Measuring & Managing BS Credit Risk FINAL

Ability to maintain mortgage payments is measured by:

(both) ✻ Gross Debt Service (GDS) ✻ Total Debt Service (TDS)

The Different Business Models

- how & where they show up in ratios... Between the Asset Management & Profitability ratios is where you see usually see/evaluate a company's business model - do they have a ... 1) high efficiency model "grocery store" or 2) high profit margin model "jewelry store" It's a strategic trade-off that nearly every company must make: Get 1 of 2 right = successful; 0 of 2= bankrupt; 2 of 2 = Apple

Commercial Credit & Lending HLT Lending

.....Large Market Lending Banks often facilitate loans to meet the borrowing needs of large companies - these solutions can be complex and varied in nature. •These can involve either direct lending, issuance of commercial paper or bonds into the capital markets, or placement of large loans among a group of financial investors •Often times the large size of an individual deal necessitates involving multiple financial institutions * *In addition to more traditional loan types (lines of credit, installment loans), the large market segment is active with highly leveraged transactions (HLT). •Highly leveraged transaction (HLT) loans are loans that finance a takeover or a merger & acquisition; the increase in debt results in a high leverage ratio for the borrower. •They can also be used for recapitalization, where debt is issued to replace equity in the capital structure of the borrowing company - new debt is used for stock buybacks or one-time dividend payments •Common rationales for HLTs were to better optimize capital structure (increase utilization of interest rate tax shield & thus lower WACC) as well as remove incentives for inefficient management (perks, other agency costs)

ROE Big Valley's return on equity indicates that the firm generates a ________ return to their shareholders than their peers.

1.05 percent lower ROE = NI/Equity = (275 + 500 − 560 − 100 − 55 − 30)/(75 + 140) = 13.95%; industry = 15%

FIXED ASSET EFFICIENCY SCORE Big Valley's fixed asset efficiency score is ________ which is ________that of the typical firm in the industry.

1.94; higher than FIXED ASSET EFFICENCY SCORE = S/FA = (275 + 500)/400 = 1.9375 Peer S/FA = 1.8

Summary of Common Steps in an HLT/LBO:

1.Build a financial forecast for the target company 2.Link the 3 financial statements & calculate free cash flow of Business 3.Create interest & debt schedules 4.Model credit metrics - how much leverage is possible 5.Calculate free cash flow to Sponsor (PE firm) 6.Determine IRR for Sponsor 7.Perform sensitivity analyses

Days' SALES IN RECEIVABLES Big Valley is collecting their receivables about ________ than the typical firm.

17 percent more slowly BV's Days' sales in receivables = (80 × 365)/500 = 58.4 days % change: 58.4/ 50 − 1 = 16.8%

TIMES INTEREST EARNED Big Valley has a times interest earned ratio that is ________, which indicates that Big Valley has ________ long-term insolvency risk than the typical firm in the industry.

3.91; more TIMES INTEREST EARNED = [(275 + 500 − 560)/55] = 3.91

•Days Receivable / Period =

365/Turnover

14. What are compensating balances? What is the relationship between the amount of compensating balance requirement and the return on the loan to the FI? (LG 21-6)

A compensating balance is the portion of a loan that a borrower must keep on deposit with the credit-granting FI. Thus, the funds are not available for use by the borrower. As the amount of compensating balance for a given loan size increases, the effective return on the loan increases for the lending institution.

What are highly leveraged transactions? What constitutes the federal regulatory definition of an HLT?

A highly leveraged transaction is a loan to finance an acquisition or merger. Often the purchase is a leverage buyout with a resulting high leverage ratio for the borrower. U.S. federal bank regulators have adopted a definition that identifies an HLT loan as one that (1) involves a buyout, acquisition, or recapitalization and (2) doubles the company's liabilities and results in a leverage ratio higher than 50 percent, results in a leverage ratio higher than 75 percent, or is designated as an HLT by a syndication agent.

2) Which one of the following five Cs of credit is NOT correctly defined? A) Capacity—Whether the borrower has enough other credit available to pay off the loan in the event of cash flow problems. B) Capital—The borrower's equity. C) Character—A measure of the borrower's intention/willingness to repay the loan. D) Conditions—Assessing how economic conditions could affect the borrower's ability to repay the loan. E) Collateral—An asset of the borrower that the lender may seize in the event of default on the loan.

