Profit Model Details Explained
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- Gerald Lawrence
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1 Profit Model Details Explained Using the Details link while in the profitability model, you generate a spreadsheet with sections described in the example below. The sample loan used is a $40,000, 4.25% 7 year amortizing loan with origination and servicing expenses. Summary Results Retail Investment 1.238% This measures the spread between loan yield and an equivalent wholesale investment after adjusting for the retail risks and cost incurred in a retail loan product. A negative spread indicates you may earn a better return in the wholesale investments market. The Investment s section describes the derivation of this spread in detail % This measures the spread between loan yield and an equivalent wholesale investment without considering the retail risks and costs. It indicates whether you are better off with a loan vs an investment while ignoring the additional costs of a retail loan. ROE 14.82% Return on equity is calculated as Avg Annual Horizon Income divided by allocated capital. Allocated capital is Avg Net Principal times the capital requirement of this loan (10% in this example). ROE Target 10.00% This is the institution policy setting for either ROA or ROE target. If the calculated values exceed the target they are displayed in green. If not they are displayed in red. ROA 2.96% Return on assets is calculated as Avg Annual Horizon Income divided by Avg Net Principal. Avg Annual Horizon Income Avg Net Principal $468 This is the total FTP dollar income over the horizon divided by the number of years in the horizon. The profit calculation horizon is an institution wide setting and is typically set to three years. However if a term instrument is shorter than the horizon, than the shorter term is used. The Horizon Income section describes the derivation of this income number in detail. $15,792 This is the average principal balance of the loan over the horizon period and is calculated by averaging the outstanding principal at the end of each month after taking amortization and prepayment into consideration. Market Value This is the calculated market value of the cash flows relative to par of 100. It is calculated by pricing the cash flows relative to the investment benchmark curve and coming up with a present value. The cash flows considered are principal and interest cash flows as well as the net cash flow from fees minus operating expenses. The discount rate curve used is the investment benchmark curve adjusted for credit risk and additional option risk Investment s Risk Free Rate 0.431% This is the current rate of the shortest term instrument on the risk free benchmark curve in this example it happens to be the Indexed Agency Bond curve as of 8/31/2010. This is the closest investment proxy to an instrument with no interest rate risk nor any option risk. Farin iprice Profit Model Details Page 1 of 5
2 + Int Rate Risk = Risk Free Match + Option Risk = Investment + Credit Risk + Expense + Add l Option Risk = Retail Equiv Wtd Loan Yield to 1.063% This is the spread between the Risk Free Match rate and the Risk Free Rate. It represents the interest rate risk inherent in the risk free benchmark curve. (Method: Risk Free Match Risk Free Rate) 1.494% This is the weighted average of the rates in the risk free benchmark curve. The rates are weighted by the size and timing of the principal cash flows. Thus the combined rate represents the rate of return on the series of principal cash flows over the term of the loan priced off the risk free curve. (Method: IRR of the RiskFIRR column of the amortization schedule.) 0.000% This is the spread between the investment benchmark rate and the risk free match. It represents the option risk embedded in the spread between the two curves. (It of course will be zero if both the risk free and investment benchmarks are designated as the same curve in the account s characteristics) 1.494% This is the weighted average of the rates in the investment benchmark curve. It represents the return on the series of principal cash flows priced off the investment benchmark curve. (Method: IRR of the MatchIRR column of the amortization schedule.) 0.600% The annualized credit risk expense (loss ratio). This value comes directly from the account characteristics, or any overridden value in the profit model screen % The annualized operating expense ratio. This is calculated by combining all of the origination and servicing expenses that may be setup for the sector or account (whether in dollars or percent), and then annualizing the rate relative to the principal balance % This is the option risk adjustment cost if specified in the account characteristics. This will typically have a value in it if the risk free and investment curves are set to the same curve, and therefore we don t use the automatically calculated option risk adjustment described above. See the section on Option Risk Methods in this section for more on the option risk cost methods % This represents the equivalent rate that has to be earned with a loan order to be better off than investing in the wholesale market (as represented by the investment benchmark curve). This benchmark is calculated by taking the Investment rate and adding the credit, expense, and option risk costs to it. In other words, a loan has to earn the same as an equivalent investment in addition to covering its credit, operating and option risk costs % The effective loan yield after considering loan fees. In the absence of fees, this will be the same as the offer rate, or in the case of adjustable rate instruments, the weighted offer and repricing rates % This is simply the difference between the Loan Yield and the Retail Equivalent. It represents the spread the loan earns over an alternative investment plus costs. Option Risk Methods Option risk represents the costs associated with the fact that with most loans the cash flows are not certain. Options are features in a loan contract that allow the consumer to change loan characteristics when it is to their advantage to do so. The most obvious example is the prepayment option in most consumer amortizing loan contracts which gives them the ability to reprice their debt when general market conditions make that favorable (e.g. when rates drop). In that case, the Farin iprice Profit Model Details Page 2 of 5
