Chapter 10

Question 1

*When is maturity gap usually negative and when is it positive?

Answer 1

Maturity gap is usually negative at the start of the schedule and becomes positive towards the end to eventually balance out

Question 2

If the schedule does NOT balance out at the end, what does this mean?

Answer 2

There is a liquidity problem

Question 3

How is maturity gap calculated?

Answer 3

Re-priceable assets - re-priceable liab

Question 4

What are the 4 types of loans?

Answer 4

1) Secured vs unsecured
2) syndicated loans
3) loan commitment
4) Real estate loans

Question 5

What is a secured loan?

Answer 5

A loan that has collateral
(ex: a house being the collateral to the mortgage loan)

Question 6

What is an unsecured loan?

Answer 6

Loan based off of character, reputation and history. The bank has access to the persons assets if they default

Question 7

What is syndicated loans?

Answer 7

It is a loan that is so big or so risky that the banks partner up to offer this loan. Depending how much each bank offers to the customer will depend on how much they get paid back (ex: bank gives $100 of $1000 loan then the ownership of that bank is only 10%)

Question 8

What is a loan commitment?

Answer 8

Total amount of a loan that was given on revolving credit

Question 9

What are the two types of real estate loans?

Answer 9

Fixed rate loans and variable rate loans

Question 10

When can mortgages be subject to default risk?

Answer 10

When the loan-to-value rises and the house prices fall below the amount of loan outstanding
(ex: $1,000,000 house with a mortgage of $800,000 but then the market corrects and the house is only worth $500,000. Therefore the mortgage is higher than the value of the house)

Question 11

What is commercial paper

Answer 11

It is similar to a t-bill but issued by businesses for short term borrowing (less than a year)

Question 12

What is home equity loans

Answer 12

Revolving type of credit given on the equity that builds on the house which is essentially a collateral line of credit

Question 13

What are the 3 types of consumer loans

Answer 13

1) personal loans
2) auto loans
3) credit card loans

Question 14

What are personal loans

Answer 14

Loans that carry a higher interest rate because the customer can do anything with the money

Question 15

In Canada, what is usury?

Answer 15

Charging a borrower more than 60% interest rate per year on any form of borrowing

Question 16

*How do mortgages work in Canada?

Answer 16

There is amortization and terms.
Amortization: the total length of time that it will take to pay off the mortgage
Term: smaller chunks of time that happen during the amortization and reflect how the amortization is broken up. These periods will reflect the same payments for the duration of that term

Question 17

What is default risk?

Answer 17

It is breaking one of the covenants/rules in the loan contract

Question 18

What are covenants?

Answer 18

Set of rules on the loan agreement that bind the customer to the agreement

Question 19

What kind of covenants/rules may be included in a loan contract

Answer 19

-Not making payments
-Making less payments
-Not showing your earnings to bank
-Etc

Question 20

How do you calculate the return (interest rate) on a CONSUMER loan

Answer 20

Consumer loan rate = Base rate + credit risk premium

Question 21

What is a base rate?

Answer 21

It is the prime rate or the lowest interest rate the bank will charge on the loan

Question 22

What is credit risk premium

Answer 22

It is a rate based on the persons credit rating, their character, what they want the loan for and so on

Question 23

Why may the return on a COMMERCIAL loan differ

Answer 23

Any fees relating to the loan
Interest rate on the loan
Risk premium on the loan
Collateral backing up the loan
Other non-price terms

Question 24

What are the 3 steps to calculating the expected return on a commercial loan?

Answer 24

1) calculate the loan rate
2) calculate the fee revenue
3) calculate the interest rate

Question 25

Calculate the expected return on the loan for the following example:

-Base lending rate: 10%
-Lender wants 1-year loan and has a profile requiring 10% risk premium
-Loan amount is $100,000
-Bank request is origination fee of 3%
-Bank requests a compensating balance of $10,000 in an account that pays 0%
-Bank sets aside reserves at a rate of 10% of deposits

Answer 25

Step 1: calculate the loan rate
= 10% base rate + 10% risk premium
= 20% * $100k borrowed
= $20,000

Step 2: calculate fee revenue
= loan value * origination fee
= $100,000 * 3%
= $3,000

Step 3: calculate return
= (step 1 + step 2) / (loan - retention)
= ($20,000 + $3,000) / ($100,000 - $9,000)
= $23,000 / $91,000
= 25.27%

Question 26

Why divide by $91,000 if the loan was $100k?

Answer 26

Because the bank takes out the 10% risk premium and then they can’t given out 10% of that risk premium since it is part of the reserve requirements and therefore add it back to the loan

$100k x 10% (risk premium) = $10k
$10K x 10% (reserve requirement) = $1k that gets added back to the loan

So in the end:
=$100k - 10K + 1K

Question 27

What is an origination fee?

Answer 27

It is a percentage of the loan charge that is required by the customer to pay as an “initiation fee” on the loan

Question 28

If you don’t get approved for the loan, do you pay for the origination fee?

Answer 28

No

Question 29

What is a compensating balance on a loan?

Answer 29

A set amount of money set aside on the loan (ex: 10% of total loan) that the bank takes and freezes it so in case of default, they have collateral

Question 30

What are front end fees

Answer 30

Fees charged as a percentage of the loan before the loan is given out (ex: origination fee)

Question 31

What are back end fees

Answer 31

Fees charged to unused portion of the loan that usually happen on commercial line of credits (ex: approved for loan of $100k but only use $70k, then there will be a % charge on the $30k not borrowed)

Question 32

Why do banks use back end fees

Answer 32

Since it is a risk for the bank and therefore want to be compensated for that risk

Question 33

What is credit rationing? How is it used?

Answer 33

The bank will use SICK codes to divide up the loans and place them into buckets by industry to see where most money is being borrowed. If the bank sees there is too much money tied up in certain industries then they will reduce giving out loans for that particular industry. The bank does this to diversify their risk

Question 34

What is implicit contract

Answer 34

The character of the borrower

Question 35

What is leverage

Answer 35

The amount of borrowing that the borrower already has associated to them

Question 36

What is the business cycle

Answer 36

When, depending on the economic state, the bank is more reluctant or less reluctant to give out loans
(ex: the bank won’t hand out as many loans if they see the economy is going to shit, which will also increase interest rate because of this risk)

Question 37

What is credit scoring models

Answer 37

Mathematical models scores the borrower to determine their probability of default and put the borrower into different classes

Question 38

What is linear discriminant models?

Answer 38

It is a model that helps determine a “z score” that gives the bank an indication at the probability of default risk

Question 39

Which is better: a high z score of a lower one? Why?

Answer 39

A higher z score since that means there is less chance of default

Question 40

What is the magical number in z score?

Answer 40

1.81
You want to have a higher Z score than 1.81

Question 41

What are some limitations to z scores

Answer 41

-Just says “default or no default” not the quality of the score and doesn’t put people in different buckets based on their industry
-Doesn’t look at the business cycle or where we are economically