Module: Finance Section: Loan Pricing EM-445

Transcription

1 Module: Finance Section: Loan Pricing EM-445 Date Published: 03/2000 Introduction Loan pricing is a critically important function in a financial institution's operations. Loan-pricing decisions directly affect the safety and soundness of financial institutions through their impact on earnings, credit risk, and, ultimately, capital adequacy. As such, institutions must price loans in a manner sufficient to cover costs, provide the capitalization needed to ensure the institution's financial viability, protect the institution against losses, provide for borrower needs, and allow for growth. Institutions must have appropriate policy direction, controls, and monitoring and reporting mechanisms to ensure appropriate loan pricing. Determining the effectiveness of loan pricing is a critical element in assessing and rating an institution's capital, asset quality, management, earnings, liquidity, and sensitivity to market risks. Examination Objectives The principal examination objective is to determine the overall adequacy of the institution's loan-pricing process in meeting the institution's financial and risk management needs. This is accomplished through the following principal objectives Determine if the institution has adequate policies and procedures that provide sufficient guidance over the loan-pricing process. Determine if the institution has an adequate process that considers all relevant loan-pricing factors including the cost of funds for loan products, the costs of options offered, and other risks posed by each loan product. Determine if management's internal controls sufficiently ensure that loan pricing practices comply with board policy. Also determine if loan pricing exceptions are within delegated authorities and reported to the board. Determine if loan pricing practices provide income sufficient to meet earnings and capital objectives prescribed in the board's business plan. Determine if transfer-pricing systems employed between the district banks and associations ensure risks present at either the bank or the association are identified and appropriately managed by the institution where risk resides. Examination Criteria Loan-pricing practices are addressed in the Farm Credit Act of 1971, FCA Regulations, FCA Bookletters, and the FCA Examination Manual. It is important that any problems discovered in loan pricing practices are appropriately linked, as applicable, to relevant criteria that define safe and sound practices. The following represent key sources of criteria used by FCA Examiners when evaluating the adequacy of an institution's loan-pricing practices: Institution business and capital plan Farm Credit Act Section 1.8 FCA Regulations 12 CFR , 4155, and 4160 FCA Regulation 12 CFR FCA Examination ManualMarch 2000 Page 1

2 FCA Regulation 12 CFR FCA Regulations 12 CFR , 9170, and 9340 FCA Bookletter BL-012 Asset/ Liability Management Practices Board and Management Responsibilities One of the most critical aspects of asset/liability management (ALM) is loan pricing. Loan pricing decisions directly impact earnings, credit risk, and ultimately, capital adequacy. Pricing decisions should ensure that the institution is generating an adequate level of profit, as measured by business plan goals such as return on equity (ROE) and return on assets (ROA), to ensure the institution achieves and maintains the optimum level of capital prescribed in the business and capital plan. The importance of loan pricing requires that the institution's board establish a formal policy that directs and controls pricing decisions. FCA Regulation 12 CFR (f) requires each institution to adopt a formal policy for loan pricing. At a minimum, the following specific items should be addressed in an institution's loan-pricing policy: Loan-pricing objectives that are defined, measurable, and consistent with the institution's overall business goals, objectives and plans; Identification of the types of loans made by the institution; Factors to be considered in establishing and adjusting interest rates; Responsibility for establishing and adjusting interest rates; If applicable, qualifying criteria for each interest rate program or tier; Internal review and controls to ensure compliance with board policy; A method to monitor the institution's loan pricing, including a means to monitor compliance with the loan-pricing policy; Guidance concerning the frequency and scope of competitive surveys; A discussion concerning the frequency, type, and content of loan-pricing information and reports provided to the board to ensure that management s decision-making process is sound; and A process that describes when and how exceptions to policy will be handled. An institution's board of directors may delegate responsibility for loan-pricing to officers or committees within the institution. The board should review, at least annually, procedures for determining the underlying cost of funding and embedded risks (including option risk) in lending programs. The board should also ensure that the officers or committee responsible for pricing loans has the necessary expertise to ensure that loans are appropriately priced to cover the risk inherent in lending and provide an adequate return to the institution. Areas to be considered in pricing include the