Lecture Notes:
 

Bank lending activity can generally be divided into three basic types: Consumer lending, Mortgage lending, and Commercial lending. While each institution may have some of each type, generally banks develop loan niches in which they are most comfortable and have the greatest expertise. Traditionally, Commercial Banks have dealt with primarily with Commercial loans, secondarily with Consumer loans and very little with Mortgage loans. Credit Unions, on the other hand have almost no dealings with Commercial loans, large portfolios of Consumer loans and minimal balances of Mortgage loans. Thrifts - have been the Mortgage lending specialist, with Consumer loans making up most of the rest of their loan portfolios and Commercial loans making up a very small part.

Consumer Loans - are generally made up of automobile, home improvement, student, credit cards, and personal loans (vacations, furniture etc.). These loans generally range from $500 to $50,000. Consumer loans greater than $50,000 are certainly possible, but simply are generally rarer, since most automobiles and most home improvements are less than that amount. Many banks also have a minimum loan amount of $2,500 to $5,000 - believing that borrowings of less than that should be accomplished with a credit card, designed for relatively minor borrowing needs.  Credit can be either Secured or Unsecured. As the names imply, a Secured loan is one that uses the security of collateral to reduce the risk associated with lending. Security can be an automobile, a home (either home improvement or home equity loans discussed below), stocks, or even furniture. Unsecured loans - nearly all credit cards fall in this category - are not secured in any manner - other than the promise of the creditor to repay. In the previous chapter we discussed the Risk Reward Ratio and it is applicable here as well. Secured loans - where there is collateral available has less risk than the same size Unsecured loan. As might be expected, the interest rates for Secured loans are generally less than for the same term Unsecured loan. Even further, the type of collateral will make a difference in the risk - and the rate of the loan. The concept of the Risk Reward Ratio is also evident in the granting of credit itself. Consumers who are deemed the most creditworthy most often will be charged a lower rate of interest than a consumer who has had credit problems in the past. The Credit Report is utilized for most all consumer loan decisions as a way of reducing risk - by understanding the credit repayment history of the borrower. Since history is often a predictor, this is a useful tool. Loan Officers (those who decide who gets the loan and who doesn't) usually consider the four "C's of Credit. Capacity, Character, Capital, and Collateral are all considered in lending decision. Capacity is the relation of current income to current expenses. Character is the history of credit repayments. Capital refers to savings and other accumulations that could be used in the event the borrowers income was reduced. Collateral is the security pledged for the loan that would be available to satisfy any outstanding indebtedness should the customer be unable to make any further payments. Collateral should ALWAYS be the last item considered - since it is impossible for collateral to make any payments. In order to make decisions - Loan Officers must rely on information they can gather from the customer and the credit report. Credit decisions traditionally have been a combination of analysis of the credit report, the credit application and a personal interview with the borrower. Recently, credit decisions have become more and more automated and impersonal - which makes the decision faster, but often overlooks the human side of the equation. If volume of loans is the primary emphasis, then automated decisions are necessary. On the other hand, if helping the customer is a concern - the lending process must take time for personal interviews. Lending automation is facilitated by the use of Credit Scoring. This method utilizes very objective measures to determining the likelihood that a particular customer will repay. Credit Scoring is utilized to different degrees by various institutions - some use the Score and an indicator and some use it as a decision maker.

Home Improvement and Home Equity Loans are similar in nature in most aspects. Strictly, a Home Improvement loan must be used to repair or improve the home and use a lien on the home as security. Home Equity loans use the home as security but proceeds can be used for any variety of purposes. Under Federal Income Tax regulations, GENERALLY interest paid on either a Home Equity or Home Improvement loan is tax deductible - which is why these loans are attractive. For example, if a Home Equity loan is made and the proceeds used to purchase an automobile, the loan interest is probably tax deductible, whereas a loan for the purchase of an automobile is not subject to tax deductible interest. These loans also present a greater interest rate risk to the bank - since the term for these loans is often 10, 15 or even 20 years in length. A variation of the Home Equity Loan is a Home Equity Line of Credit. Like other Lines of Credit, a borrower may not need all the credit balance available at one time - they are able to use as much or as little as needed with their payments corresponding to their balance.  The Texas Legislature and Texas voters approved home equity lending for the first time in our State's history in 2003.  While there are restrictions which many other States don't have, such as a minimum draw of $4000, and several others,  we do now have the credit available in Texas for the first time.

