loan pricing & profitability management solution How Does the Math Work? Carl Ryden, CEO precisionlender.com

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2 Overview How do we calculate Loan Profitability? Interest Income Interest Expense & Match Funding Non-Interest Expense Factoring in Risk Loan Loss Reserve: Adjusting Returns for Expected Loss Capital: Allocating Economic Capital for Unexpected Loss Risk Mitigants: Collateral & Guarantees Taxes and Tax Exempt Loans Conversion Loans and Rate Locks How do we calculate Deposit Profitability? Interest Income Interest Expense 2

3 Loan Profitability Financial Statement A Really Simple Example $1MM Commercial Real Estate Interest Only 5 Year Maturity/ Term 5.5% Interest Rate (Actual/360) No Origination F ee 3

4 Loan Profitability Interest Income Main Inputs: Interest Rate (5.5%) Interest Rate Basis (Actual/360) Origination Fees ($0) Origination Expenses ($2,750) Term (60 months) Average Balance ($1,000,000) Interest Income is: [Initial Interest Rate] x [Adjustment for Interest Rate Basis] x [Average Balance] + [Origination Fees Origination Expenses, Annualized over the Term] Specifically in this Example: 5.5% x (365/360) x $1,000,000 + ($0 - $2,750) x (12/60) = $55,214 4

5 Loan Profitability Interest Expense Main Inputs: Yield/Funding Curve Term Structure 1 (60 months) Average Equity (Capital) ($90,000) 2 Average Balance ($1,000,000) Interest Expense is: ([Average Balance] [Capital]) x [Funding Curve Value at 60 months] Specifically in this Example: ($1,000,000 $90,000) x 1.575% = $14,333 1 Because the example is an Interest Only loan, there is a single repayment at the 60 month term. See the Matched Funding discussion on the following slide. 2 See discussion in later slides regarding Single Factor vs Multi-Factor approaches and the corresponding impact on Average Equity (Capital). 5

6 Loan Calculations Match Funding Based on a marginal opportunity cost of funds funding curve (in our example we use a composite of the publicly available FHLBs) PrecisionLender allows you to use any funding curve that you choose, however we recommend using a marginal market opportunity cost of funds such as the FHLB. Why? This captures the opportunity cost of other investment options (e.g. risk-free municipal bonds etc.). Used to allocate Interest Expense in a way that is interest rate risk neutral sometimes called match funding Each principal repayment has a re-pricing duration and is match funding separately A 60 month fixed rate interest only loan will be funded with 60 month money (only one repayment) A 60 month fixed rate amortizing with monthly payments will be funded as a set of 60 separate interest only loans each maturing with the principal repayment in month 1, 2, 3 60 Adjustable Rate loans (e.g. a 3/1, 5/1, 3/3 etc.) are treated as if the loan repays and is re-funded each adjustment so a 3/1 will be funded with 3 year money and then 1 year money Floating rate loans are considered to re-price monthly and therefore will fund off the shortest duration on the Funding Curve Interest Expense might be adjusted by a Liquidity Premium based upon the term of the floating rate obligation. 6

7 Loan Calculations Match Funding 1 mon PrecisionLender match funds each principal repayment. Here is an example of a 12 month 2 month amortizing loan. Each month s repayment is match 3 month money funded. Each month the principal repayment increases with the amortization schedule. 4 month money 5 month money 6 month money 7 month money 8 month money 9 month money 10 month money 11 month money 12 month money 7

8 Loan Profitability Non-Interest Expense Main Inputs: Monthly Servicing Expense Non-Interest Expense is: [Monthly Servicing Expense] x 12 Specifically in this Example: $120 x 12 = $1,440 8

