Bank Management,

Management 6th edition.

Timothy W. Koch and S. Scott MacDonald
Copyright © 2006 by South-Western, a division of Thomson Learning

Evaluating Consumer
Loans

Chapter 12

William Chittenden edited and updated the PowerPoint slides for this edition.
Consumer Loans

 Consumer loans in the aggregate

currently produce greater percentage
profits for banks than commercial
loans
 This is true despite the higher default
rates on consumer loans
 Not surprisingly, consumer loan rates
typically exceed commercial loan rates
 Profitability Measures for FDIC-Insured
Banks with Different Asset Concentrations
Performance Ratios By Asset Concentration Group
Return on Assets (YTD)
December 31, 2004
5.0%
4.5% 4.01%
4.0%
3.5%
3.0%
2.5%
2.0% 1.66% 1.66%
1.23% 1.30% 1.18% 1.35%
1.5% 1.10%
1.0% 0.76%
0.5%
0.0%
International Agricultural Credit Card Commercial Mortgage Consumer Other All Other < All Other >
Banks Banks Lenders Lenders Lenders Lenders Specialized < $1 Billion $1 Billion
$1 Billion

Net Interest Margin (YTD)

December 31, 2004
10.0% 9.05%

8.0%

6.0%
4.71%
4.07% 3.86% 3.86%
4.0% 3.05% 3.20% 3.27%
2.50%
2.0%

0.0%
International Agricultural Credit Card Commercial Mortgage Consumer Other All Other < All Other >
Banks Banks Lenders Lenders Lenders Lenders Specialized < $1 Billion $1 Billion
$1 Billion
Net Charge-Offs of FDIC-Insured Banks
with Different Asset Concentrations
Net Charge-offs to Loans and Leases (YTD)
December 31, 2004

5.0% 4.67%

4.0%

3.0%

2.0%
1.57%

0.91%
1.0%
0.59%
0.21% 0.30% 0.31% 0.25%
0.12%
0.0%
International Agricultural Credit Card Commercial Mortgage Consumer Other All Other < All Other >
Banks Banks Lenders Lenders Lenders Lenders Specialized < $1 Billion $1 Billion
$1 Billion
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
 However, 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
 Can be extremely profitable
 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

 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 2004 consumers charged approximately
$2.5 trillion on credit cards
 Most banks 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

 Credit Cards and Other Revolving

Credit
 Creditcards are attractive because
they provide higher risk-adjusted
returns than do other types of loans
 Card issuers earn income from three
sources:
 Cardholders’ annual fees
 Interest on outstanding loan balances
 Discounting the charges that merchants
accept on purchases.
Credit Card Loss Rates and Personal
Bankruptcy Filings: 1984-2004
Net Charge-Off % Personal Bankruptcy Filings $000
9% 450
Credit-Card
8% Charge-Off 400
Rates
7% 350
6%
300
5%
Personal 250
4% Bankruptcy
Filings 200
3%
2% 150

1% 100

0% 50
'84 '86 '88 '90 '92 '94 '96 '98 '00 '02 '04
Types of Consumer Loans

 Credit Card Systems and Profitability

 Returnsdepend on the specific role the
bank plays
 A bank is called a card bank if it
administers its own credit card plan or
serves as the primary regional agent of
a major credit card operation
 A non-card bank does not issue its own

card
Credit Card Transaction Process

Individual 1 Retail Outlet

4 2
Card-Issuing Clearing Local Merchant
Bank 3 Network 3 Bank
2
Debit Cards and Smart Card

 Debit Cards
 Widely available
 When an individual uses the card, their
balance is immediately debited
 They have lower processing costs to
the bank
Debit Cards and Smart Card

 Smart Card
 An extension of debit and credit cards
 Contains a memory chip which can
manipulate information
 It is programmable such that users can
store information and recall this
information when effecting
transactions.
 Only modest usage in the U.S.
Debit Cards and Smart Card

 Smart Card
 Usage will likely increase dramatically
in the U.S.:
 Firms can offer a much wider range of
services
 Smart cards represent a link between

the Internet and real economic activity

 Suppliers of smart cards are

standardizing the formats so that all

cards work on the same systems
Pre-Paid Cards

 Prepaid Cards
A hybrid of debit cards in which
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