institution's cost of funds, the cost of operations, competitor rates, and inherent risks in loans. The institution board should establish internal controls that provide effective oversight of the loan-pricing function and ensure it meets the institution's overall pricing objectives, earnings projections, and optimum capital levels. Monitoring may be completed on a broad, institution-wide basis, or may be focused on the pricing decisions made by individual loan officers. The board should review its loan-pricing policy for adequacy, at least annually. Additionally, the board (or appropriate committee) minutes should evidence an analysis of whether loan-pricing policy decisions are meeting the earnings objectives and goals prescribed in the business plan. Based on the board's policy, senior management or the Asset/Liability Committee (ALCO) should develop procedures and guidance for pricing loan products. Such guidance should be reviewed at least quarterly by senior management and the ALCO, and annually by the board of directors. This guidance should FCA Examination ManualMarch 2000 Page 2

3 address minimum spread goals; risks, expenses, funding costs, and earnings objectives; monitoring of pricing performance; and defining internal controls needed to ensure ongoing compliance with board goals. Procedures should detail the authority for granting exceptions to board policy. Loan-Pricing Methodologies Examiners must develop an understanding of each institution's loan-pricing methodology to effectively examine this critical responsibility of the board. Methodologies for loan pricing range from simply matching the competition, to complex, risk-adjusted return on capital (RAROC) modeling. One of the simplest methods for establishing rates on an institution's loan portfolio is matching the competition. In this scenario, the institution changes its rates to meet market competition and to ensure it maximizes returns in a rising interest rate environment. This practice will also ensure loan pricing practices are commensurate with the market and help insulate the institution from criticism of predatory pricing in its operating environment. Institutions often look to key interest rate indices to track the competitive market. The prime rate, which is the rate theoretically offered by commercial banks to their best customers, is an example of a rate to which an institution may index its loan rates. Other competitor rate information may be obtained from surveys, which is discussed elsewhere in this section. The major advantage of indexing institution loan rates to national or local indexes is simplicity. The major disadvantage is that it does not ensure the rate charged is sufficient to cover the institution's expenses, risks, and profitability needs. Another approach is to set interest rates based on a targeted net interest rate spread. This spread is set during the institution's business planning process. Based on projected loan volume, expenses, and provisions for loan losses, institutions can calculate the net interest rate spread needed to generate the desired level of earnings. This approach helps ensure rates are set at a level that generates sufficient earnings to achieve business plan objectives. However, it may not ensure rates are sufficient given the risk assumed, account for unexpected events, or take into consideration competition. A major shortfall of this approach is that the institution may be pricing itself out of the market or underpricing loans and not reaching its full earnings potential. Also, this approach doesn't work well for risk-based or differential pricing of individual loans. Loan-pricing models are used by many institutions to assist in loan pricing. The models are typically spreadsheet programs that take a variety of information and calculate the loan rate needed to meet the institution's goals. Loan-pricing models are often used for pricing individual loans, rather than the entire portfolio, as they work well for differential loan pricing programs. Simpler models use basic information such as projected loan volume, interest rate, fees, cost of funds, operating expenses, and loan terms to calculate a projected ROA. More complex models can take into consideration a variety of additional factors such as the quality of the loan, the institution's loanable funds position, and projected loan prepayments. Some models require dozens of inputs, and calculate ROA and ROE for multiple periods of time. Loan-pricing models provide the opportunity to analyze a variety of factors and can be designed to meet the needs of the institution. However, they can be complex, and are only as good as the information inputted. Also, these models often do not consider the competition. Some institutions may use loan-pricing models that focus on RAROC. These models are unique in that they allocate capital to a loan based on the risks in the loan. The more perceived risk in the loan, the more capital allocated to it. To be profitable, the loan must meet the desired return on capital. As the perceived risk in a loan increases, the net interest rate spread is increased to meet the return on capital goal. RAROC models can utilize all of the factors that other loan-pricing models utilize. The primary benefit of these models is to fully focus loan pricing in relation to loan risk. Based on the allocation of capital, RAROC models can be used to discourage higher-risk loans even though, from a more traditional approach, they may generate the highest return. Like other loan-pricing models, RAROC models can be complex, and determining the appropriate assumptions and input can be difficult. Capital and provision expense allocations, based on loan risk, should be well researched and supported in these models. Types of Interest Rates FCA Examination ManualMarch 2000 Page 3