3 option risk represents the potential loss of spread to the institution when loan principal is rebooked at a lower prevailing market rate, but where funding costs (deposits and borrowings) may not respond as quickly. In the absence of a prepay feature, a loan contract is somewhat more valuable to the holder of the paper, since it is easier to predict the future cash flows in particular the interest flows. So the option risk rate or cost represents the price that a market charges in exchange for providing that option. In the case of a financial institution holding many kinds of contracts, an option risk spread can be considered a fee that covers the cost of hedging or insuring that future rate changes are not as detrimental to the institution as they otherwise would be without that fee included in a rate. Note that with most term deposits, like CDs and IRAs, there is already an explicit fee charged for the option to terminate the contract early the early withdrawal penalty. In the iprice model, we calculate an automatic option risk cost adjustment as the difference between the investment benchmark rate and the risk free benchmark rate. But this method does not always calculate an appropriate rate. It is an appropriate rate only when a) the risk free and investment curves are different curves and b) the investment curve represents cash flow characteristics that are similar to the loan you are pricing. For example, if the US Treasury curve is specified as the risk free curve, it represents a series of semi-annual payment bullet bonds (with very little default risk). For mortgage loans, an appropriate investment benchmark would be an agency security that has equivalent credit and liquidity risk to Treasuries (e.g. virtually none), but will have a spread due to the fact that it costs that agency something to hedge its interest rate risk since the underlying collateral (mortgage loans) have embedded options. In the past we would recommend an agency investment curve, but since the crisis of 2008 we now know that those curves have option risk, liquidity risk, and in many cases significant credit risk embedded in them. So using them would calculate an option risk adjustment that was too high. In today s world we recommend setting the risk free and investment curves the same, and using the additional option risk feature to set the option risk cost. The advantage of this approach is we are not relying on curve selection to give us an appropriate option risk. The disadvantage is that it can be very difficult to specify an option risk that is appropriate for your institution. We have some global recommendations available in the model for auto and mortgage loans, and those are the numbers that appear in the addition option risk cost sections when you select one of those. But any number can be used simply by entering it in account characteristics. RAROC (Lifetime) The RAROC section calculates the rate of return on required capital using an FTP based approach to profitability. Briefly, an FTP model calculates a loan s profitability by assigning funding costs based on wholesale alternatives, not based on any actual institution cost of funds. The FTP approach effectively separates the performance of the lending function from the deposit gathering function by insuring that any spreads generated by loan income do not benefit from an effective deposit gathering operation. Note also that RAROC calculations are for the lifetime of the loan, as opposed to the horizon calculations we use in ROE and ROA numbers. Wtd Loan Yield 4.250% The effective loan yield (before considering loan fees). With fixed rate loans this will be the same as the offer rate. In the case of adjustable rate instruments, the weighted offer and repricing rates. +Wtd Fees 0.000% The effective rate of any loan fees included. Farin iprice Profit Model Details Page 3 of 5
4 -Wtd Fund Bench 1.374% The weighted cost of funding a key FTP component. This number is determined by calculated the rate of return on all principal cash flows priced off of the specified funding benchmark curve (typically a FHLB borrowing curve). -Option Risk 0.250% This is the total of calculated option risk (Option Risk from the benchmarks section) and additional option risk. Typically only one of the option risk numbers will have a value. -Credit Risk 0.600% The annualized credit risk expense (loss ratio). This value comes directly from the account characteristics, or any overridden value in the profit model screen. -Expense 0.667% The annualized operating expense ratio. This is calculated by combining all of the origination and servicing expenses that may be setup for the sector or account (whether in dollars or percent), and then annualizing the rate relative to the principal balance. = 1.358% This is the spread, before tax, between what we earn on loan yield and the costs. Costs are simply the total of funding benchmark, option risk, credit risk and operating expenses. -Tax The income tax rate, for taxed institutions. This number comes from the institution settings. = After Tax 1.358% / Cap Req % This is the specified capital requirement for the loan, which comes from the loan product characteristics. = ROE (RAROC) % The RAROC ROE return is simply the after tax spread rate divided by the capital requirement. It estimates the return on equity over the lifetime of this loan. ROE Target % This is the target or policy return as set in the institution properties. ROE 3.585% The difference between RAROC ROE and the target. If positive it indicates that we are earning an above target ROE using the FTP method. Horizon Income Interest Income $2685 The dollar amount of interest earned during the horizon period. + Fees $0 The dollar amount of fee income collected during the horizon period (including origination fees of course). -Fund Expense $708 The funding expense in dollars. It is calculated as the funding expense of the principal remaining balances during the horizon, using the funding benchmark curve. -Option Risk $158 The option risk expense in dollars during the horizon. It is calculated by applying the option risk expense rate to the remaining principal balances for each period. -Credit Risk $379 The credit risk expense in dollars during the horizon, calculated by applying the credit risk rate to the remaining principal balances for each period. -Oper. Expense = Net Income B4 Tax $504 The dollar amount of operating expenses during the horizon. The calculation method depends on how the expense categories are designated as they can be specified in dollar costs or as percentage rates (of principal). $936 The dollar before tax income; the sum of the fees minus expenses documented above. Farin iprice Profit Model Details Page 4 of 5
5 -Taxes $0 The dollar amount of taxes; simply the tax rate times net income. = After Tax Net Income Avg Net Principal $936 $31,584 This is the average principal balance of the loan over the horizon period and is calculated by averaging the outstanding principal at the end of each month after taking amortization and prepayment into consideration. Farin iprice Profit Model Details Page 5 of 5
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