1. 11-1 11C Fundamental Credit Analysis  Topics covered: Five C’s of credit analysis Home loan underwriting Credit scoring C&I loan underwriting  Cash flow analysis  Other considerations  Ratio analysis

2. 11-2 Five C’s of Credit Analysis  Capacity  Capital  Collateral  Conditions  Character

3. 11-3 Home Loan Underwriting  Relies heavily on collateral But ability/tendency to pay also important  Recourse loan  Two key measures LTV (loan to value) Debt service ratios  GDS (gross debt service) Housing cost/gross income  Typically (interest + principal + taxes + insurance)/gross income 28% for FNMA  TDS (total debt service) (all debts & commitments/gross income) 36% for FNMA

4. 11-4 Credit Scoring  Actually began in C&I, but primarily used in consumer lending  Quick & low cost  Typical Factors: Income Mortgage/rent cost Credit card debts Payment history Age Own/rent & length of time Job stability Relationship with institution

5. 11-5 Credit Scoring (cont.)  FICO Score is the most common consumer credit score Ranges from 300 to 850 760+ Excellent credit, may get better terms 723 median US score 680 typically qualify for prime flat on HELOC 620 typically qualify for FNMA mortgage

6. 11-6 C&I Loan Underwriting  Larger loan balances  Customized Terms  Priced to credit risk rather than just accept/reject decision  Significant post-issuance monitoring  Bread and butter for local commercial banks

7. 11-7 C & I Loan Underwriting (cont.)  Focus on ability to repay Hence, extensive cash flow analysis  Financial statements are verified Tax returns a common source  Check with related parties Customers Prospects Suppliers  Capability and character of management key  Key facets of business investigated Production Marketing Capital Requirements

8. 11-8 Cash Flow Analysis  There should be enough cash flow from business operations to service debt Should not have to sell assets Should not have to borrow  Most measures are “coverage” ratios of the general form: Cash from operations/debt payments  See Handout Tables 11-A-1 and 11-A-2

9. 11-9 Ratio Analysis  Common-sizing statements is standard  Liquidity Ratios: current ratio = current assets/current liabilities Quick ratio = current assets-Inv./current liabilities  Asset management ratios: Number days receivables (DSO) = A/R x 365/sales or credit sales Number of days inventory = Inv x 365/COGS Sales to WC = Sales/WC Sales to assets = Sales/Fixed Assets Sales to total assets = sales/total assets

10. 11-10 Ratio Analysis (cont.)  Debt and Solvency ratios debt to assets = ST Liab +LT Liab/total assets note that 1:1 debt to equity =.5 debt to assets Times interest earned (interest coverage ratio) = earnings available to meet interest charges/interest charges Cash flow to debt ratio = EBIT + Depreciation/Debt this ratio should easily exceed debt interest rate

11. 11-11 Ratio Analysis (cont.)  Profitability ratios: Gross margin = gross profit/sales Operating profit margin = Operating Profit/Sales ROA = EAT/ Total Assets ROE = EAT/Total Equity Dividend payout = Dividends/EAT  Always need to be careful about comparability in ratio analysis Same items can be accounted for in different ways

12. 11-12 Lending Process  Underwriting Fundamental process described in previous slides  Loan design Amount Term Collateral – primary source of recoveries Covenants – allow timely action  Monitoring/Collection Fundamental process described in previous slides Revise loan?

13. 11-13 Typical Covenants  Reporting requirements Frequent financial statements Sales tax submissions Income tax returns  Limits on additional debt  Limits on major expenditures  Limits on distributions to owners  Key ratio compliance Profitability Coverage Debt/equity Liquidity measures  Personal guarantees

14. 11-14 Lending Rates and Rationing  At retail: Usually a simple accept/reject decision rather than adjustments to the rate. Credit rationing. If accepted, customers sorted by loan quantity. For mortgages, discrimination via loan to value rather than adjusting rates  At wholesale: Use both quantity and pricing adjustments.  Customized terms, customized documents