4 Within the context of an institution's loan-pricing programs, there are three primary types of interest rates: variable, adjustable, and fixed. Variable rates can change at any time. For example, variable rates can be indexed to a general market rate such as prime or LIBOR, or the board and management can administer them. Adjustable rates can only change during the term of the contract at pre-established points in time, or in concert with changes that occur in the indexes used. Adjustable rate mortgages (ARMs) are the most common example of variable rate loan pricing. Fixed rates remain constant for the life of the contract. In some cases, individual loans may have multiple pricing types, such as fixed for a specified period of time and adjustable thereafter. Each type of rate offered has inherent risks and special considerations that must be addressed by appropriately managing interest rate risk through the institution's asset/liability management practices. The table below outlines various issues to consider with each type of interest rate. Interest Rate Type Variable Administered Market-Indexed Adjustable Administered Market-indexed Loan-Pricing Considerations Does the institution pass through changes in the cost of funds? Are interest rate caps offered? How are they priced? How is basis risk managed? Are interest rate caps offered? How are they priced? Does the institution pass through changes in the cost of funds? Are interest rate caps offered? How are they priced? Are teaser rates used? How much do they impact profitability? Do they expose the institution to additional interest rate risk? How is basis risk managed? Are interest rate caps offered? How are they priced? Are teaser rates used? How much do they impact profitability? Do they expose the institution to additional interest rate risk? Fixed Are prepayment penalties used? If not, how is the prepayment option priced into the loan? How does the institution protect itself when offering forward rate commitments (pipeline risk)? Will the pricing generate sufficient income over the life of the loan? Would the institution generate sufficient income if all loans were priced at this rate? Factors That Should Be Considered in Loan Pricing Loans should be priced at a level sufficient to cover all costs, fund needed provisions to the allowance accounts, and facilitate the accretion of capital. Specific consideration should be given to the cost of funds, the cost of servicing loans, costs of operations, credit risks, interest rate risks (IRR), and the competitive environment. A shift in any one of these components could warrant a pricing adjustment. For instance, a change in competitor rates may require the institution to likewise adjust its rates accordingly to maintain loan volume or to prevent attracting higher risk loan volume. However, caution should be exercised to ensure that rate adjustments to meet competitive pressure remain consistent with the long-term needs of the institution. The practice of setting interest rates with a willful disregard for risk or the costs of doing business in order to attract or retain borrowers could be an unsafe and unsound banking practice if it materially impairs the institution's earnings performance or is harmful to its risk profile. The following is a list of factors that institutions should consider in loan pricing. FCA Examination ManualMarch 2000 Page 4

5 Cost of funds The cost of funds is a significant factor to consider in loan pricing. For most institutions, the cost of funds for each loan product is determined by the treasury department of the bank or association. The treasury department identifies the cost of funds that is applicable for each loan product prior to its effective date, allowing sufficient time for loan-pricing decisions and appropriate notification of borrowers. Cost of operations Unlike the cost of funds, the cost of operations is not as easy to identify. The cost of operations includes salaries and benefits, cost of space, training, travel, and all other operating expenses. In addition, it includes insurance expense, financial assistance expense, and other System assessments. Many of these expenses can change during the year, so sufficient analysis and monitoring is needed to ensure interest rate spreads remain sufficient to cover all expenses. For example, loan volume growth may result in increases in incentive pay and bonuses, which could alter the cost of operations. Credit risk requirements Allowance provisions can have a material impact on loan pricing, particularly in times of loan growth or an increasing credit risk environment. During these times, provisions for loan losses are often necessary, making it difficult to generate sufficient earnings to meet business plan goals. Whenever an institution makes a loan, it is assuming risk which it must consider in determining