Beruflich Dokumente
Kultur Dokumente
Banking
Version : 1.0
Date : 27-Jul-2004
Foundation Course in Banking
TABLE OF CONTENTS
Page 2 of 186
Foundation Course in Banking
Page 3 of 186
Foundation Course in Banking
Bancassurance.......................................................................................................161
Market Landscape...........................................................................................163
Key Players............................................................................................................163
Key Retail Banking corporations in the US.............................................................164
Mergers & Acquisitions in Retail Banking................................................................165
Appendix – A Consumer Credit Rating Agencies ......................................167
Appendix – B Mortgage Backed Securities.................................................168
Appendix – C Costs associated with Mortgages........................................172
Appendix – D Securitization of Auto Loans.................................................177
Appendix – E Securitization of Auto loan backed securities.....................179
Securitization of Auto Lease Backed Securities......................................................180
Appendix – F Differences between Leasing and Financing.......................182
Appendix – G Student-loan ABS Structure..................................................186
Page 4 of 186
Foundation Course in Banking
Retail banking can also be divided into various deposit products—including checking,
savings, and time-deposit accounts such as certificates of deposit—as well as various
asset-based products, such as auto lending, credit cards, mortgages, and home equity
loans. Big banks are likely to be in all of these businesses, and smaller ones mainly
focus on deposit gathering while offering mortgages and home equity loans.
Industry experts estimate that there are about $5 trillion in deposits in the U.S. market.
Since there is no credit risk associated with taking in deposits, banks need less capital to
run this business than, say, mortgage lending. The proper amount of capital required,
according to one of the estimates is about 1%, which translates to about $50 billion for
the industry. The return on this relatively small investment, meanwhile, is 35% to 50%, or
a minimum of $18 billion for the industry, making it a very profitable business.
In contrast, the total outstanding balances in the credit card industry amount to about $1
trillion. Since this business is riskier, it requires more capital to run, and the resulting
profits are about $12 billion to $13 billion for the industry.
While investment banking and commercial lending are related to high value deals, retail
banking is less glamorous and is associated with low value transactions - the sums of
money involved in any one transaction are likely to be in the hundreds—not tens of
thousands, or millions—of dollars.
For years, retail banking has been viewed as a commodity business. Interest rates paid
on deposits often differ so little from bank to bank that they are almost meaningless to
consumers. Also, aside from signage, most bank branches tended to look alike, with
their teller windows on one-side and platform desks on the other.
Page 5 of 186
Foundation Course in Banking
In the past couple of years, however, bank managers have been opening their eyes to
greater possibilities in retail banking. A few factors have played into this new attitude.
One is the huge hit to investment banking and trading that many banks took at the end
of the dot-com boom. New York-based J.P. Morgan Chase & Co. is a prime example of
an institution trying to decrease its reliance on investment and trading income by
expanding into retail banking. Towards this, it also acquired Chicago-based Bank One
Corp., a retail banking stalwart in the Midwest in 2004.
Page 6 of 186
Foundation Course in Banking
Aside from checking accounts, banks offer loans, certificates of deposits and money
market accounts, not to mention traditional savings accounts. Some also allow people to
set up individual retirement accounts (IRAs) and other retirement or education savings
accounts. There are, of course, other types of accounts being offered at banks across
the country, but these are the most common ones.
Savings accounts - The most common type of account, usually require either a low
minimum balance or have no minimum balance requirement, and allow people to keep
their money in a safe place while it earns a small amount of interest each month. In
standard practice, there are no restrictions on when the money can be withdrawn.
Certificates of deposit - These are accounts that allow depositors to put in a specific
amount of money for a specific period of time. In exchange for a higher interest rate, the
depositor forgoes the option of withdrawing the money for the duration of the fixed time
period. The interest rate changes based on the length of time the depositor decides to
leave the money in the account. One cannot write checks on certificates of deposit. This
arrangement not only gives the bank money they can use for other purposes, but it also
lets them know exactly how long they can use that money.
Page 7 of 186
Foundation Course in Banking
Apart from the various schemes like these to raise money, banks provide various kinds
of credit products to the individuals. Credit products include loans for house financing,
auto purchases as well as credit cards.
The key types of credit cards include Bank cards, which are issued by banks (for
example, Visa, MasterCard and Discover Card). These can either be debit or credit
cards. In a credit card, the user has a limit up to which she can make purchases (or
borrow) and the bank charges an interest on the used up sum. A debit card is used for
making payments against existing balance in the users checking account.
There are also the “Travel and entertainment (T&E) cards”, such as those issued by
American Express and Diners Club.
Loans – one of the key retail products from banks are loans made to the individuals.
There are for various purposes including mortgages for real estate activity, auto finance
for purchase of cars and automobiles, student loans to meet education expenses, and
agricultural loans. Each of these loans are for a specific requirement and their
repayment terms and criteria to provide the loans vary accordingly.