A) Capacity—Whether the borrower has enough other credit available to pay off the loan in the event of cash flow problems. INCORRECT DEFINITION

12. Consider the coefficients of Altman's Z score. Can you tell by the size of the coefficients which ratio appears most important in assessing the creditworthiness of a loan applicant? Explain. (LG 21-5)

Although X3, or EBIT/total assets, has the highest coefficient (3.3), it is not necessarily the most important variable. Since the value of X3 is likely to be small, the product of 3.3 and X3 may be quite small. For some firms, particularly those in the retail business, the asset turnover ratio, X5 may be quite large and the product of the X5 coefficient (1.0) and X5 may be substantially larger than the corresponding number for X3. Generally, the factor that adds most to Z score varies from firm to firm.

5. In what ways does the credit analysis of a mid-market borrower differ from that of a small-business borrower? (LG 21-4)

Although definitions of mid-market corporates vary, they typically have sales revenues from $5 million to $100 million a year, have a recognizable corporate structure (unlike many small businesses), but do not have ready access to deep and liquid capital markets (as do large corporations). Credit analysis of a mid-market corporate customer differs from that of a small business because, while still assessing the character of the firm's management, its main focus is on the business itself. There is also a better defined corporate structure and a clearer delineation of the corporate assets from the personal assets of the owners. The mid-market borrower is also more likely to have a track record to use as a basis for future performance.

11. Why is an FI's bargaining strength weaker when dealing with large corporate borrowers than mid-market business borrowers? (LG 21-5)

An FI's bargaining strength is severely diminished when it deals with large creditworthy corporate customers. Large corporations are able to issue debt and equity directly in the capital markets as well as to make private placements of securities. Also, they typically maintain credit relationships with several FIs and have significant in-house financial expertise. They manage their cash positions through the money markets by issuing their own commercial paper to meet fund shortfalls and use excess funds to buy Treasury bills, banker's acceptances, and other companies' commercial paper. Moreover, large corporate clients are not seriously restricted by international borders but have operations and access to international capital markets and FIs in many parts of the world. Large corporate clients are very attractive to FIs because, although spreads and fees are small in percentage terms, the transactions are often large enough to make them very profitable as long as a default does not occur and they offer the potential for cross-selling other FI products to the client. Specifically, the FI's relationship with large corporate clients goes beyond lending. The FI's role as broker, dealer, and advisor to a corporate client may rival or exceed the importance of its role as a lender. A large corporate client is likely to investigate several avenues for obtaining credit and to compare, for example, the flexibility and cost of a bond, a private placement, and borrowing from different FIs. The client may periodically poll FIs to determine opportune times to tap financial markets, even if this means inventorying funds. The FI's loan account officer must often liaise with the FI's investment banker to obtain information and indicative pricing on new security issues. Clearly, the amount of time this involves means that

13. Why could a lender's expected return be lower when the risk premium is increased on a loan? (LG 21-6)

An increase in risk premiums indicates a riskier pool of clients who are more likely to default by taking on riskier projects. This reduces the repayment probability and lowers the expected return to the lender.

CURRENT RATIO Current = (10 + 80 + 115)/160 = 1.28 Peer = 1.35

Big Valley's current ratio indicates that Big Valley is ___LESS_____ liquid than the typical firm in the industry,

QUICK RATIO Quick = (10 + 80)/160 = 0.56 Peer = 0.5

Big Valley's quick ratio indicates that Big Valley is __MORE______ liquid than the typical firm.

8. How does ratio analysis help answer questions about the production, management, and marketing capabilities of a prospective borrower? (LG 21-4)

Calculation of financial ratios is useful when performing financial statement analysis on a mid-market corporate applicant. Although stand-alone accounting ratios are used for determining the size of the credit facility, the analyst may find relative ratios more informative when determining how the applicant's business is changing over time (i.e., time series analysis) or how the applicant's ratios compare to those of its competitors (i.e., cross-sectional analysis). Ratio analysis almost always includes a comparison of one firm's ratios relative to the ratios of other firms in the industry, or cross-sectional analysis. Key to cross-sectional analysis is identifying similar firms that compete in the same markets, have similar size assets, and operate in a similar manner to the firm being analyzed. Since no two firms are identical, obtaining such a comparison group is no easy task. Thus, the choice of companies to use in cross-sectional analysis is at best subjective.