allowance needs and the interest rate that is commensurate to the risk assumed. Customer options and other IRR Many loan products contain customer options, such as the right to prepay a loan, and interest rate caps, which may expose institutions to IRR. Even loans without customer options expose institutions to other sources of IRR if the loan is not match-funded to a particular debt instrument. These risks must be priced into loans to ensure that the institution is adequately compensated. More specific details on pricing options and other sources of IRR are provided later in this section. Interest Payment and Amortization Methodology The determination of how interest is credited to a given loan (interest first or principal first) and amortization considerations can have a substantial impact on profitability. Decisions on when loan payments (principal and interest) are scheduled can affect earnings. Also, if loan payments are not first applied to interest, or if loan payment schedules are on an annual basis, consideration should be given to compounding accrued interest at specified intervals, if necessary to achieve overall earnings objectives. When evaluating the institution's performance on achieving earnings objectives prescribed in the business plan, examiners should ensure these considerations are considered as a part of loan-pricing considerations. Loanable funds Loanable funds is the amount of capital an institution has invested in loans, which determines the amount an institution must borrow to fund the loan portfolio and operations. As such, it reduces the institution's interest expense and has a direct impact on loan pricing. Some institutions rely on sizable loanable funds positions to generate satisfactory earnings, while maintaining low loan rates. A sizable loanable funds position is desirable, but reliance on loanable funds can result in less than satisfactory ROE. An institution should ensure it achieves an appropriate balance on ROA and ROE. Efficient use of capital is an important goal that should be considered in loan pricing. Patronage Refunds & Dividends Patronage refunds can impact an institution's loan pricing in several ways. Some institutions often pay patronage refunds and/or dividends to their borrowers/shareholders in lieu of lower interest rates. This approach is preferable to lowering interest rates since it can maintain consistency in earnings that may be needed later to augment capital if the risk environment increases from that projected in the business plan. After the board has determined the level of capital required to meet future needs in its business plan, it may then determine the amount of patronage that may be paid out without endangering the safety and soundness of the institution. In times of difficulty, the institution's board would likely have an easier FCA Examination ManualMarch 2000 Page 5

6 time reducing patronage refunds than raising interest rates in order to achieve or maintain optimum capital that will preserve the financial integrity of the institution. Capital and Earnings Requirements /Goals Capital and earnings requirements/goals play a key role in loan pricing. An institution must first determine its capital requirements and goals in order to determine its earnings needs. A comprehensive business planning process is needed to establish these requirements and/or goals. System institutions should consider all these factors to ensure a successful loan-pricing program. Failure to do so could result in insufficient earnings to meet capital needs. Earnings weaknesses could surface immediately, or could take several years to develop. For example, if the institution under-prices fixed-rate loans that are not match-funded, and the interest rate environment increases, the institution may not be able to sufficiently raise rates to other borrowers to achieve earnings objectives and remain competitive with other lenders in the market. In such a rising interest environment, the institution may find that it has originated so many fixed-rate loans that its future viability is threatened by excessive interest rate risk. Therefore, loan-pricing programs require constant review and management. FCA Regulation 12 CFR requires the board of directors to review interest rate plans on a continuing basis, as well as in conjunction with its review and approval of the institution's business and capital plan. Competitor Rates While competitive interest rate surveys are not specifically required by FCA regulations, timely knowledge of how competitors price their loan products is a sound business practice that is an essential part of any institution's loan-pricing system. The extent of the competitor market surveys may vary depending on the competitive environment in which the institution operates. The best surveys will include rates from various types of lenders in the operating environment for a variety of loan products and should be updated throughout the year. Failure to monitor the competitive environment, if it subsequently results in pricing of loans well below prevailing market rates, may indicate pricing deficiencies and unsafe and unsound practices. Adequate surveys are needed to ensure the institution prices loans in a manner that maximizes the return it receives on its loan portfolio. However, a delicate balance must be achieved in pricing