THE QUANTIFICATION OF LOAN

RESTRUCTURINGAn Introduction

Goal

Create Awareness of some Quantification Tools

Effect of Compounding Risk Impact of Term Extension Why Fixed Rates Create Break Costs

Topics

QUALITATIVE QUANTITATIVE

CAMPARI 5 Cs

The 5 Variables Compounding Drivers of Interest Risk Term Extension

Loan Book Management

Management of the Loan book Portfolio

Correlations Portfolio Risk Economic Capital

Facility specific Default & Migration (deterioration) Exposure at Default & Loss Given Default

Not Covere

d!

Campari

Character Know your

customer Ability

To repay Margin

Pricing: cost of funds, risk, profit

Purpose Use of loan

proceeds

Amount Size of loan

Repayment income, savings,

asset disposal Insurance

Credit enhancement Security Guarantee

5 Cs

Character Know your customer

Capacity Ability and sources of repayment

Legal(Subject to CostBenefit Analysis)

SympatheticWork-out

Legal

New ArrangementForbearance

Attitude

Ab

ilit

y

Don’t Want to Pay

Can’tPay

Want to Pay

CanPay

Current Arrangement

Character & Capacity

5 Cs

Character Know your customer

Capacity Ability and sources of repayment

Capital How much is the borrower investing in the

project? Conditions

What are the loan covenants? Collateral

Security & Credit Enhancement

QuantificationWhat are the key factors?

5 Variables…

The Variables: Number of Periods (N) Interest rate (i) Present Value (PV) Payment per Period (PMT) Future Value (FV)

[Financial Calculator]

5 Variables…

The Variables: Number of Periods (N) 1 Interest rate (i) 10% Present Value (PV) €100 Payment per Period (PMT) Future Value (FV) €0

€110

Loan of €100 – 1 year (10%)

0 1

(€100)

(€50)

€0

€50

€100

Years

Cash Flow €110 in the year

Total Cost of Credit

1 Year

Repayment €110.00

No. of Years x 1

Total €110.00

Loan Value €100.00

Cost of Credit

€10.00

5 Variables…

The Variables: Number of Periods (N) 2 Interest rate (i) 10% Present Value (PV) €100 Payment per Period (PMT) Future Value (FV) €0

€57.62

Loan of €100 – 2 years (10%)

0 1 2

(€100)

(€80)

(€60)

(€40)

(€20)

€0

€20

€40

€60

Years

Cash Flow

€57.62 per year

Total Cost of Credit

1 Year

2 Years

Repayment €110.00

€57.52

No. of Years x 1 x 2

Total €110.00

€115.04

Loan Value €100.00

€100.00

Cost of Credit

€10.00 €15.04

5 Variables…

The Variables: Number of Periods (N) 3 Interest rate (i) 10% Present Value (PV) €100 Payment per Period (PMT) Future Value (FV) €0

€40.21

Loan of €100 – 3 years (10%)

0 1 2 3

(€100)

(€80)

(€60)

(€40)

(€20)

€0

€20

€40

Years

Cash Flow

€40.21 per year

Total Cost of Credit

1 Year

2 Years

3 Years

Repayment €110.00

€57.52 €40.21

No. of Years x 1 x 2 x 3

Total €110.00

€115.04

€120.63

Loan Value €100.00

€100.00

€100.00

Cost of Credit

€10.00 €15.04 €20.63

5 Variables…

The Variables: Number of Periods (N) 5 Interest rate (i) 10% Present Value (PV) €100 Payment per Period (PMT) Future Value (FV) €0

€26.38

Loan of €100 – 5 years (10%)

0 1 2 3 4 5

(€100)

(€80)

(€60)

(€40)

(€20)

€0

€20

Years

Cash Flow

€26.38 per year

Total Cost of Credit

1 Year

2 Years

3 Years

5 years

Repayment €110.00

€57.52 €40.21 €26.38

No. of Years x 1 x 2 x 3 x 5

Total €110.00

€115.04

€120.63

€131.90

Loan Value €100.00

€100.00

€100.00

€100.00

Cost of Credit

€10.00 €15.04 €20.63 €31.90

5 Variables…

The Variables: Number of Periods (N) 10 Interest rate (i) 10% Present Value (PV) €100 Payment per Period (PMT) Future Value (FV) €0

