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REDEFINING LOAN PRICING AND ALLOCATION FOR NEW RISK BASED CAPITAL REGULATIONS
David KochPresident/[email protected] ext. 4217
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Market Challenges TodayMargins under attack for a decade• Historically low interest rates, • Weak loan demand, • Lack of appetite for growth, • Growing cash positions,• …New capital requirements forcing higher capital levels• Redefined “real” equity• Enhanced focus on risk assetsDifficulty growing saturated portfolios• Auto market competition• Fast cash flow turnover
Regulatory focus • On “locking up” longer term
liquidity– More cash\assets based sources– Less reliance on borrowings
• Concern over rising interest rates– Risk to earnings– Risks to “value” of assets
Member demand for products we don’t really like• Longer term, fixed rate• Commercial & RE
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CFO\CEO Challenge - Optimal Earning Asset Matrix
Every balance sheet mix carries maximum return\volatility combinations
Finding your optimal earnings frontier is key to strategic\capital plan• What strategy has higher
earnings potential and less “risk”
What can I do on the asset side of the balance sheet to move from 8.0% to 10.4%
Volatility of earnings
RO
E
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Outline & AgendaUnderstanding the new capital regulations on loan pricing• Balance sheet growth & capital
issues• RAROCLoan pricing & Finance\ALM• Cash flow not term• Bridging the gap between lending
and financing departments
Examples• Commercial loans• Autos loans• 1-4 Family real estate• Loan “Add-ons”
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CU Risk Based Capital RegulationsNew regulations focus capital on 2 factors• Net worth ratio
• Real capital on the balance sheet
• Risk based capital• Assign risk rating to various asset classes• Multiply asset balance times risk weight• Sum is the “total risk based” assets for denominator
• Risk ratings largely based on credit risk assumptions
• No assessment for interest rate risk• Some assessment for concentration risk
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Risk Based Capital & Loan SelectionRisk Weights under new RBC Rules• Risk weights reflect basic, inherent credit risks
• Adjust capital targets for additional market risks • Adjust capital targets for higher IRR exposures
• Most pricing actions fail to consider the cost of the new capital requirements on rate setting and risk.
• What happens if we grow loans faster than we grow the capital needed to support the new risk levels assigned?
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Risk Based Capital & Loan SelectionRisk Weights under new RBC Rules• Share secured loans – 0 to 20%• 1-4 family RE – 1st Lien (two tiers)
• 50% risk weight up to 35% of total assets• 75% risk weight on balances > 35% of total assets
• 1-4 family RE – Jr (2nd) Lien• 100% risk weight up to 20% of total assets• 150% risk weight on balances > 20%• Note that JR liens with no interceding 1st lien get 1st lien treatment
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Risk Based Capital & Loan Selection• Commercial Loans
• 100% risk weight up to 50% of total assets• 150% over 50%• Still governed by 12.25% of total asset statutory cap without a waiver from
NCUA
• Off balance sheet exposures are counted at a “factor”• Unused lines of credit• Commitments to originate• Loans sold with recourse
Have you adjusted your pricing and asset allocation\selection for the new risk based net worth standards?
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Factors in Pricing LoansCash flows, not maturity• Do you view a Mortgage Backed
security the same way as a Municipal bond?
Funding costs• Does your current cost of funds matter?• Is that what keeps you from making
longer term loans when rates are low?• Potential funding costs are what matters
Risks to consider• Interest rate risk – cash flows• Credit risk (ALLL and losses)• Servicing costs
– Origination– Incremental cost of additional servicing– Direct or general overhead allocations?
• Option risk – cash flow volatility– Prepayment– Caps/floors
• Market rates?– Competitors that are making bad decisions
should not be followed over the cliff!
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Cash Flow and Repricing Characteristics
Term or Revolving• Amortizing?• Term• Balloon?
