Evaluating Consumer

15 Loans
Evaluating Consumer Loans
 Today, many banks target individuals
as the primary source of growth in
attracting new business
 Consumer loans differ from
commercial loans
 Qualityof financial data is lower
 Primary source of repayment is current
income
Types of Consumer Loans
 Evaluating Consumer Loans
 An analyst should addresses the same
issues discussed with commercial
loans:
 The use of loan proceeds

 The amount needed

 The primary and secondary source of

repayment
Types of Consumer Loans
 Evaluating Consumer Loans
 Consumer loans differ so much in
design that no comprehensive
analytical format applies to all loans
Types of Consumer Loans
 Installment Loans
 Require the periodic payment of
principal and interest
Types of Consumer Loans
 Installment Loans
 Direct
 Negotiated between the bank and the

ultimate user of the funds

 Indirect
 Funded by a bank through a separate

retailer that sells merchandise to a

customer
Types of Consumer Loans
 Installment Loans
 Revenues and Costs from Installment
Loans
 Consumer installment loans can be

extremely profitable
 Costs $100 - $250 to originate loan

 Typically yield over 5% (loan income

minus loan acquisition costs,

collections costs and net charge-offs)
Types of Consumer Loans
 Credit Cards and Other Revolving
Credit
 Credit cards and overlines tied to
checking accounts are the two most
popular forms of revolving credit
agreements
 In 2007, over 92% of households had
credit cards (average of 13 cards)
Types of Consumer Loans
 Credit Cards and Other Revolving
Credit
 Mostbanks operate as franchises of
MasterCard and/or Visa
 Bank pays a one-time membership fee
plus an annual charge determined by
the number of its customers actively
using the cards
Types of Consumer Loans
 Debit Cards, Smart Cards, and Prepaid
Cards
 Debit Cards
 Widely available
 When an individual uses the card, their

balance is immediately debited

 Banks prefer debit card use over

checks because debit cards have lower

processing costs
Types of Consumer Loans
 Debit Cards, Smart Cards, and Prepaid
Cards
 Smart Card
 Contains a memory chip which can
store information and value
 Programmable such that users can

store information and add or transfer

value to another smart card
 Only modest usage in the U.S.
Types of Consumer Loans
 Debit Cards, Smart Cards, and Prepaid
Cards
 Prepaid Card
 A hybrid of a debit card
 Customers prepay for services to be

rendered and receive a card against

which purchases are charged
 Use of phone cards, prepaid cellular,

toll tags, subway, etc. are growing

rapidly
Types of Consumer Loans
 Credit Card Systems and Profitability
 Card issuers earn income from three
sources:
 Cardholders’ annual fees

 Interest on outstanding loan balances

 Discounting the charges that

merchants accept on purchases

Types of Consumer Loans
 Credit Card Systems and Profitability
 Despite high charge-offs, credit cards
are attractive because they provide
higher risk-adjusted returns than do
other types of loans
Types of Consumer Loans
 Overdraft Protection and Open Credit
Lines
 Overdraft Protection Against Checking
Accounts
 A type of revolving credit
 A bank authorizes qualifying individuals to
write checks in excess of actual balances
held in a checking account up to a pre-
specified limit
Types of Consumer Loans
 Overdraft Protection and Open Credit
Lines
 Open Credit Lines
 The bank provides customers with
special checks that activate a loan
when presented for payment
Types of Consumer Loans
 Home Equity Loans
 Grew from virtually nothing in the mid-
1980s to over $350 billion in 2008
 They meet the tax deductibility
requirements of the Tax Reform Act of
1986, which limits deductions for
consumer loan interest paid by
individuals, because they are secured
by equity in an individual's home
Types of Consumer Loans
 Home Equity Loans
 Some allow access to credit line by
using a credit card
 Borrowers pay interest only on the
amount borrowed, pay 1 to 2 percent of
the outstanding principal each month,
and can repay the remaining principal
at their discretion
Types of Consumer Loans
 Non-Installment Loans
 aka Bridge Loan
 Requires a single principal and interest

