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Chapter 10 Overview of Credit Policy and Loan Characteristics Chapter Objectives 1. Describe recent trends in bank loan growth and quality and data for different-size banks. 2. Provide an overview of the credit process at commercial banks. 3. Describe the characteristics of different types of loans. 4. Explain what negative and positive (affirmative) loan covenants are. 5. Introduce cash-to-cash cycle comparisons for working capital loans. Key Concepts 1. Loans are the dominant earning asset at most commercial banks comprising between 50% and 80% of total assets. Real estate loans are the dominant loans for most banks, but loan composition for individual banks reflects management’s strategies and target markets. 2. Since the early 1990s, loan quality has improved dramatically as loan charge-offs and noncurrent loans have decreased sharply. Only credit card loans experienced rising loss rates, which is particularly disturbing given the robust economic conditions in the U.S. during the 1990s. From 2000 - 2004, recent data show an increase in noncurrent and problem loans across many different types of credits followed by a decrease for real estate and commercial & industrial loans. The increase appears to be particularly strong for loans to individuals. The number of bankruptcy filings and credit card charge-off rates continue to rise as well. 3. The credit process involves three functions: business development and credit analysis, credit execution and administration, and credit review. Credit analysis involves the examination of the risks inherent in making a loan and largely determines whether a bank wants to extend credit to the prospective borrower. 4. Two types of commercial loans are short-term working capital loans and term loans for the purchase of depreciable assets and/or facilitating mergers and acquisitions. Working capital loans typically require a complete payoff within one year as trading assets are liquidated. Term loans have maturities beyond one year and are repaid from operating cash flow. 5. The working capital cycle compares the timing difference between converting current assets to cash and making cash payments on current liabilities and operating expenses. The cash-to-cash cycle is a measure in days of the time it takes for the underlying firm to convert assets or liabilities to cash. The difference in the asset cash- to-cash cycle and liability cash-to-cash cycle provides information about a firm's potential working capital borrowing requirement. The greater is the asset cash-to-cash cycle, the greater is a firm’s potential borrowing needs. 6. Loans for real estate, agriculture, and other specific purposes generally exhibit features associated with the assets financed or cash flow sources of the borrower. Such loans are priced according to the specific terms of each loan. 7. Consumer loans differ from commercial loans because they are smaller in size, are often repaid in installments, and generally carry fixed rates. Today, many of the largest institutions credit score most consumer loans and most small business loans. This centralizes the decision-making, but makes the credit granting process less personal. There is an obvious trade-off between offering the personal service in a timely fashion and cutting costs and mechanizing the credit approval process. Both approaches have been successful. Teaching suggestions Chapter 10 introduces recent trends in loan composition at different banks and the quality of different types of loans. It then describes the characteristics of different types of loans, all of which serve as background material for the detailed credit analysis discussed in later chapters. Exhibit 10.2 examines credit risk diversification across banks that have different loan concentrations. Have students assess where the concentrations appear most problematic at the end of 2004. Have students review Exhibits 10.3 through 10.6 and discuss the key trends. See if they can explain why loan quality has generally improved for all types of loans. Why then have personal bankruptcy filings and credit card charge-off rates increased so sharply since the early 1990s when economic growth has been so strong in the U.S.? Ask students to link the change in asset quality to the income statement. What is the likely impact on provisions for loan losses and net income, ceteris paribus? It is also useful to differentiate between short-term loans and term loans. Make sure that students understand why banks distinguish between the two. What are the expected sources of repayment for each? Emphasize that one way to analyze working capital loan needs is to estimate them using the cash-to-cash cycle comparison. The text introduces many issues that students will be somewhat familiar with including differences between banks, credit unions, pawn shops, car dealers, payday lenders, etc. Have them offer their perpectives on the different strategies regarding loans and different risk-return profiles. Discuss the credit process in detail. Many students want to work for banks and many new hires begin by analyzing financial information as part of the process. Have students select a non-financial firm, obtain its most recent annual report, and analyze the firm's cash-to-cash working capital cycle. Compare the estimated timing differential with the firm's actual short-term bank credit outstanding. Students should recognize the impact of seasonal trends in a firm's production process and operations, and thus the importance of interim financial statements. Answers to End of Chapter Questions 1. A bank's credit culture determines the performance of the loan portfolio. The culture indicates the importance of risk assessment and having proper controls in place to allow effective decision making and monitor performance. Some banks are driven by a credit culture where the basic philosophy is that lending drives profitability and performance. Such banks typically operate with higher loan-to-asset