– Amortization Term• Prepayment Speed
Fixed or Variable• Origination Rate• First Reprice• Repricing Rate• Repricing Frequency
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60 Month Bullet Loan
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Loan Pricing – Cash Flows
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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
Series1Series2
0
0.5
1
1.5
2
2.5
3
3.5
1 2 3 4 5
Funding Cost
Funding Rates
Match
Considers Interest Cash Flows
60 Month Single Pay Loan
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Loan Pricing – Cash Flows
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MatchConsiders 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
Assumed 20% annual prepayments
60 Month Amortizing Loan
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Loan Pricing – Cash Flows
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
60 Month Variable Rate Amortizing Loan
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Pricing Models – Separating “Fools Gold” from Real
Reality: other FI’s set ratesGoals for a pricing model• 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
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Most Common Loan Pricing MethodsFive pricing methods found in CU’s1. Cost plus approach
• Most basic approach but severe flaws
2. Investment benchmark comparison
• Are we better of investing or making the loan when we adjust for risks & costs in each option?
3. Income contribution• Does this add incremental
earnings• Fails to consider growth in
assets vs. growth in capital4. Valuation
• Is the loan able to be sold for a gain
• Not as prevalent in CUs5. Return on capital (RAROC)
• Least used but most important under new capita regs
We are only touching on 3 today. 1, 2 and 5
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1. Cost Plus Pricing Approach• Step 1: Determine Costs of Making Loan
– Begin with an institution’s current funding cost 0.5%– Add adjustments to cover credit risk and operating expense +2.0%– Add enough additional spread to meet ROE/ROA objectives. +1.0%– Total Costs + ROA Target = 3.5%
• Step 2: Set Loan Rate to Meet Income Needed – Yield– Fees– Price the loan to provide the needed spread. FAIL!
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Should I Use Cost of Funds to Price? NO – NEVER!Cost of funds is a terrible indicator of market costs.It is a historical measure of what has been done.• Movement of funding costs is slow as rates FALL
– Slow to drop deposit rates on non-maturity funds– CD rates take time to unwind– Result is higher loan rates as rates are falling
• Movement of funding costs is slow as rates RISE– Likely to LAG market rate increases on non-maturity rates– Members slow to move to CD rates– Result is LOWER than market rates
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Why You Don’t Use Cost of Funds To Price Loans
Note how Prime and 1 Yr Treas. came down fast, but CU funding costs took over 8-12 quarters to adjust
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2. Investment BenchmarkInvestment Benchmark• Market not internal benchmark• Compares performance of loan to
closest investment benchmark adjusting for risk & 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
What’s Not considered• Funding cost curve• Capital requirement• Risk Adjusted Return on Capital
Goals (RAROC)Process• Compare overnight risk free to
duration matched risk free rate• Adjust duration matched rate for
option risks and credit risks in loan offering
• Add in servicing costs• Compare “grossed up” rate to offer
rate
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Investment Benchmark Comparison - CRE
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Comparing a 4% 5/20 Balloon to a 4.5% 20 Yr FR CRE
Note scale does not show that this is ½ of total principle balance
Spread out over time vs. lump sum
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Investment Benchmark Comparison - CRE
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Comparing a 4% 5/20 Balloon to a 4.5% 20 Yr FR CRE
Making a bet with balloon that you can reinvest over the remaining 15 years are rates to “beat” the original rate.
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Investment Benchmark Comparison - CRE
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Both options look good vs. investment options.
20 Yr FR amortizing loan only 6 bp less profitable than 5/20 balloonLonger cash flows requires more IRR coverageCan a 50bp premium be collected from customer in exchange for cash flow certainty?Duration extends < 2 years
Investment Benchmarks 5/20 Balloon CRE20 Yr FR CRE
@4.5%
Risk Free Rate 0.460% 0.460%+ Int Rate Risk Adjust 0.937% 1.518%
= Risk Free Match 1.397% 1.978%+ Option Risk Adjust 0.750% 0.750%
= Investment Benchmark 2.147% 2.728%+ Credit Risk Adjust 0.250% 0.250%
+ Expense Adjust 0.795% 0.775%= Retail Equiv Benchmark 3.192% 3.753%
Wtd Loan Yield 4.000% 4.500%Spread to Benchmark 0.808% 0.747%
-0.060%Duration 3.42 5.31
Conclusion: 20 Yr FR fully amortizing CRE loan can be a profitable loan when compared to investment alternatives. Covers the inherent risks and costs!
