Applied Loan Pricing Session 1 Thomas Farin President tfarin@farin.com 1 Applied Loan Pricing Four Part Series Homework case assignments on iprice Loan Pricing Model (LoanEdge) between sessions and after Session 4 Welcome to model your own loans if you wish Session 1: Inputs and Investment Benchmark Session 2: Four potential models for pricing loans Session 3: Pricing commodity loans Session 4: Pricing deals and relationships 2 1
Session 1 Key Loan Pricing inputs Cash flow characteristics Interest rate risk Credit risk Servicing cost Option risk Crunching the numbers Funding and investment alternative matching methodology Investment benchmark analysis Homework assignment 3 Who Sets Loan Rates 30 Years Ago Rate Setters Big Local Banks Big Local Savings Institutions Pricing Models Cost plus Funding - deposits Price off Competition Smaller banks, savings institutions, credit unions More Recently Rate Setters Mortgages Freddie & Fannie Auto Loans Captive finance subs Pricing Models Funds Transfer Pricing Funding bond markets Price off Competition Virtually all banks, savings institutions, credit unions Today and Future? 4 2
Non-Rate Setters Use of Pricing Models Given others set market rates Identify well priced loans Identify poorly priced loans Aggressively compete for well priced loans Do not aggressively compete for poorly priced loans Loan pricing models Market View Investment benchmarks Valuation Balance sheet view RAROC Risk Adjusted Return on Capital ROA - Net income produced 5 Pricing Cash Flows When we price a loan We are pricing a bundle of cash flows. A good loan pricing model puts an A/L wrapper around a loan or a bundle of loans being priced. Approach and results should be consistent with. A/L model results Profitability system results Market results Assuming loan is sold 6 3
Cash Flow and Repricing Characteristics 60 Month Bullet Loan Term or Revolving Amortizing? Term Balloon? Amortization Term Prepayment Speed Fixed or Variable Origination Rate First Reprice Repricing Rate Repricing Frequency 7 Loan Pricing Cash Flows 60 Month Bullet $120,000 $100,000 $80,000 $60,000 $40,000 Series1 Series2 $20,000 $0 1 6 11 16 21 26 31 36 41 46 51 56 Cum Prin CF 60 Month Bullet Loan Rates 3.5 3 2.5 2 Match Considers Interest Cash Flows 1.5 1 0.5 0 1 2 3 4 5 Funding Cost 8 4
Loan Pricing Cash Flows 60 Month New Car - 20% PP $120,000 $100,000 $80,000 $60,000 $40,000 $20,000 $0 1 6 11 16 21 26 31 36 41 46 51 56 Cum Prin CF Considers Interest Cash Flows Match 60 Month Amortizing Loan with 25% annual prepayments 9 Loan Pricing Cash Flows 5 Year Ballon Mtg - 8% PP $50,000 $45,000 $40,000 $35,000 $30,000 $25,000 $20,000 $15,000 $10,000 $5,000 $0 1 6 11 16 21 26 31 36 41 46 51 56 Cum Prin CF 0.84 Considers Interest Cash Flows& Repricing Match 10 5
Loan Pricing Interest Rate Risk Interest Rate Risk When you are pricing loans you are pricing cash flows not maturities. With fixed-rate loans, pieces reprice as cash flows come in. Few reprice at maturity. Principal cash flows are often uncertain Prepayment options Variable rate loans reprice When cash flow pieces come in When contractual repricing occurs, but Variable rate loans may not respond immediately or completely at reset points Reset frequency Restrictions on adjustments (caps) To manage interest rate risk, institutions need to match funding to the repricing of the loans of loans. Two approaches: Simplistic match based on duration More complex Match fund x individual repricing flows. While in the real world you may not x match, in making pricing decision, we should assume matching. X Approach taken in this course 11 CurveNo CurveName 1US Treasury 5Prime 6 Fed Funds 9 Balloon MBS 10 Libor 14 FHLMC FR MBS 16 UST Strip 20 FNMA FR MBS 21 GNMA FR MBS 29 Interest Rate Swap 37 Indexed AAA Corporate Bon 40 AAA Auto Index 66 11th District COFI 84 Average FHLB ADV 87 Cost of Savings Index 90 Indexed AAA MUNI Bond 91 Indexed Agency Bond 95 National COFI 98 REPO (Overnight) 99 Retail CD Avg 100 US CMT (H.15) 119 AAA Commercial Equipmen 126 Indexed A Corporate Bond 127 Indexed B Corporate Bond 128 Indexed A- MUNI Bond 134 FR MBS 137 Balloon MBS Synthetic 138 GNMA II ARMS Market Curve Usage Curves Used for Risk Free Curves Investment Benchmarks Wholesale Funding Curves Requirements Broad range of benchmarks. Updated very frequently 12 6
