EVALUATING CONSUMER LOANSChapter 17Bank Management, 5th edition. Timothy W. Koch and S. Scott MacDonaldCopyright 2003 by South-Western, a division of Thomson Learning

Recent trends in consumer lendingCredit scoringmore lenders use statistical models to predict which individuals are good and bad credit risks. Rapid consolidation of the credit card business at year-end 1997, for example, the 10 largest bank card issuers held approximately 85% of all credit card loans. Move to subprime lending, where banks court the business of higher risk individuals. it is popular because banks credit score these loans and thus feel comfortable pricing these loans at much higher rates than prime loans.

Evaluating consumer loansWhen evaluating consumer loan requests, an analyst addresses the same issues discussed with commercial loans: the use of loan proceeds, the amount needed, the primary and secondary source of repayment. However, consumer loans differ so much in design that no comprehensive analytical format applies to all loans.

Installment loansInstallment loans require the periodic payment of principal and interest.Installment loans may be either direct or indirect loans. A direct loan is negotiated between the bank and the ultimate user of the funds.An indirect loan is funded by a bank through a separate retailer that sells merchandise to a customer.

Costs and returns on consumer installment loans: functional cost analysis data

Sheet1

Deposit Size (Millions of Dollars)

$200$200

Data

Average size of loan$5,104$5,448

Average number of loans1,1466,729

Number of banks surveyed7049

Costs per Loan

Cost to make a loan:

Electronic$202.42$84.56

Nonelectronic152.17137.49

Cost to maintain a loan (monthly)

Electronic$19.21$16.96

Nonelectronic21.7420.07

Loan loss (average size loan)27.0531.05

Total$422.59$290.13

As a Percent of Total Loans Outstanding

Loan income*10.11%9.35%

Expenses

Direct3.62.83

Net indirect0.970.7

Loan loss rate (3-year average)0.530.57

Total5.14.1

Net yield5.015.25

Cost of funds3.283.31

Net spread1.73%1.94%

Sheet2

Sheet3

Credit cards and other revolving creditCredit cards and over-lines tied to checking accounts are the two most popular forms of revolving credit agreements.In 2001 consumers charged almost $650 billion on credit cards.Most operate as franchises of MasterCard and/or Visa. bank must pay a one-time membership fee plus an annual charge determined by the number of its customers actively using the cards.

Credit card loss rate and personal bankruptcy filings

Credit cards are attractive because they provide higher risk-adjusted returns than do other types of loans.Card issuers earn income from three sources:card holders annual fees,interest on outstanding loan balances, and discounting the charges that merchants accept on purchases.

Credit card transaction processIndividualCard-Issuing BankClearing NetworkLocal Merchant BankRetail Outlet142332

Steps

Fees

1.Individual uses a credit card to purchase merchandise from a retail outlet.

1.None

2.Retail outlet deposits the sales slip or electronically transmits the purchase data at its local bank.

2.The merchant bank discounts the sales receipt. A 3 percent discount indicates the bank gives the retailer $97 in credit for each $100 receipt.

3.Local merchant bank forwards the transaction information to a clearing network, which routes the data to the bank that issued the credit card to the individual.

3.The card-issuing bank charges the merchant bank an interchange fee equal to 1 to 1.5 percent of the transaction amount for each item handled.

4.The card-issuing bank sends the individual an itemized bill for all purchases.

4.The card-issuing bank charges the customer interest and an annual fee for the privilege of using the card. A card-issuing bank also serves as a merchant bank.

Debit cards, smart cards, and prepaid cardsDebit cards are widely availablewhen an individual uses the card, their balance is immediately debited.they have lower processing costs to the bankA smart card is an extension of debit and credit cardscontains a memory chip which can manipulate informationit is programmable such that users can store information and recall this information when effecting transactions.only modest usage in the U.S.

The future of smart cardsSmart card usage will likely increase dramatically in the U.S.:firms can offer a much wider range of servicessmart cards represent a link between the internet and real economic activitysuppliers of smart cards are standardizing the formats so that all cards work on the same systems

Prepaid cardsPrepaid cards such as phone cards, prepaid cellular, toll tags, subway, etc. are growing rapidly.Prepaid cards are a hybrid of debit cards in which customers prepay for services to be rendered and receive a card against which purchases are charged.

Overdraft protection and open credit linesRevolving credit also takes the form of overdraft protection against checking accounts.One relatively recent innovation is to offer open credit lines to affluent individuals whether or not they have an existing account relationship.In most instances, the bank provides customers with special checks that activate a loan when presented for payment.