payment
 Typically, the individual’s borrowing

needs are temporary and repayment is

from a well-defined future cash inflow
Subprime Loans
 One of the hottest growth areas during
the early 2000s
 Subprime loans are higher-risk loans
labeled “B,” “C,” and “D” credits
 They have been especially popular in
auto, home equity, and mortgage
lending
 Typically have the same risk as loans
originated through consumer finance
companies
Subprime Loans
 Many subprime lenders make loans to
individuals that a bank would not
traditionally make and keep on-
balance sheet
 Subprime lenders charge higher rates
and have more restrictive covenants
Subprime Loans
 What Happens When Housing Prices Fall
 Subprime loans can be attractive when
housing values are rising
 Individuals who are overextended and

cannot make their monthly payments, can

often sell the home or refinance and
withdraw equity to pay the debts if the
price increases are sufficiently high
 The opposite occurs when housing prices

fall
Subprime Loans
 What Happens When Housing Prices
Fall
 During2007–2008, banks were forced
to charge-off historically high amounts
of mortgage loans as delinquencies
and foreclosures skyrocketed
Consumer Credit Regulations
 Equal Credit Opportunity
 Makes it illegal for lenders to
discriminate on the basis of race,
religion, sex, marital status, age, or
national origin
Consumer Credit Regulations
 Prohibited Information Requests
 The applicant's marital status
 Whether alimony, child support, and
public assistance are included in
reported income
 A woman's childbearing capability and
plans
 Whether an applicant has a telephone
Consumer Credit Regulations
 Credit Scoring Systems
 Acceptable if they do not require
prohibited information and are
statistically justified
 Can use information about age, sex,
and marital status as long as these
factors contribute positively to the
applicant's creditworthiness
Consumer Credit Regulations
 Credit Reporting
 Lenders must report credit extended
jointly to married couples in both
spouses' names
 Whenever lenders reject a loan, they
must notify applicants of the credit
denial within 30 days and indicate why
the request was turned down
Consumer Credit Regulations
 Truth In Lending
 Regulations apply to all individual
loans up to $25,000 where the
borrower's primary residence does not
serve as collateral
Consumer Credit Regulations
 Truth In Lending
 Requires that lenders disclose to
potential borrowers both the total
finance charge and an annual
percentage rate (APR)
 Historically, consumer loan rates were
quoted as:
 Add-On Rates

 Discount Rates

 Simple Interest Rates

Consumer Credit Regulations
 Fair Credit Reporting
 Fair Credit Reporting Act
 Enables individuals to examine their

credit reports provided by credit

bureaus
 If any information is incorrect, the

individual can have the bureau make

changes and notify all lenders who
obtained the inaccurate data
Consumer Credit Regulations
 Fair Credit Reporting
 There are three primary credit
reporting agencies:
 Equifax

 Experian

 Trans Union

 Unfortunately, the credit reports that

they produce are quite often wrong
Consumer Credit Regulations
 Fair Credit Reporting
 Credit Score
 Like a bond rating for individuals

 Based on several factors

 Payment History
 Amounts Owed
 Length of Credit History
 Types of Credit
 New Credit
Consumer Credit Regulations
 Community Reinvestment Act
 CRA prohibits redlining and
encourages lenders to extend credit
within their immediate trade area and
the markets where they collect
deposits
Consumer Credit Regulations
 Community Reinvestment Act
 Financial Institutions Reform, Recover,
and Enforcement Act of 1989 raised the
profile of the CRA by mandating public
disclosure of bank lending policies and
regulatory ratings of bank compliance
Consumer Credit Regulations
 Community Reinvestment Act
 Regulators must also take CRA
compliance into account when
evaluating a bank's request to charter
a new bank, acquire a bank, open a
branch, or merge with another
institution
Consumer Credit Regulations
 Bankruptcy Reform
 Individuals who cannot repay their
debts on time can file for bankruptcy
and receive court protection against
creditors
Consumer Credit Regulations
 Bankruptcy Reform
 Individuals can file for bankruptcy
under:
 Chapter 7

