Question 1

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

Accepted Answer

"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.

Accepted Answer

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.

Accepted Answer

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?

Accepted Answer

The answer of What is the purpose of a loan...

Question 5

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

Accepted Answer

The answer of Why is it important for banks to...

Question 6

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

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The answer of Give an overview of items usually included...

Question 7

Discuss CreditMetrics and other portfolio approaches.

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The answer of Discuss CreditMetrics and other portfolio approaches....

Question 8

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

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The answer of Why are terms for loans important, and...

Question 9

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

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The answer of Why are special considerations for different types...

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?

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The answer of Give an overview of the structure and...

Question 11

What are different types of loan sales?

Accepted Answer

The answer of What are different types of loan sales?...

Question 12

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

Accepted Answer

The 5 C's of Credit are Character, Capacity, Capital, Collateral, and Conditions. These are the key factors that lenders consider when evaluating a borrower's creditworthiness.

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.

Accepted Answer

If interest rates rise, the borrower's payments on the variable rate loan will increase, possibly making it more difficult for them to make payments and increasing their default risk. The bank, on the other hand, is protected from interest rate risk since they can adjust the interest rate on the loan to reflect changes in market rates.

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)

Accepted Answer

Zeta = 1.2 WC + 1.4RE + 3.3ROA + .6 Equity + 1 AT= 1.2 (2,938,700/4,500,430) + 1.4 (393,000/4,500,430) + 3.3 (970,000/4,500,430) + .6 (10*100,000/1,687,000) + 1 (4,200,900/4,500,430)= 2.54

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?

Accepted Answer

: Interest Expense = $1,000,000 x .10 = $100,000 
Non-interest Expense = Commitment fee .0050 x $1,000,000 = $5,000 
Compensating Balance Less Reserve Requirements 
= $1,000,000 x .10 (1 - .10) = $90,000 
Investable Funds = Loan Balance - Compensating Balance 
= $1,000,000 - $90,000 = $910,000 
Implicit Return = Total Expenses / Investable Funds 
= $105,000/$910,000 = .1154 or 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?

Accepted Answer

The Community Reinvestment Act (CRA) is a federal law that requires banks to meet the credit needs of the communities in which they operate, including low- and moderate-income neighborhoods. The act requires banks to lend money in the areas where they accept deposits, and encourages them to provide services to all members of their community, regardless of income or race. The Equal Credit Opportunity Act prohibits lenders from discriminating based on race, sex, marital status, religion, national origin, age, or receipt of public assistance. The Fair Housing Act prohibits discrimination in the housing market based on race, color, national origin, religion, sex, familial status, or disability. The Home Mortgage Disclosure Act requires lenders to report information about their mortgage lending activity to federal regulators to help identify possible discriminatory lending practices.

Question 17

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

Accepted Answer

All of the factors listed (pricing of the loan, borrower's gross monthly income before taxes relative to the monthly loan payment, Loan to Value (LTV) Ratio, proper appraisal of property values) can help reduce the default risk of a loan. By ensuring that the loan is priced correctly and that the borrower has sufficient income to make the monthly payments, the lender can reduce the risk that the borrower will default. Additionally, by ensuring that the Loan to Value Ratio is appropriate and that the property is properly appraised, the lender can reduce the risk of loss in the event of a default.

Question 18

Which of the following statements is false?

Accepted Answer

The answer of Which of the following statements is false?
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Question 19

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

Accepted Answer

: False, a discounted loan has a higher effective annual rate, since the borrower is given lower usable funds, i.e. the loan amount less the discount.

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:

Accepted Answer

: EAR = [Interest Expense / (Loan Amount) (1 - discount%)] 
= [$12,000/($200,000)(1 - .10)] = $12,000/$180,000 = .0667 or 6.67%

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