Home equity loans and credit cardsHome equity loans grew from virtually nothing in the mid-1980s to over $220 billion in 2001Home equity loans meet the tax deductibility requirements of the Tax Reform Act of 1986, which limits deductions for consumer loan interest paid by individuals, because they are secured by equity in an individual's home.These credit arrangements combine the risks of a second mortgage with the temptation of a credit card, a potentially dangerous combination.

Non-installment loansA limited number of consumer loans require a single principal and interest payment.Bridge loans are representative of single payment consumer loans.Bridge loans often arise when an individual borrows funds for the down payment on a new house.

Subprime loansDuring the 1990s, one of the hottest growth areas was subprime lending. Subprime loans are higher-risk loans labeled labeled B, C, and D creditsThey have been especially popular in auto, home equity, and mortgage lending. These are the same risk loans as those originated through consumer finance companies.

What are subprime loans?Although no precise definitions exist, B, C, and D credits exhibit increasingly greater risk and must be priced consistently higher than prime-grade loans. Paul Finfer of Franklin Acceptance Corp, a subprime auto lender, provided the following definitions:B: typically scores 600+ under the Fair Isaac system; has some 90-day past dues but is now current. When extended credit, typical delinquencies are 2%-5%; repossessions are 2.5%-6%; and losses are 1.5%-3%.C: typically scores between 500 and 600 and has had write-offs and judgments. The borrower has made subsequent payments of some or all of the loans. When extended credit, delinquencies are typically 5%-10%; repos, 5%-20%; and losses 3%-10%.D: typically scores between 440 and 500 and has charge-offs and judgments that have not been repaid and has not made payments on these loans. When extended credit, delinquencies are 10%-20%; repos, 16%-40%; losses, 10%-20%.

High LTV loansDuring the latter half of the 1990s, many lenders upped the stakes by making high LTV (loan-to-value) loans based on the equity in a borrowers home. Where traditional home equity loans are capped at 75 percent of appraised value minus the outstanding principal balance, high LTV loans equal as much as 125% of the value of a home.

Consumer credit regulationsEqual Credit Opportunity Act (ECOA), makes it illegal for lenders to discriminate.Prohibits Information Requests on:the applicant's marital status,whether alimony, child support, and public assistance are included in reported income,a woman's childbearing capability and plans,whether an applicant has a telephone.

Credit scoring systemsCredit scoring systems are acceptable if they do not require prohibited information and are statistically justified.Credit scoring systems can use information about age, sex, and marital status as long as these factors contribute positively to the applicant's creditworthiness.

Credit reportingLenders must report credit extended jointly to married couples in both spouses' names.Whenever lenders reject a loan, they must notify applicants of the credit denial within 30 days and indicate why the request was turned down.

Truth in lendingTruth in lending regulations apply to all individual loans up to $25,000 where the borrower's primary residence does not serve as collateral.Legislation arose because lenders quoted interest rates in many different ways and often included supplemental charges in a loan that substantially increased the actual cost.

Truth in lending disclosure requirementsrequires that lenders disclose to potential borrowers both the total finance charge and an annual percentage rate (APR).The APR equals the total finance charge computed against the loan balance as a simple annual interest rate equivalent.Historically, consumer loan rates were quoted as add-on rates, discount rates, or simple interest rates.

Add-on ratesapplied against the entire principal of installment loans.Gross interest is added to the principal with the total divided by the number of periodic payments to determine the size of each payment.Example: suppose that a customer borrows $3,000 for one year at a 12 percent add-on rate with the loan to be repaid in 12 equal monthly installments. Total interest equals $360, monthly payment equals $280, and the effective annual interest cost is approximately 21.5%.

Discount rate methodthe quoted rate is applied against the sum of principal and interest, yet the borrower gets to use only the principal, as interest is immediately deducted from the total loan.Example: consider a 1-year loan with a single $3,000 payment at maturity. The borrower receives only $2,640, or the total loan minus 12% discount rate interest. The effective annual percentage rate, or APR, equals 13.64%Interest charge = 0.12 ($3,000)= $360

Simple interestinterest paid on only the principal sum.Example: $3,000 loan at 12% simple interest per year produces $360 in interest, or a 12 percent effective rate Interest (is): = $3,000(0.12)(1)= $360 The quoted rate (APR) is adjusted to its monthly equivalent, which is applied against the unpaid principal balance on a loan. Hence a $3,000 loan, repaid in 12 monthly installments at 1% monthly simple interest, produces interest under $200. The monthly interest rate equals 1 percent of the outstanding principal balance at each interval. Depending on how it is quoted, a 12 percent rate exhibits a noticeably different effective rate, ranging from 12% to 21.5% in the examples to follow.