What are the five Cs of credit? Briefly describe each.

Character: Character of applicant; applicant's willingness to work hard to repay the loan.....probability that applicant will honor the loan obligation Capacity: Borrower's ability to generate enough cash to repay the loan..... ability of the applicant to pay according to the terms of the loan obligation (cash flow) Condition: How changing economic and other conditions will affect the borrower's ability to repay.... Economic situation and contract covenants under which the loan will be offered and applicant then paying it back (hopefully) Capital: How much capital (protection from insolvency) the borrower has.... General financial condition and wherewithall of the applicant to pay under the terms of the loan agreement Collateral: The value of assets pledged against the loan....Assets that help secure the loan as a secondary source of repayment

For most business loans, growing earnings are not a sufficient reason to grant a loan. Why?

Collateral is still important because economic conditions can change over the life of the loan and the bank would like to be able to limit its losses in the event the borrower's earnings are not sufficient to repay the loan. The lender must also evaluate how sensitive the borrower's earnings are to economic conditions and how much the economy might change over the period of the loan. Finally, earnings are not cash; cash is required to repay the loan and the lender will be more concerned about sources and uses of cash than about earnings.

10. What are conditions precedent? (LG 21-4)

Conditions precedent are those conditions specified in the credit agreement that must be fulfilled before drawdowns are permitted. These include various title searches, perfecting of collateral, and the like. Following drawdown, the credit must be monitored throughout the loan's life to ensure that the borrower is living up to its commitments and to detect any deterioration in the borrower's creditworthiness so as to protect the FI's interest in the loan being repaid in full with the promised interest return.

1. Why is credit risk analysis an important component of FI risk management? (LG 21-1)

Credit risk management is important for FI managers because it determines several features of a loan: interest rate, maturity, collateral and other covenants. Riskier projects require more analysis before loans are approved. If credit risk analysis is inadequate, default rates could be higher and push an FI into insolvency, especially if lending markets are competitive and the margins are low.

3. What are the purposes of credit-scoring models? How do these models assist an FI manager to better administer credit?

Credit scoring models are used to calculate the probability of default or to sort borrowers into different default risk classes. The primary benefit of credit scoring models is to improve the accuracy of predicting borrower's performance without using additional resources. This benefit results in fewer defaults and chargeoffs to the FI. The models use data on observed economic and financial borrower characteristics to assist an FI manager in (a) identifying factors of importance in explaining default risk, (b) evaluating the relative degree of importance of these factors, (c) improving the pricing of default risk, (d) screening bad loan applicants, and (e) more efficiently calculating the necessary reserves to protect against future loan losses.

Explain the purpose/benefits in adding a credit-scoring model to evaluate a loan application.

Credit-scoring models allow the loan officer to quickly make a decision about a loan. The idea behind a credit-scoring model is to identify how characteristics of past borrowers that repaid their loan on time differ from borrowers that defaulted. The differences are then weighted with a point system and new loan applicants are then scored to see if they fall into the sound or default category.

Cash (Conversion) Cycle =

Days Inventory +. Days Receivables - Days Payables

Real Estate Lending - Key Processes

Documentation: before an FI accepts a mortgage, it generally... •Confirms the title and legal description of the property •Obtains a surveyor's certificate confirming that the house is within the property's boundaries •Checks with the tax office to confirm that there are no unpaid property taxes or liens •Requests a land title search to determine that there are no other claims against the property •Obtains an independent appraisal to confirm that the purchase price is in line with the market value Collections: FIs do not desire to become involved in loans that are likely to go into default...However, in the event of default, lenders usually have recourse •Foreclosure is the process of taking possession of the mortgaged property in satisfaction of a defaulting borrower's indebtedness and forgoing claim to any deficiency •Power of sale is the process of taking the proceedings of the forced sale of a mortgaged property in satisfaction of the indebtedness and returning to the mortgagor the excess over the indebtedness or claiming any shortfall as an unsecured creditor

4) Individual credit-scoring models typically include all of the following information except A) income. B) length of time in residence. C) credit history. D) age. E) ethnic background.

E) ethnic background.

