Bank Management,

Management 5th edition.

Timothy W. Koch and S. Scott MacDonald
Copyright © 2003 by South-Western, a division of Thomson Learning

EVALUATING
CONSUMER LOANS

Chapter 17
Recent trends in consumer lending
 Credit scoring
 more lenders use statistical models to predict
which individuals are good and bad credit risks.
 Rapid consolidation of the credit card
business
 at year-end 1997, for example, the 10 largest
bank card issuers held approximately 85% of all
credit card loans.
 Move to subprime lending, where banks court
the business of higher risk individuals.
 it is popular because banks credit score these
loans and thus feel comfortable pricing these
loans at much higher rates than prime loans.
Evaluating consumer loans
 When evaluating consumer loan requests, an
analyst addresses the same issues discussed
with commercial loans:
 the use of loan proceeds,
 the amount needed,
 the primary and secondary source of
repayment.
 However, consumer loans differ so much in
design that no comprehensive analytical
format applies to all loans.
Installment loans
 Installment loans require the periodic
payment of principal and interest.
 Installment loans may be either direct or
indirect loans.
 A direct loan is negotiated between the bank
and the ultimate user of the funds.
 An indirect loan is funded by a bank through a
separate retailer that sells merchandise to a
customer.
 Deposit Size (Millions of Dollars)
Costs and returns on consumer installment loans:
$200 $200
Data
Average size of loan $5,104 $5,448
Average number of loans 1,146 6,729
Number of banks surveyed 70 49
Costs per Loan
Cost to make a loan:
Electronic $202.42 $84.56
Nonelectronic 152.17 137.49
Cost to maintain a loan (monthly)
functional cost analysis data

Electronic $19.21 $16.96

Nonelectronic 21.74 20.07
Loan loss (average size loan) 27.05 31.05
Total $422.59 $290.13
As a Percent of Total Loans Outstanding
Loan income* 10.11% 9.35%
Expenses
Direct 3.6 2.83
Net indirect 0.97 0.7
Loan loss rate (3-year average) 0.53 0.57
Total 5.1 4.1
Net yield 5.01 5.25
Cost of funds 3.28 3.31
Net spread 1.73% 1.94%
Credit cards and other revolving credit
 Credit cards and over-lines tied to checking
accounts are the two most popular forms of
revolving credit agreements.
 In 2001 consumers charged almost $650
billion on credit cards.
 Most operate as franchises of MasterCard
and/or Visa.
 bank must pay a one-time membership fee
plus an annual charge determined by the
number of its customers actively using the
cards.
Credit card loss rate and personal bankruptcy filings Net Charge-off Rate (%) Number of Bankruptcy Filings (Thousands)
7 400

6 Personal 350
Bankruptcy
Filings

5 300

4 250

3 200

2 150

Credit Card Charge-Off Rates

1 100

0 50
1984 1985 1986 1987 1988 1989 1990 1991 1992 1993 1994 1995 1996 1997 1998 1999 2000 2001
Credit cards are attractive because
they provide higher risk-adjusted
returns than do other types of loans.

 Card issuers earn income from three sources:

 card holders annual fees,
 interest on outstanding loan balances, and
 discounting the charges that merchants accept
on purchases.
 Credit card transaction process

Individual 1 Retail Outlet

4 2
Card-Issuing Clearing Local Merchant
Bank 3 Network 3 Bank
2

Steps
1. Individual uses a credit card to purchase
merchandise from a retail outlet.
2. Retail outlet deposits the sales slip or
electronically transmits the purchase data
at its local bank.
3. Local merchant bank forwards the
transaction information to a clearing
network, which routes the data to the bank
that issued the credit card to the individual.
4. The card-issuing bank sends the individual
an itemized bill for all purchases.
Fees
1. None
2. The merchant bank discounts the sales receipt. A 3
percent discount indicates the bank gives the retailer
$97 in credit for each $100 receipt.
3. The card-issuing bank charges the merchant bank an
interchange fee equal to 1 to 1.5 percent of the
transaction amount for each item handled.
4. The card-issuing bank charges the customer interest
and an annual fee for the privilege of using the card.
A card-issuing bank also serves as a merchant bank.
Debit cards, smart cards, and prepaid cards

