Financial Institutions: Stretched Too Thin?

By Justin Kuepper AAA

Loan portfolios held by financial institutions are notoriously difficult to value. This is because long repayment periods make valuations unpredictable and derivatives only multiply the complexity. So how does the average investor stand a chance against Wall Street? Fortunately, common sense and simple math can go a long way! This article will explore how you can easily evaluate a financial institution's loan portfolio. (For background reading, see Analyzing A Bank's Financial Statements.)

How a Loan Works
There are three basic parts to any loan:

  1. Principal: The amount of money being loaned.
  2. Interest Rate: The percent of the loan being paid each period as a fee in addition to repaying the principal amount loaned.
  3. Amortization Period: The amount of time that the borrower has to repay the loan amount to the lender.

There are also two basic types of loans:

  1. Fixed Rate: These loans carry a fixed interest rate that doesn't change during the life of the loan.
  2. Variable Rate: These loans carry an interest rate that changes based on the prevailing interest rate set by central banks or other economic indicators.

The dynamics of a fixed rate mortgage loan are pretty straightforward. Payments are comprised of interest and principal and remain constant throughout the life of the loan. As the loan is paid down, interest is charged on a lower principal amount. This means that less interest is charged, but because the borrower is paying a set amount, the rest goes toward repayment of the loan. As time goes on, the amount paid toward the principal increases and interest charged decreases.

A variable rate mortgage will see changes to the amount paid as the interest rate changes. The concept is still similar in that as time goes on, there will be less principal on which to charge interest. (Read more in Mortgage Basics: Introduction.)

The Mortgage Loan
Mortgage loans are the most popular type of loan in the United States. These loans are either originated and serviced by commercial banks or mortgage banks. Mortgage banks can participate in the origination, financing, securitization, selling and servicing of mortgage loans that are secured by some of type of real estate.
The process works something like this:

  1. A borrower requests a loan from a mortgage bank.
  2. The mortgage bank evaluates the borrower's creditworthiness.
  3. The mortgage bank borrows money from a financial institution and makes the loan to the borrower.
  4. The mortgage bank securitizes the resulting mortgage and sells it to investors.
  5. The mortgage bank uses the proceeds to pay back the financial institution.
  6. The mortgage bank collects loan servicing fee income for collecting payments.

The process of securitization is the core of this process and represents efforts to transfer risk from the mortgage bank to investors. Securitization itself involves the pooling of mortgages into a single security - known as a mortgage-backed security (MBS) - that is sold to investors. The net present value of future interest payments represents the return on investment. (Read more in Behind The Scenes Of Your Mortgage.)

The buyers of these mortgage-backed securities include investment banks, hedge funds, private investors and foreign investment firms, among others. According to the Bond Market Association, the market for these securities was in excess of $1 trillion dollars in 2007.

Valuing Mortgage Loans
Mortgage loans are priced based on default risk (or credit risk), interest rate exposure and early redemption risk (or prepayment risk). Combined, these risks are known as the risk premium associated with the loan. Risk analysis is an integral part of lending, but it is also perhaps the most misunderstood and chronically forgotten field in the lending business!

Default Risk
Default risk is the risk that the borrower will not make good on his or her payments to the lender. This often happens when the borrower's cash flows are reduced or the asset put up as collateral (ie. a house in a mortgage's case) decreases in value. The risk of defaults is priced into loans based on market conditions or borrower profiles and demographics.

Interest Rate Risk
Interest rates themselves, which are subject to change several times during the term of a loan, also play a large part in a loan's valuation. Obviously, a higher interest rate lowers the value of a loan as the loan's interest rate spread (ie. profit for the lender) is reduced. Meanwhile, lower interest rates increase the value of loans in a reverse effect. (Learn all about predicting these risks in Managing Interest Rate Risk.)

Early Redemption Risk
Early redemption risk is the third and final risk that lenders must consider when valuing a loan. Homeowners, for example, have the ability to refinance their loans at lower fixed rates, which means the prepayment risk goes up when interest rates go down and more borrowers look to refinance at lower rates. Prepayments themselves equate to a loss of future cash flows and, therefore, a lower present value for the loan. (For more on the life of a mortgage, check out Understanding The Mortgage Payment Structure.)

Mortgage Risk Evaluation
Lenders evaluate the risk of a mortgage by looking at several characteristics, but these calculations all take place internally away from the scrutinizing eyes of investors. Instead, investors are left with several ratios that can provide a glimpse into the overall quality of borrowers to which the institution lends.

The four major considerations are:

  1. Asset Categorization: Financial institutions categorize the quality of the loans on their books based on the risk associated with them. Investors can simply refer to the subprime mortgage crisis, to see an example of subprime risk - a term used to describe riskier loans. The three major types of mortgage categorizations are:
    • A-Paper: This is a top-quality mortgage in which the borrower has a credit score of 680 or higher, fully documented income and assets, a debt-to-income ratio below 35%, provides at least 20% equity down, and retains two months of mortgage payments in reserves after closing.

    Alt-A Paper: This is a mortgage that carries more risk than an A-Paper mortgage, but is less risky than subprime paper (described below). Most of the added risk is due to undocumented income or assets, which has caused many problems in the past.

  2. B/C-Paper (Subprime): This is a mortgage that carries a high degree of risk and is reserved for borrowers who have a history of loan delinquencies, a recorded bankruptcy, or limited experience with debt.
  3. Net Charge-Offs: Financial institutions are required to report the cost of bad loans that won't be fully repaid as "net charge-offs". Any increase in this number without a corresponding increase in loan loss provisions (see below) is a sign that the bank is experiencing losses that it didn't necessarily expect to take.
  4. Loan Loss Provisions: Financial institutions also regularly put money aside for bad loans that they expect to be forced to cover in the future. This is done to ensure that they have the required capital reserve to qualify as a lender. Any increase in these numbers is a sign that the firm expects trouble down the road.
  5. Ratings Agencies: Ratings agencies also regularly evaluate loan portfolios using information that the general public doesn't get to see. Firms like Moody's, Fitch and S&P then regularly issue credit ratings on these assets that investors can use to evaluate the firms. (For related reading, see The Debt Ratings Debate.)

Information on asset categorization, net charge-offs and loan loss provisions can typically be found in the institution's filings with the U.S. Securities and Exchange Commission (SEC). The most common filings to use are the 10-K and 10-Q annual and quarterly report filings. Often, the information can be found in the breakdown of revenues below the Management Discussion and Analysis section. Meanwhile, the ratings agencies also maintain their ratings on their website and in press releases issued on the individual companies when changes occur.

Conclusion
Financial institutions that hold loan portfolios must carefully track the portfolios and the individual loans in order to diversify risk and enhance returns. They do this by evaluating credit risk, interest rate risk, liquidity risk and various other types of risk. Investors, in turn, can evaluate risks associated with a bank by checking the loan types held, net charge-offs, loan loss provisions, and ratings made by various agencies.

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