GSB Credit Track Effective Loan Pricing Session 3

1. GSB Credit TrackEffective Loan PricingSession 3 Thomas Farin President tfarin@farin.com

2. Goals For This Session Review most important points from Sessions 1 and 2 at GSB Review assignment Walk you through software and model a loan

3. Pricing Cash Flows • When we price a loan • We are pricing a bundle of cash flows. • A good loan pricing model puts an A/L wrapper around a loan or a bundle of loans being priced. Approach and results should be consistent with. • A/L model results • Profitability system results • Market results – Assuming loan is sold

4. Fixed or Variable Origination Rate First Reprice Repricing Rate Repricing Frequency Term or Revolving Amortizing? Term Balloon? Amortization Term Prepayment Speed Cash Flow and Repricing Characteristics 60 Month Bullet Loan You don’t control in LoanEdge

5. Loan Pricing – Cash Flows 60 Month Bullet Loan Match Considers Interest Cash Flows Rates

6. Loan Pricing – Cash Flows Considers Interest Cash Flows 60 Month Amortizing Loanwith 25% annual prepayments Match

7. Interest Rate Risk When you are pricing loans you are pricing cash flows not maturities. With fixed-rate loans, pieces reprice as cash flows come in. Few reprice at maturity. Principal cash flows are often uncertain Prepayment options Variable rate loans reprice When cash flow pieces come in When contractual repricing occurs, but … Variable rate loans may not respond immediately or completely at reset points Reset frequency Restrictions on adjustments (caps) To manage interest rate risk, institutions need to match funding to the repricing of the loans of loans. Two approaches: Simplistic – match based on duration More complex – Match fund individual repricing flows. While in the real world you may not match, in making pricing decision, we should assume matching. Loan Pricing – Interest Rate Risk x x X – Approach taken in this course

8. Curves Used for Risk Free Curves Investment Benchmarks Wholesale Funding Curves Requirements Broad range of benchmarks. Updated very frequently Market Curve Usage You don’t control Market Curves or spreads in LoanEdge

9. Cash Flow Matching Example Weighted averageinvestment benchmarksand funding costs arecalculated from thesematches. 60 Month Auto loan – 1st 12 months of amortization You can view amortization schedules in LoanEdge

10. Loan Pricing – The Basics Interest Rate Risk – Conclusions • Interest rate risk driven by the cash flow and repricing characteristics of the loan rather than the term of the loan • To model most accurately, each cash flow and repricing point is matched • The loan can be matched up to an appropriate point of: • A funding curve when matching funding • Funds Transfer Pricing (FTP) • An investment curve when looking at investment alternatives. • Pricing loans off investment alternatives • Valuing loans

11. Credit Risk Provision for Loan Loss? Charge-Offs Problem with Using Provisions 1% Reserves 0.15% Charge-Offs Loan Pricing – The Basics 0.15% C/O + (1% * 0%) Growth 0.15% C/O + (1% * 25%) Growth 0.15% C/O + (1% * 10%) Growth

12. Which History to Use? You will be coming up with the credit risk adjustment for your loans • Was history from 2005-2007 a legitimate predictor of recent credit losses? • Are 2008-2010 losses a legitimate predictor of losses of newly originated loans in 2011? • Do we even have legitimate loss history for loans originated today? • Changes in collateral coverage • Changes in underwriting standards • Changes in kinds of loans originated

13. Servicing Cost Marginal Origination Cost Cost of originating the next loan Marginal Servicing Cost Cost of servicing the next loan Direct Overhead Allocation Fixed costs directly related to loan production General Overhead Allocation President’s salary, human resources, etc. Arguments Economist – Continue to produce widgets until marginal revenue equals marginal cost. Accountant – Without overhead allocation, you end up with profitable loans and an unprofitable institution. OTS Cost Assumptions 0.20% - FR Mortgages 0.38% - ARMs 0.20% - Multi & Non-Res 0.20% - Const & Land 0.20% - Second Mtg. 0.20% - Commercial 0.20% - Consumer 1.00% - Credit Card Is there a better source for generic servicing costs Loan Pricing – Servicing

14. Servicing Example • Differential pricing on A, B, C credits should reflect both additional charge offs, and additional servicing costs due to legal and collection fees. In LoanEdge you can add servicing costs but you can’t delete what is there.

15. Option Risk – What Is It • 15 year FRM example showing remaining principal under different rate environments • Falling – 25% CPR – 2.75 year duration • Flat – 8% CPR – 4.64 Year duration • Rising – 5% CPR – 5.21 Year Duration

16. Against Not a true cost like charge offs, servicing costs, or costs of matching funding. Considering option risk will cause loans to be unprofitable. Not the loan officer’s problem. Very difficult to calculate May be inherently hedged in balance sheet of retail financial institution. For Option risk can damage the performance of un-hedged institutions. It costs money to hedge option risk Price/yield of securities reflects option risk. Securities are securitized loans If loan officers are not ‘charged’ for options, they will give away options in exchange for rate Can be derived from securities market. Source Securities Markets Consider Option Risk in Pricing Loans?