€16.27

Loan of €100 – 10 years (10%)

0 1 2 3 4 5 6 7 8 9 10

(€100)

(€80)

(€60)

(€40)

(€20)

€0

€20

Years

Cash Flow

€16.27 per year

Total Cost of Credit

1 Year

2 Years

3 Years

5 years

10 years

Repayment €110.00

€57.52 €40.21 €26.38 €16.27

No. of Years x 1 x 2 x 3 x 5 x 10

Total €110.00

€115.04

€120.63

€131.90

€162.70

Loan Value €100.00

€100.00

€100.00

€100.00

€100.00

Cost of Credit

€10.00 €15.04 €20.63 €31.90 €62.70

As the Term Increases

Repayments reduced More time to repay

Total Cost of Credit increases More borrowed for longer

Bank’s Exposure increases More later

In Summary

1 Year

2 Years

3 Years

5 years

10 years

Repayment €110.00

€57.52 €40.21 €26.38 €16.27

No. of Years x 1 x 2 x 3 x 5 x 10

Total €110.00

€115.04

€120.63

€131.90

€162.70

Loan Value €100.00

€100.00

€100.00

€100.00

€100.00

Cost of Credit

€10.00 €15.04 €20.63 €31.90 €62.70

5 Variables…

The Variables: Number of Periods (N) Interest rate (i) Present Value (PV) Payment per Period (PMT) Future Value (FV)

Interest Calculations How many payments per year? How often is interest charged?

Compounding

Compounding…

Daily Interest Rate: Late Payment of CAT

A mere 0.0219% per day! What is the APR?

The rate if interest was compounded once a year

(1+ 0.0219100 )365

=1.083207=8.32%

CAT 2012 & 2016…

(1+ 0.0219100 )366

=1.084444=8.34%

(1+ 0.0219100 )365

=1.083207=8.32%

Compounding…

More Frequent Charging Higher Effective

Rate Example

Rate of 10% PV = 100 No payments in

the year Calculate the

Future Value (FV)

Effect of Compounding Once a Year Twice a year? Once a Quarter? Once a Month?

Loan of €100 – 1 year (10%)

0 1

(€100)

(€50)

€0

€50

€100

Years

Cash Flow €110 in the year

Impact of Compounding…

The Formula

(1+ 𝑅𝑎𝑡𝑒𝐶𝑜𝑚𝑝𝑜𝑢𝑛𝑑 𝑃𝑒𝑟𝑖𝑜𝑑𝑠 )

𝐶𝑜𝑚𝑝𝑜𝑢𝑛𝑑𝑃𝑒𝑟𝑖𝑜𝑑𝑠

−1

(1+ .102 )2

−1=1.052−1=1.1025−1

(1+ .104 )4

−1=1.0254−1=1.103812891−1

What Drives the Rate?

Costs of Funds Cost of Borrowing

Risk Credit Risk Interest Rate Risk Capital Required (driven by Risk)

Equity: Dearer than Debt Expenses

Administration Profit Margin

Cost of Funds

Liquidity Preference Theory (JM Keynes) Transactions Motive

Cash for Pints! Parking

Precautionary Motive Rainy Day

Speculative Motive Speculation

Supply & Demand Inter-Bank Liquidity

What will it Cost to Borrow?

Bank of Ireland Homeloan Variable Rates for existing

customers Variable VRP15 – all amounts, all LTVs

3.85% (APR: 3.9%)Lending criteria and terms and conditions apply. Security and insurance required. The maximum mortgage is normally 90% of the property value. As a general rule, mortgage amounts up to 4-5 times an individual's gross annual income are considered and will vary according to individual circumstances. A typical variable rate mortgage of €100,000 over 20 years costs €596.94 per month (Annual Percentage Rate (APR) 3.9%). The cost of your monthly repayments may increase. A 1% interest rate rise will increase this repayment to €650.08 (APR4.9%). This is an increase of €53.14 per month. Information correct as at the 19th December 2011. Bank of Ireland Mortgage Bank is a member of Bank of Ireland Group. Bank of Ireland and Bank of Ireland Mortgage Bank, trading as Bank of Ireland Mortgages are regulated by the Central Bank of Ireland.http://personalbanking.bankofireland.com/mortgages/first-time-buyers-package#rates-accordion