$3,000 loan for 1 year, 1% monthly simple interest rate, repaid in 12 equal monthly installments.

Repayment Schedule

End of Month

MonthlyPayment

Interest Portion

Principal

Outstanding Principal Balance

January

$266.55

$30.00

$236.55

$2,763.45

February

266.55

27.63

238.92

2,524.53

March

266.55

25.25

241.30

2,283.23

April

266.55

22.83

243.72

2,039.51

May

266.55

20.40

246.15

1,793.36

June

266.55

17.93

248.62

1,544.74

July

266.55

15.45

251.10

1,293.64

August

266.55

12.94

253.61

1,040.03

September

266.55

10.40

256.15

783.88

October

266.55

7.84

258.71

525.17

November

266.55

5.25

261.30

263.87

December

266.51

2.64

263.87

0.00

Total

$3,198.56

$198.56

$3,000.00

Effective interest rate:Monthly rate= 1%

Annual precentage rate= 12%

_1090302027.unknown

Fair credit reportingThe Fair Credit Reporting Act enables individuals to examine their credit reports provided by credit bureaus. If any information is incorrect, the individual can have the bureau make changes and notify all lenders who obtained the inaccurate data.There are three primary credit reporting agencies:Equifax, Experian, and Trans Union. Unfortunately, the credit reports that they produce are quite often wrong.

Sample Credit Report

Community reinvestmentThe Community Reinvestment Act (CRA) was passed in 1977 to prohibit redlining and to encourage lenders to extend within their immediate trade area and the markets where they collect deposits.FIRREA of 1989 raised the profile of the CRA by: mandating public disclosure of bank lending policies and regulatory ratings of bank compliance.Regulators must also take lending performance into account when evaluating a bank's request to charter a new bank, acquire a bank, open a branch, or merge with another institution.

Bankruptcy reformIndividuals who cannot repay their debts on time can file for bankruptcy and receive court protection against creditors.Individuals can file for bankruptcy under:Chapter 7, individuals liquidate qualified assets and distribute the proceeds to creditors.Chapter 13, an individual works out a repayment plan with court supervision.Individuals appear to be using bankruptcy as a financial planning tool; the stigma of bankruptcy is largely gone.

Credit analysisThe objective of consumer credit analysis is to assess the risks associated with lending to individuals.When evaluating loans, bankers cite the Cs of credit: character:the most important element--difficult to assesscapital:refers to the individual's wealth positioncapacity:the lender often imposes minimum down payment requirements and maximum allowable debt-service to income ratiosconditions:the impact of economic events on the borrower's capacity to pay collateral:the importance of collateral is in providing a secondary source of repayment.

Two additional Cs have been added reflecting customer relationships and competitionCustomer relationshipA banks prior relationship with a customer reveals information about past credit and deposit experience that is useful in assessing willingness and ability to repay. Competition has an impact by affecting the pricing of a loan. all loans should generate positive risk-adjusted returns. lenders periodically react to competitive pressures by undercutting competitors rates in order to attract new business. still, such competition should not affect the accept/reject decision.

Policy guidelines Acceptable LoansConsumer loans are extended for a variety of purposes. Acceptable LoansAutomobileBoatHome ImprovementPersonal-UnsecuredSingle PaymentCosigned

Policy guidelines Unacceptable LoansUnacceptable LoansLoans for speculative purposes.Loans secured by a second lien, other than home improvement or home equity loans.Any participation with a correspondent bank in a loan that the bank would not normally approve.Accommodation loans to a poor credit risk based on the strength of the cosigner.Single payment automobile or boat loans.Loans secured by existing home furnishings.Loans for skydiving equipment and hang gliders.

Evaluation procedures: Judgmental and credit scoringBanks employ basically two procedures when evaluating consumer loans :judgmental procedures the loan officer subjectively interprets the information in light of the banks lending guidelines and accepts or rejects the loanquantitative credit scoring or credit scoring model the loan officer grades the loan request according to a statistically sound model that assigns points to selected characteristics of the prospective borrowerIn both cases, a lending officer collects information regarding the borrowers character, capacity, and collateral.

An application: credit scoringCredit scoring models are based on historical data obtained from applicants who actually received loans.Statistical techniques assign weights to various borrower characteristics that represent each factor's contribution toward distinguishing between good loans that were repaid on time and problem loans that produced losses.