17. Adding Option Risk Applied to internal profitability calculations You can’t control the option risk adjustments in LoanEDGE

18. Sample Loan – 72 Month New Auto • Cash Flows • Pricing • Expenses • Risk Assum • Benchmarks

19. Market rather than internal benchmark Compares performance of loan to closest investment benchmark after adjusting for risk and cost differences. Most relevant when You are trying to decide how to invest cash already raised. Anytime investing in a security is an alternative to making a loan You are trying to derive market adjustments for Interest rate risk Option risk Required inputs Cash flow characteristics Risk free curve Investment benchmark curve Pricing – Rates and fees Operating expenses Credit risk adjustment Additional option risk adjustments Calculated adjustments Interest rate risk adjustment Option risk adjustment Loan’s spread to investment benchmark after adjustments Test – Is spread positive (good) or negative (bad)? Not considered Funding cost curve Capital requirement RAROC Goal Institution Tax Rate Investment Benchmark

20. Investment Benchmark - Steps 1 Month Agency IRR Adjustment Agency Match Investment Benchmark Credit Risk Adjustment Servicing Cost Adj Option Adjustment Retail Benchmark Loan Rate Spread to Benchmark You can view the detailed Investment Benchmark analysis in LoanEdge

21. Market rather than internal benchmark Compares market value of loan as compared to book at time of origination. Most relevant when You are going to sell loan after origination. When you are trying to improve the franchise value of your institution by holding well priced loans Required inputs Cash flow characteristics Risk free curve Investment benchmark curve Discount rate curve Pricing – Rates and fees Operating expenses Credit risk adjustment Additional option risk adjustments Calculated outputs Market value vs book value of loan Price With and without origination fees Test – Is price at or above 100 (good) or below 100 (bad)? Not considered Funding cost curve Capital requirement RAROC Goal Institution Tax Rate Valuation

22. Valuation - Steps • Value Cash flows • Project amount and timing of cash flows • Use discount rates to mark cash flows to market. Discount Rate = Investment Benchmark + Adjustments (not including expense) The sum of the market valuesof individual cash flows is the market value of the instrument. You can view the market value cash flows in LoanEdge n i FV PV PV1 = FV1 / (1+i)n = 1086.14 / (1 + (1.22%/12))1 = 1085.05 Note: Cash flows continue for an additional 60 months

23. Valuation - Steps Book Amount of Loan With Fees Sum of Cash Flow Market Values 100 * MV / BV Without Fees Sum of Cash Flow Market Values 100 * MV / BV Note: By Valuation standards, this is a well priced loan as its market value exceeds book at the time of origination. You can view the market value analysis in LoanEdge

24. FTP Analysis - RAROC Balance weighted costs Assumed tax rate of 40% RAROC (ROE) RAROC Goal Lifetime Decision – Don’t make the loan !!! Horizon You can view the RAROC analysis in LoanEdge

25. FTP Analysis - Income Ratio analysis restated in dollars You can view the incomeanalysis in LoanEdge Decision Tool Make the loan !!! Note: The net incomefigure is converted into ROA

26. Decision Tree

27. Intersession Assignment Note: This is the 1st of 4 criteria

28. Intersession Assignment Note: This is the 2nd of 4 criteria

29. Intersession Assignment Note: In your first loan you will model anindividual loan. In the second you will modela relationship. Note: This is the 3rd of 4 criteria

30. Intersession Assignment You are probablythinking, “But Farin,you haven’t showedme how to use the model.” Note: This is the 4th of 4 criteria

31. In Order to Follow Along … Register – click registration link on resource page and follow instructions Download Getting Started Guide – click download link on registration page Have the loan you wish to model selected and have the information to model the loan assembled Have this window open as well as the software. You can pause the recording, switch windows, and model your loan as I walk you through.

32. Logging Onto iPrice Process URLipriceweb.farin.com Click here to beginlog on LoanEDGE is Web based …

33. Logging Onto iPrice Process Click Logonlink Enter User Name andPassword Click OK Resource pages have information on user name and password. Each attendeecan have his or her own logon.

34. Creating New Relationship Will say LoanEDGE for GSB School 2012 Process Click here Give Relationshipa name Click Add Note: You won’t have these.

35. Add Product to Relationship Process Click categoryof loan you wish to add Then clickselect to getto nextscreen. Note: pick theloan from thelist that mostclosely matchesthe loan youwish to model

36. Select Product to Add Process Select product to be added Click Select

37. Product Modeling Screen Productcharacteristicspreset Structure Fees/Expenses Credit Risk Note: You will beable to edit some characteristicsbut not othersdepending onaccount typeselected inprevious step.

38. Entering Product Data • To see: • Amort Schedule • Details Enter Rate Balance Creditadjustment Reviewproductresults

39. Amortization Schedule Process Review Done Note: if youscroll rightyou will beable to seemarket valuecash flows

40. Detailed Results Process Investmentbenchmark Characteristics Scroll downto see othermethods Done to close

41. Detailed Results Duration MoreCharacteristics RAROC Summary

42. Detailed Results Full Summary Horizon Income

43. Exporting Details If you find ithelpful, you canuse the Save Asbutton to exportthis information to an Excel filefor comparison and printing.

44. Notes • Everything you have done persists on our server. • If you want to modify a deal later you can: • Log onto LoanEDGE • Open (View) a relationship • Modify or enhance • In Session 4 you will be either modifying an existing relationship or creating a new one. • Our support people will be able to view the loan you have been working on. • Feel free to model additional loans if you wish.

45. Notes • Limits – You accept our management assumptions • Resource Page • Self-registration link • Getting started guide • Links to the two recorded Webinars • Links to the PowerPoints as PDFs • Support number should you need help • Model two situations • Two separate loans • Comparison • Sensitivity testing • A loan and a relationship • Session 4 focuses on last three