Deck 9: Loan Analysis, Credit Risk Management, and Loan Securitization

Question 1

In an introductory quote, Professor Uday Rajan (University of Michigan) observes:

Answer 1

"Statistical models that predict loan defaults failed to warn lenders about risky borrowers, because these models relied too much on hard information, such as credit scores and loan-to value ratios, and not enough on soft information from personal contact with borrowers, such as a person's job security, upcoming expenses or other observable behaviors that may help prevent the likelihood of default...A fundamental cause for this failure was that the models ignored changes in the incentives of lenders to collect soft information about borrowers and residential properties."… "When incentives change, the link between the data and predicted outcomes changes in a fundamental manner."

Question 2

Explain the Five C's of Credit, and discuss why soft information on borrowers can be important for depository institutions to carefully underwrite a loan. Also, discuss incentives for loan underwriter during the period prior to the Subprime Loan Crisis that contributed to poor underwriting practices that contributed to the crisis.

Answer 2

The 5 C's of Credit include character, capacity, capital, collateral, and conditions.
• Character (the willingness of a customer to pay). Character includes soft information on a customer in determining the willingness of a customers to pay, often assessed by loan officers using their experience to evaluate the character of individuals during a loan interview. Other evidence of character includes past credit history, credit ratings of firms and individuals, and for firm's reputation from customers and suppliers.
• Capacity (the ability of a customer to pay in terms of cash flow). Capacity is often evaluated by looking at current and projected cash flow statements of corporate customers to determine if cash flow will be adequate to cover loan payments.
• Capital (the soundness of a borrower's financial position in terms of equity). The net worth or equity position of a corporate borrower relative to assets provides information on the cushion that the borrower has to absorb potential losses. For consumer customers, net worth is estimated as personal assets less personal liabilities.
• Conditions (the industry and economic conditions that may affect a firm's ability to repay a loan). For instance, during recessions, mortgage delinquencies also tend to rise, and real estate booms and busts in particular areas can affect the likelihood of foreclosures, such as occurred during the U.S. Subprime Loan Crisis.
• Collateral (secondary sources of repayment) (asset-based lending). Collateral and at times for private firms' personal guarantees based on personal assets are used as a secondary source of repayment for the bank, particularly for more risky company loans. However, taking possession of the collateral is expensive, so lenders should reply on cash flow for primary payment of a loan, with collateral only as a secondary source of repayment, and independent appraisals need to be made.
Incentives for loan underwriter during the period prior to the Subprime Loan Crisis that contributed to poor underwriting practices that contributed to the crisis included bonuses for underwriting more loans versus the quality of loans, and since loans were sold for securitization, no responsibility for loan officers to monitor or be responsible for loan defaults. Hence, a moral hazard problem was created encouraging poor quality loans to be made and incentives for predatory lending and taking on subprime loans. Heavy reliance on quantitative models for loans and the use of low doc loan documentation for qualifying for loans that was popular including applying for online loans with quick decisions, failed to incorporate soft information including character, the willingness to pay, capital, and conditions, with loan officers assuming that market values of properties would continue to rise and failing to consider adverse conditions with very low down payments for loans required and high loan to value ratios. Thus, when the market values of properties fell, many borrowers with loans now greater than the value of the properties, walked away from their loans.

Question 3

Discuss the function of the credit process as protection against default risk and loan structure factors that help to reduce default risk on a loan.

Answer 3

The function of the credit process is to structure a loan to reduce its default risk, with the risk of loans including default risk as the result of both firm-specific processes and industry problems. With proper structuring of loans whereby the cash flow generated by a firm or income generated by a consumer borrower is adequate to cover loan payments.
Loan structure factors that help to reduce the credit risk of a loan include:
(a) The proper pricing of the loan, ensuring that borrower's cash flow or income before taxes is adequate to cover loan payments. For instance, with variable rate loans, when interest rates rise borrowers may not be able to meet the higher payments, increasing the credit risk of the loan. This occurred during the Subprime Loan Crisis, where with low teaser rates, followed by higher rates when rates rose, subprime borrowers were not able to make their loan payments, contributing to bankruptcies.
(b) Borrower's debt to income ratios, ensuring that a loan amount is not greater than, for instance, 30% of a borrower's gross monthly income before taxes. Typically lenders also require a higher credit score for a borrower when there is a lower down payment than 20%, and a higher required down payment of 30%, and required credit score that is higher for self-employed individuals.
(c) Loan to Value (LTV) ratios, ensuring that the ratio of the loan amount to the loan amount is less than the appraised value of a property to protect the lender in the case of default and reduce the incentive of the borrower to walk away from the loan. Generally banks like to have a maximum of 75% loan to value ratio.
(d) Proper Appraisal of Property Values. Lenders need to have policies in place for having certified, well-trained real estate appraisers. Prior to the U.S. Subprime Loan Crisis, many financial institutions allowed unqualified appraisers to make appraisals, which resulted in inflated valuations that made lenders more willing to lend to subprime borrowers with low down-payments. Since appraised values are historically based, it's also important for lenders to consider future cash flows expected, especially for commercial real estate loans to determine if cash flows projected will be sufficient for loan repayments.
Hence, the structuring of loans to ensure repayment by the borrower is one of the keys to having an effective bank lending process. The credit evaluation process is also critical. To protect the bank and maximize the profitability of loans that are made, banks must have a credit process in place including a carefully written loan policy, loan request procedures and a process for credit analysis, a process for credit execution and administration, and a credit review process to identify problems early for loans that have been made. The loan process must also conform to a large number of lending regulations, with a number of other specifications and regulations to follow if loans are to be securitized including maximum loan-to-value ratios.