ratios, higher net interest margins, and higher noninterest expense. They also typically have higher loan charge-offs. 2. Business development and credit analysis generates loan applicants and then evaluates the loan requests. Credit execution and administration makes the accept/reject decision and establishes the necessary paperwork to obtain an enforceable contract. Credit review monitors loan performance to determine whether risk and return objectives are met. 3. Character: Is the borrower honest? Does the borrower intend to repay the loan? Capital: Does the borrower possess the financial resources to withstand any deterioration in wealth or income? Does the borrower show a commitment to the project? Capacity: Does the borrower have the legal standing to enter into a contract, and the management expertise to handle the financial requirements? Conditions: How will the economic environment, industry, and firm's environment affect the borrower's ability to repay? Collateral: What secondary sources of repayment are available? The 5 C's of bad credit include: Complacency: over-reliance on past record of borrower Carelessness: poor underwriting Communication breakdown: failure to communicate problems in a loan to other officers Contingencies: tendency to ignore bad things that potentially affect a loan's performance Competition: following what competitors do rather than adhering to the bank's own credit philosophy 4. Credit risk management is forward looking. What is the likelihood of charge-offs in future periods? Historical charge-offs may reflect a different composition of the loan portfolio and will generally reflect a different economic climate. Some borrowers may also differ. Past due loans are typically those that ultimately are charged-off. Thus, data on past due loans and non-accrual loans are leading indicators of future charge-offs. 5. The process of credit scoring involves using standardized information, such as financial statement information and a borrower’s credit history, to mechanically evaluate a borrower’s credit quality. It assigns a score to the data utilized. As such, it does not require much human effort other than to assess scores that do not clearly indicate accept or reject decisions. The net effect is that the cost of handling a credit-scored loan, the loan administration expense, is lower. Thus, a lender can earn the same or higher return on a credit-scored loan even when losses are higher. 6. Banks generate fee income, obtain balances to invest, and earn interest on loans. These revenues must exceed the bank's loan administration expense, loan charge-offs, and the cost of financing the loan. Typically, loans serve as the product to bring in other business from a customer. For commercial accounts, this other business may be item processing, cash management, wire transfers, etc. For consumer customers, this may be transactions accounts, other savings vehicles, mutual funds, trust services, etc. 7. a. Controls cash outflows and helps the firm finance growth internally. b. Allows the bank to better monitor seasonal fluctuations in cash flow and ability to service debt. c. Helps prevent the borrower from accumulating too much inventory and forces the borrower to get rid of outdated or unnecessary inventory. d. Limits growth to expenditures that can be reasonably financed. 8. The practice of ‘perfecting the bank’s security interest’ involves performing the documentation necessary to ensure that the bank’s claim against a loan and access to collateral is superior to any other claimant. A lender should require a borrower (small business owner) to sign a security agreement that assigns collateral to the bank in the event of default or other triggers. The agreement specifically identifies the collateral and any related covenants or warranties. The bank should also maintain control of the collateral, hold it, and file a financing statement. 9. Permanent working capital needs are those representing a firm's minimum level of current assets minus the minimum adjusted current liabilities. Adjusted current liabilities are current liabilities minus short-term bank credit and current maturities of long-term debt. Permanent working capital needs must be financed by long-term sources of debt and equity. Seasonal working capital needs represent a temporary increase in current assets relative to current liabilities in excess of permanent working capital needs. Seasonal requirements are normally financed by short-term bank credit and repaid annually. 10. Bank move loans off-balance sheet by selling loan participations to other lenders, and by acting as loan brokers. As loan brokers, banks make loans but place them with other investors. Banks also securitize loans by packaging standardized assets into pools and selling securities backed by the promised loan payments. If this is done without recourse, the loans are taken off the bank's books. Banks, such as PNC introduced in Chapters 3 – 4, moved problem loans off-balance sheet and were forced by the regulators and SEC to move them back onto the bank’s financial statements thereby increasing losses and the reported risk of the institution. Not surprisingly, PNC’s stock price immediately dropped after the regulatory action. In recent years, the largest banks have occasionally participated in credit derivatives. One such derivative, a total return swap, allows banks to effectively shift credit risk to a counterparty. 11. With adjustable rate mortgages, lenders transfer interest rate risk to the borrower. Rates on these mortgages are typically below fixed rates as an inducement to borrowers to accept the interest rate risk. If loan rates regress to some average, or normal, level, banks should be expected to decrease fixed-rate loans as the level of rates declines mid vice versa. Thus, adjustable rate loans should increase in declining rate environments and decrease in rising rate environments. 