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3 & 4 – Income Statement FTP & Valuation Methods
3. Income Statement (FTP)• Internal profitability measurement• Evaluates profitability within
balance sheet context• Most relevant when
– You are trying to decide if you can make money originating a loan.
– Anytime you are evaluating profitability of a relationship, product or profit center.
– Outputs• Dollar contribution to income (ROA)
4. Valuation• Uses the market to determine
profitability vs. a benchmark rate• Compares market value of loan as
compared to the “book value” at time of origination
• Most relevant when– You are going to sell loan after
origination.– When you are trying to improve
franchise (NEV|EVE) value by holding best priced assets.
– Outputs• Price vs market• + make and sell (or keep?)• - don’t make
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5. Risk Adjusted Return on Capital (RAROC)5. RAROC (FTP)• Internal profitability measurement• Evaluates profitability within
balance sheet context• Most relevant when
– You are trying to decide if you can make money originating a loan.
– Anytime you are evaluating profitability of a relationship, product or profit center.
– Outputs• Dollar contribution to income (ROA)• Return on required capital (RAROC)
What’s Not considered• Risk free returns• Investment alternativesProcess• Compare overall return to a
funding curve and other costs – Operating expense– Credit risks– Option risks– Fee income– Capital requirement & goals
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Capital Allocation In Loan Pricing Why assign a capital requirement to a loan?• Relates profitability of an entity (loan)
to a primary earnings measurement ratio.
• Allows for adjustments in return based on differential capital needs for different loans and investments.
Should you bother with a capital allocation model?• Will adding this level of complexity
have a material effect on analysis or decisions?
• Is capital a constraint– Regulatory requirements– Self-imposed requirements
What capital allocation model should I use?• Leverage Requirement
– Core net worth requirement– Internal capital goals
• Risk Based Requirement– NCUA levels
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Required Capital By StrategyRBNW has a key role in assessing various options on potential growth?• Many CU’s have excess capital today• Risk weights can help tell story of possible growth pathsConsider the following• $300 million CU
– Traditional mix of RE, Auto, Consumer loans– Net worth ratio 13.75%, Minimum ratio required by NCUA 8%– Expense structure to support a $500-700 million shop, very high given size
• Strategy is to grow assets to lower costs– Asset growth options
• Increase RE exposures• Find options to increase consumer loans (indirect, purchase loans, low rates)• Move to commercial loans
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What Growth path is Right for You?Determining required return to meet capital needs• Assume your CU is targeting a 12% RBNW ratio
• How do we set capital requirement by asset class?
• RBNW Target * Risk weight• 150% RW asset – RAROC (ROE) target = 18%• 100% RW asset – RAROC (ROE) target = 12%• 75% RW asset – RAROC (ROE) target = 9% • 50% RW asset – RAROC (ROE) target = 6%• 20% RW asset – RAROC (ROE) target = 2.4%• 0% RW asset - RAROC (ROE) not important, focus on ROA
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RAROC (Lifetime) 5/20 Balloon 20 Yr FRWtd Loan Yield 4.000% 4.500%+Wtd Fees 0.000% 0.000%- Wtd Fund Bench 1.642% 2.330%- Option Risk 0.375% 0.375%- Credit Risk 0.250% 0.250%- Expense 0.792% 0.775%= Spread 0.941% 0.770%- Tax Adjust 0.000% 0.000%= After Tax Spread 0.941% 0.770%/ Capital Req. 12.000% 12.000%= ROE (RAROC) 7.842% 6.417%ROE Target 12.000% 12.000%ROE Spread -4.158% -5.583%
RAROC Comparison - CRE Lifetime
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This lifetime analysis considers all the cash flows.Assuming a 12% ROE target
• 100% risk weighted asset• 12% targeted capital ratio
Note funding costs are higher based on longer term remaining balances.Neither loan produces desired ROEExpenses slightly lower as you amortize fixed costs over longer termKey question is funding cost
• Analysis assumes 100% funding at wholesale advance rates
• Can you “beat” that cost in any way?• Do you have a “budget” or “pool” of long
term funding and is it being allocated already?
