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Understanding the Dynamics of Loans: Economic Environment and Business Cycles

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This comprehensive guide explores the intricate landscape of commercial and industrial lending, focusing on the economic environment impacting interest rates and business cycles. Topics include the relationship between economic activity phases—trough, growth, peak, and recession—and their effects on lending patterns. We delve into the complexities of asymmetric information in commercial lending, types of loans, collateral characteristics, and strategies for pricing. Additionally, insights into consumer lending dynamics, including popular loan types and their risks, are provided to foster informed decision-making.

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Understanding the Dynamics of Loans: Economic Environment and Business Cycles

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  1. Loans

  2. Loans • G&K, Chps. 9 & 10 • Economic Environment • Commercial and Industrial Lending • Real Estate and Consumer Lending

  3. Economic Environment • Pattern of Interest Rates with unfolding Business Cycle. • Predict Business Cycle (Trough, Growth, Boom, Peak, Slowdown, Recession, Trough……)  Pattern of Interest Rates • 1-period ahead relatively easy (Simulation) • Discussion here is expectation 2 + periods ahead…….

  4. Business Cycle and Interest Rates • Trough: Low economic activity; low demand for funds, high demand for safe, liquid investments  Low relative rates, + curve • Growth to Peak: Increasing economic activity; high demand for funds, low demand for interest-rate investments  Higher relative rates, + to flattening curve • SlowdownTrough; Slowing economic activity, early high demand for funds gives rise to drop off  High rates drop, with inverted-curve returning to positive slope

  5. Commercial Lending • Asymmetric Information (AI) gives: • Adverse Selection: The reason bad borrowers are coming to banks is they can’t get capital elsewhere, but AI makes it hard to separate from good borrowers • Moral Hazard: Given loan granted, higher-risk activities may be substituted to gain extra return that goes to owners, not loan….MONITOR!

  6. The Business Dynamics of Loans • Trade-off between: • Interest and fees gained, and • Credit Risk of default and costs • Types: • Lines of Credit, Term Loans, Bridge Loans • Technology has buffered: • Securitization of loans: Mtgs, Cars, CCs • Credit Scoring and Credit Risk transfer

  7. Definition of Collateral • Reduces Risk, but Increases Monitoring • Characteristics of good collateral: • Durability is the ability of the asset to withstand wear. Durable versus nondurable collateral. • Identification due to physical uniqueness or serial numbers. • Marketability of the property if resold. • Stability of value over the period of the loan. • Standardization by government or industry guidelines in grading quality of assets.

  8. Types of Collateral • A/R – Pledging or Factoring • Inventory • Securities • Property or Equipment • Loan Guarantees – US Gov’t, State

  9. Lending Evaluation • Six C’s: • Character (personal traits) • Capacity (cash flows) • Capital (net worth) • Collateral (pledged assets) • Conditions (economic conditions) • Compliance (Legal standing)

  10. Methods of Pricing • Markup – BPs over index (prime) • Cost of Funds – WACC + Profit Goal • Relationship – Not just loan, but fees made elsewhere as an offset • Match funding – BPs over match funds cost of money • Adjustable rate – not just market yields, but also risk changes • Requires extra monitoring and compliance review……

  11. Real Estate • Residential, Commercial, Farm, Multi-family • Origination, Securitization and Servicing • Brokering, Securitization Resale and Real Estate Industry assistance

  12. Real Estate Loan Characteristics • Downpayment: 5 , 10 , 20% • <20% usually requires Private Mortgage Insurance (PMI) • Loan then for (RE value-DownPymt) • Prepay makes std 30 year mortgage into an average 7-12 year loan. • Falling interest rates can make this average even shorter. • RE good loan as well collateralized

  13. Residential RE Loan Terms • Guarantor: • FHA, VA (as little as 3% down!) • Rates: • Fixed, 30 vs. 15, ARMs • ARMs: • 3 and 1, 5 and 1, X and Y…… • Index, Caps, Resets • Other Terms: • Buydowns, Assumables, Balloons, Points, Graduated Payments (GPMs), Growing Equity (GEMs), Shared Apprec

  14. Commercial Real Estate • Land, construction and real estate development, and commercial properties • Construction loans: • Disbursements over time as project completed • Usually of “Bridge” variety • Land serves as collateral for loans. • Pricing Prime Plus • Origination as high as 3 Points

  15. Consumer Lending • Personal Loans • Small Dollar, usually no collateral • Open Lines (CC) or Closed (Auto/Boat) • Higher Risk  Higher Rate • Attempt to diversify geographically

  16. Consumer Loan Types • Auto/Boat/Other Asset – High Competition, Med Risk • Can be securitized with high volume • Credit Cards – High Competition, Hi Risk • 25-30 day int grace on purch, immed int on cash advance……FEES! • Lines of Credit – Low Competition, Med Risk • Revolving Lines with Check Writing

  17. Other Consumer Lending • Mobile Homes • Balloon Loans • Leasing – High Competition, Low Risk • Bank buys and “rents” to customer • Open-end: Customer must buy (sell) at end of lease, Pay diff to residual value • Closed-end: Bank takes asset back.

  18. Consumer Loan Characteristics • Amortized Loan • Pymt = $Loan / PVA (rate, term) • Balloon/Disc’d Loan • Pymt = $Loan * FVF (rate, term) • Pymt due only at term • Disc’d Money Recv’d = Pymt * PVF • Annual Percentage Rate vs. Effective Annual Rate

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