 Debit cards are widely available

 when an individual uses the card, their balance
is immediately debited.
 they have lower processing costs to the bank
 A smart card is an extension of debit and
credit cards
 contains a memory chip which can manipulate
information
 it is programmable such that users can store
information and recall this information when
effecting transactions.
 only modest usage in the U.S.
The future of smart cards
 Smart card usage will likely
increase dramatically in
the U.S.:
 firms can offer a much
wider range of services
 smart cards represent a
link between the internet
and real economic activity
 suppliers of smart cards are standardizing the
formats so that all cards work on the same
systems
Prepaid cards
 Prepaid cards such as phone cards, prepaid
cellular, toll tags, subway, etc. are growing
rapidly.
 Prepaid cards are a hybrid of debit cards in
which customers prepay for services to be
rendered and receive a card against which
purchases are charged.
Overdraft protection and open credit lines

 Revolving credit also takes the form of

overdraft protection against checking
accounts.
 One relatively recent innovation is to offer
open credit lines to affluent individuals
whether or not they have an existing account
relationship.
 In most instances, the bank provides
customers with special checks that activate a
loan when presented for payment.
Home equity loans and credit cards
 Home equity loans grew from virtually nothing
in the mid-1980s to over $220 billion in 2001
 Home equity loans 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.
 These credit arrangements combine the risks
of a second mortgage with the temptation of a
credit card, a potentially dangerous
combination.
Non-installment loans
 A limited number of consumer loans require a
single principal and interest payment.
 Bridge loans are representative of single
payment consumer loans.
 Bridge loans often arise when an individual
borrows funds for the down payment on a new
house.
Subprime loans
 During the 1990s, one of the hottest growth
areas was subprime lending.
 Subprime loans are higher-risk loans labeled
labeled “B,” “C,” and “D” credits
 They have been especially popular in auto,
home equity, and mortgage lending.
 These are the same risk loans as those
originated through consumer finance
companies.
 What are subprime loans?
 Although no precise definitions exist, “B,” “C,” and
“D” credits exhibit increasingly greater risk and must
be priced consistently higher than prime-grade loans.
 Paul Finfer of Franklin Acceptance Corp, a subprime
auto lender, provided the following definitions:
 B: typically scores 600+ under the Fair Isaac system;
has some 90-day past dues but is now current. When
extended credit, typical delinquencies are 2%-5%;
repossessions are 2.5%-6%; and losses are 1.5%-3%.
 C: typically scores between 500 and 600 and has had
write-offs and judgments. The borrower has made
subsequent payments of some or all of the loans. When
extended credit, delinquencies are typically 5%-10%;
repos, 5%-20%; and losses 3%-10%.
 D: typically scores between 440 and 500 and has charge-
offs and judgments that have not been repaid and has
not made payments on these loans. When extended
credit, delinquencies are 10%-20%; repos, 16%-40%;
losses, 10%-20%.
High LTV loans

 During the latter half of the 1990s, many

lenders upped the stakes by making
“high LTV” (loan-to-value) loans based
on the equity in a borrower’s home.
 Where traditional home equity loans are
capped at 75 percent of appraised value
minus the outstanding principal
balance, high LTV loans equal as much
as 125% of the value of a home.
Consumer credit regulations
 Equal Credit Opportunity Act (ECOA), makes
it illegal for lenders to discriminate.
 Prohibits Information Requests on:
 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

 Credit scoring systems are acceptable if they

do not require prohibited information and are
statistically justified.
 Credit scoring systems 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

 Truth in lending regulations apply to all

individual loans up to $25,000 where the
borrower's primary residence does not serve
as collateral.
 Legislation arose because lenders quoted
interest rates in many different ways and
often included supplemental charges in a loan
that substantially increased the actual cost.
Truth in lending disclosure requirements
…requires that lenders disclose to potential
borrowers both the total finance charge and
an annual percentage rate (APR).
 The APR equals the total finance charge
computed against the loan balance as a
simple annual interest rate equivalent.
 Historically, consumer loan rates were quoted
as add-on rates, discount rates, or simple
interest rates.
Add-on rates
…applied against the entire principal of
installment loans.
 Gross interest is added to the principal with the total
divided by the number of periodic payments to
determine the size of each payment.
 Example: suppose that a customer borrows $3,000 for
one year at a 12 percent add-on rate with the loan to
be repaid in 12 equal monthly installments.
 Total interest equals $360,
 monthly payment equals $280, and
the effective annual interest cost is approximately
21.5%.
[0.12($3,000)  $3,000]
monthly payment   $280
12
12
$280
Effective interest rate (i) :  t
 $3,000
t=1(1 + i)
 Discount rate method
…the quoted rate is applied against the sum of
principal and interest, yet the borrower gets to use
only the principal, as interest is immediately
deducted from the total loan.
 Example: consider a 1-year loan with a single $3,000 payment
at maturity.
 The borrower receives only $2,640, or the total loan minus 12%
discount rate interest.
 The effective annual percentage rate, or APR, equals 13.64%
 Interest charge = 0.12 ($3,000) = $360

