EVALUATING CONSUMER LOANS

Chapter 17

Bank ManagementBank Management, 5th edition.5th edition.Timothy W. Koch and S. Scott MacDonaldTimothy W. Koch and S. Scott MacDonaldCopyright © 2003 by South-Western, a division of Thomson Learning

Recent trends in consumer lending

Credit scoring more 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 loans

When 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 loans

Installment 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.

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DataAverage size of loan $5,104 $5,448Average number of loans 1,146 6,729Number of banks surveyed 70 49Costs per LoanCost to make a loan:

Electronic $202.42 $84.56Nonelectronic 152.17 137.49

Cost to maintain a loan (monthly)Electronic $19.21 $16.96Nonelectronic 21.74 20.07

Loan loss (average size loan) 27.05 31.05Total $422.59 $290.13

As a Percent of Total Loans OutstandingLoan income* 10.11% 9.35%Expenses

Direct 3.6 2.83Net indirect 0.97 0.7Loan loss rate (3-year average) 0.53 0.57

Total 5.1 4.1Net yield 5.01 5.25Cost of funds 3.28 3.31

Net spread 1.73% 1.94%

Deposit Size (Millions of Dollars)

Credit cards and other revolving credit

Credit 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.

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501984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001

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 process

Individual

Card-Issuing Bank

ClearingNetwork

Local MerchantBank

Retail Outlet1

4

23 3

2

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 cards

Debit cards are widely available when an individual uses the card, their balance

is immediately debited. they have lower processing costs to the bank

A smart card is an extension of debit and credit cards contains a memory chip which can manipulate

information it 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 cards

Smart card usage will likely increase dramatically in the U.S.: firms can offer a much

wider range of services smart cards represent a

link between the internet and real economic activity

suppliers of smart cards are standardizing the formats so that all cards work on the same systems

Prepaid cards

Prepaid 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 lines

Revolving 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 cards

Home equity loans grew from virtually nothing in the mid-1980s to over $220 billion in 2001 Home 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 loans

A 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 loans

During the 1990s, one of the hottest growth areas was subprime lending.

Subprime loans are higher-risk loans labeled labeled “B,” “C,” and “D” credits

They 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 loans

During 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 borrower’s 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 regulations

Equal 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 systems

Credit 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 reporting

Lenders 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 lending

Truth 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 requirements…requires 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 rates…applied 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%.

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Discount rate method…the 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

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Simple interest…interest 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.

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Fair credit reporting

The 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.

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Community reinvestment

The 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 reform

Individuals who cannot repay their debts on time can file for bankruptcy and receive court protection against creditors.

Individuals can file for bankruptcy under:1. Chapter 7, individuals liquidate qualified

assets and distribute the proceeds to creditors.

2. 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 analysis

The objective of consumer credit analysis is to assess the risks associated with lending to individuals.

When evaluating loans, bankers cite the Cs of credit: 1. character:

the most important element--difficult to assess2. capital:

refers to the individual's wealth position3. capacity:

the lender often imposes minimum down payment requirements and maximum allowable debt-service to income ratios

4. conditions: the impact of economic events on the borrower's capacity

to pay 5. collateral:

the importance of collateral is in providing a secondary source of repayment.

Two additional Cs have been added reflecting customer relationships and competition

6. Customer relationship A bank’s prior relationship with a customer reveals

information about past credit and deposit experience that is useful in assessing willingness and ability to repay.

7. 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 Loans

Consumer loans are extended for a variety of purposes.

Acceptable Loans Automobile Boat Home Improvement Personal-Unsecured Single Payment Cosigned

Policy guidelines …Unacceptable Loans

Unacceptable Loans1. Loans for speculative purposes.2. Loans secured by a second lien, other than

home improvement or home equity loans.3. Any participation with a correspondent bank

in a loan that the bank would not normally approve.

4. Accommodation loans to a poor credit risk based on the strength of the cosigner.

5. Single payment automobile or boat loans.6. Loans secured by existing home furnishings.7. Loans for skydiving equipment and hang

gliders.

Evaluation procedures: Judgmental and credit scoring

Banks employ basically two procedures when evaluating consumer loans :

1. judgmental procedures…the loan officer subjectively interprets the information in light of the bank’s lending guidelines and accepts or rejects the loan

2. quantitative 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 borrower

In both cases, a lending officer collects information regarding the borrower’s character, capacity, and collateral.

An application: credit scoring

Credit 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.

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

Category Characteristics/Weights

Annual Gross Income <$10,000

5 $10,000-$20,000

15 $20,000-$40,000

30 $40,000-60,000

45 >$60,000

60

Monthly Debt Payment Monthly Net Income

>40% 0

30-40% 5

20-30% 20

10-20% 35

<10% 50

Bank Relationship Checking/Saving

None 0

Checking Only 30

Saving only 30

Checking & Saving 50

No answer 0

Major Credit Cards None

0 1 or more

30 No answer

0

Credit History Any derogatory within 7 yrs.

-10 No record

0 Met obligated payments

30

Applicant's Age < 50 yrs.

5 >50 yrs.

25 No answer

0

Residence Rent

15 Own/Buying

40 Own outright

50 No answer

15

Residence Stability < 1 yr. 0

1-2 yrs. 15

2-4 yrs. 35

>4 yrs. 50

No answer 0

Job Stability < 1 yr. 5

1-2 yrs. 20

2-4 yrs. 50

>4 yrs. 70

Unemployed 5

Retired 70

NOTE: Minimum score for automatic credit approval is 200; score for judgmental evaluation, 150 to 1 95; score for automatic credit denial is less than 150. Melanie Groome's credit score is 185.

An application: The credit score

A 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.

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National Distribution of FICO Scores

Delinquency Rates by FICO Score

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FICO Score RangeUp to 499 500-549 550-599 600-649 650-699 700-749 750-799 800+

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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 Year Interest Earned* Total Bank Difference 1 54.96% $1,187.14 $923.33 $263.81 2 33.33 719.33 559.94 159.99 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 loans

The attraction is two-fold:1. Competition for commercial customers

narrowed commercial loan yields so that returns fell relative to potential risks

2. Developing loan and deposit relationships with individuals presumably represents a strategic response to deregulation

Revenues from consumer loans

Consumer 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 losses

Losses 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 credit

The 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:1. price more consumer loans on a floating-rate

basis2. commercial and investment banks have

created a secondary market in consumer loans, allowing loan originators to sell a package of loans

EVALUATING CONSUMER LOANS

Chapter 17

Bank ManagementBank Management, 5th edition.5th edition.Timothy W. Koch and S. Scott MacDonaldTimothy W. Koch and S. Scott MacDonaldCopyright © 2003 by South-Western, a division of Thomson Learning