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Horizon Income 5/20 Balloon CRE20 Yr FR CRE
@4.5%
Horizon Period (yrs) 3.0 3.0Interest Income $99,158 $111,831+ Fees $0 $0- Fund Expense $39,524 $49,478- Option Risk $9,296 $9,319- Credit Risk $6,197 $6,213- Oper. Expense $20,092 $20,139= Net Income B4 Tax $24,048 $26,683- Taxes $0 $0= After Tax Net Income $24,048 $26,683
Horizon ROE 9.701% 10.737%
RAROC Comparison - CRE 3 Yr Horizon
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Considering just the first 3 years income statement, shows that in the short run the 20 yr CRE more profitable than balloon.Key issue is the funding cost in the later years (the cost of the “tail”)
• How can a FI manage this to be less expensive than using bulleted FHLB advances in years 5 through 20?
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RAROC Comparison - CRE How can we raise the ROE on these loans? • Origination fee • Higher rate?• Additional
relationships?
Goal – Find options that are win\win to get to 12% ROE• Key concern, can you
sell it?
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RAROC (Lifetime)20 YR @
5%
5/20 Balloon w\fee
20 Yr @ 4.5 w\fee
Wtd Loan Yield 5.000% 4.000% 4.500%+Wtd Fees 0.000% 0.250% 0.250%- Wtd Fund Bench 2.330% 1.642% 2.330%- Option Risk 0.375% 0.375% 0.375%- Credit Risk 0.250% 0.250% 0.250%- Expense 0.775% 0.792% 0.775%= Spread 1.270% 1.191% 1.020%- Tax Adjust 0.000% 0.000% 0.000%= After Tax Spread 1.270% 1.191% 1.020%/ Capital Req. 12.000% 12.000% 12.000%= ROE (RAROC) 10.583% 9.925% 8.500%ROE Target 12.000% 12.000% 12.000%ROE Spread -1.417% -2.075% -3.500%
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OTHER COMMON CU EXAMPLES
Assessing profitability of loans
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RATE SHEET
A+ A B C730+ 680-729 640-679 600-639
% % % %
36 months 2.99 3.24 4.49 6.4948 months 3.24 3.49 4.49 6.4960 months 3.24 3.49 4.49 6.4972 months 3.99 4.24 5.24 7.2484 months 4.99 5.24 6.24 n/a
% % % %
36 months 2.99 3.49 4.74 6.7448 months 3.24 3.74 4.74 6.7460 months 3.24 3.74 4.74 6.7472 months 3.99 4.24 5.24 n/a84 months 4.99 5.24 n/a n/a
% % % %
36 months 3.24 3.49 4.74 6.7448 months 3.49 3.74 4.74 6.7460 months 3.49 3.74 4.74 7.2472 months 4.24 4.74 n/a n/a84 months 5.24 n/a n/a n/a
% % % %
36 months 4.24 4.49 5.49 7.4948 months 4.24 4.49 5.49 7.4960 months 4.24 4.49 5.99 7.9972 months 4.74 n/a n/a n/a
2013 & newer
2010 - 2012
2008 & 2009
2007
Typical CU Car Loan Rate SheetCredit Risk Adjustments
Col
late
ral a
nd IR
R A
djus
tmen
ts
Typical 2 factor pricing model• Collateral• Credit
No loan size factor
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Indirect 60 Month Used Auto What would you have to charge to get a 12% ROE• $30k avg. balance• 2.99% buy rate• $350 internal cost
to originate• 0.50% servicing• 0.50% credit loss• 1% dealer fee• 9% (75% RW)
required capitalReturn on Assets• -1.34%Return on Equity• -7.47%
Is it possible to make this loan profitable?