Many FIs were unable to survive the mortgage crisis

Example: Countrywide Financial acquired by BofA Bank loan portfolios were exposed to losses from the recent European debt crisis Overall, credit losses and bankruptcies (while fewer in number than successful loan decisions) dwarf good loan outcomes in their impact. Note: The acquisition of Countrywide proved costly for Bank of America Even in 2014, BofA paid a record $17 billion settlement to the US Justice Department over questionable mortgages issued by Countrywide before the acquisition The settlement was the largest ever reached between the US and a single company, and was approximately equal to BofA's total profit for the previous 3 years

The default of one major borrower can have significant impact on the value & reputation of many Fis

Example: WorldCom, Enron bankruptcies Likewise, a single major economic event can cause losses to many FIs' loan portfolios Example: Hurricanes Katrina and Rita in 2005 resulted in over $13 billion in bad loans for major banks operating in areas hit by the storm Example: financial crisis of 2008-2009 resulted in the largest ever credit risk-related losses for US financial institutions

Consumer - Credit Scoring Systems (traditional)

FIs also use credit scoring systems to evaluate potential borrowers •Definition: Credit scoring systems are mathematical models that use observed loan applicant's characteristics to calculate a score that represents the applicant's probability of default •Loan officers can often give immediate "yes" or "no" answers —along with justifications for the decisions

GDS & TDS CALCULATION

GDS cutoff: 30 percent TDS cutoff: 35 percent Explanation: Joe: GDS = ((2,100 × 12) + 3,000)/100,000 = 28.20%; Bill: GDS = ((1,000 × 12) + 1,400)/45,000 = 29.78%; both are under the max of 30%. answer: Both get the loan.

GDS

GDS= (Total Accomodation Expenses) / (Gross Income) (annual mortgage payments = monthly *12 + annual property taxes) pass = below threshold

A $40,000 one-year loan with a 1 percent origination fee and a 7.50 percent interest rate is funded with money on which the bank owes 3 percent. What is the expected pretax dollar spread on the loan? If the bank needs to net at least 3.5 percent on the funds lent to make its ROE, how many dollars can the bank spend on credit investigation, loan servicing, and so forth? Would the bank be able to spend more if the loan amount was greater? What does this example suggest about credit analysis?

Gross Revenue = (7.50% − 3.00% + 1.00%) × $40,000 = $2,200 Minimum Revenue = 7.50% − 3.00% + 1.00% − 3.50% = 2.00% of $40,000 = $800 The bank would be able to spend more money for a larger loan amount. This indicates the need for the lender to employ credit scoring and other quick, low-cost methods of evaluating small loan amounts to maintain profitability on these transactions.

7. Why must an account officer be well versed in the FI's credit policy before talking to potential mid-market business borrowers? (LG 21-4)

Having gathered information about the credit applicant, an account officer decides whether it is worthwhile to pursue the new business, given the applicant's needs, the FI's credit policies, the current economy, and the competitive lending environment. If it is, the account officer structures and prices the credit agreement with reference to the FI's credit granting policy. This includes several areas of analysis, including the five Cs of credit, cash flow analysis, ratio analysis, and financial statement comparisons (described below). At any time in this process, conditions could change or new information could be revealed, significantly changing the borrower's situation and forcing the account officer to begin the process again. Once the applicant and an account officer tentatively agree on a loan, the account officer must obtain internal approval from the FI's credit risk management team. Generally, even for the smallest mid-market credit, at least two officers must approve a new loan customer. Larger credit requests must be presented formally (either in hard copy or through a computer network) to a credit approval officer and/or committee before they can be signed. This means that, during the negotiations, the account officer must be very well acquainted with the FI's overall credit philosophy and current strategy.