 Individuals liquidate qualified assets and

distribute the proceeds to creditors
 Chapter 13
 An individual works out a repayment plan
with court supervision
Consumer Credit Regulations
 Bankruptcy Reform
 In 2005, Congress passed bankruptcy
reform legislation that made it more
difficult for individuals to completely
avoid repaying their debts
 In particular, an individual whose

income exceeds the state median has

to file for Chapter 13 and will repay at
least a portion of his or her debts
Credit Analysis
 Objective of consumer credit analysis
is to assess the risks associated with
lending to individuals
Credit Analysis
 When evaluating loans, bankers cite
the Cs of credit:
 Character
 Capital
 Capacity
 Conditions
 Collateral
Credit Analysis
 Two additional Cs
 Customer Relationship
 A bank’s prior relationship with a

customer reveals information about

past credit experience
 Competition
 Lenders periodically react to

competitive pressures
 Competition should not affect the

accept/reject decision
Credit Analysis
 Policy Guidelines
 Acceptable Loans
 Automobile

 Boat

 Home Improvement

 Personal-Unsecured

 Single Payment

 Cosigned
Credit Analysis
 Policy Guidelines
 Unacceptable Loans
 Loans for speculative purposes

 Loans secured by a second lien

 Other than home improvement or home

equity loans
 Any participation with a correspondent

bank in a loan that the bank would not

normally approve
Credit Analysis
 Policy Guidelines
 Unacceptable Loans
 Loans to a poor credit risk based on

the strength of the cosigner

 Single payment automobile or boat

loans
 Loans secured by existing home

furnishings
 Loans for skydiving equipment and

hang gliders
Credit Analysis
 Evaluation Procedures: Judgmental
and Credit Scoring
 Judgmental
 Subjectively interpret the information in
light of the bank’s lending guidelines
and accepts or rejects the loan
 Assessment can be completed shortly

after receiving the loan application and

visiting with the applicant
Credit Analysis
 Evaluation Procedures: Judgmental
and Credit Scoring
 Credit Scoring
 Grades the loan request according to a
statistically sound model that assigns
points to selected characteristics of the
prospective borrower
Credit Analysis
 Evaluation Procedures: Judgmental
and Credit Scoring
 Credit Scoring
 If the total points exceeds the accept
threshold, the officer approves the loan
 If the total is below the reject threshold,

the officer denies the loan

Credit Analysis
 Evaluation Procedures: Judgmental
and Credit Scoring
 Inboth cases, judgmental and
quantitative, a lending officer collects
information regarding the borrower’s
character, capacity, and collateral
Credit Analysis
 An Application: Credit Scoring a
Consumer Loan
 Youreceive an application for a
customer to purchase a 2007 Jeep
Cherokee
 Do you make the loan?
Credit Analysis
 An Application: Credit Scoring a
Consumer Loan
 The Credit Score
 At this bank, the loan is automatically
approved if the total score equals at
least 200
 The loan is automatically denied if the

total score is below 150

 Accept/Reject is indeterminate for

scores between 150 & 200

Credit Analysis
 An Application: Credit Scoring a
Consumer Loan
 The Credit Decision
 The credit decision rests on the loan
officer’s evaluation of the applicant’s
character and capacity to repay the
debt
Credit Analysis
 An Application: Credit Scoring a
Consumer Loan
 The Credit Decision
 The loan officer has numerous grounds
for denying credit
 Limited credit history
 Local residence was established too
recently
 Employed too recently
Credit Analysis
 An Application: Credit Scoring a
Consumer Loan
 The Credit Decision
 The loan officer sees some positive
things
 Applicant appears to be a hard worker who
is the victim of circumstances resulting
from her husband’s death
 It is unlikely that anyone who puts almost
30 percent down on a new model is going
to walk away from a debt
Credit Analysis
 An Application: Credit Scoring a
Consumer Loan
 The Credit Decision
 The loan officer sees some positive
things
 The bank will likely lose Groome as a
depositor if it denies the application

 What would you recommend?

