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GSB Credit Track Effective Loan Pricing Session 4

GSB Credit Track Effective Loan Pricing Session 4. Thomas Farin President tfarin@farin.com. Goals For This Session. Review Funds Transfer Pricing as applied to relationships Take you through a number of deal and relationship pricing examples

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GSB Credit Track Effective Loan Pricing Session 4

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  1. GSB Credit TrackEffective Loan PricingSession 4 Thomas Farin President tfarin@farin.com

  2. Goals For This Session • Review Funds Transfer Pricing as applied to relationships • Take you through a number of deal and relationship pricing examples • As I walk through the examples, I’ll show you how to do it. • Review assignment

  3. Multiple Loans New Customer - Same Origination Dates Existing Customer – Different Origination Dates Old loans – current or past FTP rates? Multiple Deposits New Customer – Same Origination Dates Existing Customer – Different Origination Dates Old Deposits – current or past FTP rates Relationship Pricing

  4. Internal profitability benchmark Evaluates whether a loan is profitable within context of balance sheet Most relevant when You are trying to decide whether you can make money originating a loan Anytime you are trying to asses the profitability of a relationship, product or profit center Can focus on: Dollar contribution to profit (ROA) Return on required capital (RAROC) Required inputs Cash flow characteristics Cost Curve Pricing – Rates and fees Operating expenses Credit risk adjustment Additional option risk adjustments Capital Requirement (RAROC) Capital Goal (RAROC) Institution Tax Rate Calculated adjustments Pretax Spread ($ or %) After tax spread ($ or %) RAROC Spread to RAROC Goal Test – Is spread positive (good) or negative (bad)? Not considered Risk free curve Investment benchmark curve Capital requirement Funds Transfer Pricing

  5. Not Recommended - Your Cost of Funds Curve Penalizes loan function for inefficient funds gathering, rewards for efficient funds gathering. Could force you to price out of the market. Fails to reward and provide an incentive for funds providers to gather funds efficiently. History based curve is used to price newly originated instruments. Recommended - Your true wholesale funding alternative FHLB Advance Jumbo/Brokered/I-net CD AAA corporate Swap Curve Use the one that comes closest to your true wholesale funding cost. Credits deposit gathering functions for sub-wholesale deposits. Levels the playing field for lending functions. Selecting a FTP Curve

  6. Assume an entity originates a $100K 7 year duration loan yielding 6% and raises a $80K 1 year deposit at a cost of 2%. Do they deserve to be credited with the 4% spread they generated? A FTP curve is plotted representing the cost of different durations of wholesale funding Many shops compromise by using a funding curve at a spread below wholesale rates. Doing so: Improves profitability of loans Reduces profitability of deposits Loan and deposit plotted on curve based on rate and duration Loan is above FTP curve Deposit is below FTP curve Transfer Pricing Components 6% - Loan 5% - FTP Curve 4% - 3% - Deposit 2% - 1 Yr 7 Yr

  7. Spread - Deposit is credited to the entity. In this example: Deposit rate for 1 year deposit is 2.0% FTP rate for 1 year deposit is 3.0%. A spread of 1.0% on $80K is allocated to the deposit gathering unit. Transfer Pricing Components 6% - Loan 5% - FTP Curve 4% - 3% - Spread - Deposit Deposit 2% - 1 Yr 7 Yr

  8. Spread – Rate Risk due to mismatch is transferred to Treasury. Only the Treasury can manage this risk and they need the margin contribution to do so. In this example, the slope in the yield curve between the 1 and 7 year points is 1% (4% - 3%). Transfer Pricing Components 6% - Loan 5% - FTP Curve 4% - Spread – Rate Risk 3% - Spread - Deposit Deposit 2% - 1 Yr 7 Yr

  9. Spread – Option Risk is transferred to Treasury Most FTP systems ignore this risk, but it is becoming a more and more substantial portion of the risk on financial institution balance sheets. To not transfer this risk adjustment would encourage lenders to grant options in exchange for higher rates and/or volumes. Lenders cannot manage option risk. This can only be done by Treasury and the spread needs to be available to buy the risk protection. Transfer Pricing Components 6% - Loan 5% - FTP Curve Spread – Option Risk 4% - Spread – Rate Risk 3% - Spread - Deposit Deposit 2% - 1 Yr 7 Yr • In this example, spread-option risk of 1% is transferred to the Treasury.

  10. Spread – Loan is credited to lending unit. Spread includes credit risk which is unit’s responsibility to manage. In this example, spread-loan is 1% on $100K. The entity retains 2% of the 4% spread between loan rate and deposit rate The other 2% is transferred to Treasury to provide spread needed to manage the institution’s interest rate risk and option risk. Transfer Pricing Components 6% - Loan Spread – Loan 5% - FTP Curve Spread – Option Risk 4% - Spread – Rate Risk 3% - Spread - Deposit Deposit 2% - 1 Yr 7 Yr

  11. Return on Equity(RAROC) for the transaction - is calculated by: Summing net interest income contribution from loan and investment Adding fees and subtracting allocated operating expenses. Net income is divided by capital required to calculate Return on Capital (ROE) So FTP income can be measured with Net Income (ROA) RAROC Transfer Pricing Components 6% - Loan Spread – Loan 5% - FTP Curve Spread – Option Risk 4% - Spread – Rate Risk 3% - Spread - Deposit Deposit 2% - 1 Yr 7 Yr

  12. Transfer Pricing Summary • Relationship profitability looks at profitability of entire relationship • Loans • Deposits • Fee income generating activities • Is best assessed over a horizon • 1 Year – Too short • 2-3 Years – Ideal • 4+ Years – too long • Can be used to assess existing relationships as long as: • FTP rates on old loans and deposits are set based on time of origination or time of last repricing • Assumptions need to be made as to related behavior of component parts. For example, if the commercial loan leaves, the commercial deposit is likely to leave with it.