Credit Application, University National Bank

Credit Application, University National Bank (continued)

Credit scoring system, university national bank, applied to credit application for purchase of a 2000 Jeep

Category

Characteristics/Weights

Annual Gross Income

$60,000

60

Monthly Debt Payment

Monthly Net Income

>40%

0

30-40%

5

20-30%

20

10-20%

35

An application: The credit scoreA loan is automatically approved if the applicant's total score equals at least 200.The applicant is denied credit if the total score falls below 150.At University National bank, five factors, including employment status, principal residence, monthly debt relative to monthly income, total income, and banking references are weighted heaviest.

Fico scores, August 2001

Indirect lending is an attractive form of consumer lending when a bank deals with reputable retailers.A retailer sells merchandise and takes the credit application.Because many firms do not have the resources to carry their receivables, they sell the loans to banks or other financial institutions.These loans are collectively referred to as dealer paper. Banks aggressively compete for paper originated by well-established automobile, mobile home, and furniture dealers.

Indirect lending (continued)Dealers negotiate finance charges directly with their customers. A bank, in turn, agrees to purchase the paper at predetermined rates that vary with the default risk assumed by the bank, the quality of the assets sold, and the maturity of the consumer loan.A dealer normally negotiates a higher rate with the car buyer than the determined rate charged by the bank.This differential varies with competitive conditions but potentially represents a significant source of dealer profit.

Indirect lending (continued)Most indirect loan arrangements provide for dealer reserves that reduce the risk in indirect lending. The reserves are derived from the differential between the normal, or contract loan rate and the bank rate, and help protect the bank against customer defaults and refunds.

Role of dealer reserves in indirect lending: Automobile paper

Terms of the Dealer Agreement

Bank buys dealer paper at a 12 percent rate. Dealer charges customers a higher rate (15 percent APR), with 25 percent of difference allocated to a reserve.

Sample Automobile Loan

Principal= $8,000

Maturity= 3 years, 36 monthly installments

Loan rate= 15% annual percentage rate (APR)

Monthly payment= $8,000/[(I/.0125) - (1/.0125(l.0125)36)]$277.32

Allocation to the Dealer Reserve

Total interest expense to customer= $1,983.52

Total interest income for bank= 1,565.72

Differential interest

- $ 417.80

75% allocated to dealer: 0.75(417.80) = $313.35

25% allocated to reserve: 0.25(417.80)= $104.45

Interest Refunds on Prepayments with Add-on Rates

Loan is written on a precomputed basis, and bank accrues interest using rule of 78s"*

Interest expense to customer = 0.09($8,000)(3) = $2,160

Interest income for bank= 0.07($8,000)(3) = 1,680

Differential interest= $ 480

75% allocated to dealer:0.75($480) = $360

25% allocated to reserve: 0.25($480) = 120

End of YearInterest Earned*TotalBankDifference

154.96%$1,187.14$923.33$263.81

233.33719.33559.94159.99

3 11.71 252.93 196.73 56.20

100.00%$2,160.00$1,680.00$480.00

*Rule of 78s factors are 366/666, 222/666, and 78/666, respectively.

Recent risk and return characteristics of consumer loansThe attraction is two-fold:Competition for commercial customers narrowed commercial loan yields so that returns fell relative to potential risksDeveloping loan and deposit relationships with individuals presumably represents a strategic response to deregulation

Revenues from consumer loansConsumer loan rates have been among the highest rates quoted at banks in recent years.Consumer groups still argue that consumer loan rates are too high, especially when the prime rate declines.In addition to interest income, banks generate substantial noninterest revenues from consumer loans. With traditional installment credit, banks often encourage borrowers to purchase credit life insurance on which the bank may earn a premium.

Consumer loan lossesLosses on consumer loans are normally the highest among all categories of bank credit.Losses are anticipated because of mass marketing efforts pursued by many lenders, particularly with credit cards.Credit card fraud arises out of the traditional lender/merchant relationship.

Interest rate and liquidity risk with consumer creditThe majority of consumer loans are priced at fixed rates. New auto loans typically carry 4-year maturities, and credit card loans exhibit an average 15- to 18-month maturity.Bankers have responded in two ways:price more consumer loans on a floating-rate basiscommercial and investment banks have created a secondary market in consumer loans, allowing loan originators to sell a package of loans

EVALUATING CONSUMER LOANSChapter 17Bank Management, 5th edition. Timothy W. Koch and S. Scott MacDonaldCopyright 2003 by South-Western, a division of Thomson Learning