loans, as pricing above the market can cause the institution to sacrifice good quality loan volume which may reduce profitability. Conversely, large increases in the volume of new loans may signal potential concern with loan-pricing practices that may strain the adequacy of capital. Institutions should support loan-pricing decisions with a documented analysis of the competitive environment. Differential Loan Pricing Institutions may employ differential or tier-based pricing programs to ensure loan rates reflect inherent risks and costs associated with specific loans or loan types. Although the level of sophistication varies among institutions, many institutions establish different rates for different loan products. Differential loan pricing allows institutions to reflect the variances in costs associated with various loan products and also provides a means whereby the institution may "target" certain groups of borrowers, and should ensure that equitable rate treatments are achieved within categories of borrowers as required by FCA Regulation Interest rates may be differentiated by risk factors (e.g., credit score, risk rating, or classification), loan characteristics (e.g., size, enterprise, servicing costs, or credit factors), geographic area, or a combination of these and other factors. The establishment of differential interest rates requires analysis of risk in the loan portfolio to show that spreads are adequate given the level of risk in the particular loan or group of loans. Criteria used in differential or tier-based programs should receive board approval. Additionally, controls should be in place to ensure that loans are assigned differential rates according to established policy. A concern for differential or tier-based programs may be over-reliance on one loan factor (or failure to consider others) when differentiating based on risk. If, for instance, loan rates are assigned based solely on projected repayment ability, then other factors may be overlooked and loans with well-defined FCA Examination ManualMarch 2000 Page 6

7 weaknesses in other credit factors may receive rates that do not provide an adequate return for the risk inherent in the loan portfolio. Also, because of the divergent costs associated with loans of different types and sizes (i.e., smaller loans normally represent higher cost per unit), these factors may demand consideration in establishing pricing criteria. At times, an institution may offer reduced, "teaser" rates on various loan products with the intention of increasing loan volume and market share. An institution may target a specific industry or type of loan to meet objectives in its overall portfolio mix. However, reduced rates may not attract enough additional business to cover the costs associated with the program or provide enough long-term business to make the program worthwhile. The success of such a program should be evaluated by management to ensure that the costs of the program are justified. Negotiated Rates/Pricing Exceptions Institutions often allow for negotiated rates or pricing exceptions from the established standard interest rates. In most cases, negotiated rates/exceptions are offered on large and/or high quality loans that are highly desired. These borrowers typically have many choices for financing and frequently shop around for the lowest price. Pricing exceptions may also be made to borrowers experiencing financial difficulties. In these cases, the institution's differential pricing mechanism may result in progressively higher rates to compensate for higher risk. If the borrower is still a desirable customer, the institution may provide an exception in order to keep the borrower's business. Another example of an exception is the waiver of loan fees and default interest to retain business that may have higher risk but is still acceptable business. If an institution allows for negotiated rates or pricing exceptions, appropriate controls are needed to ensure they contribute to the generation of sufficient earnings. Policies and procedures should clearly establish who is authorized to negotiate rates or grant exceptions. In addition, negotiated rates/exceptions should be monitored, summarized, and reported to the board in a routine and timely manner. Incentive Programs Institutions may, at times, implement special programs that provide incentives to loan officers for achieving new business goals, customer retention, or relationship expansion. Bonuses are sometimes provided based on increases in loan volume. However, such programs should have a loan quality or loan performance factor built into the bonus program to ensure that the increased loan volume is of proven quality over sustained periods. Therefore, it is critical that institutions have controls in place to ensure the loan portfolio achieves the desired earnings level and is managed within the risk tolerance levels established by the board. Ongoing monitoring is needed to ensure loan officers price loans adequately to cover costs and compensate for perceived risk. Rates of return on various segments of the loan portfolio should be evaluated on an ongoing basis to ensure that portfolio risk is appropriately priced and controlled. So, in summary, programs that emphasize loan volume growth should be in accordance with the level of credit risk established by the