Evaluating Consumer Loans

Evaluating Consumer Loans
Chapter 15 Evaluating Consumer Loans

Today, many banks target individuals as the primary source of growth in attracting new business Consumer loans differ from commercial loans Quality of financial data is lower Primary source of repayment is current income

Types of Consumer Loans
Evaluating Consumer Loans An analyst should addresses the same issues discussed with commercial loans: The use of loan proceeds The amount needed The primary and secondary source of repayment

Evaluating Consumer Loans Consumer loans differ so much in design that no comprehensive analytical format applies to all loans

Installment Loans Require the periodic payment of principal and interest

Installment Loans Direct Negotiated between the bank and the ultimate user of the funds Indirect Funded by a bank through a separate retailer that sells merchandise to a customer

Installment Loans Revenues and Costs from Installment Loans Consumer installment loans can be extremely profitable Costs $100 - $250 to originate loan Typically yield over 5% (loan income minus loan acquisition costs, collections costs and net charge-offs)

Credit Cards and Other Revolving Credit Credit cards and overlines tied to checking accounts are the two most popular forms of revolving credit agreements In 2007, over 92% of households had credit cards (average of 13 cards)

Credit Cards and Other Revolving Credit Most banks operate as franchises of MasterCard and/or Visa Bank pays a one-time membership fee plus an annual charge determined by the number of its customers actively using the cards

Debit Cards, Smart Cards, and Prepaid Cards Debit Cards Widely available When an individual uses the card, their balance is immediately debited Banks prefer debit card use over checks because debit cards have lower processing costs

Debit Cards, Smart Cards, and Prepaid Cards Smart Card Contains a memory chip which can store information and value Programmable such that users can store information and add or transfer value to another smart card Only modest usage in the U.S.

Debit Cards, Smart Cards, and Prepaid Cards Prepaid Card A hybrid of a debit card Customers prepay for services to be rendered and receive a card against which purchases are charged Use of phone cards, prepaid cellular, toll tags, subway, etc. are growing rapidly

Credit Card Systems and Profitability Card issuers earn income from three sources: Cardholders’ annual fees Interest on outstanding loan balances Discounting the charges that merchants accept on purchases

Credit Card Systems and Profitability Despite high charge-offs, credit cards are attractive because they provide higher risk-adjusted returns than do other types of loans

Overdraft Protection and Open Credit Lines Overdraft Protection Against Checking Accounts A type of revolving credit A bank authorizes qualifying individuals to write checks in excess of actual balances held in a checking account up to a pre-specified limit

Overdraft Protection and Open Credit Lines Open Credit Lines The bank provides customers with special checks that activate a loan when presented for payment

Home Equity Loans Grew from virtually nothing in the mid-1980s to over $350 billion in 2008 They 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

Home Equity Loans Some allow access to credit line by using a credit card Borrowers pay interest only on the amount borrowed, pay 1 to 2 percent of the outstanding principal each month, and can repay the remaining principal at their discretion

Non-Installment Loans aka Bridge Loan Requires a single principal and interest payment Typically, the individual’s borrowing needs are temporary and repayment is from a well-defined future cash inflow

Subprime Loans One of the hottest growth areas during the early 2000s
Subprime loans are higher-risk loans labeled “B,” “C,” and “D” credits They have been especially popular in auto, home equity, and mortgage lending Typically have the same risk as loans originated through consumer finance companies

Subprime Loans Many subprime lenders make loans to individuals that a bank would not traditionally make and keep on-balance sheet Subprime lenders charge higher rates and have more restrictive covenants

Subprime Loans What Happens When Housing Prices Fall
Subprime loans can be attractive when housing values are rising Individuals who are overextended and cannot make their monthly payments, can often sell the home or refinance and withdraw equity to pay the debts if the price increases are sufficiently high The opposite occurs when housing prices fall

Subprime Loans What Happens When Housing Prices Fall
During 2007–2008, banks were forced to charge-off historically high amounts of mortgage loans as delinquencies and foreclosures skyrocketed

