McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter Seventeen Lending to Business Firms and Pricing Business Loans

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Types of Loans Made By Banks Real Estate Loans Financial Institution Loans Agriculture Loans Commercial and Industrial Loans Loans to Individuals Miscellaneous Loans Lease Financing Receivables 16-2

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Loans Outstanding for U.S. Banks (2007) 16-3

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Short Term Business Loans Self-Liquidating Inventory Loans Working Capital Loans Interim Construction Loans Security Dealer Financing Retailer and Equipment Financing Asset-Based Financing Syndicated Loans 17-4

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Long Term Business Loans Term Loans Revolving Credit Lines Project Loans Loans to Support Acquisitions of Other Business Firms Question: What are the essential differences between various short- and long-term business loans? 17-5

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Sources of Repayment for Business Loans The Borrower’s Profits or Cash Flows Business Assets Pledged as Collateral Strong Balance Sheet With Ample Marketable Assets and Net Worth Guarantees Given By Businesses 17-6

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Common Types of Loan Collateral Reasons for Taking Collateral Types of Collateral: ▫ Accounts Receivables ▫ Factoring ▫ Inventory ▫ Real Property ▫ Personal Property ▫ Personal Guarantees 16-7

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. The Six Basic C’s of Lending Character – Specific Purpose of Loan and Serious Intent to Repay Loan Capacity – Legal Authority to Sign Binding Contract Cash – Ability to Generate Enough Cash to Repay Loan Collateral – Adequate Assets to Support the Loan Conditions – Economic Conditions Faced By Borrower Control – Does Loan Meet Written Loan Policy and How Would Loan Be Affected By Changing Laws and Regulations 16-8

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 16-9

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Analyzing Business Loan Applications Common Size Ratios of Customer Over Time Financial Ratio Analysis of Customer’s Financial Statements Current and Pro Forma Sources and Uses of Funds Statement 17-10

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Financial Ratio Analysis Control Over Expenses Operating Efficiency Marketability of Product or Service Coverage Ratios: Measuring Adequacy of Earnings Liquidity Indicators for Business Customers Profitability Indicators The Financial Leverage Factor as a Barometer of a Business Firm’s Capital Structure 17-11

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Expense Control Measures Cost of Goods Sold/Net Sales Selling, Administrative and Other Expenses/Net Sales Depreciation Expenses/Net Sales Interest Expenses on Borrowed Funds /Net Sales Taxes/Net Sales 17-12

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Operating Efficiency Annual Costs of Goods Sold/Average Inventory Average Receivables Collection Period Net Sales/Net Fixed Assets Net Sales/Total Assets Net Sales/Accounts Receivables 17-13

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Marketability of Product or Service Gross Profit Margin=(Net Sales- CGS)/Net Sales Net Profit Margin=Net Income After Taxes/Net Sales 17-14

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Coverage Measures Interest Coverage Coverage of Interest and Principal Payments 17-15

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Liquidity Measures Current Assets/Current Liabilities Acid Test Ratio Working Capital Net Liquid Assets 17-16

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Profitability Measures Before Tax Net Income/Total Assets After Tax Net Income/Total Assets Before Tax Net Income/Net Worth After Tax Net Income/Net Worth 17-17

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Leverage or Capital Structure Measures Leverage Ratio Total Liabilities/Net Worth Capitalization Ratio Debt to Sales Ratio 17-18

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Types of Contingent Liabilities Guarantees or Warrantees Behind Products Litigation or Pending Lawsuits Unfunded Pension Liabilities Taxes Owed But Unpaid Limiting Regulations 17-19

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Component of Sources and Uses of Funds Statement Cash Flows from Operations Cash Flows from Investing Activities Cash Flows from Financing Activities 17-20

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Traditional (Direct) Operating Cash Flows Net Sales Revenue – Cost of Goods Sold – Selling, General and Administrative – Taxes Paid in Cash + Non Cash Expenses 17-21

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Indirect Operating Cash Flows Net Income + Non Cash Expenses + Losses from the Sale of Assets – Gains from the Sale of Assets – Increases in Assets Associated with Operations + Increases in Current Liabilities Associated with Operations – Decreases in Current Liabilities Associated with Operations + Decreases in Current Assets Associated with Operations 17-22

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Methods Used to Price Business Loans Cost-Plus Loan Pricing Method Price Leadership Model Below Prime Market Pricing Customer Profitability Analysis 17-23

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Cost-Plus Loan Pricing 17-24

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Price Leadership Model 17-25

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Prime Rate Major Banks Established a Base Lending Fee During the Great Depression. At that Time It Was the Lowest Interest Rate Charged Their Most Credit Worthy Customers for Short-Term Working Capital Loans 17-26

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. LIBOR The London Interbank Offer Rate. The Rate Offered on Short-Term Eurodollar Deposits With Maturities Ranging From a Few Days to a Few Months 17-27

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Below-Prime Market Pricing 17-28

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter Eighteen Consumer Loans, Credit Cards, and Real Estate Lending

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Consumer Lending Has been among the most popular financial services offered in recent years One of the most important sources of revenues and deposits for banks and their competitors (credit unions, savings associations, and finance and insurance companies); a source of supplemental income On the other hand, presents a special challenge due to higher-than-average default rates

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Performance and Chargeoffs by Bank Category, 12/ % 1.23% 4.01% 1.30% 1.18% 1.66% 1.10% 1.35% 0.0% 0.5% 1.0% 1.5% 2.0% 2.5% 3.0% 3.5% 4.0% 4.5% 5.0% International Banks Agricultural Banks Credit Card Lenders Commercial Lenders Mortgage Lenders Consumer Lenders Other Specialized < $1 Billion All Other < $1 Billion All Other > $1 Billion 18-31