Cash Flow Matching Example 60 Month Auto loan 1 st 12 months of amortization Weighted average investment benchmarks and funding costs are calculated from these matches. 13 Loan Pricing The Basics Interest Rate Risk Conclusions Interest rate risk driven by the cash flow and repricing characteristics of the loan rather than the term of the loan To model most accurately, each cash flow and repricing point is matched The loan can be matched up to an appropriate point of: A funding curve when matching funding Funds Transfer Pricing (FTP) An investment curve when looking at investment alternatives. Pricing loans off investment alternatives Valuing loans 14 7
Credit Risk - Which History to Use? Was history from 2005-2007 a legitimate predictor of recent credit losses? Are 2008-2010 losses a legitimate predictor of losses of newly originated loans in 2011? Do we even have legitimate loss history for loans originated today? Changes in collateral coverage Changes in underwriting standards Changes in kinds of loans originated 15 Risk Tables Loss Experience Capital Requirements (more on this later) 16 8
Loan Pricing Servicing Servicing Cost Marginal Origination Cost Cost of originating the next loan Marginal Servicing Cost Cost of servicing the next loan Direct Overhead Allocation Fixed costs directly related to loan production General Overhead Allocation President s salary, human resources, etc. Arguments Economist Continue to produce widgets until marginal revenue equals marginal cost. Accountant Without overhead allocation, you end up with profitable loans and an unprofitable institution. OTS Cost Assumptions 0.20% - FR Mortgages 0.38% - ARMs 0.20% - Multi & Non-Res 0.20% - Const & Land 0.20% - Second Mtg. 0.20% - Commercial 0.20% - Consumer 1.00% - Credit Card Is there a better source for generic servicing costs 17 Servicing Example Differential pricing on A, B, C credits should reflect both additional charge offs, and additional servicing costs due to legal and collection fees. 18 9
Loan Pricing The Basics Option Risk Dealing with uncertain cash flows We imbed options in loan contracts that allow customers to modify cash flow characteristics of loans when they consider it to their advantage to do so. Prepayments Basic prepayment levels death, divorce, transfer, upgrades, etc. Incentive driven prepayments Customer prepays to refinance at a lower rate Customer can t afford to move or upgrade because of interest rate jump. Up to the customer to execute the option In some cases, subject to penalty primarily commercial contracts Adjustable rate mortgage caps Annual caps, lifetime caps Automatically executed by the institution. Loan floors Ideally the institution is compensated with rate for making the option available. 19 Option Risk What Is It 15 year FRM example showing remaining principal under different rate environments Falling 25% CPR 2.75 year duration Flat 8% CPR 4.64 Year duration Rising 5% CPR 5.21 Year Duration 15 Year FRM 120,000.00 Remaining Principal 100,000.00 80,000.00 60,000.00 40,000.00 20,000.00 5% CPR 8% CPR 25% CPR - 1 14 27 40 53 66 79 92 105 118 131 144 157 170 Month 20 10
Against Not a true cost like charge offs, servicing costs, or costs of matching funding. Considering option risk will cause loans to be unprofitable. Not the loan officer s problem. Very difficult to calculate May be inherently hedged in balance sheet of retail financial institution. Consider Option Risk in Pricing Loans? For Option risk can damage the performance of un-hedged institutions. It costs money to hedge option risk Price/yield of securities reflects option risk. Securities are securitized loans If loan officers are not charged for options, they will give away options in exchange for rate Can be derived from securities market. Source Securities Markets 21 Adding Option Risk Applied to internal profitability calculations 22 11
Sample Loan 72 Month New Auto Cash Flows Pricing Expenses Risk Assum Benchmarks 23 Investment Benchmark Market rather than internal benchmark Compares performance of loan to closest investment benchmark after adjusting for risk and cost differences. Most relevant when You are trying to decide how to invest cash already raised. Anytime investing in a security is an alternative to making a loan You are trying to derive market adjustments for Interest rate risk Option risk Required inputs Cash flow characteristics Risk free curve Investment benchmark curve Pricing Rates and fees Operating expenses Credit risk adjustment Additional option risk adjustments Calculated adjustments Interest rate risk adjustment Option risk adjustment Loan s spread to investment benchmark after adjustments Test Is spread positive (good) or negative (bad)? Not considered Funding cost curve Capital requirement RAROC Goal Institution Tax Rate 24 12