board for the loan portfolio. Transfer Pricing A transfer-pricing system is an integral part of the loan-pricing process at System banks. Transfer pricing is a process for assigning funding costs to individual loans, departments, and/or profit centers. The banks use transfer pricing mechanisms to 1) determine the direct loan rate for associations, 2) insulate associations from IRR, and 3) measure loan profitability of various departments. Determining the Direct Loan Rate for Associations: Typically, an association's direct loan rate is a weighted average of the marginal cost of debt assigned to each loan in an association's portfolio, plus a spread established by the bank. The transfer pricing system is used to determine the cost of debt for each direct loan. The cost of debt is established for each loan at loan origination and at each re-pricing interval. Banks determine the cost of debt based on actual or potential debt issuance costs. For FCA Examination ManualMarch 2000 Page 7

8 example, a bank may use the going rate for a 1-year System bond to determine the cost of debt for a 1-year, adjustable-rate mortgage. However, the bank may, or may not, actually issue a 1-year bond. This will be determined based on the bank's overall balance sheet and IRR position. Insulating Associations from IRR: The transfer-pricing system insulates associations from IRR by allowing the cost of debt assigned to individual loans to change as changes occur in the loan. For example, most banks allow associations to prepay the debt underlying individual loans, regardless of the original terms of the loan or the underlying debt that the bank issues to fund the association's needs. If the borrower repays a 15-year, fixed-rate loan after 1 year, the association will often repay the underlying debt to the bank at the same time. By matching the terms of the loan to the borrower with the terms of the loan from the bank, the association does not assume any mismatch risk. The bank, however, likely issued bonds with maturities much longer than 1 year to fund the loan. The degree to which associations are insulated from IRR can vary. In some cases, associations have chosen to manage particular sources of IRR themselves. In these cases, the transfer-pricing mechanism is used in such a way as to transfer the IRR to the association. Measuring Profitability of Various Departments: With a cost of funds assigned to each individual loan and investment, the total interest expense of loans in each department can be determined as well as the interest income. Net interest income for each department can then be determined. Another key component to determining the net earnings for each department is an accurate allocation of bank operating expenses to each department. With this information, bank management can determine each department's contribution to the bank's profitability. Loan Funding An important decision in setting the cost of a loan is determining how the loan should be funded. The complexity of determining which debt instrument to use to fund a loan varies significantly by loan product. Variable, adjustable, and fixed rate loans have unique factors that must be considered in determining what debt instrument to use to fund the loan. The funding considerations associated with each loan product are discussed separately below. Variable-rate loan pricing is one of the principal tools used to manage interest rate risk because the loans can be administered closely to the cost of funds and changes in market rates. However, some risk is involved. Theoretically, the cost of funds for variable-rate loans could change daily, but daily repricing of loans is not practical because it poses several operational problems. Under this scenario, the institution would be forced to constantly issue large amounts of very short-term discount notes, which could cause significant liquidity problems. In addition, the multitude of rate changes would complicate loan pricing, including borrower notification issues. Most institutions reprice variable-rate loans on a monthly basis. Even monthly repricing, however, can create funding difficulties. To have the entire variable rate portfolio reprice monthly still requires significant levels of discount notes maturing monthly, structured, medium-term notes that reprice monthly, or large amounts of swaps where the bank pays a variable rate. Therefore, many banks utilize 3- and 6-month bonds and discount notes with maturities greater than 30 days to fund the variable-rate portfolio. The bank bases the pricing of the variable rate loan portfolio on the mix of debt it uses to fund the portfolio. This results in the funding costs of the variable-rate portfolio to lag the market somewhat. For fixed-rate loans, the primary challenge in establishing the cost of funds is determining the appropriate maturity of bond(s) to issue. Institutions cannot simply utilize the cost of a 30-year bond to determine the cost of funds for a 30-year loan, since loans are amortized and bonds are not. That is, borrowers repay principal systematically over the life of the loan, whereas the entire principal balance on a bond is outstanding over its entire life. Therefore, a $100,000, 30-year loan, with annual payments and an 8 percent interest rate, will have an average balance of approximately $67,000. The $100,000, 30-year bond with semiannual interest payments and an 8 percent interest rate will have an average balance of $100,000. As such, the average amounts of the principals result in a slight mismatch in asset/liability management models. In order to compare a loan and bond, institutions utilize measurements such as the weighted-average life FCA Examination ManualMarch 2000 Page 8