Credit Cards - are certainly one of the most successful developments in banking this century. However, it should be noted that what was once a product offered by most every bank has become a product that is now offered by relatively FEW institutions that hold most of the credit card business for the nation. The general exception to this trend has been in the credit union arena - where most credit unions issue and underwrite the credit of cards issued under their name.

Consumer Credit Regulations - are, like most areas of commerce, necessary to ensure that consumers are treated equally and can know what to expect when they borrow. Certainly, there was a time when money lenders were not as forthright and upfront as maybe they should have been - which is why we have laws and regulations to help correct that oversight. Every lender (and bank employee, too) should be aware of the requirements of Truth In Lending; the Fair Credit Reporting Act; the Equal Credit Opportunity Act; the Community Reinvestment Act; the Fair Debt Collection Practices Act; the Fair Credit Billing Act; The Fair Credit and Charge Card Disclosure Act and the regulations that enforce these laws.

For over 50 years, if you mentioned the term "Mortgage" - most of the consumers in the U.S. would immediately assume "Savings and Loan". As a result of charter limitations and market preferences, the "S&L industry was the primary lender for the purchase of home for nearly half a century. With changes already discussed in earlier chapters, the production of mortgages has moved from the thrift industry to a variety of other institutions, including insurance companies, mortgage banking firms, credit unions and of course, banks of all types. In discussing Mortgage loans - it is important to differentiate between institutions that originate and sell the mortgages and those that originate and hold the mortgages. Origination - refers to the initial making of the mortgage, dealing with the customer, creating the loan and all documents and sending the funds to the seller to pay for the purchase of the house. Numerous institutions are now in the market for originating Mortgages. However, very few of them book the loans - or keep the loan on as part of their portfolio. Instead - most originators now group the loans originated by similarities and sell them on the secondary market.  The secondary market is comprised of investors that wish to invest in groups of Mortgages, but have neither the interest nor the ability to hold the Mortgages and provide the necessary servicing (more on servicing later). What the secondary market allows - is the efficient meeting of groups of consumers who wish to borrow Mortgage money - and the investors willing to funds such borrowings.

For many years - Mortgages were divided into two basic types - Government Guaranteed and regular Mortgages. Government Guaranteed further consisted of FHA and VA loans. FHA or Federal Housing Administration loans were generally made to first time buyers or lower income buyers, while VA or Veterans Administration loans were made to families who qualified as the result of military service. Both guaranteed loans programs provided for less than market rate loans - since they had little or know credit risk under the government guarantee.  During this simpler time, loans were generally for 20 year terms and later during the period, and as home prices were rising, 30 year terms.

Far more recently, and to accommodate both investors and borrowers, the variety of Mortgage loans types has significantly increased. Fixed rate, Variable rate, 15, 20, 30 year terms - 1 , 3 and 5 year adjustments, convertible, balloons - the offerings now are are designed to meet a wide variety of conditions and it is important that Mortgage lenders work with customers to help determine the appropriate variety for the consumer's.

As in the discussion in the last chapter on Consumer loans - all the criteria for loan approval appropriate for consumer loans - is a consideration for Mortgage loans. Considering the size of the typical Mortgage loan - the four "C"s are even more important. Further, in order for a Mortgage to be considered in the secondary market it must meet rather rigidly defined standards.

