© 2013 FARIN & Associates Inc. · – Servicing cost – Option risk ... • Pricing Models – Funds Transfer Pricing • Funding ... Few reprice at maturity

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© 2013 FARIN & Associates Inc. 1

Applied Loan PricingSession 1

Thomas Farin

President

[email protected]

© 2013 FARIN & Associates Inc.

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

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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

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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?

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Non-Rate SettersUse 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


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

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Cash Flow and Repricing Characteristics

• Fixed or Variable– Origination Rate– First Reprice– Repricing Rate– Repricing Frequency

• Term or Revolving– Amortizing?– Term– Balloon?

• Amortization Term

– Prepayment Speed

60 Month Bullet Loan


Loan Pricing – Cash Flows

0

0.5

1

1.5

2

2.5

3

3.5

1 2 3 4 5

Funding Cost

Rates

Match

60 Month Bullet

$0

$20,000

$40,000

$60,000

$80,000

$100,000

$120,000

1 6

11

16

21

26

31

36

41

46

51

56

Cum Prin CF

Series1

Series2

Considers Interest Cash Flows

60 Month Bullet Loan

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Match

Considers Interest Cash Flows

60 Month New Car - 20% PP

$0

$20,000

$40,000

$60,000

$80,000

$100,000

$120,000

1 6 11 16 21 26 31 36 41 46 51 56

Cum Prin CF

60 Month Amortizing Loanwith 25% annual prepayments



Match

Considers Interest Cash Flows& Repricing

5 Year Ballon Mtg - 8% PP

$0$5,000

$10,000$15,000$20,000$25,000$30,000$35,000$40,000$45,000$50,000

1 6 11 16 21 26 31 36 41 46 51 56

Cum Prin CF

0.84

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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 individual repricing flows.

– While in the real world you may not match, in making pricing decision, we should assume matching.

x

x

X – Approach taken in this course


Market Curve UsageCurveNo CurveName

1 US Treasury5 Prime6 Fed Funds9 Balloon MBS

10 Libor14 FHLMC FR MBS16 UST Strip20 FNMA FR MBS21 GNMA FR MBS29 Interest Rate Swap37 Indexed AAA Corporate Bon40 AAA Auto Index66 11th District COFI84 Average FHLB ADV87 Cost of Savings Index90 Indexed AAA MUNI Bond91 Indexed Agency Bond95 National COFI98 REPO (Overnight)99 Retail CD Avg

100 US CMT (H.15)119 AAA Commercial Equipmen126 Indexed A Corporate Bond127 Indexed B Corporate Bond128 Indexed A- MUNI Bond134 FR MBS137 Balloon MBS Synthetic138 GNMA II ARMS

• Curves Used for– Risk Free Curves

– Investment Benchmarks

– Wholesale Funding Curves

• Requirements– Broad range of benchmarks.

– Updated very frequently

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Cash Flow Matching Example

60 Month Auto loan – 1st 12 months of amortization

Weighted averageinvestment benchmarksand funding costs arecalculated from thesematches.


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

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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

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Risk Tables

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Loss Experience

Capital Requirements (more on this later)

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Loan Pricing – ServicingServicing 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


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.

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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.


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

-

20,000.00

40,000.00

60,000.00

80,000.00

100,000.00

120,000.00

1 14 27 40 53 66 79 92 105 118 131 144 157 170

Month

Re

ma

inin

g P

rin

cip

al

5% CPR

8% CPR

25% CPR

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Consider Option Risk in Pricing Loans?

• 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.

• 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


Adding Option Risk

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Applied to internal profitability calculations

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Sample Loan – 72 Month New Auto

•Cash Flows•Pricing•Expenses•Risk Assum•Benchmarks


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

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Investment Benchmark - Steps

1 Month AgencyIRR AdjustmentAgency Match

Investment BenchmarkCredit Risk AdjustmentServicing Cost AdjOption AdjustmentRetail BenchmarkLoan RateSpread to Benchmark

Investment BenchmarksRisk 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%


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.

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Logging Onto iPrice

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Process1. URL

ipriceweb.farin.com2. Click here to begin

log on


Logging Onto iPrice

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Process1. Click Logon

link2. Enter User

Name andPassword

3. Click OK

Resource pages have information on user name and password. Each attendeecan have his or her own logon.

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Creating New Relationship

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Process1. Click here2. Give Relationship

a name3. Click Add


Add Product to Relationship

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Process1. Click the

loan youwish to add.Plus symbolscan be usedto drill down

2. Then clickselect to getto nextscreen.

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Product Modeling Screen

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Productcharacteristicspreset

1. Structure2. Fees/Expenses3. Credit Risk

(sometimes)

Note: You will beable to edit some characteristicsbut not othersdepending onaccount typeselected inprevious step.


Entering Product Data

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Enter1. Rate2. Balance3. Credit

adjustment4. Review

productresults

To see: • Amort Schedule• Details

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Amortization Schedule

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Process1. Review2. Done


Detailed Results

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Process1. Investment

benchmark2. Characteristics3. Other

methods4. Done to

close

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Exporting Details

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If you find ithelpful, you canuse the Save Asbutton to exportthis information to an Excel filefor comparison and printing.


Adding A Second Account

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Process1. Click Add

Account2. Select

Product3. Click

Select

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Multiple Account Relationship

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Results1. Two accounts

in Relationship2. Active at

top of stack3. Click top bar on

account tobring to top ofstack – That’show the 5/20got there.


Model Second Account

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Process1. Enter rate,

Amount, &Credit Riskfor second account

2. ProductResults

3. RelationshipResults (notrelevant fornow)

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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.

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Assignment – Session 1, Exercise 1Purpose – Familiarize you with how to use the

Spread to Benchmark analysis tools

Method – Evaluate comparative performance oftwo 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.

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Documents

© 2013 FARIN & Associates Inc. · – Servicing cost – Option risk ... • Pricing Models – Funds Transfer Pricing • Funding ... Few reprice at maturity