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Evaluating How Your Loans are Priced Relative to Risks and Costs

February 20, 2013
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Today’s Lending Environment

Competition for quality loans is becoming intense.  We’re commonly seeing it on the retail side with auto loan pricing, especially for indirect loans.  We’re seeing it on the commercial side, particularly for 5/15 and 5/20 balloon commercial real estate loans.  I’ll separate you into two camps – those of you that price by the seat of your pants off competitor rates, and those of you that use loan pricing models.

Pricing by the Seat of Your Pants

The advocates of the seat of the pants approach claim that the market sets rates, not some loan pricing model.  “I don’t need a model because I price off my competition.”  But many members of the seat of the pants crowd are currently looking at the rates in the market and saying, “I’m not sure I can make loans at rates this low.  Do I compete or do I pass?”  Without a loan pricing model, you have nothing to use as a benchmark to evaluate whether these low rate loans are well priced relative to your risks and costs.   Which raises an important point.  In most circumstances loan pricing models are not used to price loans (as the name implies).  Rather they are used to separate the well priced from the poorly priced loans based on rates being offered in your market.

Using a Loan Pricing Model

The mere fact that you have/use a loan pricing model doesn’t necessarily solve the problems encountered by the seat of the pants crowd.  The model needs good data, needs to consider all the risks and costs associated with your loan, and needs to focus on the right decision tool for making decisions.  Let’s examine these issues in a little more detail.

  • Make sure you have good data – When you price a loan you are pricing cash flows, not maturities.  So we need to know how a loan gives off its cash flows and whether the interest flows are fixed or variable.  In addition, we need to have data relative to fees, origination, and servicing costs.
  • Make sure you are considering all the risks – They include interest rate risk, credit risk, option risk, and capital risk.  A common problem in pricing models is that they fail to consider some of the risks, and miscalculate adjustments for the others.  A good example is interest rate risk.  Many models use the institution’s cost of funds as a funding expense.  In doing so they fail to consider that it takes more expensive funding to fund a 30 year fixed-rate mortgage as compared to a variable-rate home equity line.
  • Make sure you are using the right decision tool – Most loan pricing models focus on Risk Adjusted Return on Capital (RAROC or ROE).  A RAROC tool is appropriate when funding is tight and capital is scarce.  It makes sense to book the loans that maximize return on the scarcest resources (capital and funding).  However, RAROC is the wrong tool for many of you to use today.  If you are very liquid, I could argue that your cost of funds is a sunk cost.  You are already paying for the funding.  The real issue is do you make the loan or park it in the investment portfolio.  If you reject a loan because its ROE is 8%, well below your hurdle rate of 15%, the money is going to end up in your investment portfolio.  Have any of you checked the ROE on your investments lately?  On the other hand, what if your model contains a tool that allows you to compare the yield on a loan to a comparable bundle of investments, after adjusting for the risks and costs associated with the loan have been considered.  If the loan offers a meaningful spread over the investment alternative, wouldn’t you be better off making the loan, even if it doesn’t meet your ROE (RAROC) hurdle?


Stepping Outside The Box

It is hard to duck the fundamental rules of microeconomics in dealing with loan pricing.  Say a large number of institutions are attempting to sell (supply) 5/20 commercial real estate loans to a relatively small number of quality A credit borrowers (demand).  When supply exceeds demand, price gets bid lower.  In our market price is measured by rates, fees, and economic value of the loan being originated.  That is what we are experiencing in the most commonly marketed commercial real estate and consumer auto loans – a supply/demand imbalance that favors the borrower.

On the other hand, say only a few institutions are willing to make (supply) fixed rate fully amortizing 15 and 20 year commercial real estate loans.  Customers for those loans (demand) would love to lock in rates at the bottom of the rate cycle.  To the extent demand exceeds supply, prices get bid up. – rates, fees, economic value.

If institutions want to make more loans, then why is the supply of products like fully amortizing commercial real estate loans so limited?  The most common reason I’ve heard is that institutions are unwilling to take on the interest rate risk in these products.  But what if the loan is priced in such a way that rate more than covers the additional interest rate risk?  Wouldn’t it make sense to make the loan, turn the additional rate risk premium over to the CFO and say, “Here’s the additional revenue needed to hedge the interest rate risk in this loan.  It is up to you to decide whether to spend the money.”  Use of a properly set up loan pricing model allows you to identify situations where the supply/demand imbalance is in your favor.

Many of our customers are asset sensitive.  Yield will go up faster than cost of funds in a rising rate environment.  Adding a fixed-rate loan to an asset sensitive balance sheet reduces interest rate sensitivity in that balance sheet.  A CFO in an asset-sensitive situation may elect to stick the additional premium provided to hedge interest rate risk in his pocket, rather than paying to hedge the risk in the loan.  The hedge is already in place on his balance sheet to offset the interest rate risk in the fixed-rate loan.  In that situation, the loan becomes even more profitable as the money doesn’t need to be spent to hedge the risk in the fixed-rate loan.

Don’t think all of this is theoretical.  I just spent two hours with a good customer, examining his options for commercial real estate lending.  He’d been rejecting loans because they didn’t meet his ROE (RAROC) hurdle.  He is fairly liquid.  When I ran the loans through the investment benchmark test, on average they were beating the investment benchmark by 100 bp.  That’s 100 bp more yield on the loans as compared to investments after adjusting for all the loan’s risks and costs.  That analysis was a real eye opener to his lending staff.  It also turns out the institution is asset sensitive.  So for a number of months, they could take funds out of short-term investments and deploy them into longer-term loans, reducing their asset sensitivity in the process.

We’ll be able to determine how many months they can continue this strategy by running it through their A-L model and testing the effect of the strategy on income and value at risk.  The idea is that once they become relatively interest rate risk neutral, they will begin funding these loans with a blended funding model.  50% of the funding will be in the form of FHLB advances that are structured to match fund the loans.  The other half will be funded with core deposits.  Spread will narrow once the FHLB Advances come on stream.  But they will still be at least 100 bp better off than had they left the funds in investments.

Does this approach sound appealing to you?  Do you want to learn more?  You may want to consider two upcoming Webinars.  The first, Pricing: Individual Deals and Customer Relationships is a two part Webinar that examines the concepts discussed in this post in detail with plenty of examples of different kinds of loans.  The second, Loan Pricing: Application to Real World Situations is a four part webinar that covers the same ground.  However, we will turn you loose on our web based loan pricing model, LoanEdge, and you will be able to apply the techniques taught in class to modeling your own loans.

A third option is to sign up for our new Consulting Workshop in Madison.  Bring 3-4 team members.  We’ll work with you in developing a capital plan using our Capital SpeedBoat model including running some credit risk stress tests.  We’ll introduce you to the loan pricing concepts in the two webinars then work with you on modeling loan examples you will be asked bring with you to the workshop.  We’ll also work with you in developing funding strategies for rising rates and run some scenarios using our marginal cost spreadsheet.  When the seminar is done, Capital Speedboat and the marginal cost model will go home with you.  You will also have free access to LoanEdge for 90 days following the workshop so you can model additional loan strategies.

So what are you waiting for?

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