Loan Pricing = Costs + (Profit Margin + Risk)

During my initial training as a loan officer I was joined by a young recruit that had the knack for asking great fundamental questions. In my field, familiarity with the world of finance and economics is usually not required as employers expect new hires to pick up the basics along the way, and often, passionate officers end up becoming quite knowledgeable.

My fellow trainee knew all about our employer’s pricing matrix, credit scores and what proportion of assets/cost could qualify you for each set of terms on our hard money loans. However, he did not have a clue on what was driving the actual pricing. In effect, he was completely oblivious to his employer’s business model!!!… until he asked - but unfortunately… He asked me.

Crap! How do I get into this without boring the guy with a primer on risk free rates, the capital asset pricing model and managerial economics? Or even worse! What if I just couldn’t simply explain it? How does that reflect on me?! So, I gave it a shot… I wrote on the black board the following equation:

Loan Pricing = Costs + Profit Margin + Risk

The terms that you get are based on mixture of the variables above and each variable is affected by other external factors that, depending on whether you can manage them, become the basis for risk management.

Cost: This covers the general cost of underwriting, processing and overhead involved with the loan. It includes, among many other things, our salaries, attorneys, paperwork, accountants, back office staff, electricity, fees and the coffee that keeps us sharp while prospecting. Most of this amount is captured by points we charge upfront.

Profit Margin: Defined as the revenue from sales exceeding costs. A minimum return expected by investors to go through the trouble of lending us a dollar. Moreover, investors want to make sure that we, as a bank, are effective enough to convert sales into dividends and this is evidenced by our profit margin.

Depending on competition and business strategy, most lenders adjust their margins based on the market segment they want to target, thus maximizing margins in several ways:

a) Cutting cost and becoming a price leader – these shops aim for volume of submissions instead of dollar quantity and quality. They are often troubled with poor customer service and turnaround times. Typical customer only seeks to engage them on average once every 7 years.

b) Offering excellent customer service and attracting quality repeat business with large sums of money. This segment is willing to pay a premium for ease and speed in order to take advantage of opportunistic investments.

c) Lowering customer rating standards (Underwriting criteria) and charging higher interest and points to make up for the default probability of the market segment.

Risk: “No risk, no reward”, right? Not so fast... The lender wants to maximize its profit margin but at the same time look for ways to mitigate the added risk while making an acceptable return. Risk is based on the probability of default of the borrower and the loss given default. To determine the riskiness of a borrower the lender has outsourced this labor to the “Big Three” credit reporting agencies (CRAs). Lenders have found that their scoring system (FICO) has a high degree of predictability on a borrower’s capacity and willingness to repay. This is why pricing matrices exist. If you are within a certain range, then you get a certain rate. Lenders will often stall borrowers and ask them to pay off some of their debt to get them over pricing thresholds (e.g. rates for consumers between 620 – 649 are radically different to borrowers with 650 – 680).

Additionally, lenders mitigate risk by asking the borrower to maintain liquid reserves (e.g. cash in checking or savings) as a percentage of total costs of a deal “just to show”. This is not an expense, it does not come out of their pockets. Having the reserves just serves as reassurance to the lender that the borrower has access to funds. Furthermore, they’ll ask the client to “put some skin in the game” and demand a 5% - 15% down payment injecting equity to the deal and making it more painful for the borrower to behave irresponsibly.

In essence, we make money by balancing these three variables. It’s equilibrium level is always in flux and has to be recalculated diligently to meet demand and remain profitable regardless of competition, economic growth, interest rate volatility, unemployment level or housing availability.

I am aware this is all one huge oversimplification. Furthermore, omitting the rich history and theory of this topic might be even sacrilegious to most finance professionals. That being said, If my co-worker’s expectation was to become an expert in debt capital markets during our chat, then I failed him miserably. However, if I was able to keep him intrigued (and awake) … Modesty aside, I did OK.