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Types of Consumer Loans Classify Consumer Loans by Purpose – What the Borrowed Funds are Used For, or by Type – Whether the Borrower Must Repay in Installments or in One Lump Sum Residential Mortgage Loans Nonresidential Loans ▫ Installment Loans ▫ Noninstallment Loans Credit Card Loans and Revolving Credit 18-32

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Residential Mortgage Loans Credit to Finance the Purchase of Residential Property in the Form of Houses and Multifamily Dwellings. This is Usually a Long-Term Loan ( years) Which is Secured By the Property Itself. Fixed or Variable Rate of Interest 18-33

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Nonresidential Loans: Installment Loans Short-Term to Medium-Term Loans Repayable in Two or More Consecutive Payments, Usually Monthly or Quarterly. These Are Often Used to Finance Big Ticket Purchases or Consolidate Existing Debt (automobile, furniture, appliances)

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Noninstallment Loans Short-Term Loans By Individuals for Immediate Cash Needs and Repayable in One Lump Sum When the Borrower’s Note Matures (charge accounts, medical care, auto and home repairs) 18-35

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Credit Card Loans Credit Cards Offer Holders Access to Either Installment or Noninstallment Credit. Banks Find That the Installment Users of Credit Cards are the Most Profitable – Provide Higher Risk-Adjusted Returns Than Other Types of Loans. Card issuers earn income from:  Cardholders’ annual fees  Interest on outstanding loan balances  Discounting the charges that merchants accept on purchases

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Credit Card Regulations U.S. Regulators of Depository Institutions -- OCC, Fed, FDIC, and OTS -- in 2003, Moved to Slow the Expansion of Card Offers to Customers with Low Credit Ratings More recently, May 2009: ▫ Strict limits on marketing to college students and other prospective cardholders under the age of 21 ▫ Preventing cardholder accounts from being charged beyond their limits ▫ Clearer disclosure of credit card interest rates and repayment estimates, using standard text sizes and styles ▫ Tougher rules related to raising interest rates on delinquent cardholders, with clear paths to rehabilitate credit card accounts

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Debit Cards Debit Cards Can Be Used To Pay For Goods And Services, But Not To Extend Credit. They Are A Convenient Vehicle For Making Deposits Into And Withdrawals From ATMs And They Facilitate Check Cashing

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Outstanding Consumer Debt as a Percent of Disposable Income 18-39

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Consumer Debt Service Ratio 18-40

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Characteristics of Consumer Loans Most Costly and Most Risky to Make Per Dollar Cyclically Sensitive Interest Inelastic 18-41

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Evaluating a Consumer Loan Application Character and Purpose Income Levels Deposit Balances Employment and Residential Stability Pyramiding of Debt 18-42

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Credit Bureaus Credit Reporting Agencies or Credit Bureaus Assemble and Distribute to Lenders the Credit History of Millions of Borrowers Information ▫ Personal Identifying Data ▫ Personal Credit Histories ▫ Public Information That May Have Bearing on Loan 18-43

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Credit Scoring Credit Scoring Systems are Based on Sophisticated Statistical Models in Which Several Variables are Joined to Establish a Numerical Score to Separate Good Loans From Bad Loans. The Most Famous of These is the FICO Scoring System Developed by Fair Isaac

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Laws and Regulations Applying to Consumer Loans 1.Disclosure Rules ▫ Truth in Lending Act, passed in 1968, simplified in 1981 ▫ Fair Credit Reporting Act, 1974 ▫ Fair Credit Billing Act ▫ Fair Debt Collection Practices Act 2.Antidiscrimination Laws ▫ Equal Credit Opportunity Act ▫ Community Reinvestment Act ▫ Home Ownership and Equity Protection Act 18-46

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Predatory Lending and Subprime Loans An Abusive Practice Among Some Lenders That Consists of Granting Loans to Subprime Borrowers and Charging Them Excessive Interest Rates and Fees, Increasing the Risk of Default. Subprime Lending Played Important Role in the 2007 Credit Crisis

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Real Estate Loans Among the Riskiest Loans Banks Can Make Average Size is Larger Than the Average Size of Other Loans Tend to Have Longer Maturities Than Other Loans 18-48

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Factors Used in Evaluating Real Estate Loans Size of Down Payment Relative to Purchase Price of Property Should Be Evaluated in Terms of Total Relationship Need to Pay Attention to Particular Aspects of Credit Application: ▫ Amount and Stability of Income (Gross Debt Service) ▫ Available Savings and Source of Down Payment ▫ Track Record in Maintaining Property ▫ Outlook for Real Estate Market in Local Area ▫ Outlook for Interest Rates If Variable Rate Loan 18-49

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Home Equity Lending Home Owners Can Use the Difference in Home’s Estimated Value and Remaining Mortgages as a Borrowing Base Two Types of Credit ▫ Closed End Credit ▫ Lines of Credit Can Be Used for Any Legitimate Purpose The 1986 Tax Reform Act Has Helped This Type of Loan Grow in Popularity 18-50

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Interest Only Mortgages: The Most Controversial of Home Mortgage Loans Many of these are Adjustable Rate Mortgages Home Owner Can Pay the Interest Only for an Initial Period Mortgage Payments Can be Much Higher When Principal Payments are Due Because of the Shorter Period to Repay the Loan Especially Problematic When House Prices Stop Climbing Upward During the Recent Crisis, the Fed Moved to Tighten the Rules on Mortgage Lending to Promote Greater Transparency in Loan Terms 18-51

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Cost-Plus Model of Pricing Loans 18-52