 Overdraft Protection and Open Credit Lines

 Overdraft Protection Against Checking
Accounts
 A type of revolving credit
 Open Credit Lines
 A recent trend is to offer open credit lines to
affluent individuals whether or not they have
an existing account relationship
 Typically, 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 $250 billion in 2004
 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
 Some allow access to credit line by
using a credit card
Types of Consumer Loans

 Non-Installment Loans
 Oftenrequire a single principal and
interest payment
 Bridge loans are representative of
single payment consumer loans.
 Bridge loans often arise when an individual
borrows funds for the down payment on a
new house
 The loan is repaid when the borrower sells
the previous home
Subprime Loans

 One of the hottest growth areas during

the 1990s
 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
 Subprime loans have greater risk and must be priced
consistently higher than prime-grade loans
 Example Definitions:
 B: Typically scores 600+ under the Fair Isaac system;
has some 90-day past dues but is now current. Typical
delinquencies are 2%-5%; repossessions are 2.5%-6%;
and losses are 1.5%-3%
 C: Typically scores between 500 and 600 and has had
write-offs and judgments. The borrower has made
subsequent payments of some or all of the loans. Typical
delinquencies are 5%-10%; repossessions, 5%-20%; and
losses 3%-10%
 D: Typically scores between 440 and 500 and has charge-
offs and judgments that have not been repaid and has
not made payments on these loans. Delinquencies are
10%-20%; repossessions, 16%-40%; losses, 10%-20%
Subprime Loans

 High LTV Loans

 High Loan-To-Value
 Many lenders upped the stakes by
making “high LTV” loans based on the
equity in a borrower’s home
 Where traditional home equity loans are

capped at 75 percent of appraised value

minus the outstanding principal
balance, high LTV loans equal as much
as 125% of the value of a home
Consumer Credit Regulations

 Equal Credit Opportunity

 Makes it illegal for lenders to
discriminate
 Prohibits Information Requests on:
 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

 Equal Credit Opportunity

 Credit Scoring Systems
 Credit scoring systems are acceptable if
they do not require prohibited
information and are statistically justified
 Credit scoring systems can use

information about age, sex, and marital

status as long as these factors
contribute positively to the applicant's
creditworthiness
Consumer Credit Regulations

 Equal Credit Opportunity

 Credit Scoring Systems
 Credit scoring models are based on
historical data obtained from applicants
who actually received loans
 Statistical techniques assign weights to

various borrower characteristics that

represent each factor's contribution
toward distinguishing between good
loans that were repaid on time and
problem loans that produced losses
Consumer Credit Regulations

 Equal Credit Opportunity

 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
 Requires that lenders disclose to
potential borrowers both the total
finance charge and an annual
percentage rate (APR)
 The APR equals the total finance charge

computed against the loan balance as a

simple annual interest rate equivalent
Consumer Credit Regulations

 Truth In Lending
 Historically,
consumer loan rates were
quoted as add-on rates, discount rates,
or simple interest rates
 Add-on Rates
 Appliedagainst the entire principal of
installment
 Gross interest is added to the principal
with the total divided by the number of
periodic payments to determine the size
of each payment
Consumer Credit Regulations

 Add-on Rates
 Appliedagainst the entire principal of
installment
 Gross interest is added to the principal
with the total divided by the number of
periodic payments to determine the size
of each payment
 Consumer Credit Regulations

 Add-on Rates
 Example:
 Suppose that a customer borrows $3,000 for
one year at a 12 percent add-on rate with the
loan to be repaid in 12 equal monthly
installments
 Total interest equals $360, monthly payment
equals $280, and the effective annual interest
cost is approximately 21.5%
[0.12($3,000)  $3,000]
Monthly Payment   $280
12
12
$280
Effective Interest Rate(i) :  t
 $3,000 i  21.46%
t=1(1+ i)
Consumer Credit Regulations

 Discount Rate Method

 Quoted rate is applied against the sum
of principal and interest, yet the
borrower gets to use only the principal,
as interest is immediately deducted
from the total loan
Consumer Credit Regulations

 Discount Rate Method

 Example:
 Consider a 1-year loan with a single

$3,000 payment at maturity.