9 (WAL) or duration. The WAL is the weighted time until receipt of principal from a security, with the weights being the fraction of principal received in each payment period, taking into consideration expected prepayments of various loan products. Duration is similar, but it also takes into consideration the interest received in each payment period, as well as the principal. It also discounts the payments based on their present value. In the above example, the 30-year loan has a WAL of 20.7 years. The duration is 10.2 years. The 30-year bond has a WAL of 30 years and the duration is 11.8 years. By using such measurements, institutions can better determine the appropriate length of bond to use in establishing the cost of funds. Determining the underlying debt instrument to fund adjustable-rate loans is somewhat less complex. Adjustable-rate loans typically reprice in 1, 3, or 5 years, although some go longer. Funding adjustable-rate loans doesn't create a liquidity problem as variable-rate loans do. Also, they do not have as much amortization or principal repayment between repricing, which causes difficulty with longer-term, fixed-rate loans. Therefore, some institutions use the all-in-cost of debt instruments with similar maturities for establishing the cost of funding these loans. Once the option-free cost of funds is determined, the institution can then determine the appropriate cost of the options in the loan. Pricing Options Many loan products contain customer options that must be priced into the loan. These options have value to the borrower, but they also involve a cost to the institution. It is important that institutions consider these options in their ALM practices. Some customer options that may exist in the FCS include: Prepayments This is the right to prepay a loan which gives a borrower a call option on the debt. If rates decline, the borrower can pay off the debt and refinance it at a lower rate. The institution may assume some interest rate risk with this option if it is unable to also liquidate the debt instrument that funded this loan. Interest Rate Caps Many adjustable-rate mortgage loans have embedded period and lifetime caps which preclude loan rates from increasing beyond a specific amount in a given period of time and a maximum increase over the loan term. If these loans are not match-funded, a rising interest rate environment could increase the institution's interest rate risk and reduce its earnings. Forward Funding This is a commitment to lend in the future at a stated rate of interest. These commitments expose the institution to risks if rates increase between the commitment date and loan closing. Many other sources of IRR exist, but since these options are, in effect, sold to borrowers, they require special loan-pricing consideration. System institutions must determine how much to charge the borrower, through higher spreads or fees, for the cost of these options. Institutions have several options to determine how much to charge the borrower. Many banks utilize option-adjusted spread (OAS) models to determine the cost of options and the loan spread needed to cover this cost. Option models are typically purchased from outside firms that specialize in developing these models. Conversely, some banks simply purchase the information from outside firms who utilize these models. OAS models utilize complex formulas to determine the cost of options and they rely on key information and assumptions. As with any model, OAS models require accurate information and reliable assumptions. Key elements of an OAS model include interest rate generation methods and constraints, rate volatility estimates, and customer behavior assumptions. Interest rate generation methods and constraints are a key element of OAS models. OAS models value options by determining the average value of the option under numerous rate paths. Some rate paths will result in options being "in the money." For example, if a fixed-rate loan has an 8 percent interest rate and the rate path results in a 6 percent rate for similar fixed-rate loans, the prepayment option in the 8 percent FCA Examination ManualMarch 2000 Page 9

10 loan has value since the borrower can refinance the loan at a significantly lower rate. The interest rate generation method provides the various rate paths used to value the option. Various interest rate generation methods are utilized and are accepted industry practice. More important from an examination standpoint are the constraints placed on the interest rate generation method. An interest rate generation method without constraints would result in interest rate paths that are impossible or highly unlikely. For example, key market interest rates will never be below zero, yet an unconstrained generation method may produce that as a possible path. Constraints are utilized to establish highs and lows and maximum rate movements in one period. In addition, additional parameters may be introduced to increase