12. Loans collateralized by inventory and receivables are risky to the extent that these assets may not be worth the amount of the loan. Thus banks lend some fraction less than 100% against the estimated value. With fad items, the inventory will be potentially volatile in value dropping sharply if the items fall out of favor. Receivables are better collateral here because they evidence a credit sale and thus, should be easier to collect against. A lender would need to carefully monitor sales and the terms of credit sales, as well as inventory turnover rates at least monthly, to verify that the product is not stale and sitting on store shelves. 13. Loans can be readily securitized if they have standardized features that lenders or investors can easily understand and if the loans have predictable default rates. Of the loans listed, residential mortgages are the most easily securitized, followed by home equity loans, credit card loans, and small business loans. Of the loans listed, only loans to farmers for production purposes are difficult to securitize because each loan differ sharply across borrowers. Open credit lines: loans up to some pre-specified limit for a fixed period of time; returns arise from fees and interest on actual borrowings; risk is that the borrower determines the timing of takedowns, and this might occur when its financial condition has deteriorated. It may also coincide with other borrowers taking down their lines such that the bank experiences a sharp increase in liquidity needs. Asset-based loans: loans secured by the borrower's assets, typically inventory and receivables; returns in the form of fees and interest; risk is that the underlying assets do not retain their value and may not exist. Term commercial loans: long-term financing for the purchase of depreciable assets, permanent working capital needs, or financing of mergers and acquisitions; returns in the form of fees and interest on borrowing; risk is that the borrower's cash flow from operations will be insufficient to meet the obligated payments. Short-term real estate loans: loans with maturities under 1 year, secured by real estate; income from fees and interest; risk is that tenants for the property might not appear, that the real estate might decline in value, and that the borrower's cash flow is insufficient to meet the payment obligations. 14. Agriculture loans are used to finance the purchase of land, equipment, and working capital. Farmers need inventory in the form of seed, fertilizer, and pesticides. These constitute working capital and qualify for short-term loans. Using this inventory as collateral may not provide much protection because the items have a short life span and need special handling (storage, etc.) to retain their value. Once applied to the land, the inventory cannot be resold. Banks should lend against the cash flow of the borrower rather than the inventory. 15. A farmer’s receivables typically consist of sales related to whatever is produced, such as corn, soybeans, tobacco, peaches, etc. Farmers who handle livestock generate sales from selling hogs, cattle, etc. Receivables arise from these bills of sale. Collateral on working capital loans is typically linked to inventory and receivables. One significant risk in farming is uncertainty regarding whether and commodity or livestock prices. It is difficult to estimate expected values at sale unless the farmer uses forward and/or futures contracts. 16. Consumer credit card lending has produced substantial profits for banks with large portfolios. Many consumers are not rate sensitive such that consumer card loan rates are among the highest rates around. Defaults are also predictable if the borrowing pool is large enough. Banks can charge fees and the cost of making these loans has decreased, on average, with the advent of credit scoring. 17. If the days cash-to-cash cycle is longer for assets than liabilities, the borrower does not normally need working capital financing. In this case, the borrower converts inventory to cash sooner than it needs to pay its trade creditors and employees, on average. 18. Control credit risk a. Loan covenants provide practical guidelines or constraints on the borrower’s behavior. Covenants help prevent borrowers from overextending by assuming too much debt, maintaining management succession, etc. b. Risk rating systems provide information about general trends in the quality of specific loans and the overall loan portfolio. They provide a warning system as to whether asset quality is improving or worsening. As such, management can implement changes to correct for problems before the problems get too severe. c. Position limits provide a maximum exposure to any one borrower, to any specific line of business or industry, or to any geographic market. They prevent unwise concentrations that may ultimately lead to severe earnings problems when loans go bad. Problem RSM Publishing Co. 1. Current assets = $935,000 and current liabilities = $303,000; thus $632,000 is financed long-term. 2. Average daily sales = $12,665; average CGS = $9,600; average daily operating expense = $2,447; average daily purchases = $8,537 Days cash = 4.0 Days payable = 19.4 Days inventory = 53.1 Days accruals = 15.1 Days A/R = 29.6 Total 86.7 34.5 Estimate of working capital needs = (86.7 - 34.5) x $9,600 = $501,120 3. General concerns: what will the loan proceeds be used for? What is the source and timing of repayment? What is the value of existing inventory and equipment in market terms? 4. RSM's extraordinary amount of equity reduces its interest expense and the need for working capital financing. This is revealed by the fact that the estimate of $501,120 for working capital financing needs far exceeds the firm's actual short-term financing from banks. In essence, equity and long-term debt are financing part of the firm's working capital needs. The cash-to-cash cycle comparison does not indicate directly how much equity a firm has, but does indirectly when comparing the loan needs figure with outstanding short-term bank credit.
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