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Investment BenchmarksRisk Free Rate 0.476%+ Int Rate Risk Adjust 0.452%
= Risk Free Match 0.928%+ Option Risk Adjust 0.000%= Investment Benchmark 0.928%+ Credit Risk Adjust 0.500%
+ Expense Adjust 1.743%
+ Add'l Option Risk Adjust 0.250%= Retail Equiv Benchmark 3.420%Wtd Loan Yield 2.990%Spread to Benchmark -0.430%
Indirect 60 Month Used Auto
High cost of acquisition is spread out over a short duration causing higher costs
RAROC (Lifetime)Wtd Loan Yield 2.990%+Wtd Fees 0.000%
- Wtd Fund Bench 1.090%- Option Risk 0.250%- Credit Risk 0.500%- Expense 1.743%= Spread -0.592%- Tax Adjust 0.000%= After Tax Spread -0.592%
/ Capital Req. 9.000%= ROE (RAROC) -6.579%ROE Target 12.000%ROE Spread -18.579%
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Indirect 60 Month Used Auto What would you have to charge to get a 12% ROE• Rate of 4.733%
gets the breakeven RAROC for capital needs.
• Does it make any sense to book loans that when adjusted for credit & interest rate risks is not better than a risk free investment?
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Indirect 60 Month Used Auto – Low Balance Look at horizon profitability measures for smaller dollar value loans using same cost and risk assumptions• Small dollar car loans fail to generate earnings fast enough to cover the
fixed origination costs and services• 1% dealer fee strips most of the profitability on a loan priced at 2.99%
• $30,000 avg balance on higher credit tiers need to adjust for credit costs• Assume 4.99% rate and 0.75% credit loss factor• ROE = +12.09% ROA = +2.18% Retail Benchmark = +1.332%
• $15,000 avg balance on higher credit tiers need to adjust for credit costs• Assume 4.99% rate and 0.75% credit loss factor• ROE = +4.12% ROA = +0.74% Retail Benchmark = +0.653%
Profitability comparison byaverage loan size $5,000 $10,000 $15,000 $20,000 $90,000
Retail Benchmark -4.006% -1.819% -1.18% -0.77% +0.02%
3 Yr ROA -8.59% -4.24% -2.79% -2.07% -0.38%
3 Yr ROE -47.47% -23.57% -15.52% -11.50% -2.11%
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1-4 Family Mortgage – 5 Yr balloon Assumptions• $300k avg. balance• 3.50% rate• $2k orig. cost • 0.20% servicing fee• 6% required capitalReturn on Assets• 0.27%Return on Equity• 2.28%
Can we grow assets and maintain same risk based net worth using this loan?
Do we like this profitability?
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1-4 Family Mortgage – 30 Yr Fixed 16% PPAssumptions• $300k avg. balance• 3.50% rate• $2k orig. cost • 0.20% servicing fee• 6% required capital• 16% PrepaymentRetail Spread: 0.22%Return on Assets• 3 Yr avg. = 0.21%Return on Equity• 3 Yr avg. = 1.74%Better than investment options but do we cover cost of capital?
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1-4 Family Mortgage – 30 Yr Fixed 12% PPAssumptions• $300k avg. balance• 3.50% rate• $2k orig. cost • 0.20% servicing fee• 6% required capital• 12% prepaymentRetail Spread: 0.13%Return on Assets• 0.01%Return on Equity• 0.11%Why did profitability go down on all measures?