the likelihood that rates will return to a historic norm or the current rate. Examiners should closely evaluate the reasonableness of constraints utilized in OAS models. Volatility estimates are arguably the most important assumption utilized by OAS models. Volatility is the measure that indicates the magnitude of the change in the interest rate paths. Higher volatility results in more significant changes in the interest rate as the various rate paths are formed. In addition, higher volatility results in a higher value of the option. Volatility estimates are either historic or implied. Historic volatility estimates are based on the observed volatility of interest rates over a certain time period. Implied volatility estimates are based on the current market price of debt instruments containing options (callable corporate bonds, mortgage-backed securities, etc.) or the price of individual options (calls, puts, etc.). Based on the market price, the assumed volatility of the rate can be derived using an OAS model. The implied volatility is then used to calculate the price of the options where the price is not known. The volatility estimate used by institutions should be closely scrutinized. Consumer behavior assumptions also play a significant role in OAS models as it relates to prepayments. OAS models typically utilize assumptions on how likely a borrower is to prepay. Just because an option is "in the money" doesn't mean that a borrower will actually exercise the option. A borrower may have a financial incentive to refinance, but may be unable to do so because of credit problems, or the borrower may refinance or pay off the loan even without a financial incentive. Behavior assumptions impact interest rate caps as well as the prepayment assumption on fixed-rate loans. An interest rate cap has no value to the borrower if the borrower repaid the loan prior to the cap coming "in the money." Like the interest rate generator constraints and volatility estimates, behavior assumptions used in OAS models should be evaluated. Furthermore, the receipt of loan penalties and fees should be considered in the modeling completed for pricing loan products. Some System banks analyze information available from the capital markets to estimate the cost of options. For example, some banks calculate the difference in rates between callable and bullet Farm Credit debt. Based on this spread, they estimate the appropriate spread to be added to cover the prepayment risk on their fixed-rate loans. For interest rate caps, they obtain market quotes for derivatives to synthetically remove the caps from the loans. Based on the price of the derivatives, they determine the needed spread. Analysis of this nature can be misleading and needs careful documentation. Internal controls and monitoring for this technique are extremely important. Banks may also utilize a process of mixing various debt instruments to obtain an appropriate marginal cost of debt for loans with prepayment risk. The debt mix contains callable and bullet debt of varying maturities, as appropriate to match the predicted repayment behavior. The duration is compared under both low and high prepayment speed scenarios. In addition, the bank compares the run-off of principal over time for the debt mix and loan product for consistency. The weighted-average rate for the debt mix becomes the marginal cost of debt for that loan product. These methods of pricing options also require evaluation. How closely does the debt mix match the characteristics of the loans being priced? Are the high and low prepayment assumptions reasonable and adequately supported? Are the model/spreadsheet calculations accurate? Is the cost of the options recovered quickly enough? Institutions should be able to support and justify their approach to pricing options and the assumptions they utilize. Pricing Other Sources of Risk FCA Examination ManualMarch 2000 Page 10

11 Other sources of IRR exist that must be considered in loan pricing. The Interest Rate Risk section of this Manual discusses various sources of IRR, including mismatch risk, basis risk, and yield curve risk. While most banks typically try to limit their IRR exposure, such risks can never be completely eliminated. And at times, the assumption of some risk provides an opportunity to generate additional earnings. Therefore, banks and associations must price loans appropriately to ensure sufficient returns to cover IRR. Establishing the Wholesale Bank Spread The wholesale bank spread is the key factor impacting the earnings of most banks. Similar to the pricing of individual loans, banks must consider a variety of factors in establishing the wholesale bank spread. In fact, all of the factors previously discussed should be considered when establishing the wholesale bank spread and the resulting direct loan rate to associations. In addition, board policy direction and controls are needed. Differential loan pricing of direct loans has become increasingly common and should be closely evaluated. Examination Procedures Examination procedures for evaluating an institution's loan pricing are detailed in FCA Workpaper Consistent with risk-based examination principles, examiners should add, delete, or modify procedures as needed based on the particular circumstances of the institution. FCA Examination ManualMarch 2000 Page 11