Lending criteria and terms and conditions apply. Security and insurance required. The maximum mortgage is normally 90% of the property value. As a general rule, mortgage amounts up to 4-5 times an individual's gross annual income are considered and will vary according to individual circumstances. A typical variable rate mortgage of €100,000 over 20 years costs €596.94 per month (Annual Percentage Rate (APR) 3.9%). The cost of your monthly repayments may increase. A 1% interest rate rise will increase this repayment to €650.08 (APR4.9%). This is an increase of €53.14 per month. Information correct as at the 19th December 2011. Bank of Ireland Mortgage Bank is a member of Bank of Ireland Group. Bank of Ireland and Bank of Ireland Mortgage Bank, trading as Bank of Ireland Mortgages are regulated by the Central Bank of Ireland.http://personalbanking.bankofireland.com/mortgages/first-time-buyers-package#rates-accordion

Real Rates

Time Value of MoneyNPV & IRR

Time Value of Money

Money Today Is worth more than money tomorrow! How much?

What is your “exchange rate”?

TVM Game

NPV: Would you buy this?

0 1 2 3 4 5

(€1,000)

(€750)

(€500)

(€250)

€0

€250

€500

(€1,000)

€100 €200

€300 €400

€300

Years

Cash Flow

Discount Rate & Value

5.50

%

6.00

%

6.50

%

7.00

%

7.50

%

8.00

%

8.50

%

9.00

%

9.50

%

10.0

0%

10.5

0%

11.0

0%

11.5

0%

12.0

0%

12.5

0%

13.0

0%

-€150

-€100

-€50

€0

€50

€100IRRThe rate which yields an NPV of €0!In this case, the IRR is 8.01%

Risk!

What Drives the Rate?

Costs of Funds Cost of Borrowing

Risk Credit Risk Interest Rate Risk Capital Required (driven by Risk)

Equity: Dearer than Debt Expenses

Administration Profit Margin

Loan of €100 – 1 year (10%)

0 1

(€100)

(€50)

€0

€50

€100

Years

Cash Flow €110 in the year

Impact of Risk

OK Total

Nominal €110.00

Probability 1.0

Expected Return

€110.00

€110.00

Interest Rate 10%

Value of Debt €100.00=€100

Risk Fr

ee

Impact of Risk

OK Default

Total

Nominal €110.00

€0.00

Probability 0.8 0.2

Expected Return

€88.00

€0.00 €88.00

Interest Rate 10%

Value of Debt €80.00

You would pay €80 for a loan note paying 10% with a 20% probability of default

=€80

Risk

What is the Interest Rate?

OK Default

Total

Nominal €110.00

€0.00

Probability 0.8 0.2

Expected Return

€88.00

€0.00 €88.00

Interest Rate 10%

Value of Debt €80.00

€110€80

?𝐼𝑛𝑡𝑒𝑟𝑒𝑠𝑡=𝑃𝑟𝑜𝑚𝑖𝑠𝑒𝑑𝑅𝑒𝑡𝑢𝑟𝑛𝑉𝑎𝑙𝑢𝑒𝑜𝑓 𝐷𝑒𝑏𝑡

=€ 110€ 80

=37.5%

€uro Bonds

Bonds Denominated in €uro No currency risk

Issued by Different Countries Credit Risk

Germany – Best Greece – Worst

March 3rd

Germany 1.81%1.92%

Greece 38.8%37.1%

February 25th 2012

What Drives the Rate?

Costs of Funds Cost of Borrowing

Risk Credit Risk Interest Rate Risk Capital Required (driven by Risk)

Equity: Dearer than Debt Expenses

Administration Profit Margin

Expenses & Profit

Banks are in Business to Make Profit! Cover Expenses Yield a Profit

How priced Included in the Margin

What Happens when Variables Change?The main restructure options!