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Duration 4.60
RAROC (Lifetime)Wtd Loan Yield 3.500%
+Wtd Fees 0.000%- Wtd Fund Bench 1.941%- Option Risk 0.887%- Credit Risk 0.350%- Expense 0.327%= Spread -0.005%- Tax Adjust 0.000%
= After Tax Spread -0.005%/ Capital Req. 6.000%= ROE (RAROC) -0.087%ROE Target 12.000%ROE Spread -12.087%
1-4 Family RE – 30 Yr Fixed – 16 % CPR
Investment BenchmarksRisk Free Rate 0.476%+ Int Rate Risk Adjust 1.236%
= Risk Free Match 1.712%+ Option Risk Adjust 0.887%= Investment Benchmark 2.599%+ Credit Risk Adjust 0.350%
+ Expense Adjust 0.327%
+ Add'l Option Risk Adjust 0.000%= Retail Equiv Benchmark 3.276%Wtd Loan Yield 3.500%
Spread to Benchmark 0.224%
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1-4 Family RE – 30 Yr Fixed – 12 % CPRDuration 5.53
RAROC (Lifetime)Wtd Loan Yield 3.500%
+Wtd Fees 0.000%- Wtd Fund Bench 2.110%- Option Risk 0.852%- Credit Risk 0.350%- Expense 0.302%= Spread -0.114%- Tax Adjust 0.000%
= After Tax Spread -0.114%/ Capital Req. 6.000%= ROE (RAROC) -1.899%ROE Target 12.000%ROE Spread -13.899%
Investment BenchmarksRisk Free Rate 0.476%+ Int Rate Risk Adjust 1.392%
= Risk Free Match 1.868%+ Option Risk Adjust 0.852%= Investment Benchmark 2.719%+ Credit Risk Adjust 0.350%
+ Expense Adjust 0.302%
+ Add'l Option Risk Adjust 0.000%= Retail Equiv Benchmark 3.372%Wtd Loan Yield 3.500%
Spread to Benchmark 0.128%
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Investment BenchmarksRisk Free Rate 0.476%+ Int Rate Risk Adjust 1.392%
= Risk Free Match 1.868%+ Option Risk Adjust 0.852%= Investment Benchmark 2.719%+ Credit Risk Adjust 0.350%
+ Expense Adjust 0.302%
+ Add'l Option Risk Adjust 0.000%= Retail Equiv Benchmark 3.372%Wtd Loan Yield 3.500%
Spread to Benchmark 0.128%
Investment BenchmarksRisk Free Rate 0.476%+ Int Rate Risk Adjust 1.236%
= Risk Free Match 1.712%+ Option Risk Adjust 0.887%= Investment Benchmark 2.599%+ Credit Risk Adjust 0.350%
+ Expense Adjust 0.327%
+ Add'l Option Risk Adjust 0.000%= Retail Equiv Benchmark 3.276%Wtd Loan Yield 3.500%
Spread to Benchmark 0.224%
1-4 Family RE – 30 Yr Comparison of Prepay Effect
16% Prepayment 12% Prepayment
Slower prepay means more adjustment required for longer term cash flows on the books which cuts profitability
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Summary ResultsRetail Benchmark Spread 0.128%Investment Benchmark Spread 0.781%ROE 0.11%ROE Target 12.00%ROA 0.01%
Summary ResultsRetail Benchmark Spread 0.224%Investment Benchmark Spread 0.901%ROE 1.74%ROE Target 12.00%ROA 0.21%
1-4 Family RE – 30 Yr Comparison of Prepay Effect
16% Prepayment 12% Prepayment
Both loans look to add value to the income statement with positive ROA values, and a positive spread to investments when adjusted for risks and costs. But can we grow with these and maintain our capital?
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Duration 5.53
RAROC (Lifetime)Wtd Loan Yield 3.500%
+Wtd Fees 0.000%- Wtd Fund Bench 2.110%- Option Risk 0.852%- Credit Risk 0.350%- Expense 0.302%= Spread -0.114%- Tax Adjust 0.000%
= After Tax Spread -0.114%/ Capital Req. 6.000%= ROE (RAROC) -1.899%ROE Target 12.000%ROE Spread -13.899%
Duration 4.60
RAROC (Lifetime)Wtd Loan Yield 3.500%
+Wtd Fees 0.000%- Wtd Fund Bench 1.941%- Option Risk 0.887%- Credit Risk 0.350%- Expense 0.327%= Spread -0.005%- Tax Adjust 0.000%
= After Tax Spread -0.005%/ Capital Req. 6.000%= ROE (RAROC) -0.087%ROE Target 12.000%ROE Spread -12.087%
1-4 Family RE – 30 Yr Comparison of Prepay Effect
16% Prepayment 12% Prepayment
Overall profitability is lower because cash flows remain on books longer, and we are assuming we have to fully fund with FHLB advances which are more $$ in longer terms.
