WHOLE, LOAN PRICING: Introducing CECL in ALCO Meeting

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1 WHOLE, LOAN PRICING: Introducing CECL in ALCO Meeting Summary THC Asset-Liability Management (ALM) Insight Issue 4 Yield measures are an approximate measure of profitability. Value measures have direct applications to transactions and provide a holistic methodology to assist in profitably, managing both long term interest rate risk and credit risk. Loan profitability varies when selling to the agencies because both the G-Spreads and the LLPA are only approximate measures of risk. Banks should select loans to sell to the agencies to maximize profits. CECL is an important component of loan value. For this reason, CECL can be used to facilitate transactions between buyers and sellers of whole loans. The analysis clearly shows that the combination of typical agency loan pricing and investors TBA (MBS) pricing create significantly better opportunities for banks to transact whole loans among themselves. Introduction FASB introduced Current Expected Credit Loss (CECL) on June 16, American Bankers Association (ABA) CECL Backgrounder June 2016 remarks: "the new standard represents the most sweeping change to bank accounting ever." By introducing the life-of-loan concept to financial accounting, CECL methodology has moved the banking industry toward fair value accounting. This is another major step away from book value accounting. The credit risk under CECL will be measured in economic value and not the current ALLL measure that is almost indifferent to the prevailing market conditions. For these reasons, CECL will be an important component of the regulatory reports such as Economic Value of Equity (EVE) report and Net Economic Value (NEV) report. Incorporating financial accounting to market risk reporting has tremendous implications to asset-liability management. The Asset-Liability Committee (ALCO) meetings will need to evaluate the bank s or credit union s market risk and credit risk exposure as an integral part of the projected earnings discussion; interest rate risk and credit risk will be inseparable in reporting earnings. I believe implementing CECL is not a cost, but a benefit to banks. The purpose of this paper is to explain the benefits of adapting CECL methodology in your ALCO decision making processes. In today s dynamic, but uncertain banking environment, I believe this will clearly help you enhance your institution s capital, Net Interest Income, and loan origination pricing. As an example of applying CECL to ALM, this paper will discuss a CECL-based ALM approach, which I refer to as the Value Attribution and Yield Attribution Model. I will then apply the model to analyze a sample loan portfolio of a bank. 1

2 The value attribution and yield attribution models are derived from a set of established and widely cited models including Ho Lee Interest Rate model, Dunsky-Ho Prepayment Default model (also described in FHFA Mortgage Analytical Platform) and Ho -Stoll Dealer Bid-Ask Pricing model. Extensive descriptions of these models are available in public websites for readers reference. Value Attribution and Yield Attribution Historically, earnings have primarily been evaluated on net interest income using $ value and the margin between the loans effective yield and the funding rate using %. In the ALCO process, the yield and $ value measures are used together to measure revenues. For example, the income of a 30- year fixed rate mortgage can be quoted as 3.5% rate with a one-point fee as opposed to a mortgage of 3.6% with no upfront fee. Government Sponsored Enterprises (GSE) charge for a G spread in rate (%) while adding the Loan Level Price Adjustment (LLPA) in value ($). The conversion between rate and value is expected to be done by institutions, even though the conversion is far from simple. Also, while banks use price convention to transact, much of ALCO management decisions are based on rates in percentages. How should ALCO evaluate the credit charge of loans? If all loans and funding sources are simple bullet payments, then the use of yields (or rates) is somewhat tractable. However, most loans are not bullets, and converting fees to rates is simple only if community banks and credit unions are willing to make approximations. Indeed, capital market participants exploit these approximations to profit in market transactions. Credit risk can illustrate the problem in mixing of rate and $ value in ALM. The current ALLL approach reports the expected annualized charge off as a rate, even though the balance sheet is $ valuebased. In fact, CECL is introduced with a life-of-loan principle, in part, to remedy this problem. Also, the credit charge should relate directly to profitability. I have discussed many deficiencies using yield as profitability measure elsewhere. For example, there are significant problems with the yield measures for hybrid ARMS, such as 10-1, 7-1 and others as the project interest rates affect the repricing of these loans and hence the yield measure. Also, the prepayments of loans results in mismeasurements of yields. Furthermore, yields cannot capture the life-of-loan concept. Economic Value of Equity, a regulatory interest rate risk measure, was introduced to capture the long-term interest rate risk to augment the Earnings-at-Risk report that uses a short-term horizon. Likewise, CECL is introduced to make sure that the long-term credit risk is captured and incorporated in ALM. For these reasons, ALCO decisions should use rate and value interchangeably based on robust models. The ability to relate value and rate accurately and with one consistent methodology enables institutions to originate loans or execute any transactions more profitably. The tools used to present profitability in rates or value are yield attribution and value attribution. Yield Attribution Consider a whole loan based on the THC whole loan valuation model using a multi-factor prepayment-default model. The rate of a mortgage loan at origination can be decomposed as presented below. Yield attribution decomposes a reported yield to the rates of all the economic components of a balance sheet instrument. 2