Calculating the Three Ratios (with 2 years info)

Inventory period (note: use COGS, not SALES) Average inventory = (y1 + y2 inventory)/2 Inventory turnover = costs / avg inventory = 5X Inventory period = 365 / inv. turnover= x days same for below Receivables period Average receivables= (500+700)/2 = 600 Receivables turnover=8,800/600 = 14.7X Receivables period= 365 / 14.7 = 24.9 days Payables Period Average payables = (135 + 120)/2 = 127.5 Payables turnover = 5,600 / 127.5 = 43.9X Payables period = 365 / 43.9 = 8.3 days Operating Cycle = inventory period + receivables period = x days Cash (Conversion) Cycle = operating cycle- payables period = x days .... number of days before seeing any cash With a CCC of x daysmust finance the NWC for almost y months before seeing any cash Concerns: 1) Inventory period is >>> Payables and 2) Receivables are > Payables

9. Why should a credit officer be concerned if a mid-market business borrower's liquidity ratios differ from the industry norm? (LG 21-4)

Liquidity provides the defensive cash and near-cash resources for firms to meet claims for payment. Liquidity ratios express the variability of liquid resources relative to potential claims. When considering the liquidity of a loan applicant, high levels of liquidity effectively guard against liquidity crises but at the cost of lower returns on investment. Note that a company with a very predictable cash flow can maintain low levels of liquidity without much liquidity risk. Account officers frequently request detailed cash flow projections from an applicant that specify exactly when cash inflows and outflows are anticipated.

15. How does loan portfolio risk differ from individual loan risk? (LG 21-6)

Loan portfolio risk, as the name implies, refers to the risk of a portfolio of loans as opposed to the risk of a single loan. Inherent in the distinction is the elimination of some of the risks of individual loans because of benefits from diversification.

Mid-Market Commercial Loans

Mid-Market is generally a profitable market for credit-granting FIs. Typically, mid-market corporates: ⁻Have sales revenues from $5 - 100 million per year, with recognizable corporate structures, but no access to deep/liquid capital markets •Commercial loans can be for as short as a few weeks to 8 years or more Short-term loans are used to finance working capital needs Long-term loans finance fixed asset purchases ⁻Loan approvals done generally with at least 2 Loan Officers / Larger requests go to formal Loan Committee ⁻Following approval of the loan, the account officer ensures that conditions precedent have been cleared o Any conditions specified in the credit agreement must be fulfilled before funding (title searches, UCC filings etc) •FIs typically wish to develop long-term, mutually beneficial relationships with their mid-market commercial customers

16. Explain how modern portfolio theory can be applied to lower the credit risk of an FI's portfolio. (LG 21-6)

Modern portfolio theory has demonstrated that a well-diversified portfolio can provide opportunities for individuals to invest in a set of efficient frontier portfolios, defined as those portfolios that provide the maximum returns for a given level of risk or the lowest risk for a given level of returns. By choosing portfolios on the efficient frontier, a banker may be able to reduce credit risk to its fullest. A manager's selection of a particular portfolio on the efficient frontier is determined by his or her risk-return trade-off.

6. What are some of the special risks and considerations when lending to small businesses rather than large businesses? (LG 21-4, LG 21-5)

One particular consideration is the life of the company. Typically, loans are made to small businesses to help start up the company. This creates several problems. There is less history to base the loan on. Numerical scoring rules may be less useful in this case. A start-up business that fails may also have less collateral value compared to a larger company. Because of this, the personal assets of the small business owner may be used as collateral on the loan. A loan to a small business will necessarily be small, so the size of the profits to be earned by the FI from the loan is not likely to be very substantial.

Cash Cycle =

Operating Cycle - Accounts Payable Period •In practice, the inventory period, the accounts receivable period, and the accounts payable period are measured by days in inventory, receivables, and payables, respectively

•Receivable Turnover =

Sales / Receivable

LBO's & Acquisitions

Syndicated loans grew rapidly in the '80s due to the expansion of HLT loans, especially LBOs •Key Purposes of the Loans were often for acquisitions - friendly or otherwise... Leveraged Buyouts •Secured by assets of borrower •Long maturity - often 3 to 6 years •Interest rates are floating •Have strong covenant protection •May be distressed/non-distressed Degree of Leverage •Significant levels of debt •Covenants - but weakening of late Deal size often mandated syndication (RJR was $25B in '88; equiv to $55B now) •Lead bank(s) negotiate & manage transaction (fees) •Sell portions of deal to other institutions (int'l banks, insurers) •Structured as participation or assignment (level of control varies)

TDS

TDS= (Total Accomodation Expenses + All Other Debt Service Payments). /. (Gross Income) Other Debt Service Payments: • Annual Homeowner's Insurance • Other Debt Payments per year add on annual homeowner's insurance and other annual debt payments pass = below threshold

Consumer - Credit Decisioning Today...

