Copyright © 2015 Lender Performance Group, LLC. All rights reserved.
loan pricing & profitability management solution
How Does the Math Work?
Carl Ryden, CEO
2
Overview
•
How do we calculate Loan Profitability?
•
Interest Income
•
Interest Expense & Match Funding
•
Non-Interest Expense
•
Factoring in Risk
•
Loan Loss Reserve: Adjusting Returns for Expected Loss
•
Capital: Allocating Economic Capital for Unexpected Loss
•
Risk Mitigants: Collateral & Guarantees
•
Taxes and Tax Exempt Loans
•
Conversion Loans and Rate Locks
•
How do we calculate Deposit Profitability?
•
Interest Income
•
Interest Expense
3
Loan Profitability – Financial Statement
•
A Really Simple Example
•
$1MM Commercial Real Estate
•
Interest Only
•
5 Year Maturity/ Term
•
5.5% Interest Rate (Actual/360)
•
No Origination F ee
4
Loan Profitability – Interest Income
•
Main Inputs:
•
Interest Rate (5.5%)
•
Interest Rate Basis (Actual/360)
•
Origination Fees ($0)
•
Origination Expenses ($2,750)
•
Term (60 months)
•
Average Balance ($1,000,000)
•
Interest Income is:
•
[Initial Interest Rate] x
•
[Adjustment for Interest Rate Basis] x
•
[Average Balance] +
•
[Origination Fees – Origination Expenses,
Annualized over the Term]
•
Specifically in this Example:
•
5.5% x (365/360) x $1,000,000 + ($0 - $2,750) x (12/60)
5
Loan Profitability – Interest Expense
• Main Inputs:
• Yield/Funding Curve
• Term Structure
1(60 months)
• Average Equity (Capital) ($90,000)
2• Average Balance ($1,000,000)
• Interest Expense is:
• ([Average Balance] – [Capital]) x
• [Funding Curve Value at 60 months]
• Specifically in this Example:
•
($1,000,000 – $90,000) x 1.575%
•
= $14,333
1 Because the example is an Interest Only loan, there is a single
repayment at the 60 month term. See the Matched Funding discussion on the following slide.
2 See discussion in later slides regarding Single Factor vs Multi-Factor approaches and the corresponding impact on Average Equity (Capital).
6
Loan Calculations – Match Funding
• Based on a “marginal opportunity cost of funds” funding curve (in our
example we use a composite of the publicly available FHLBs)
•
PrecisionLender allows you to use any funding curve that you choose, however we recommend
using a “marginal market opportunity cost of funds” such as the FHLB. Why? This captures the
opportunity cost of other investment options (e.g. risk-free municipal bonds etc.).
• Used to allocate Interest Expense in a way that is “interest rate risk
neutral” – sometimes called “match funding”
• Each principal repayment has a re-pricing duration and is match
funding separately
•
A 60 month fixed rate interest only loan will be funded with 60 month money (only one repayment)
•
A 60 month fixed rate amortizing with monthly payments will be funded as a set of 60 separate
interest only loans each maturing with the principal repayment in month 1, 2, 3…60
• Adjustable Rate loans (e.g. a 3/1, 5/1, 3/3 etc.) are treated as if the
loan repays and is re-funded each adjustment so a 3/1 will be funded
with 3 year money and then 1 year money
• Floating rate loans are considered to re-price monthly and therefore
will fund off the shortest duration on the Funding Curve
•
Interest Expense might be adjusted by a Liquidity Premium based upon the term of the floating
rate obligation.
7
Loan Calculations – Match Funding
12 month money
11 month money
10 month money
9 month money
8 month money
7 month money
6 month money
5 month money
4 month money
3 month money
2 month
1 mon
PrecisionLender match funds each principal
repayment. Here is an example of a 12 month
amortizing loan. Each month’s repayment is match
funded. Each month the principal repayment
8
Loan Profitability – Non-Interest Expense
• Main Inputs:
• Monthly Servicing Expense
• Non-Interest Expense is:
• [Monthly Servicing Expense] x 12
• Specifically in this Example:
•
$120 x 12
•
= $1,440
9
Loan Calculations – Factoring in Risk
Single Factor Approach
•
Loan Loss Reserve and Credit
Capital are based on a single risk
factor:
•
Risk Rating for the Loan
•
The Risk Rating for the Loan
includes all underwriting criteria
such as:
•
Exposure, Risk of Default, Collateral,
Guarantees, etc.
•
Loan Loss Reserve and Credit
Capital can also be varied by the
duration of the exposure for each
risk rating
Multi-Factor Approach
•
Loan Loss Reserve and Credit
Capital are based on a multiple
risk factors:
•
Risk Rating for the Borrower (the
borrower Probability of Default or
PD)
•
The size of the Exposure at Default
(EAD)
•
Collateral and guarantees (these
affect the Loss Given Default or
LGD)
•
Loan Loss Reserve and Credit
Capital can also be varied by the
duration of the exposure for each
risk rating
PrecisionLender allows you a range of options on how to factor in risk. You can choose a
simple, single-factor approach or a more comprehensive (Basel III - style) multi-factor
approach, or almost any point in between these two. You can also use different
approaches for different regions or even different products within the same region.