Commercial Lending - is significantly more complicated that either Consumer or Mortgage lending. The principal is similar and the 4 "C"s are still important, but the processes and the risk are considerable greater. Like the name implies, Commercial Lending is the process of making loans to Commercial enterprises or businesses. Businesses, of course, can vary from the smallest 'mom and pop' to General Motors or Microsoft, and everything in between. The purposes of a commercial loan can be as varied as the acquisition of property for a new plant or store, the building of that plant or store, working capital or even funds to purchase another business. Whatever a business needs money for - a bank will try to satisfy with a commercial loan. All forms of businesses have borrowing needs, sole proprietorships, partnerships, and corporations all have the need to borrow. Borrowing needs can be short term or long term. Lines of Credit - are often established to meet the short term needs of businesses. You might think of these as Credit Cards for business - but with limits into the millions of dollars. With the variety of businesses - and the tremendous variance in size - what a small business might borrow for, a larger business could pay for with current cash balances. However, most every business benefits from the ability to borrow to meet whatever opportunity that might be presented. The complexities of commercial loans has to do with a number of factors. First, the bank is not dealing with a person - but an entity. Depending on how long that entity has been in business, the bank will have more - or less - information on which to make a decision. Then, the bank must consider the purpose of the loan. Is this loan going to help the business be more successful - or will it be such a burden that it may not survive? Further, the bank must monitor the business to ensure that the loan it made is being used as promised and that the operation of that business is such that the bank can maintain an expectation of repayment. This monitoring is just as critical for a smaller loan to a small business - as it is to a large loan to a larger business. Even the use of collateral is different in a commercial loan. As in other loans, the security could be in buildings or land, but it could just as easily be in 'accounts receivable' or 'inventories' (either raw, in process, or finished). Again, the monitoring of the value of the bank's collateral is part of the complexity of Commercial Lending.

Chapter Notes:
 

Why make loans - because they have a higher return than investments - and because the bank's charter provides that they will meet the needs of the public they were organized to serve by providing basic banking services.

Loans - by their vary nature of complex. In the American economy, consumers have come to rely on the availability of loans to make purchases. The alternative - is to save until there is sufficient funds available to pay 'cash'. Can you imagine what differences there would be if ours was a cash society instead of a credit society.

Loans are granted on the 4 "C"s. - Capacity, Character, Capital and Collateral. A loan should NEVER be made on the basis of collateral alone since collateral can't make payments. In today's market place - many loans are approved based on the credit score. Financial institutions that make all their decision son the basis of the credit score alone - may miss many opportunities to make profitable loans - and help their customers in the process.

Indirect lending is a method of increasing lending volume without necessarily increasing supporting staff. The auto dealer approves the financing and then immediately sells the loan to a participating financial institution. Each bank involved with the dealership - has the opportunity to set minimum interest rates and credit standards for their institution and the dealer's "Finance" person is responsible for selling that loan to one of the banks. Often - financial institutions may end up with dealer 'paper' that they would not have approved on their own - as the result of arrangements with the dealership. Traditionally, Indirect lending loans have a high delinquency rate that bank originated loans.

In order to market deposit products, such as checking accounts, many banks now provide convenience products such as Overdraft Protection, Credit Reserve or other similarly named products designed to protect the customer from the expense and embarrassment of NSF checks. These are truly credit decisions and generally are based on the creditworthiness of the customer.

All banks must pay specific attention to the regulations they operate under. To not do so is extremely expensive in terms of both fines and civil remedies to the consumer/customer.

Any financial institution that makes  loans - will most likely have at least a few  bad loans.  That is, one that repayment is not as promised.  The magic for bank managers is to manage "Credit Risk" - not try to eliminate it. Even loans made to marginal credit worthy customers can be profitable if the loan is priced properly.

A "Mortgage" - by text definition is: "a legal document by which real property is pledged a security for the repayment of a loan." Most often, when we speak of a Mortgage we are speaking of the loan not the legal document. Certainly, a Mortgage is both the document and the Loan that exists as a result of that document.

Mortgage loans - are also first lien loans - contrasted to a Home Equity or Home Improvement loan which may be first liens but are more probably second lien loans. The use of 'first' or 'second' in reference to the lien refers to the precedence that the lender has in claims to title. Mortgage loans are also generally considered purchase loans - where a first lien Home Equity or Home Improvement loan has other implications.