Investment Benchmark - Steps Investment Benchmarks Risk Free Rate 0.620% + Int Rate Risk Adjust 1.107% = Risk Free Match 1.727% + Option Risk Adjust 0.000% = Investment Benchmark 1.727% + Credit Risk Adjust 0.350% + Expense Adjust 0.682% + Add'l Option Risk Adjust 0.250% = Retail Equiv Benchmark 3.009% Wtd Loan Yield 4.500% Spread to Benchmark 1.491% 1 Month Agency IRR Adjustment Agency Match Investment Benchmark Credit Risk Adjustment Servicing Cost Adj Option Adjustment Retail Benchmark Loan Rate Spread to Benchmark 25 Homework Assignment Completion Every person can work on their own Each must register see registration link on Course Resource page. Give us 24 hours to set you up. Log on using authentication information - see Quick Start Document on Course Page for details and instructions. Run your assignment Estimated time is 1 hour or less. Assignments and their results will persist on the system. This is important as in later assignments we may add to work already performed. Homework is not graded. We will discuss results in the following session. 26 13
Logging Onto iprice Process 1. URL ipriceweb.farin.com 2. Click here to begin log on 27 Logging Onto iprice Process 1. Click Logon link 2. Enter User Name and Password 3. Click OK Resource pages have information on user name and password. Each attendee can have his or her own logon. 28 14
Creating New Relationship Process 1. Click here 2. Give Relationship a name 3. Click Add 29 Add Product to Relationship Process 1. Click the loan you wish to add. Plus symbols can be used to drill down 2. Then click select to get to next screen. 30 15
Product Modeling Screen Product characteristics preset 1. Structure 2. Fees/Expenses 3. Credit Risk (sometimes) Note: You will be able to edit some characteristics but not others depending on account type selected in previous step. 31 Entering Product Data To see: Amort Schedule Details Enter 1. Rate 2. Balance 3. Credit adjustment 4. Review product results 32 16
Amortization Schedule Process 1. Review 2. Done 33 Detailed Results Process 1. Investment benchmark 2. Characteristics 3. Other methods 4. Done to close 34 17
Exporting Details If you find it helpful, you can use the Save As button to export this information to an Excel file for comparison and printing. 35 Adding A Second Account Process 1. Click Add Account 2. Select Product 3. Click Select 36 18
Multiple Account Relationship Results 1. Two accounts in Relationship 2. Active at top of stack 3. Click top bar on account to bring to top of stack That s how the 5/20 got there. 37 Model Second Account Process 1. Enter rate, Amount, & Credit Risk for second account 2. Product Results 3. Relationship Results (not relevant for now) 38 19
Assignment Technical Requirements Recommended Configuration There are certain combinations of PC operating systems and browsers that do not work well with LoanEDGE; including interaction problems between Internet Explorer versions 6/7 and Windows XP. These problems are worse on a laptop or netbook with a small screen. Therefore we recommend the following minimum requirements for running the application. Microsoft Windows 7, Windows Vista, or Macintosh OS X operating system. Minimum screen resolution of 1024x768. If that is not possible, be sure to maximize the browser or run the browser in full screen mode. You can also use the browser zoom capabilities to reduce display size to less than 100% Use Firefox, Google Chrome, or Internet Explorer version 8/9/10 browser if at all possible (and if permitted on institution owned equipment). Safari on Windows or Mac OS X is also compatible. PC/laptop/notebook with dual core processors at 2 GHz or better are recommended. If no dual core available, use the fastest computer CPU you have available to you. Netbooks and older laptops have trouble refreshing the screen fast enough. 39 Assignment Session 1, Exercise 1 Purpose Familiarize you with how to use the Spread to Benchmark analysis tools Method Evaluate comparative performance of two loans 5/20 Balloon Commercial Real Estate Loan Fully Amortizing 20 Year Fixed-rate Commercial Real Estate Loan Details See course resource page for a Word document with detailed assignment. 40 20