9 Loan Calculations Factoring in Risk PrecisionLender allows you a range of options on how to factor in risk. You can choose a simple, single-factor approach or a more comprehensive (Basel III - style) multi-factor approach, or almost any point in between these two. You can also use different approaches for different regions or even different products within the same region. Single Factor Approach Loan Loss Reserve and Credit Capital are based on a single risk factor: Risk Rating for the Loan The Risk Rating for the Loan includes all underwriting criteria such as: Exposure, Risk of Default, Collateral, Guarantees, etc. Loan Loss Reserve and Credit Capital can also be varied by the duration of the exposure for each risk rating Multi-Factor Approach Loan Loss Reserve and Credit Capital are based on a multiple risk factors: Risk Rating for the Borrower (the borrower Probability of Default or PD) The size of the Exposure at Default (EAD) Collateral and guarantees (these affect the Loss Given Default or LGD) Loan Loss Reserve and Credit Capital can also be varied by the duration of the exposure for each risk rating 9

10 Loan Profitability Single Factor Risk (1 of 2) Main Inputs: Loan Risk Rating (3. Average) Average Balance ($1,000,000) Term Structure 1 (60 months) Loan Loss Reserve is: [Annual Loss (based on Risk Rating and potentially Term)] x [Average Balance] Average Equity (Capital) is: ([Credit Capital (based on Risk Rating and potentially Term)] + [Unmitigatable Capital 2 ]) x [Average Balance] Specifically in this Example: Loan Loss Reserve = $1,000,000 x 0.55% = $5,500 Average Equity = $1,000,000 x (8% + 1%) = $90,000 1 Because the example is an Interest Only loan, there is a single repayment at the 60 month term. Term affects the duration of the exposure and you can vary Annual Loss and Credit Capital by duration. 2 Unmitigatable Capital is the total Operational & Market Risk Capital. It does not vary with Risk Rating or duration. 10

11 Loan Profitability Single Factor Risk (2 of 2) PrecisionLender allows you set the Annual Loss and Credit Capital for each Risk Rating by the duration of the exposure. This can be set differently by Product or by Region. Also notice that for products that allow future draws (e.g. Lines of Credit) you can specify a Usage Given Default (UGD)). This is the percentage of the unused balance to count in the Exposure at Default (EAD). 11

12 Loan Profitability Multi-Factor Risk (1 of 3) Main Inputs: Borrower Risk Rating Average Balance Term Structure 1 Type and Value of Collateral Type and Amount of Guarantees Loan Loss Reserve is: [Annual Loss (based on Risk Rating and potentially Term)] x [Adjusted Exposure at Default 2 ] Average Equity (Capital) is: ([Credit Capital (based on Risk Rating and potentially Term)] x [Adjusted Exposure at Default 2 ] + [Unmitigatable Capital 3 ]) x [Average Balance] 1 Because the example is an Interest Only loan, there is a single repayment at the 60 month term. Term affects the duration of the exposure and you can vary Annual Loss and Credit Capital by duration. 2 Adjusted Exposure at Default is covered in the next slide. 3 Unmitigatable Capital is the total Operational & Market Risk Capital. It does not vary with Risk Rating or duration. 12

13 Loan Profitability Multi-Factor Risk (2 of 3) When using a multi-factor risk approach in PrecisionLender, the lender specifies the type(s) and amount(s) of collateral. Each type of collateral has a Recovery Factor defined. The Recovery Factor is the ratio of the present value of the recovered collateral after expenses as a percentage of the nominal collateral value. $1MM ($625M) Collateral Exposure Mitigation: 80% LTV ($1.25MM Collateral Value) 50% Economic Recovery Rate 1 = (50%) x ($1.25MM) = $625,000 $375M Adjusted Exposure at Default: (Exposure at Default) (Collateral Exposure Mitigation) = $1,000,000 $625,000 = $375,000 Exposure At Default Collateral Mitigation Adjusted Exposure At Default Example 2 : Loan Loss Reserve = $375,000 x 1.47% = $5,500 Average Equity = $375,000 x 21.33% + $1,000,000 x 1% = $90,000 1 Each type of collateral type has its own Recovery Rate and a loan can have multiple layers of collateral. For example, the collateral above is Commercial Real Estate and has a 50% Recovery Rate. A CD held at the bank would have a 95% recovery rate (and therefore is worth more as a mitigant). 2 Here we show that the assumed Annual Loss (1.47%) and the Credit Capital (21.33%) are both different and substantially higher than in the Single Factor approach. This is common as these are the completely unsecured values. The Single Factor values already incorporate the impact of average collateral and standard guarantees. Multi-factor offers more granularity and precision. 13