Question 4

What is the purpose of a loan committee, who is on a loan committee, and what considerations are made in determining whether a loan should be made?

Question 5

Why is it important for banks to have written loan policies? What are Credit Execution Policies and why are they important?

Question 6

Give an overview of items usually included in loan request summaries prepared for a loan committee review.

Question 7

Discuss CreditMetrics and other portfolio approaches.

Question 8

Why are terms for loans important, and what do they typically include?

Question 9

Why are special considerations for different types of loans important? Give some examples.

Question 10

Give an overview of the structure and mechanics of securitizations by discussing the steps in securitizations. What are different types of structured finance securitizations?

Question 11

What are different types of loan sales?

Question 12

The 5 C's of Credit include which of the following:

A) Congeniality, Cash, Collateral, Capacity, & Credit
B) Credit Scoring, Credit Ratings, Collateral, Capital, & Conditions
C) Compensation, Capacity, Credibility, Collateral, & Capital
D) Character, Capacity, Capital, Collateral, & Conditions

Question 13

If a bank makes a loan and prices it with a variable rate, the bank passes on interest-rate risk to the borrower, possibly increasing the borrower's default risk for the loan if interest rates rise.

Question 14

The Zorro Corporation applies for a loan at Bank Zeta and provides the following information to the bank to calculate its Zeta Score (using the model):
Zeta = 1.2 WC + 1.4RE + 3.3ROA + .6 Equity + 1 AT, where WC = net working capital to total assets; RE = retained earnings to total assets; ROA is operating profit to total assets; Equity is the market Value of Equity to Total Debt; and AT is Sales/Total Assets.
What is the firm's Zeta Score? Given the following information:
Sales $= \$ 4,200,900 \quad\quad\quad\quad\quad$ Retained Earnings $= \$ 393,000$
Current Assets $= \$ 2,938,700\quad\quad$ Current Liabs. $= \$ 1,369,000$
Operating Profit $= \$ 970,000\quad\quad\quad$ Total Debt $= \$ 1,687,000$
Total Assets $= \$ 4,500,430 \quad\quad\quad$ Stock Price $= \$ 10$
$\quad\quad\quad\quad\quad\quad\quad\quad\quad\quad\quad\quad\quad$ (With 100,000 Shares Outstanding)

A) 2.54
B) 3.54
C) 4.54
D) 1.54

Question 15

If a line of credit is given to a borrower for $2,000,000, with a stated rate of 10% on any used portion, a commitment fee of 0.50% on the unused portion of the line of credit. The average loan balance is 50% of the line of credit, and a compensating balance is required of 10% on the used portion of the loan commitment, and the bank has a reserve requirement of 10%, what is the actual implicit return to the bank?

A) 10%
B) 11.18%
C) 10.54%
D) 11.54%

Question 16

Which of the following U.S. Acts requires that a bank must meet the credit needs of its area, especially in low and moderate income areas?

A) Community Reinvestment Act (CRA)
B) Equal Credit Opportunity Act
C) Fair Housing Act
D) Home Mortgage Disclosure Act

Question 17

Which of the following factors(s) are important factors to help reduce the default risk of a loan?

A) The pricing of the loan
B) A borrower's gross monthly income before taxes relative to the monthly loan payment
C) The Loan to Value (LTV) Ratio
D) Proper appraisal of property values
E) All of the above

Question 18

Which of the following statements is false?

A) The Equal Credit Opportunity Act (Reg B) in the U.S. forbids discrimination in lending on the basis of race, color, national origin, sex, age, and marital status.
B) U.S. banks to not have any limits on how much they can lend to one borrower and has no restrictions on loans given to insiders.
C) The U.S. Fair Housing Act forbids discrimination based on any handicap or family status.
D) The U.S. Fair Credit Reporting Act of 1970 requires consumer credit agencies to stress accuracy, correct errors promptly, and to release individual consumer histories only for legitimate purposes.
E) The U.S. Truth in Lending (TIL) requirement requires that a bank must quote its rates as annual percentage rates.