 The borrower receives only $2,640, or the
total loan minus 12% discount rate
interest.
 The effective annual percentage rate, or
APR, equals 13.64%
 Interest charge = 0.12 ($3,000) = $360
$3,000
Annual Percentage Rate (in ) $2,640 =
(1+ in )
i  13.64%
Consumer Credit Regulations

 Simple Interest
 Interest is paid on only the principal
sum
 Example:
 $3,000 loan at 12% simple interest per year
produces $360 in interest, or a 12 percent
effective rate interest (is): = $3,000(0.12)
(1)= $360
$3,360
$3,000 =
(1+ is )
is  12%
Consumer Credit Regulations

 Simple Interest
 The quoted rate (APR) is adjusted to its
monthly equivalent, which is applied
against the unpaid principal balance on
a loan
 The loan is repaid in 12 monthly
installments and the monthly interest
rate equals 1 percent of the
outstanding principal balance at each
month
Consumer Credit Regulations
 Simple Interest
Repayment Schedule
End of Month Monthly Interest Principal Outstanding
Payment Portion Principal
Balance

January $266.55 $30.00 $236.55 $2,763.45

February 266.55 27.63 238.92 2,524.53
March 266.55 25.25 241.30 2,283.23
April 266.55 22.83 243.72 2,039.51
May 266.55 20.40 246.15 1,793.36
June 266.55 17.93 248.62 1,544.74
July 266.55 15.45 251.10 1,293.64
August 266.55 12.94 253.61 1,040.03
September 266.55 10.40 256.15 783.88
October 266.55 7.84 258.71 525.17
November 266.55 5.25 261.30 263.87
December 266.51 2.64 263.87 0.00
Total $3,198.56 $198.56 $3,000.00

Effective interest rate: Monthly rate = 1%

Annual precentage rate = 12%
12
1
Monthly payment = $3,000 
i=1 (1.01)
t
Consumer Credit Regulations
 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
 There are three primary credit reporting
agencies:
 Equifax

 Experian

 Trans Union

 Unfortunately, the credit reports that they produce

are quite often wrong
Sample Credit Report
Consumer Credit Regulations

 Fair Credit Reporting Act

 Credit Score
 Like a bond rating for individuals
 Based on several factors

Facotor
Contributing to Facotor
Credit Score, Contributing to
Facotor 10% Credit Score,
Contributing to 30.00%
Credit Score,
15%

Facotor Facotor
Contributing to Contributing to
Credit Score, Credit Score,
10% 35%
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
 FIRREA of 1989 raised the profile of the CRA
by:
 Mandating public disclosure of bank lending

policies and regulatory ratings of bank

compliance
 Regulators must also take lending performance

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
 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.
 Unfortunately, individuals appear to be using
bankruptcy as a financial planning tool
 It appears the stigma of bankruptcy is largely
gone
Credit Analysis
 Objective of consumer credit analysis is to assess the
risks associated with lending to individuals
 When evaluating loans, bankers cite the Cs of credit:
 Character

 The most important element, but difficult to assess

 Capital

 Refers to the individual's wealth position

 Capacity

 The lender often imposes maximum allowable debt-

service to income ratios
 Conditions

 The impact of economic events on the borrower's

capacity to pay
 Collateral

 The importance of collateral is in providing a

secondary source of repayment
Credit Analysis
 Two additional Cs
 Customer Relationship
 A bank’s prior relationship with a customer

reveals information about past credit and

deposit experience that is useful in assessing
willingness and ability to repay.
 Competition
 Has an impact by affecting the pricing of a loan.

 All loans should generate positive risk-adjusted

returns
 Lenders periodically react to competitive

pressures by undercutting competitors’ rates in

order to attract new business
 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
 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
 Quantitative, Credit Scoring
Credit Analysis: Judgmental Procedures

 Judgmental
 The loan officer subjectively interprets
the information in light of the bank’s
lending guidelines and accepts or
rejects the loan
Credit Analysis: Quantitative

 Quantitative credit scoring / Credit

scoring model
 The loan officer grades the loan request
according to a statistically sound model
that assigns points to selected
characteristics of the prospective
borrower
 In both cases, judgmental and
quantitative, a lending officer collects
information regarding the borrower’s
character, capacity, and collateral
An Application: Credit Scoring a Consumer Loan