TODAY: Lenders have moved primarily to standard credit score models •Different variations of FICO (Fair Isaac Corporation) have been introduced over time •FICO scores run from 300 to 850, with majority of scores between 600 and 800 •FICO Scores of 720 or higher are usually sufficient to receive a good mortgage rate COMPONENTS: 1.Payment history (35%) - How successful you've been in paying credit account bills on time 2.Amounts owed aka Credit utilization (30%) - The amount of credit & loans you're borrowing compared to the amount of credit you have available (~30%) 3.Length of credit history (15%) - How long you've had credit 4.New credit inquiries (10%) - Frequency of credit inquiries and new account openings 5.Credit mix (10%) - The various types of credit you have - can be a mix of credit cards, installment loans, student loans, auto loans, and real estate loans

Consumer - Credit Decisioning Tomorrow?

TOMORROW: there is a heightened focus on finding alternative credit factors for those who are disadvantaged by current scoring models that **focus on length & type of credit** Length: People w/o lengthy credit histories Catch 22 - how do you get credit if you haven't had credit previously Type: People who do not use much traditional credit (use cash or other) Yet they still pay their bills... CONSIDERATIONS: •Concerns that alternative data could either enable more credit or create "digital redlining" •Concerns about recreation of existing biases into a new form •Is "Big Data" even truly predictive? •CFPB called for lender input, created a "sandbox" to explore alternative data •Banks interested since provides opportunity to expand lending - in early '21 began using bank account data even when no credit exists

Describe the credit analysis process for a mid-market corporate loan applicant.

The account officer gathers information about the loan applicant's business. This may include meeting the client's existing customers, checking referrals, and cold calling new business prospects. The account officer analyzes the risk of the applicant by applying the five Cs of credit. If the account officer decides to pursue the loan application, the loan is submitted for review and approval by senior lending officials and/or a loan review committee.

Before allowing the borrower to actually acquire the funds for a mid-market collateralized loan, what must the lender ensure? What type of monitoring occurs by the lender after the loan is granted?

The lender must perfect the security interest in the collateral. This process includes confirming that the collateral does not have a preexisting lien that would prevent foreclosure and sale, ensuring that back taxes are not owed, and in certain cases, obtaining an independent assessment of the collateral value. Following the draw down, the lender must monitor the condition of the collateral periodically and reassess the borrower's ability to continue to service the loan. This review normally takes place annually.

Total Assets turnover ratio

The ratio that measures the firm's efficiency in utilizing its assets to generate revenue is

4. How does an FI evaluate its credit risks with respect to consumer and small-business loans? (LG 21-3)

The techniques used for mortgage loan credit analysis are very similar to those applied to individual and small business loans. Individual consumer loans are scored like mortgages, often without the borrower ever meeting the loan officer. Unlike mortgage loans for which the focus is on a property, however, nonmortgage consumer loans focus on the individual's ability to repay. Thus, credit scoring models put more weight on personal characteristics such as annual gross income, the TDS score, and so on. Small business loans are more complicated because the FI is frequently asked to assume the credit risk of an individual whose business cash flows require considerable analysis, often with incomplete accounting information available to the credit officer. The payoff for this analysis is also small, by definition, because loan principal amounts are usually small. A $50,000 loan with a 3 percent interest spread over the cost of funds provides only $1,500 of gross revenues before loan loss provisions, monitoring costs, and allocation of overheads. This low profitability has caused many FIs to build small business scoring models similar to, but more sophisticated than, those used for mortgages and consumer credit. These models often combine computer-based financial analysis of borrower financial statements with behavioral analysis of the owner of the small business.

A corporate loan applicant has had a growing cash account for the last three years, but cash flow from operations has been negative in every year. Would this concern you if you were the loan officer charged with approving the loan? If so, why? If not, why not?

This would be a concern because it indicates cash growth is being generated by borrowing, new equity issued, or by selling assets. None of these are sustainable sources of financing. Moreover, the applicant is not generating cash flow from its operations. This may be acceptable if the firm is in a growth period and has good collateral, but the loan officer would normally desire to have positive cash flow from operations.