Consumer Credit Regulations
Equal Credit Opportunity Makes it illegal for lenders to discriminate on the basis of race, religion, sex, marital status, age, or national origin

Prohibited Information Requests 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 Acceptable if they do not require prohibited information and are statistically justified 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 Regulations apply to all individual loans up to $25,000 where the borrower's primary residence does not serve as collateral

Truth In Lending Requires that lenders disclose to potential borrowers both the total finance charge and an annual percentage rate (APR) Historically, consumer loan rates were quoted as: Add-On Rates Discount Rates Simple Interest Rates

Fair Credit Reporting 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

Fair Credit Reporting There are three primary credit reporting agencies: Equifax Experian Trans Union Unfortunately, the credit reports that they produce are quite often wrong

Fair Credit Reporting Credit Score Like a bond rating for individuals Based on several factors Payment History Amounts Owed Length of Credit History Types of Credit New Credit

Community Reinvestment Act CRA prohibits redlining and encourages lenders to extend credit within their immediate trade area and the markets where they collect deposits

Community Reinvestment Act Financial Institutions Reform, Recover, and Enforcement Act of 1989 raised the profile of the CRA by mandating public disclosure of bank lending policies and regulatory ratings of bank compliance

Community Reinvestment Act Regulators must also take CRA compliance 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

Bankruptcy Reform Individuals can file for bankruptcy under: Chapter 7 Individuals liquidate qualified assets and distribute the proceeds to creditors Chapter 13 An individual works out a repayment plan with court supervision

Bankruptcy Reform In 2005, Congress passed bankruptcy reform legislation that made it more difficult for individuals to completely avoid repaying their debts In particular, an individual whose income exceeds the state median has to file for Chapter 13 and will repay at least a portion of his or her debts

Credit Analysis Objective of consumer credit analysis is to assess the risks associated with lending to individuals

Credit Analysis When evaluating loans, bankers cite the Cs of credit:
Character Capital Capacity Conditions Collateral

Credit Analysis Two additional Cs Customer Relationship Competition
A bank’s prior relationship with a customer reveals information about past credit experience Competition Lenders periodically react to competitive pressures Competition should not affect the accept/reject decision

Credit Analysis Policy Guidelines Acceptable Loans Automobile Boat
Home Improvement Personal-Unsecured Single Payment Cosigned

Credit Analysis Policy Guidelines Unacceptable Loans
Loans for speculative purposes Loans secured by a second lien Other than home improvement or home equity loans Any participation with a correspondent bank in a loan that the bank would not normally approve

Credit Analysis Policy Guidelines Unacceptable Loans
Loans to a poor credit risk based on the strength of the cosigner Single payment automobile or boat loans Loans secured by existing home furnishings Loans for skydiving equipment and hang gliders

Credit Analysis Evaluation Procedures: Judgmental and Credit Scoring
Subjectively interpret the information in light of the bank’s lending guidelines and accepts or rejects the loan Assessment can be completed shortly after receiving the loan application and visiting with the applicant

Grades the loan request according to a statistically sound model that assigns points to selected characteristics of the prospective borrower

If the total points exceeds the accept threshold, the officer approves the loan If the total is below the reject threshold, the officer denies the loan

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

Credit Analysis An Application: Credit Scoring a Consumer Loan
You receive an application for a customer to purchase a 2007 Jeep Cherokee Do you make the loan?

The Credit Score At this bank, the loan is automatically approved if the total score equals at least 200 The loan is automatically denied if the total score is below 150 Accept/Reject is indeterminate for scores between 150 & 200

The Credit Decision The credit decision rests on the loan officer’s evaluation of the applicant’s character and capacity to repay the debt

The Credit Decision The loan officer has numerous grounds for denying credit Limited credit history Local residence was established too recently Employed too recently

The Credit Decision The loan officer sees some positive things Applicant appears to be a hard worker who is the victim of circumstances resulting from her husband’s death It is unlikely that anyone who puts almost 30 percent down on a new model is going to walk away from a debt

The Credit Decision The loan officer sees some positive things The bank will likely lose Groome as a depositor if it denies the application What would you recommend?