  13. Business Checking Decay rate is a crucial assumption • The following are good on deposits • Spread below benchmark • Market value below book • RAROC on deposits can’t be calculated unless a capital requirement is assigned.

  14. Decay Rates to Cash Flows $20,000 * (14.49% / 12) = $241.50 Also applies to VR Lines of credit. Note: You don’t control decay rates in LoanEDGE

  15. Loan #2 Options • Model a completely different loan • Compare two loans that represent alternatives to your customer • Model a relationship • In the next sequence, I’m going to show you how to execute model features and provide educational insight concurrently • Portions of the material that follows will allow you to model any of the three options to the left.

  16. Becoming More Commodity Like Common term commercial R/E (5 balloon, 20 ammo) is becoming a commodity. Hard to make money on this product in many markets. Beating the Commodity Game Give the customer what they want Relationship pricing Sequence Model a 5/20 Balloon without and with origination fees. Compare to a fully amortizing 20 year FR Commercial R/E Loan Go with the loan the customer prefers knowing relative pricing Add a deposit to the preferred loan and model the relationship Commercial R/E

  17. Commercial R/E Log on Create NewRelationship Or View a relationship I elected toCreate New

  18. Commercial R/E Give name Add

  19. Commercial R/E Pick firstloan to add Click Select

  20. Commercial R/E Loan • Note: Numbers run in Aug 2012 • Entered: • Rate • Amount • Overrode Credit Risk Adjustment Loan fails tomeet ROEtarget Solve for B/E ROE

  21. Commercial R/E Loan Make sure you are solving forproduct ROE Copy rate topricing Click Done

  22. Commercial R/E Loan How cool,we know exactlywhat to chargeto hit 15% Problem!Rate is 30 bpover competition.now what?Maybe we couldcharge anorigination fee …

  23. Commercial R/E Loan Completeedit boxClick Done

  24. Commercial R/E Ahaaaa Now letsre-solve forbreakevenrate

  25. Commercial R/E At 5.126% webreak even. At5.25%, we’llexceed breakeven. But what if wecan’t sell the point? I wonder whether thecustomer would prefer a fullyamortizing 20 year FRM? Add an account You can use a relationship as a container to compare two or more loans

  26. Commercial R/E Add 20 YrFR ComR/E Loan

  27. Commercial R/E • Enter • Rate • Amount • Override credit adjustment • Ouch !!!! • Solve for B/E rate Relationshipnow has 2 loans Switch back and forth by clickingtitle bar.

  28. Commercial R/E Will customerpay 6.11% zeropoints to lock inrate for 20 years? Let’s add the pointand solve for B/Erate so we cancompare the twoloans

  29. Commercial R/E Difference is57.6 bp, allother thingsequal Now its time todiscuss optionswith customer,explore preferences, obtain information on rest of relationship. Customer likesfixed-rate option,is balking on price,and has $50K ACB checking accountto offer. Select 5/20 Balloon by clicking title bar

  30. Commercial R/E 20 Year FRM 5/20 Balloon +0.85 +0.85 +0.85 -0.07 +0.78 +0.46 -0.32 Note: This is a sample comparison. Loans were modeled at an earlier point in time.

  31. Commercial R/E Removefromrelationship

  32. Commercial R/E Add a businesscheckingaccount

  33. Commercial R/E • Enter: • Balance • Annual Fees • Can’t calculateROE on checking as nocapital isassigned. • But look at ROEon relationship • Select 20 yearFRM by clickingtitle bar

  34. Commercial R/E Solve for rate onloan to hitRelationship ROEtarget then copyto pricing

  35. Commercial R/E At 5.138% wefall below product ROE target of 15%, but hit relationshipROE target of 15% Now let’s deletethe fee the customerdislikes and resolvefor relationshipROE.

  36. Commercial R/E Deletethe fee

  37. Commercial R/E Both productand relationshipROE fall below15%. Now lets solve fora 15% RelationshipROE.

  38. Commercial R/E

  39. Commercial R/E I’ll bet I can sella fullyamortizing 20year commercialR/E loan at 30 bp above 5/20 rates.

  40. Session Summary • Institutions able to evaluate relationship profitability have an advantage over those focusing on loan only. • Relationship profitability can still use all relevant market and balance sheet measures. • Primary focus is on a single goal – ROA or ROE. • Can be used for: • Pricing individual deals • Evaluating relationship pricing strategies on commodity products.

  41. Note • Everything you have done persists on our server. • If you want to modify a deal later you can: • Log onto LoanEDGE • Open (View) a relationship • Modify or enhance • In Session 4 you will be either modifying an existing relationship or creating a new one. • Our support people will be able to view the loan you have been working on. • Feel free to model additional loans if you wish.

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