Turnover Ratios Period Ratio

Turnover Ratios •Income Statement Item / Balance Sheet Item •Sales or COGS / Rec'bles or Inventory or Payable •Sales vs Receivables; COGS vs Inventory/ Payable Period Ratio (aka Days of ...X) •365 / Turnover Ratio Example: Receivable related ratios •Receivable Turnover = Sales / Receivable •Days Receivable / Period = 365/Turnover

2. What are the primary considerations used by FIs to evaluate mortgage loans? (LG 21-2)

Two considerations dominate an FI's decision to approve a mortgage loan application: (1) the applicant's ability and willingness to make timely interest and principal repayments and (2) the value of the borrower's collateral. Ability and willingness of the borrower to repay debt outstanding is usually established by application of qualitative and quantitative models. The character of the applicant is also extremely important. Stability of residence, occupation, family status (e.g., married, single), previous history of savings, and credit (or bill payment) history are frequently used in assessing character. The loan officer must also establish whether the applicant has sufficient income. In particular, the loan amortization (i.e., principal and interest payments) should be reasonable when compared with the applicant's income and age. The loan officer should also consider the applicant's monthly expenditures. Family responsibilities and marital stability are also important. Monthly financial obligations relating to auto, personal, and credit card loans should be ascertained, and an applicant's personal balance sheet and income statement should be constructed.

Balancing working capital costs with business strategy/opportunity

Working Capital - inventory, receivables, and payables - are fundamentally linked to the type of company and how it is managed. Each represent a decision about how to maximize value (both a threat & opportunity)

With good loans, banks ....

earn the return.

Inventory:

have significant inventory choices available (physical retailer) vs deliver product only when ordered? •More inventory means more choice for customer but at greater cost to company •Need to look at profits - is there sufficient gross margin %?

Payables:

longer payments can preserve cash, save cost but also may irritate vendors •Get less favorable terms? •Utilize vendor credit to save cash versus pay early to get better pricing/preferred treatment (example 2% 10 or net 30)

In loan losses, banks .....

lose both the return and the underlying assets.

Financial institutions (FIs) are special because

of their ability to transform financial claims of household savers into claims issued to corporations, individuals, and governments

Receivables:

offer financing - even extended financing - to attract more customers? •Longer terms may enable more sales but at higher risk •Does the sales increase offset the cost of financing/credit losses? Are there other financing options available?

Benefits of NWC

operational and strategic benefits, + NWC management can drive direct cost savings due to lower required NWC for the same level of production

noncurrent loan rates

represent the % of loans that are past due 90 days or more or in a nonaccrual status.

most standardized credit application

residential mortgage loan applications

Perfecting collateral

the process of ensuring that collateral used to secure a loan is free and clear to the lender should the borrower default on the loan

Foreclosure

the process of taking possession of the mortgaged property to satisfy the debt in the event of failure to repay the mortgage and foregoing claim to any deficiency.

Power of sale

the process of taking the proceedings of the forced sale of a mortgaged property in satisfaction of the indebtedness and returning to the mortgagor the excess over the indebtedness or claiming any shortfall as an unsecured creditor

Delinquency Roll Rates

track the loans becoming delinquent and whether they "cure" or get worse Allows the step-by-step tracking of when loans become delinquent and how effective collection efforts have been Provides an early warning sign and pinpoints areas of greatest change versus prior periods (where the change is occurring & how much) trend... the more delinquent a loan becomes, the less likely it is to become current (cure)

Receivable Aging Schedules

track the money owed to a company, by whom, and how long it's been unpaid •Allows firms to track which customers to either contact or take other collection efforts (take action before it is too late) •When probability of collection is added, can provide a stark analysis of "revenue" versus ...you know...actually getting paid...in cash

FIs' ability to process and evaluate information and control and monitor borrowers allows them to

transform these claims at the lowest possible cost to all parties

Calculating the Three Ratios (current year info only)

§Inventory period (note: use COGS, not SALES) 2014 inventory = total inventory that year Inventory turnover = costs / inventory = X Inventory period = 365 / inv. turnover = x days Receivables period Payables period Operating Cycle = same

Credit allocation is an important type of financial claim transformation because....