10
Loan Profitability – Single Factor Risk
(1 of 2)
• Main Inputs:
• Loan Risk Rating (3. Average)
• Average Balance ($1,000,000)
• Term Structure
1(60 months)
• Loan Loss Reserve is:
• [Annual Loss (based on Risk Rating and
potentially Term)] x [Average Balance]
• Average Equity (Capital) is:
• ([Credit Capital (based on Risk Rating and
potentially Term)] + [Unmitigatable
Capital
2]) x [Average Balance]
• Specifically in this Example:
•
Loan Loss Reserve = $1,000,000 x 0.55% = $5,500
•
Average Equity = $1,000,000 x (8% + 1%) = $90,000
1 Because the example is an Interest Only loan, there is a single repayment at the 60 month term. Term affects the duration of the exposure and you can vary Annual Loss and Credit Capital by duration.
2 Unmitigatable Capital is the total Operational & Market Risk Capital. It does not vary with Risk Rating or duration.
11
Loan Profitability – Single Factor Risk
(2 of 2)
PrecisionLender allows you set the Annual Loss and Credit Capital for each Risk Rating by the
duration of the exposure. This can be set differently by Product or by Region. Also notice
that for products that allow future draws (e.g. Lines of Credit) you can specify a Usage
Given Default (UGD)). This is the percentage of the unused balance to count in the
Exposure at Default (EAD).
12
Loan Profitability – Multi-Factor Risk
(1 of 3)
• Main Inputs:
• Borrower Risk Rating
• Average Balance
• Term Structure
1• Type and Value of Collateral
• Type and Amount of Guarantees
• Loan Loss Reserve is:
• [Annual Loss (based on Risk Rating and
potentially Term)] x [Adjusted Exposure at
Default
2]
• Average Equity (Capital) is:
• ([Credit Capital (based on Risk Rating and
potentially Term)] x [Adjusted Exposure at
Default
2] + [Unmitigatable Capital
3]) x
[Average Balance]
1 Because the example is an Interest Only loan, there is a single repayment at the 60 month term. Term affects the duration of the exposure and you can vary Annual Loss and Credit Capital by duration.
2 Adjusted Exposure at Default is covered in the next slide.
3 Unmitigatable Capital is the total Operational & Market Risk Capital. It does not vary with Risk Rating or duration.
13
Loan Profitability – Multi-Factor Risk
(2 of 3)
•
Collateral Exposure Mitigation:
•
80% LTV ($1.25MM Collateral Value)
•
50% Economic Recovery Rate
1•
= (50%) x ($1.25MM) = $625,000
•
Adjusted Exposure at Default:
•
(Exposure at Default) – (Collateral Exposure Mitigation)
•
= $1,000,000 – $625,000 = $375,000
•
Example
2
:
•
Loan Loss Reserve = $375,000 x 1.47% = $5,500
•
Average Equity = $375,000 x 21.33% + $1,000,000 x 1% =
$90,000
$1MM
Exposure
At Default Mitigation Collateral ($625M)
$375M
Adjusted Exposure At Default
When using a multi-factor risk approach in PrecisionLender, the lender specifies the type(s)
and amount(s) of collateral. Each type of collateral has a Recovery Factor defined. The
Recovery Factor is the ratio of the present value of the recovered collateral after expenses
as a percentage of the nominal collateral value.
1 Each type of collateral type has its own Recovery Rate and a loan can have multiple layers of collateral. For example, the collateral above is Commercial Real Estate and has a 50% Recovery Rate. A CD held at the bank would have a 95% recovery rate (and therefore is worth more as a mitigant).
2 Here we show that the assumed Annual Loss (1.47%) and the Credit Capital (21.33%) are both different and substantially higher than in the Single Factor approach. This is common as these are the completely unsecured values. The Single Factor values already incorporate the impact of “average” collateral and “standard” guarantees. Multi-factor offers more granularity and precision.
14
Loan Profitability – Multi-Factor Risk
(3 of 3)
•
Guarantee Mitigation:
• $150,000 Personal Guarantee
• Guarantor is a “1” Risk Rating and that Risk Rating has a 50% Guarantee Factor1
• 80% Economic Recovery Rate
• Obligor Is a “3” Risk Rating and has a Credit Capital rate of 21.33% (for a 60 month duration)
• = 80% x $150,000 = $120,000 of Guarantee mitigation
•
Loan Loss Reserves:
• [Unmitigated Exposure] x [Annual Loss] • $255,000 x 1.47% = $3,749
•
Average Equity (Capital)
:
• [Guarantee Mitigated Exposure] x [Credit Capital Rate] x [Guarantor Factor] +[Unmitigated Exposure] x [Credit Capital Rate] • $120,000 x 21.33% x 50% + $255,000 x 21.33% = $67,190 $375M Adjusted Exposure At Default
When using a multi-factor risk approach in PrecisionLender, the lender can specify the type(s) and
amount(s) of guarantees. Each guarantee has a Recovery Factor defined that operates like the collateral
Recovery Factor. In addition, each guarantee can have additional origination and servicing expenses
associated with it. Finally, guarantees can either be risky guarantees (e.g. a personal or corporate
guarantee) or considered riskless (such as a government guarantee). Riskless guarantees operate just like
collateral except with additional expenses. Risky guarantees do not affect the Adjusted Exposure at
Default, but instead affect how capital and annual loss are applied.
1 Each Risk Rating has a Guarantee Factor as an assumption. This approach is taken from the Basel III approach to guarantees.
This factor is determined solely by the guarantor’s Risk Rating and is then multiplied by the obligor’s Credit Capital.
2 This is actually the “one-way” double default probability - the obligor annual loss x the guarantor annual loss. It is typically ~0%.
$255M Unmitigated $120M Guarantee Mitigated Credit Capital 21.33% 21.33% x 50% Annual Loss 1.47% 0%2