5 Variables…

The Variables: Number of Periods (N) Interest rate (i) Present Value (PV) Payment per Period (PMT) Future Value (FV)

This is a term extension

Term Extension

Monthly Repayments Fall Increase Affordability

Term Increases! Balance Outstanding Increases

Example €100,000 @ 5% over 20 years Becomes… €100,000 @ 5% over 25 years

Should the Rate be the same?

Effect of Term Extension

0 1 2 3 4 5 6 7 8 9 10111213141516171819202122232425€0

€20,000

€40,000

€60,000

€80,000

€100,000

Effect of Term Extension

0 1 2 3 4 5 6 7 8 9 10111213141516171819202122232425€0

€20,000

€40,000

€60,000

€80,000

€100,000

Effect of Term Extension

0 1 2 3 4 5 6 7 8 9 10111213141516171819202122232425€0

€20,000

€40,000

€60,000

€80,000

€100,000

Effect of Term Extension

0 2 4 6 8 10 12 14 16 18 20 22 24€0

€5,000

€10,000

€15,000

€20,000

€25,000

€30,000

€35,000

5 Variables…

The Variables: Number of Periods (N) Interest rate (i) Present Value (PV) Payment per Period (PMT) Future Value (FV)

This is a Bullet Repayment( “split” mortgage)

Bullet Repayment

Monthly Repayments Fall Increase Affordability

Term? May Increase Alternative Source of Repayment?

Balance Outstanding Increases Example

€100,000 @ 5% over 20 years Becomes… €100,000 @ 5% over 20 years owing €30k in year

20!

Should the Rate be the same?

Effect of Bullet Repayment

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20€0

€5,000

€10,000

€15,000

€20,000

€25,000

€30,000

€35,000

€30,719

Source of Repayment:Asset Sale?Pension Lump Sum?Inheritance?Term Extension?

Probability of Default

The risk you will have a default Risk of a failure

What drives risk? Many Factors… Length of a loan!

If every payment has a 1% chance of default…

1 13 25 37 49 61 73 85 97 1091211331451571691811932052172290.00

0.25

0.50

0.75

1.00

Default

If every payment has a 0.1% chance of default…

1 13 25 37 49 61 73 85 97 1091211331451571691811932052172290.00

0.25

0.50

0.75

1.00

Default

If every payment has a 0.01% chance of default…

1 13 25 37 49 61 73 85 97 1091211331451571691811932052172290.960

0.965

0.970

0.975

0.980

0.985

0.990

0.995

1.000

Default

If every payment has a 0.001% chance of default…

1 13 25 37 49 61 73 85 97 1091211331451571691811932052172290.9960

0.9965

0.9970

0.9975

0.9980

0.9985

0.9990

0.9995

1.0000

Default

Loss Given Default

Security? Default does not mean total loss

Exposure at Default Security Other Costs

Summary

“Kicking the Can” Not always the right answer

Risk Length of a loan Riskiness of a repayment

The more repayments… The greater the overall risk

Asset Value Cover: “positive” equity Asset value vs loan value

It’s a Fixed Rate!What Happens?

Fixed Rate Lending

Fixed Rates Provide Certainty Customer Knows Repayment Amount

Risk? Interest Rates Change!

Rates Go Up… Bank Loses money

Rates Go Down… Bank Makes Money

Manage Interest Rate Risk Interest Rate Swap

How Does a Swap Work?

Counterparty A

BANKCounterparty

B

VariableVariable

Fixed Fixed

Investors Receive Fixed

Investors Receive Variable

How Does a Swap Work?

Counterparty A

BANKCounterparty

B

VariableVariable

Investors Receive Fixed

Investors Receive Variable

5% 5%

How Does a Swap Work?

Counterparty A

BANK

Fixed Rate Mortgage

Holder

Variable

Variable

Fixed

Fixed

Investors Receive Fixed

Bank Depositor

Fixed

Variable

Counterparty B

Interest RateRisk is “Locked Out”

How Does a Swap Work?