 You receive an application for a

customer to purchase a 2003 Jeep
Cherokee
 Do you make the loan?
An Application: Credit Scoring a Consumer Loan
 Credit scoring system, University
National Bank, applied to credit
application for purchase of a 2003 Jeep
Category Characteristics/Weights
<$10,000 $10,000-$20,000 $20,000-$40,000 $40,000-60,000 >$60,000
Annual Gross Income
5 15 30 45 60
Monthly Debt Payment >40% 30-40% 20-30% 10-20% <10%
Monthly Net Income 0 5 20 35 50
Bank Relationship None Checking Only Saving only Checking & Saving No answer
Checking/Saving 0 30 30 50 0
None 1 or more No answer
Major Credit Cards
0 30 0
Any derogatory within 7 yrs. No record Met obligated payments
Credit History
-10 0 30
< 50 yrs. >50 yrs. No answer
Applicant's Age
5 25 0
Rent Own/Buying Own outright No answer
Residence
15 40 50 15
Residence Stability < 1 yr. 1-2 yrs. 2-4 yrs. >4 yrs. No answer
0 15 35 50 0
Job Stability < 1 yr. 1-2 yrs. 2-4 yrs. >4 yrs. Unemployed Retired
5 20 50 70 5 70
NOTE: Minimum score for automatic credit approval is 200; score for judgmental evaluation, 150 to 1 95; score for
automatic credit denial is less than 150. Melanie Groome's credit score is 185.
FICO Credit Scores
National Distribution of FICO Scores
30
28%
25
20
19%
15 16%
10 12% 11%
5 8%
1% 5%
0 Up to 499 500-549 550-599 600-649 650-699 700-749 750-799 800+
FICO Score Range

Delinquency Rates by FICO Score

100%
80% 87%
71%
60%
51%
40%
31%
20%
15% 5% 2% 1%
0%
Up to 499 500-549 550-599 600-649 650-699 700-749 750-799 800+
FICO Score Range
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
 These loans are collectively referred to as
dealer paper
 Banks aggressively compete for paper
originated by well-established automobile,
mobile home, and furniture dealers
An Application: Indirect Lending
 Indirect lending is an attractive form of consumer
lending when a bank deals with reputable retailers
 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
 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
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
 Terms of the Dealer Agreement
Bank buys dealer paper at a 12 percent rate. Dealer charges customers a higher rate
(15 percent APR), with 25 percent of difference allocated to a reserve.
Sample Automobile Loan
Principal = $8,000
Maturity = 3 years, 36 monthly installments
Loan rate = 15% annual percentage rate (APR)
Monthly payment = $8,000/[(I/.0125) - (1/.0125(l.0125)36)] $277.32
Allocation to the Dealer Reserve
Total interest expense to customer = $1,983.52
An Application: Indirect Lending

Total interest income for bank = 1,565.72

Differential interest - $ 417.80
75% allocated to dealer: 0.75(417.80) = $313.35
25% allocated to reserve: 0.25(417.80) = $104.45
Interest Refunds on Prepayments with Add-on Rates
Loan is written on a precomputed basis, and bank accrues interest using “rule of 78s"*
Interest expense to customer = 0.09($8,000)(3) = $2,160
Interest income for bank = 0.07($8,000)(3) = 1,680
Differential interest = $ 480
75% allocated to dealer: 0.75($480) = $360
25% allocated to reserve: 0.25($480) = 120
End of Year Interest Earned* Total Bank Difference
1 54.96% $1,187.14 $923.33 $263.81
2 33.33 719.33 559.94 159.99
3 11.71 252.93 196.73 56.20
100.00% $2,160.00 $1,680.00 $480.00
*Rule of 78s factors are 366/666, 222/666, and 78/666, respectively.
Recent Risks 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 Risks 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
 With traditional installment credit,
banks often encourage borrowers to
purchase credit life insurance on which
the bank may earn a premium
Recent Risks 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 fraud losses amounted to
more than $2.4 billion in mid-2004
Recent Risks 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 Risks and Return Characteristics of
Consumer Loans
 Interest Rate and Liquidity Risk with
Consumer Credit
 Bankers have responded in two ways:
 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
 Bank Management,
Management 6th edition.
Timothy W. Koch and S. Scott MacDonald
Copyright © 2006 by South-Western, a division of Thomson Learning

Evaluating Consumer Loans

Chapter 12

William Chittenden edited and updated the PowerPoint slides for this edition.