$3,000
Annual percentage rate (APR) (in ) : $2,640 =
(1+ in )
i  13.64%
 Simple interest
…interest paid on only the principal sum.
 Example: $3,000 loan at 12% simple interest per year
produces $360 in interest, or a 12 percent effective rate
Interest (is): = $3,000(0.12)(1)= $360

$3,000
$3,000 =
(1 + is )
 The quoted rate (APR) is adjusted
is  12% to its monthly equivalent,
which is applied against the unpaid principal balance on a
loan.
 Hence a $3,000 loan, repaid in 12 monthly installments at 1%
monthly simple interest, produces interest under $200.
 The monthly interest rate equals 1 percent of the outstanding
principal balance at each interval.
 Depending on how it is quoted, a 12 percent rate exhibits a
noticeably different effective rate, ranging from 12% to 21.5% in the
examples to follow.
$3,000 loan for 1 year, 1% monthly simple interest
rate, repaid in 12 equal monthly installments.
Fair credit reporting
 The 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.
 There are three primary credit reporting
agencies:
 Equifax,
 Experian, and
 Trans Union.
 Unfortunately, the credit reports that they
produce are quite often wrong.
Sample Credit Report
Community reinvestment
 The Community Reinvestment Act (CRA) was
passed in 1977 to prohibit redlining and to
encourage lenders to extend within their
immediate trade area and the markets where
they collect deposits.
 FIRREA of 1989 raised the profile of the CRA
by:
 mandating public disclosure of bank lending
policies and regulatory ratings of bank
compliance.
 Regulators must also take lending performance
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.
 Individuals can file for bankruptcy under:
1. Chapter 7, individuals liquidate qualified
assets and distribute the proceeds to
creditors.
2. Chapter 13, an individual works out a
repayment plan with court supervision.
 Individuals appear to be using bankruptcy as
a financial planning tool; the stigma of
bankruptcy is largely gone.
Credit analysis
 The objective of consumer credit analysis is to assess
the risks associated with lending to individuals.
 When evaluating loans, bankers cite the Cs of credit:
1. character:
 the most important element--difficult to assess
2. capital:
 refers to the individual's wealth position
3. capacity:
 the lender often imposes minimum down payment
requirements and maximum allowable debt-service to
income ratios
4. conditions:
 the impact of economic events on the borrower's capacity
to pay
5. collateral:
 the importance of collateral is in providing a secondary
source of repayment.
 Two additional Cs have been added reflecting
customer relationships and competition
6. Customer relationship
 A bank’s prior relationship with a customer reveals
information about past credit and deposit experience that is
useful in assessing willingness and ability to repay.
7. Competition
 has an impact by affecting the pricing of a loan.
 all loans should generate positive risk-adjusted returns.
 lenders periodically react to competitive pressures by
undercutting competitors’ rates in order to attract new
business.
 still, such competition should not affect the
accept/reject decision.
Policy guidelines
… Acceptable Loans
 Consumer loans are extended for a variety
of purposes.
 Acceptable Loans
 Automobile
 Boat
 Home Improvement
 Personal-Unsecured
 Single Payment
 Cosigned
Policy guidelines
…Unacceptable Loans
 Unacceptable Loans
1. Loans for speculative purposes.
2. Loans secured by a second lien, other than
home improvement or home equity loans.
3. Any participation with a correspondent bank in
a loan that the bank would not normally
approve.
4. Accommodation loans to a poor credit risk
based on the strength of the cosigner.
5. Single payment automobile or boat loans.
6. Loans secured by existing home furnishings.
7. Loans for skydiving equipment and hang
gliders.
Evaluation procedures:
Judgmental and credit scoring
 Banks employ basically two procedures when
evaluating consumer loans :
1. judgmental procedures
…the loan officer subjectively interprets the
information in light of the bank’s lending
guidelines and accepts or rejects the loan
2. quantitative credit scoring or credit scoring
model
…the loan officer grades the loan request
according to a statistically sound model that
assigns points to selected characteristics of the
prospective borrower
 In both cases, a lending officer collects
information regarding the borrower’s character,
capacity, and collateral.
An application: credit scoring
 Credit scoring models are based on historical
data obtained from applicants who actually
received loans.
 Statistical techniques assign weights to
various borrower characteristics that
represent each factor's contribution toward
distinguishing between good loans that were
repaid on time and problem loans that
produced losses.
Credit Application, University National Bank
Credit Application, University National Bank
(continued)
 Credit scoring system, university national
bank, applied to credit application for
purchase of a 2000 Jeep