3 YTM time value Yield Attribution (%) option spread credit spread clean OAS YTM is the yield to maturity or the loan rate at par. The time value is the funding rate. Option spread is the additional rate to compensate for the extension risk or prepayment risk of a loan. The credit spread is the estimated net loss rate. The clean option-adjusted spread (Clean OAS) is the residual of YTM after netting the three cost components. Clean OAS represents the profit released annually to the bank. The use of yield attribution for asset-liability management is explained in THC Research. Value Attribution The value of a loan or portfolio of loans is decomposed into the values of all the economic components. Consider the following examples of fixed rate 1-4 family owner-occupied whole loans. The components of the attribution are explained below, using the first whole loan, 30-year FRM at 3.875% for illustration. All values are based on 100 par and the valuation is based on July 21, If the loan is valued as a bullet loan, like a bond based on a benchmark curve, say the Treasury curve, then the loan would be valued or a premium of The bank may sell the servicing fees. The value of the servicing fees is the Mortgage Servicing Right (MSR). The value is The loan CECL is which has to be deducted from the premium to isolate credit risks from profitability. Based on the option-adjusted spread (OAS) estimated from the TBA MBS market, the investors required profit of an equivalent TBA pool in the capital market is The premium net of all the cost components is the loan excess profit. The loan excess profit is the profit additional to that required by the capital market, and in this case, the excess profit is (= ). Loan excess profits enable ALCO to understand a relative valuation or profitability of the loans. 3

4 Table A. Value Attribution of a Loan from a Bank s Perspective in Loan Pricing Loan Term Note Date Loan Rate MSR Price b m a Ba P c v Profit when Ba CECL priced as excess profit TBA to TBA total premium 30 11/03/ % /05/ % /17/ % /23/ % The loan excess profit can be used to determine the relative profitability of each loan, including loans to be sold to the agencies. The value attribution table enables ALCO to make an apple to apple comparison when evaluating the merits and demerits of each loan. Whole Loan Transaction: an Application on Value Attribution Value attribution is particularly important in any transaction, and valuation is often established through the arbitrage process of the capital market. Capital market participants seek to buy low and sell high almost instantaneously. I will first describe the GSE arbitrage pricing process. Government Sponsored Enterprise (Fannie and Freddie Agencies) Loan Pricing These agencies buy loans from loan originators and sell them as mortgage-backed securities. Therefore, the agencies loan pricing must take the capital market s required return into consideration when determining the loan bid price to the loan seller. Further, the agencies must charge the loan seller for the following items: Guarantees for the credit risk of the loans. The agencies provide an implicit guarantee against any credit loss for the investors of mortgage-backed securities Capital charge. Even though the capital ratios are very low at the agencies, the capital charge is significant. Federal regulation restricts the US Government from infusing capital to the agencies. However, a line of credit is provided to support the operations of the agencies, resulting in an additional capital charge. Operating costs. Operating costs include transaction fees, interest rate risk and liquidity risk management and required profits to the shareholders. These charges are G-Spreads in % and LLPA fees in $ combined. Based on these costs, the agencies provide whole loan sellers non-negotiable bid prices. The Value Attribution Table B below illustrates the arbitrage between the bid price for sellers and the ask price for the capital market investors. 4

5 Table B: The value attribution on arbitrage pricing Price Attribution for Ag c Price for Loan Sellers Loan Term Note Date Loan Rate G-spread Investment Profit loan profit total premium 30 11/03/ % /05/ % /17/ % /23/ % Arbitrage Pricing The loan profit ensures the loan originators supply the loans. The investment profit ensures that the securities can be sold to the capital market. The G-spread pays for the cost of risk transform and payments to the stakeholders. Application to Whole Loan Transactions Value Attribution can be used profitably for whole loan transactions. While whole loan transactions have gathered much attention among banks and credit unions in today s market environment, the crucial impediment for buyers and sellers is to agree on a transaction price. Price discovery is always an important aspect in market formation. Extensive academic literature has been devoted to the subject called Microstructure Theory where I was one of the early contributors to the research in co-authoring the Ho- Stoll model that studies the bid ask quotes of dealers. By studying formation of bid and ask prices, instead of the transaction price, the model can provide a useful tool in submitting bid or ask prices to the market or to counter-parties. The bid and ask quotes must, in turn, be determined by the reservation bid and ask prices. The reservation bid price of the buyer is the highest price that the buyer is willing to pay. The reservation ask price of the seller is the lowest price that the seller is willing to sell. A necessary condition for any transaction to occur is that the seller s reservation ask price has to be lower than the buyer s reservation bid price. The Trade Margin is defined as the reservation bid price net of the reservation ask price. When the trade margin is positive, buyer and seller can find a transaction price that both sides can profit from. Otherwise, a transaction is not possible. Reservation Bid Price Buyer s highest bid price Reservation Ask Price Seller s lowest ask price Trade Margin Buyer and seller can find a transaction price in this region that both side can make a profit 5