• FIs transform claims of household savers (in the form of deposits) into loans issued to corporations, individuals, and governments • The FI accepts the credit risk on these loans in exchange for a fair return sufficient to cover the cost of funding paid (to household savers), the credit risk involved in lending, and a profit margin reflecting competitive conditions

Asset management ratios ****(Often used for secured, revolving lines of credit for working capital)****

•# of days in receivable = (receivables x 365) / credit sales •# of days in inventory = (inventory x 365) / COGS •sales to working capital = •sales to fixed assets = sales / fixed assets •sales to total assets (ie, the asset turnover ratio) = sales / total assets •See Operating and Cash Cycles in later slides

Equity value is arguably more about opportunity (where's the growth) while debt is about risk (where's the cash)

•As the "financial circulatory system" of the company, working capital is vital to most non-technology firms •Key source for due diligence insight to creditors & investors alike (unlike FTX, due diligence is still done in the real world) •Asking the "why" rather than just the "what" can be a big difference between a decision's success or failure •Inventory - reasons why a company's inventory, measured in days, rose (fell)? •Payables - reasons why a company's payables, measured in days, rose (fell)? •Receivables - reasons why a company's receivables, measured in days, rose (fell)?

Working Capital Lending - Asset Backed Lending (ABL)

•Asset Based Lending (ABL) is a well-established form of lending for less credit worthy firms •These firms are not bad credits, just not strong enough to support fully unsecured general cash flow loans •Recent disruptions to the globalization trends of the '90s and '00s have increased ABL's relevance •This is due to Covid & Geopolitical factors causing firms to seek closer suppliers and retain greater inventories •Typical ABLs are revolving credit lines, secured by receivables/inventory, using a "borrowing base" •Example: a bank may agree to advance 75% of eligible receivables (<90 days old) and 50% of inventory •The borrowing firm submits evidence of their receivable & inventory levels and can draw up to the formula maximum •Among other covenants, banks will require the company to have all receivable payments go to a "lockbox" •The bank controls the lockbox (PO Box), lowers the current loan balance upon collection...for the borrow to re-draw later •Advantages of ABL lines of credit •Uses asset value (not just cash flow) to provide financing to companies to order inventory & finance sales to customers •Especially useful for seasonal companies such as landscape products, holiday merchandise

Liquidity ratios ****(Often used for secured, revolving lines of credit for working capital)****

•Current ratio = CA / SL •Quick (that is acid test) ratio = (cash + cash eq. + receivables) / CL

Debt and solvency ratios ****(Often used in term loans for general purposes ... unsecured)****

•Debt-to-asset (aka total debt ratio) = total L / Total A •Times interest earned = EBIT / interest expense •Cash-flow-to-debt ratios = (EBIT + dep.) / debt

Profitability ratios ****(Often used in term loans for general purposes ... unsecured)****

•Gross margin = gross profit / sales •Operating profit margin = op. profit / sales •Return on assets (ROA) = EAT / avg total assets •Return on equity (ROE) = EAT / total equity net profit margin = EAT / sales dividend payout = dividends / EAT EAT earnings after taxes

Recent Changes for FICO Score 9 & 10

•Reduced the negative impact of unpaid medical bills in collections •Positive benefit for subsequently paying bills in collection •Rental history can be considered •Requires landlord to report •CFPB mandated annual free access of consumers to their credit reports

Possible future alternative sources of credit related info:

•Rental payments •Cell phone bill •Cable TV/Internet bill And more challenging alternatives: •Social media usage •Purchase patterns •Shopping location history

HLTs / LBOs & Debt Ratios Characteristics of a good LBO candidate (none are perfect):

•Strong, predictable operating cash flows (to pay down debt) •Mature, steady (non-cyclical), and perhaps even boring •Well-established business and products and leading industry position •Moderate CapEx, R&D with limited working capital requirements •Strong tangible asset coverage •Undervalued or out-of-favor •Seller is motivated, perhaps under pressure to maximize shareholder value •Strong management team and a viable exit strategy

Defined credit score algorithms also help reduce issues w/ factors excluded under fair lending laws:

•race or color •national origin •religion •sex •marital status •age* (provided of legal age)

Total Accomodation Expenses:

● Annual Mortgage Payments ● Lease condominium ● Management fees ● Real estate taxes ● Property taxes ● etc.

Things that led to extreme real estate loan losses during the subprime crisis:

★ Banks losing all needed documents to pursue collections since it ultimately wasn't going to be their loan ★

Things that led to extreme real estate loan losses during the subprime crisis:

★ skipping almost every step involved in a normal documentation process ★