Question 19

A discounted loan offers a lower loan rate than a regular (non-discounted) loan.

Question 20

A borrower who borrows $200,000 with a 6% stated annual rate with a 10% discount stipulation has an effective annual rate of:

A) 10%
B) 6%
C) 6.67%
D) 8.2%

Question 21

Which of the following is not a typical restrictive covenant for a bank commercial loan?

A) Life insurance for key personnel
B) Minimum current and quick ratios
C) Bank is allowed to run the firm if repayment difficulties
D) Limits on borrower taking on additional debt and dividend payments

Question 22

Loan terms that increase the effective rate on a loan do not include which of the following:

A) A discount loan
B) Points on a mortgage loan
C) Having a loan syndicate
D) Required compensating balance
E) Loan fees

Question 23

Lenders can reduce the risk of loan default by:

A) Increasing the frequency of payments
B) Requiring assets to be pledged as collateral
C) Requiring a larger down payment and lower loan to value ratio
D) All of the above
E) a. and b. only

Question 24

Which of the following is false concerning seasonal working capital loans?

A) Seasonal working capital loans are usually paid back over 5 years.
B) Seasonal working capital loans are typically collateralized by inventory and accounts receivables.
C) Seasonal working capital loans are usually paid back within a year.
D) A rough estimate of annual working capital needs is the daily cost of goods sold times a firm's cash conversion cycle days.

Question 25

Which of the following is false concerning a term loan?

A) A term loan is typically an amortized loan with equal payments over the life of the loan that Include interest and principal payments.
B) Longer-term loans to purchase depreciable assets are often for 20 to 30 years.
C) Longer-term loans to purchase depreciable assets typically have a maturity of 1 to 7 years.
D) Term loans are typically structured to match cash flows generated by the firm over the life of the equipment.
E) Collateral for a term loan is often the equipment being purchased.

Question 26

Special considerations for commercial real estate and construction and development loans include which of the following:

A) Take-out commitments from a long-term lender after the completion of a project or after a certain number of years.
B) Surety bonds guaranteeing the completion of a project.
C) Higher loan rates and fees to compensate for the great risk of these loans.
D) Careful consideration of projected vacancy rates to reduce the risk of taking on a construction and development loan.
E) All of the above.

Question 27

Which of the following is not a step in a loan securitization?

A) Banks keep pools of loans on their books to be able to service and monitor these loans and pay investors that purchase mortgage backed securities (MBS).
B) Banks sell pools of loans on a recourse basis to a limited purpose corporation or special enterprise vehicle.
C) A Limited Purpose Corporation (LPC) buys the loan pool and a trust company is set up to purchase loans from the LPC, and the trust company packages the loans into certificates that can be sold to investors.
D) An agency rates the issue with often a reserve for losses as well as credit guarantees from large credit worth banks included to gain a favorable rating.

Question 28

Which of the following is false about mezzanine lending?

A) Mezzanine loans are longer-term, unsecured loans in which a firm's cash flow is the major source of repayment.
B) Start-up firms typically get mezzanine loans before they are able to generate large cash flows.
C) Mezzanine loans often contain an option through which the lender can share in the increased value of the business to compensate for the relatively high risk of the loan, allowing a lower interest rate, with financing often containing layers of different investors with senior and junior debt including warrants attached that allow future equity stake in a firm and bond financing privately placed.
D) Mezzanine loans are for more established firms that have stable cash flows to be able to make loan payments.

Question 29

Which of the following is false about adjustable rate mortgage (ARMs) loans?

A) There are special regulations in the U.S. for adjustable rate
Mortgage loans including the indexes that can be used and requirements that lenders explain to borrowers exactly how the interest rate is related to an index and how it will be adjusted as the index changes, with a 15-year history of the index provided.
B) Banks have limits called caps on the size of the periodic rate
Adjustments, and an overall cap is required by federal law.
C) Borrowers with ARMs are never allowed to switch to fixed rate mortgages.
D) ARMs increase the credit risk for a loan, if interest rates rise.

Question 30

Agriculture loans should be made solely on the value of the real estate for a farm, and are typically for seasonal needs for planting that are repaid at harvest time.

Question 31

Which of the following is false concerning asset based lending?

A) Asset based lending generally as lower loan rates than unsecured loans for the same degree of safety.
B) For asset based loans collateral is typically matched with the use and term of the loan.
C) For asset based lending, determining the value of the assets to be pledged as collateral, including how liquid and marketable they are is important, and for accounts receivables, the quality of the accounts, including evaluating concentration of large accounts that could default.
D) As a rule of thumb the maximum loan to value ratio for lending is 40 to 60% against raw materials and finished goods inventory and 50 to 80% against accounts receivables depending on the aging schedule and collection experience.