and CECL%, which is defined as the CECL as a percent of the loan value. The use of the equity ratio enables ALCO to evaluate the loan profitability benchmark against the bank s target ROE. In summary, this Insight #8 describes each driver of loan profitability. Figure 2 summarizes how RAROC takes the operating leverage, efficiency ratio, and contribution margin ratio, into consideration. The profitability measures in Figure 1 are derived in the worksheet of Figure 2 below to provide an explanation of the profitability measure calculation. 6

7 Figure 2. FRM 30-year Loan RAROC Calculation (unit in %) Where Asset Liability Management and Transactions Meet Conclusions The Model identifies the Loan RAROC components based on financial valuation models. The Model calculates the Lending Contribution and the Funding Contribution, both of which are the main contributors of profits. Other components considered are Indirect Costs, provision for taxes, and economic capital, which have to be minimized to enhance profitability. Using the components relevant to profitability, the Model calculates the Loan Risk-Adjusted Return on Capital (RAROC) to determine the relative profitability of each loan product. RAROC can then be compared to the bank s ROE. Loan RAROC can be used to determine the marginal contribution of bank profits in originating or purchasing a loan. I welcome your comments. Regards, Tom Ho PhD President Thomas Ho Company Ltd Tom.ho@thomasho.com

8 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 8