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Outline
Increasing competition
Expectation of high returns attracts competition.
Banks syndicate loans to compete with investment bankers to finance large
firms.
Nonbank lenders have increased their lending activities.
Changes in technology
Securitization to package and sell otherwise unmarketable loans.
Credit scoring to estimate the probability a borrower will default based on
statistical/computer models (e.g., Fair Isaac -- see www.fairisaac.com).
J.P. Morgan (1997) introduces CreditMetrics, a VAR approach to measuring
credit portfolio risk. Other firms are developing VAR models.
Collateral
Definition: An asset pledged against the performance of an
obligation.
Does not reduce the risk of the loan per se (which is tied to ability of the
borrower to repay a loan and other factors).
Reduces bank risk but increases costs of lending and monitoring.
Characteristics of good collateral:
Durability is the ability of the asset to withstand wear. Durable versus
nondurable collateral.
Identification due to physical uniqueness or serial numbers.
Marketability of the property if resold.
Stability of value over the period of the loan.
Standardization by government or industry guidelines in grading quality of
assets.
Collateral
Types of collateral:
Accounts receivable can be used by means of:
Pledging wherein the firm retains ownership of the receivables and no
notification to the buyer of the goods.
Factoring wherein the receivables are sold to a factor such as a bank or
finance company. The buyer now pays the factor for the goods.
Factors usually buy receivables on a nonrecourse basis (so they
cannot be returned to the seller by the bank).
Bankers acceptance to finance foreign goods in transit, which is an
account receivable to the exporter. A time draft is created which must
be paid by the importer when goods are finally delivered. The time
draft becomes a negotiable instrument that can be traded in securities
markets after the importers bank accepts it.
Inventory
Marketable securities
Real property and equipment
Guarantees by third parties (e.g., a U.S. government agency)
x
10.02%
$1,000,000.00 345
Effective =
The same process (with the appropriate number of days in lines 4 and 6) may be used to calculate the effective yields for 360-day
years with actual number of days and 365-day year with actual number of days. The effective yield for the three methods are as
follows:
Effective Yield
360-day year/30-day month
360-day year/actual number of days
365-day year/actual number of days
10.02%
10.14%
10.00%
Effect of Payment Frequency on Interest Earned and Yields. The frequency of loan
payments has a major impact on interest earned and the yield received on loans. Suppose that a bank is
considering making a one-year, $100,000 loan at 12% interest. The $100,000 loan will be repaid at the end
of the year. The bank earns $12,000.00 if interest is paid annually, and $12,747.46 if it is paid daily. The
bank earns more when interest is collected frequently.
Payment Periods Interest earned on $100,000 loan
Continuous
$12,748.28
Daily
$12,747.46
Monthly
$12,682.50
Quarterly
$12,550.88
Annually
$12,000.00
Yield
12.748%
12.747%
12.683%
12.551%
12.000%
The amount that the bank receives at the end of the period may be determined by the equation for the future
value of $1:
FVn = PVo(1 + i/m)nm
FVn = future value at end of n periods
PVo = present value ($100,000 in this example)
i = interest rate
n = number of periods
m = number of interyear periods (days, months, quarters).
Loan pricing
Markups:
Index rate (i.e., prime rate) plus a markup of one or more percentage points.
Cost of funds (i.e., 90-day CD rate) plus a markup.
These methods are simple but may not properly account for loan risk, cost of funds, and
operating expenses.
Minimum spread:
Compare the lending rate to the cost of funds plus a profit margin.
Performance pricing:
Change the loan rate if the firms riskiness changes.