6 Determining the Trade Margin and the Fair Transaction Price I will use the Value Attribution analysis of the sample fixed rate mortgage loans to illustrate the determination of the reservation bid and ask prices of the seller s servicing retained loans. The figure below depicts the formation of these prices. The seller s calculation and the buyer s calculation are on the left and right respectively. Since the agency s bid price determines the seller reservation price, I label the bar Agency. Consider the value attribution of an average of a sample of fixed rate mortgages from an institution s loan portfolio from the buyer s and seller s perspectives in Table C below. Table C a. Value Attribution of the Loan from the Buyer Perspective P c b m a Ba P c v Loan Term Note Date Loan Rate MSR CECL Investment Profit Loan Excess Profit Total Premium 30 11/03/ % Table C b. Value Attribution of the Loan from the Seller Perspective Loan Term Note Date Loan Rate Price Attribution g c P c L a S ll G-spread Investment Profit Loan Profit Total Premium 30 11/03/ % Table C c. Comparing the Reservation Prices Reservation prices are the loan excess profit plus par. Total Premium MSR CECL G-spread Investment Profit Loan Excess Profit Reservation Prices Average (1) (2) (3) (4) (5) (6)=(1)-(2)-(3)-(4)-(5) (7)=(6)+100 Bank (seller) Bank (buyer) As explained above and referring to the figure below, starting from the premium (a), after deducting the investor s required profit and the G- Spread, the agency would be typically quoting a premium to buy from the bank. For this particular example, using all the information of this particular loan, THC model calculates the agency bid price to the loan originator to be (= net premium). In this case, the Net premium = Total Premium Investment Profit- G-spread ( ) = 1.372, which I also call the loan excess profit. Therefore, the loan seller would not sell the loan for less than to another investor because the seller can always sell to the agencies. Hence, , in this case, is the seller s reservation ask price. Now I consider the buyer s calculation. Often a secondary market loan purchase is viewed conceptually as an investment in the ALCO meeting. A whole loan purchase is basically an investment, except that the 6

7 purchase goes through the bank s loan origination process and the transaction is not regulated by FINRA as a securities transaction. For this reason, an alternative to buying whole loans for the buyer would be purchasing TBA (MBS) securities. Referring to the figure below, starting from the premium (a), the buyers would deduct the investor s profit because the buyer would need to lower the price to receive the profits if he/she would buy a TBA with the same underlying mortgage loans. The buyer then marks down the bid price for CECL. Since the loan is seller servicing retained and will not receive the fee income, the loan again is marked down for the mortgage servicing right (MSR) value. The reservation bid price is therefore Reservation Bid Price is = (Par +Total Premium Investor s Profit CECL MSR) or ( ) = The Trade Margin is established to be any transaction price between and These reservation prices, of course, are determined based on a set of assumptions. The buyer may need to adjust the MSR and CECL based on the ALCO s estimates and not the THC model. Likewise, the seller may also adjust the ask price. However, since the THC mortgage loan valuation model is based on objective industry data, both the buyer and seller can use the THC model calculated reservation prices as benchmarks to set their respective prices. Given the objectivity of the THC model, a fair transaction price can be the mean of the two reservation prices without being seller or buyer biased. In this example, therefore the fair transaction price is The Trade Margin is (= ). I have calculated the indicative Trade Margin recognizing that there are other issues that have been ignored for clarity of exposition. For example, the mark up and mark down of the Agency pricing and other factors. On average, I believe, these effects do not affect the estimated Trade Margin in a consequential way. Conclusions This paper introduces the yield attribution and valuation attribution based on CECL as an analytical tool to convert the rate measure to and from the fair value measure. These tools can be used in many ALM decisions. This paper describes on application: whole loan transactions. Current Expected Credit Loss (CECL) will have significant impact on financial institutions asset-liability management. While the life-of-loan concept ensures economic valuation is used for financial reporting, I believe the impact of CECL will have broader impact on ALM, including loan origination, pricing, purchases, and sales. This subject I will discuss in the next THC ALM Insight. 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