IT’S ALL ABOUT CASH FLOW!
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Add on loan exampleCurrent member with 72 month car loan at 4%• Remaining term of 54 months (1.5 yrs old)
Member wants to borrow $3,000 to:• Consolidate credit card debt, • Add a deck to house, or…• What are your options:
– Sell a Home Equity Loan– Sell a Personal Loan– Refinance Car Loan with add-on balance
• What do you do?
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Consider This Common CU LoanFirst, consider the profitability of the $3,000 car loan• Can’t consider the total loan balance as a new loan because you
already have that loan. • Must look at the value of only adding $3,000 more• We know that the cost of the new loan documentation, filings, etc.
are not being covered
But what happens to overall net interest income or margin?
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Consider This Common CU LoanLoan Details Strategy 1: Current Loan
Retail Balances Rate IncomeOriginal Car Loan 15,000$ 4.000% 600$ 0.000% -$ Total Loans 15,000$ 4.000% 600$ Investments -$ 0.000% -$ Total Assets 15,000$ 4.000% 600$
• Current Loan @ 4% earning $600 per year in interest
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Consider This Common CU LoanMarginal Return Calculation by FARIN iPriceNew Loan Option Strategy 2: Lower car rate & +3k
Detail Balances Rate IncomeOriginal Car Loan 15,000$ 2.990% 449$ Additional Loan $s 3,000$ 2.990% 90$ Total Retail Funds 18,000$ 2.990% 538$ Investments -$ 0.000% -$ Total Assets 18,000$ 2.990% 538$
Reduce rate on existing loan to new offer rate of 2.99%• Remember, is 2.99% even profitable?
Add additional $3,000 @ 2.99%Total Income from new loan $538 per year• Down $62 in total income despite more balances in loans!
How many deals can you do like this and make money?
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Consider This Common CU LoanSummary Balances Rate IncomeRetailStrategy 1: Current Loan 15,000$ 4.000% 1,760$ Strategy 2: Lower car rate & +3k 18,000$ 2.990% 2,330$ Change 3,000$ -1.010% (62)$ Marginal Return on Loans -2.060%
Normally CU’s look at spread being reduced by 1.01% • Difference in the AVERAGE return of 4% to 2.99%• But that’s not the real story…
The real return on the new $3,000 loan is calculated by dividing the change in the income by change in the balances
(62) / 3,000 = -2.06%
Do we make this up on volume?
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Loan Pricing in the RBNW WorldTake Aways• CU’s intend to grow assets, and therefore loans
• Pressure on capital will result over time• Lenders and finance teams must unite to find win\win solutions
• Terms to meet market demands and asset growth expectations• Build understanding of risk and cost realities in loan profitability• Use pricing tools effectively to avoid buying “Fool’s Gold”
• Common thoughts on loan profitability and risk must be measured and assessed for reality
• Gut reactions and prevailing thought may not be right
• What may “feel like a good idea” may in fact be costing opportunities for other growth
• More interaction between finance\treasury and lending departments to build a solid foundation for loan pricing that meets everyone’s needs.
• Volume is NOT the answer!
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FARIN Financial Risk ManagementAdvisory Services• From education to strategy FARIN
can recharge your approach to ALCO
Capital Planning• Capital plan development• Integrated stress testing• Capital buffer calculations Asset/Liability Management• Institution managed• Outsourced• Hybrid
Core Deposit Analysis• Vintage analysis• Sensitivity testingCredit Services• ALLL calculation (CECL ready)• Dual loan grading & migration• Credit stress testing• Customer management & trackingLoan & Deposit Pricing• Integrate CFO analytics with needs
of the front-line• Strategy developmentData Warehousing• One data source for all risk analysis
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