Counterparty A

BANK

Variable

Investors Receive Fixed

Variable

Counterparty B

Interest RateRisk is “Locked Out”

5% Fixed3%

The Replacement Swap is at 3%... not 5%.

What is the Cost?

The Mortgage was 5% The new counterparty is 3% Gap 2%

What is the Break Cost? Let’s use the Earlier Example

20 year Mortgage 5% €100,000

Expected Balances

0 1 2 3 4 5 6 7 8 9 1011121314151617181920€0

€20,000

€40,000

€60,000

€80,000

€100,000

20 years

Fixed Interest Payment

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20€0

€1,000

€2,000

€3,000

€4,000

€5,000

LossNew Amt

Interest Lost…

0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20€0

€500

€1,000

€1,500

€2,000

Loss

The Value of Break CostsPeriod New Amt Loss 5% PV Value

0 €3,000 €2,000 1 €2,0001 €2,909 €1,940 0.952381 €1,8482 €2,814 €1,876 0.907029 €1,7023 €2,714 €1,809 0.863838 €1,5634 €2,609 €1,739 0.822702 €1,4315 €2,499 €1,666 0.783526 €1,3056 €2,383 €1,589 0.746215 €1,1867 €2,261 €1,508 0.710681 €1,0728 €2,134 €1,422 0.676839 €9629 €2,000 €1,333 0.644609 €859

10 €1,859 €1,239 0.613913 €76111 €1,711 €1,141 0.584679 €66712 €1,556 €1,037 0.556837 €57713 €1,393 €929 0.530321 €49314 €1,222 €815 0.505068 €41215 €1,042 €695 0.481017 €33416 €854 €569 0.458112 €26117 €656 €437 0.436297 €19118 €448 €298 0.415521 €12419 €229 €153 0.395734 €6120 €0 €0 0.376889 €0

Total €24,195 €17,807

1

(1+0.05)4=0.822702

0.822702×€ 1,739=€ 1,431

How to Value Break Costs

Interest Lost Calculate Take the Present Value

Amortising Swaps Difficult to Value Our Example is simplified!

For Example, the 5% is a bit more complicated!! “Break” Costs

CPC Rules

Let’s Look at Real Rates

New Loans are Easy!

I can afford €1,000 per month… how much can I borrow?

APR 3.9% 20 Years €167,521 25 Years €192,912 30 Years €213,887

Scrap “Book” of screen shots

Restructuring Options

Tracker RatesThe Impact of a Term Extension

Trackers: Extending the Term

Trackers are Loss Making ECB rate + margin ECB rate is LESS than our cost of funds

CCMA Cannot move someone from a tracker due to

arrears Impact of term extension

Funding a greater exposure at loss making rates!

Effect of Term Extension

0 1 2 3 4 5 6 7 8 9 10111213141516171819202122232425€0

€20,000

€40,000

€60,000

€80,000

€100,000

Effect of Term Extension

0 2 4 6 8 10 12 14 16 18 20 22 24€0

€5,000

€10,000

€15,000

€20,000

€25,000

€30,000

€35,000

Restructure: Generate Cash

Cash Recovery Earnings Inheritance Asset Disposal

How much Cash? Principal Cost of Funds Profit Risk Premium

Restructure is Difficult!

Many Variables Term Extension Sources of

Repayment Income Asset Disposal

House? Risk

P[D] – Probability of Default ↑

LGD – Loss Given Default?

Regulatory Compliance CCMA CPC

Need to “fit” customer’s circumstances Sustainability

Restructure – Watch for…

Costs Taking Possession is Expensive Liability for NPPR

Currently €200 p.a. Insurance Maintenance

Sustainability Need to prove in hindsight (keep your workings)

Legal(Subject to CostBenefit Analysis)

SympatheticWork-out

Legal

New ArrangementForbearance

Attitude

Ab

ilit

y

Don’t Want to Pay

Can’tPay

Want to Pay

CanPay

Current Arrangement

Character & Capacity

• Restructure – is a people business.

• The quants are just a support

Restructure Options

Qualitative Factors 5 Cs Campari

Quantitative Factors Interest Rate Risk