14 Loan Profitability Multi-Factor Risk (3 of 3) When using a multi-factor risk approach in PrecisionLender, the lender can specify the type(s) and amount(s) of guarantees. Each guarantee has a Recovery Factor defined that operates like the collateral Recovery Factor. In addition, each guarantee can have additional origination and servicing expenses associated with it. Finally, guarantees can either be risky guarantees (e.g. a personal or corporate guarantee) or considered riskless (such as a government guarantee). Riskless guarantees operate just like collateral except with additional expenses. Risky guarantees do not affect the Adjusted Exposure at Default, but instead affect how capital and annual loss are applied. $120M Guarantee Mitigated $255M Unmitigated $375M Adjusted Exposure At Default 21.33% x 50% 21.33% Credit Capital 0% % Annual Loss Guarantee Mitigation: $150,000 Personal Guarantee Guarantor is a 1 Risk Rating and that Risk Rating has a 50% Guarantee Factor 1 80% Economic Recovery Rate Obligor Is a 3 Risk Rating and has a Credit Capital rate of 21.33% (for a 60 month duration) = 80% x $150,000 = $120,000 of Guarantee mitigation Loan Loss Reserves: [Unmitigated Exposure] x [Annual Loss] $255,000 x 1.47% = $3,749 Average Equity (Capital) : [Guarantee Mitigated Exposure] x [Credit Capital Rate] x [Guarantor Factor] +[Unmitigated Exposure] x [Credit Capital Rate] $120,000 x 21.33% x 50% + $255,000 x 21.33% = $67,190 1 Each Risk Rating has a Guarantee Factor as an assumption. This approach is taken from the Basel III approach to guarantees. This factor is determined solely by the guarantor s Risk Rating and is then multiplied by the obligor s Credit Capital. 2 This is actually the one-way double default probability - the obligor annual loss x the guarantor annual loss. It is typically ~0%. 14

15 Loan Profitability Taxes & Other Net Interest Income [Interest Income] [Interest Expense] Other Income Not used for loans (used for Other Fee-Based Products) Pre-Tax Income Taxes [Net Interest Income] [Non Interest Expense] [Loan Loss Reserves] + [Other Income] [Pre-Tax Income] x [Tax Rate] Net Income [Pre-Tax Income] [Taxes] Average Balance The average monthly balance (average assets) of the loan. 15

16 Loan Profitability Forward Rates We use Implied Forward Rates as a part of the match funding process whenever there is a guaranteed fixed rate on a future commitment. Examples: A Construction loan that converts to Permanent Financing AND the rate on the Permanent Financing is Fixed and guaranteed at the closing of the Construction loan. Example: a 12 month floating rate Construction loan that converts into a 60 month Commercial Real Estate loan with a guaranteed fixed rate. To match fund the CRE loan we buy 72 month money and sell 12 month money A fixed rate Construction or Land Development loan with draws scheduled in the future Note: we never use implied forward rates to attempt to predict rates in the future. We use them as a way to accurately match-fund and allocate Interest Expense. 16

17 Deposit Profitability Financial Statement Interest Income (1 - [Float & Reserves]) x [Average Balance] x [Funding Curve Transfer Rate] [Funding Curve Transfer Rate] is based on the duration of the deposit. For demand deposits this is a part of the Product definition. For Timed Deposits, this is set by the Term of the Timed Deposit. Interest Expense [Average Balance] x [Interest Rate Paid] Non-Interest Expense [Average Annual Fee Income] - [Average Annual Operating Expense] Average Balance The average monthly balance (average assets) of the deposit. Average Equity [Average Balance] x [Deposit Capital Rate] 17