Credit Analysis Your FICO Credit Score
Summarizes in one number an individual’s credit history Lenders often use this number when evaluating whether to approve a consumer loan or mortgage Many insurance companies consider the score when determining whether to offer insurance coverage and how to price the insurance

Summarizes in one number an individual’s credit history The scores range from 300 to 850 with a higher figure indicating a better credit history The national average is 670 The higher the score is, the more likely it is a lender will see the individual as making the promised payments in a timely manner

An individual’s credit score is based on five broad factors: Payment history 35% Amounts owed 30% Length of credit history 15% New credit 10% Type of credit in use 10%

Credit Analysis An Application: Indirect Lending
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

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

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

Recent Risk and Return Characteristics of Consumer Loans
Revenues from Consumer Loans The attraction is two-fold: Competition for commercial customers narrowed commercial loan yields so that returns fell relative to potential risks 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 In addition to interest income, banks generate substantial non-interest revenues from consumer loans

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 losses and fraud amounted to more than $12 billion in 2005

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

Interest Rate and Liquidity Risk with Consumer Credit Bankers have responded in two ways to deal with the interest rate risk: Price more consumer loans on a floating-rate basis Commercial and investment banks have created a secondary market in consumer loans, allowing loan originators to sell a package of loans

Exhibit 15 -14 EA and SEA Economies Have a Discernible Pattern of Economic Growth

Cheap Labor from Rural to Industrial Exporting Sector & Lewis Turning Point
The stylized pattern of aggregate consumption in EA and SEA economies important in formation of household consumption. All EA and SEA economies were able to migrate cheap rural labor to industrial exporting sector. This kept industrial production costs low and gave them an internationally competitive export market The export sector’s infrastructure investment absorbed most of the savings obtained by falling household consumption. In time, the economies had to rebalance when surplus cheap rural labor dried up and real wages were bid up. This point was the Lewis turning point.

Exhibit 15-15 Household Consumption Shares by Income: EA and SEA 1996-2010

China Experiencing Necessity to Rebalance
From Exhibit 15-15, China is the economy now requiring rebalancing. Complications to its rebalancing: Increased fertility extends period to the Lewis tipping point Relaxation of the hukou extends period to the Lewis tipping point Technological progress in the industrial sector shortens the period to the Lewis tipping point

Large Trade Surpluses Allows China to Rebalance Its Economy

Policy Actions to Create Suitable Environment to Rebalance the Economy
Economy market driven Income distribution improved – more to middle incomes Cut bureaucracies and government departments Reform remaining bureaucracies – fight corruption, hedonism, extravagance and other misconduct Implement timetable to clean up provinces and industries creating pollution

Foster electronic payments infrastructure
Some Major Drivers of Consumption in EA and SEA Economies – China as an Example Foster electronic payments infrastructure China already built high speed fiber optic telecommunications network throughout China Moody’s Analytics study reinforces decisions to invest in electronic and internet payments China is a leading beneficiary of card payment penetration and growth New consumer finance companies created Tourism and transport promoted. See Exhibit for 12th Five Year Plan ( ) for Integrated Transport System

Non-Performing Loans: EA and SEA Performed Better than US and EU Economies
During the Great Recession, EA and SEA economies had better non-performing loans to total gross loans figures than US and EU economies. See Exhibit Deregulated Lending Environment: China Previously bank lending to SOEs in China were “underwritten” by the government & therefore secure Lending to private companies and SMEs requires the bank lending officer to be more vigilant re credit risk. Five Cs of Credit is an evaluation procedure that works everywhere. Capable of working in guanxi environments. Many credit scoring or sophisticated credit selecting programs from US or EU countries require databases not available in SEA or EA economies or may be misapplied.

Chapter 15 Evaluating Consumer Loans

Evaluating Consumer Loans

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