Category Characteristics/Weights
<$10,000 $10,000-$20,000 $20,000-$40,000 $40,000-60,000 >$60,000
Annual Gross Income
5 15 30 45 60
Monthly Debt Payment >40% 30-40% 20-30% 10-20% <10%
Monthly Net Income 0 5 20 35 50
Bank Relationship None Checking Only Saving only Checking & Saving No answer
Checking/Saving 0 30 30 50 0
None 1 or more No answer
Major Credit Cards
0 30 0
Any derogatory within 7 yrs. No record Met obligated payments
Credit History
-10 0 30
< 50 yrs. >50 yrs. No answer
Applicant's Age
5 25 0
Rent Own/Buying Own outright No answer
Residence
15 40 50 15
Residence Stability < 1 yr. 1-2 yrs. 2-4 yrs. >4 yrs. No answer
0 15 35 50 0
Job Stability < 1 yr. 1-2 yrs. 2-4 yrs. >4 yrs. Unemployed Retired
5 20 50 70 5 70
NOTE: Minimum score for automatic credit approval is 200; score for judgmental evaluation, 150 to 1 95; score for
automatic credit denial is less than 150. Melanie Groome's credit score is 185.
An application: The credit score
 A loan is automatically approved if the
applicant's total score equals at least 200.
 The applicant is denied credit if the total score
falls below 150.
 At University National bank, five factors,
including employment status, principal
residence, monthly debt relative to monthly
income, total income, and banking references
are weighted heaviest.
 National Distribution of FICO Scores
30
29%
$% of Population 25
20
20%
15 16%
10 11% 11%
5 7%
1% 5%
0
Up to 499 500-549 550-599 600-649 650-699 700-749 750-799 800+
FICO Score Range
Fico scores, August 2001

Delinquency Rates by FICO Score

Rate of Credit Delinquincies

100%

80% 87%
71%
60%
51%
40%
31%
20%
15% 5% 2% 1%
0%
Up to 499 500-549 550-599 600-649 650-699 700-749 750-799 800+
FICO Score Range
Indirect lending is an attractive form
of consumer lending when a bank
deals with reputable retailers.
 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.
Indirect lending (continued)
 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.
Indirect lending (continued)
 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.
Role of dealer reserves in indirect lending:
Automobile paper
Terms of the Dealer Agreement
Bank buys dealer paper at a 12 percent rate. Dealer charges customers a higher
rate (15 percent APR), with 25 percent of difference allocated to a reserve.
Sample Automobile Loan
Principal = $8,000
Maturity = 3 years, 36 monthly installments
Loan rate = 15% annual percentage rate (APR)
Monthly payment = $8,000/[(I/.0125) - (1/.0125(l.0125)36)] $277.32
Allocation to the Dealer Reserve
Total interest expense to customer = $1,983.52
Total interest income for bank = 1,565.72
Differential interest - $ 417.80
75% allocated to dealer: 0.75(417.80) = $313.35
25% allocated to reserve: 0.25(417.80) = $104.45
Interest Refunds on Prepayments with Add-on Rates
Loan is written on a precomputed basis, and bank accrues interest using “rule of 78s"*
Interest expense to customer = 0.09($8,000)(3) = $2,160
Interest income for bank = 0.07($8,000)(3) = 1,680
Differential interest = $ 480
75% allocated to dealer: 0.75($480) = $360
25% allocated to reserve: 0.25($480) = 120
End of Year Interest Earned* Total Bank Difference
1 54.96% $1,187.14 $923.33 $263.81
2 33.33 719.33 559.94 159.99
3 11.71 252.93 196.73 56.20
100.00% $2,160.00 $1,680.00 $480.00
*Rule of 78s factors are 366/666, 222/666, and 78/666, respectively.
Recent risk and return characteristics
of consumer loans
 The attraction is two-fold:
1. Competition for commercial customers
narrowed commercial loan yields so that
returns fell relative to potential risks
2. 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.
 Consumer groups still argue that consumer
loan rates are too high, especially when the
prime rate declines.
 In addition to interest income, banks generate
substantial noninterest 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 fraud arises out of the traditional
lender/merchant relationship.
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.
 Bankers have responded in two ways:
1. price more consumer loans on a floating-rate
basis
2. commercial and investment banks have
created a secondary market in consumer
loans, allowing loan originators to sell a
package of loans
Bank Management,
Management 5th edition.
Timothy W. Koch and S. Scott MacDonald
Copyright © 2003 by South-Western, a division of Thomson Learning

EVALUATING
CONSUMER LOANS

Chapter 17