Credit Analysis
 Your FICO Credit Score
 Summarizes in one number an
individual’s credit history
 Lenders often use this number when

evaluating whether to approve a

consumer loan or mortgage
 Many insurance companies consider

the score when determining whether to

offer insurance coverage and how to
price the insurance
Credit Analysis
 Your FICO Credit Score
 Summarizes in one number an
individual’s credit history
 The scores range from 300 to 850 with

a higher figure indicating a better credit

history
 The national average is 670
 The higher the score is, the more likely it is
a lender will see the individual as making
the promised payments in a timely manner
Credit Analysis
 Your FICO Credit Score
 An individual’s credit score is based
on five broad factors:
 Payment history 35%

 Amounts owed 30%

 Length of credit history 15%

 New credit 10%

 Type of credit in use 10%

Credit Analysis
 An Application: Indirect Lending
 A retailer sells merchandise and takes
the credit application
 Because many firms do not have the

resources to carry their receivables,

they sell the loans to banks or other
financial institutions
Credit Analysis
 An Application: Indirect Lending
 These loans are collectively referred to
as dealer paper
 Banks aggressively compete for paper
originated by well-established
automobile, mobile home, and furniture
dealers
Credit Analysis
 An Application: Indirect Lending
 Dealers negotiate finance charges
directly with their customers
 A bank, in turn, agrees to purchase the

paper at predetermined rates that vary

with the default risk assumed by the
bank, the quality of the assets sold, and
the maturity of the consumer loan
Credit Analysis
 An Application: Indirect Lending
 A dealer normally negotiates a higher
rate with the car buyer than the
determined rate charged by the bank
 This differential varies with competitive
conditions but potentially represents a
significant source of dealer profit
Credit Analysis
 An Application: Indirect Lending
 Most indirect loan arrangements
provide for dealer reserves that reduce
the risk in indirect lending
 The reserves are derived from the
differential between the normal, or
contract loan rate and the bank rate,
and help protect the bank against
customer defaults and refunds
Recent Risk and Return
Characteristics of Consumer Loans
 Revenues from Consumer Loans
 The attraction is two-fold:
 Competition for commercial customers

narrowed commercial loan yields so

that returns fell relative to potential
risks
 Developing loan and deposit

relationships with individuals

presumably represents a strategic
response to deregulation
Recent Risk and Return
Characteristics of Consumer Loans
 Revenues from Consumer Loans
 Consumer loan rates have been among
the highest rates quoted at banks in
recent years
 In addition to interest income, banks
generate substantial non-interest
revenues from consumer loans
Recent Risk and Return
Characteristics of Consumer Loans
 Revenues from Consumer Loans
 With traditional installment credit,
banks often encourage borrowers to
purchase credit life insurance on which
the bank may earn a premium
Recent Risk and Return
Characteristics of Consumer Loans
 Consumer Loan Losses
 Losses on consumer loans are
normally the highest among all
categories of bank credit
 Losses are anticipated because of
mass marketing efforts pursued by
many lenders, particularly with credit
cards
 Credit card losses and fraud amounted
to more than $12 billion in 2005
Recent Risk and Return
Characteristics of Consumer Loans
 Interest Rate and Liquidity Risk with
Consumer Credit
 The majority of consumer loans are
priced at fixed rates
 New auto loans typically carry 4-year
maturities, and credit card loans
exhibit an average 15- to 18-month
maturity
Recent Risk and Return
Characteristics of Consumer Loans
 Interest Rate and Liquidity Risk with
Consumer Credit
 Bankers have responded in two ways
to deal with the interest rate risk:
 Price more consumer loans on a
floating-rate basis
 Commercial and investment banks

have created a secondary market in

consumer loans, allowing loan
originators to sell a package of loans