Each of the varieties of types of home mortgages exist to meet a specific need, either of the borrower or the lender. ARM's exist to help lenders meet home buyer's needs - while maintaining an asset that is appropriate for a bank's asset/liability management program,. Consumers, generally would prefer fixed rate - fixed term loans, as there is certainty in knowing the interest rate - and generally the payments over the life of the loan. With ARM's since the rate is adjustable - the payment fluctuation could have a positive or negative impact on the customers cash flow during periods of rate fluctuation..

Spend enough time in the discussion of Mortgage qualifications to understand it. In its simplest terms, qualifying for a Mortgage is very similar to any other Consumer loan - again, except for the size of the loan. Based on the size and term of the loan - it is critical to loan underwriting that the clearest possible picture of the customer's ability and inclination to repay the loan are understood. Remember the 4 "C"s of lending, then remember this is a 30 year decision for as much as $250,000 or more. The text's example of qualifying is as clear as any - though it is still very confusing. For those that have had a Finance course - this becomes a bit clearer - in that all that is being done is to compare the applicants financial situation with others that have a predictability of success.

As with Consumer loans - beware of the Federal laws and regulations that are applicable to the Mortgage loan process. In addition to the Truth in Lending Act; Fair Credit Reporting Act etc. of the last chapter, Mortgages are also subject to the Fair Housing Act; the Home Mortgage Disclosure Act (Regulation "C"); and the Real Estate Settlement Procedures Act (Regulation "X"). Even though not mentioned in this chapter, Mortgage lending is also subject to the terms of the Community Reinvestment Act which requires financial institutions to meet the borrowing needs of their community.

The 'Secondary" mortgage market has had a significant of making funds available for long term home loans. With too many who remember the interest rate fluctuations of the 1980's - it is often difficult for a lender to willing agree to a 30 year fixed rate loan. The willingness of investors to assume that risk makes it a far more agreeable proposition for lenders - who only have to make and service the loan.

The 4 "C"s	The 4 "C"s apply to Commercial lending just as they do to Consumer and Mortgage loans. In Commercial lending, the first "C" or capacity cannot be established by review paychecks. Instead, an analysis of the customer's financial statements is necessary to show the capacity to repay the loan.
	The second "C" or Character - is also a very necessary item. This is determined by how the business has paid back other borrowings - either to that bank or another - even as to how well it pays dividends to stockholders.
	The next "C" or Capital - is a determination of the businesses' net worth. Again,this is done by a review of the financial statements. As with capacity, the review of the financial statements is dependent on to some extent on the accuracy of those statements. Since there are substantial sums involved, most often the bank will want to review only 'audited' financial statements prepared and verified by an independent Certified Professional Accounting (CPA) firm.
	The final "C" or collateral - is again very important. As discussed above, the collateral for a commercial loan could be 'accounts receivable', inventories, land, building(s) or even All the assets of the business.
The loan approval process, decision making, and closing the loan - are, of course far more complicated than personal loans - but again the process is somewhat similar. There is, however, a significant difference found in loan servicing. As a result of the very nature of a commercial loan - the repayment terms - and the collateral, loan servicing can be a very complicated process. Under the servicing process - it is necessary to maintain a continual review of the collateral and its underlying value, and that funds are either being advanced or repaid according to the loan agreement between the bank of the business.
Banks, like investors have to decide what market segment in which they want to specialize. The cost of making a $10,000 loan is not significantly different that making a $10,000,000 loan, with servicing costs perhaps being different. However, the cost to the bank of writing off a bad lending decision on a $10,000,000 IS significantly different that in writing off a bad decision on a $10,000 loan. As a result, each bank must decide, based in part on its size, what size loans and what market segments it will pursue. Occasionally, a business will present a lending opportunity to a bank that it considers a rare and fantastic investment - but because of the size of the borrowing - the bank cannot make the entire loan itself. In that case, the bank will work with other lenders - in a loan participation agreement - to make a single loan to a single borrower using funds from multiple banks.