Mortgages – Mortgages are loans given to individuals for the purchase, construction, or
repair real estate property. Typically, the property is used up as an collateral.
Auto Loans – These are loans given to individuals for the purchase of cars or
automobiles. They are given against the security of the vehicle or in some cases with the
homes as a security.
Student Loans – These are loans provided to students who are pursuing undergraduate
or graduate courses. A majority of them are made available at subsidized interest rates
due to the insurance provided by the US Government to the lending banks.
Agricultural Loans – Agricultural Loans are the loans granted to finance the agricultural
industry. These are loans given to individuals towards acquisition of work animals, farm
equipment and machinery, farm inputs (i.e., seeds, fertilizer, feeds), poultry, livestock
and similar items. It also includes construction and/or acquisition of facilities for
production, processing, storage and marketing; and efficient and effective merchandising
of agricultural commodities.
Fee based Services – Banks also provide various fee based services to the customers.
These usually involve managing the payments that need to be made or to be collected.
They also provide advisory services to help consumers manage their investments and
meet the investment goals. Although most of these services are related to Payments
they can broadly be categorized under the broad headings of Collections Services,
Payment Services, Investment Advisory Services, and Fund Transfer Services.
Page 8 of 186
Foundation Course in Banking
Page 9 of 186
Foundation Course in Banking
BANK ACCOUNTS
It is possible to manage money using just cash, but putting money in a bank account can
have several advantages as described below
• A bank account enables one to access her money quickly and easily, such as by
writing checks and by withdrawing money from an ATM
• A bank is the safest place to put money, because funds in U.S. bank accounts
are insured against loss by the federal government for up to $100,000 per
depositor
• Some accounts pay interest on the money deposited in them even though the
interest rates may be low
• Most of these bank accounts are "free" accounts if the customer maintains a
substantial balance
Where to Bank
Credit unions, savings and loans, mutual funds, and brokerages offer checking and
savings services similar to what banks offer. Before we discuss banks in more detail,
here is a brief discussion of these other options:
Credit Unions
Credit unions are non-profit, member-owned, financial cooperatives. They are operated
entirely by and for their members. When a customer deposits money in a credit union,
she becomes a member of the union because her deposit is considered partial
ownership to the credit union. To join a credit union, a customer ordinarily must belong
to a participating organization, such as a college alumni association or labor union.
While the accounts are similar to bank accounts, the names are different: share draft
accounts (like checking accounts), share accounts (like savings accounts), and share
certificate accounts (like certificate of deposit accounts). For nearly all credit unions, the
National Credit Union Share Insurance Fund insures most of the deposits up to
$100,000. Interest rates tend to be higher and fees tend to be lower than at commercial
banks, because they exist to serve their member-owners rather than to maximize profits.
On the downside, credit unions usually have very few branch offices and ATMs.
However, to compensate for this, in most states credit unions have formed surcharge-
free ATM networks among themselves.
Page 10 of 186
Foundation Course in Banking
Brokerage
Another substitute for a bank account is a cash-management account at a brokerage. A
customer will earn money-market rates, which will usually be significantly higher than the
interest the bank would pay. The fees will generally be less than what the bank would
charge, and the fees might be waived entirely if the customer has a substantial portfolio
at the brokerage. If the customer overdraws her account, the interest rate will be lower
than what the bank would charge, and in addition it's usually tax-deductible because it's
considered margin interest. The customer will be able to perform all the basic banking
functions, such as check writing and using a Visa debit card at any ATM. However, there
are a few downsides. Very few brokerages have ATM networks, so when the customer
uses an ATM she will be charged by that ATM's owner and possibly also by the
brokerage's bank partner (if the brokerage itself isn't a bank). Also, as with credit unions,
brokerages lack some of the bells and whistles that commercial banks offer. Some
brokerages don't allow the customer to drop by a branch to deposit checks, some don't
offer automatic bill paying, and some don't accept checks written to the customer from
someone else.
Mutual Fund
A final banking alternative is a money market account at a mutual fund company. They
offer basic features such as check writing, but lack a lot of the other services banks offer.
The rates tend to be significantly higher than those offered by banks. However, the
accounts aren't FDIC insured against losses.
Banks
Although banks offer a wide variety of accounts, they can be broadly divided into the
following categories:
• Savings accounts
• Checking accounts
• Money market deposit accounts, and
• Certificates of deposit accounts
All these type of accounts are insured by the FDIC (in most cases, up to $100,000 per
account).
TYPE OF ACCOUNTS
In this Section we list down the common types of accounts offered by Commercial Banks
followed by a brief description of each type of account:
Page 11 of 186
Foundation Course in Banking
Savings Accounts
The most common type of bank account, and probably the first account a person ever
has, is a savings account. These are intended to provide an incentive for the customer to
save money. These accounts usually require either a low minimum balance or may
require no minimum balance at all. This depends on the bank and the type of account.
Savings accounts allow the customer to keep her money in a safe place while it earns a
small amount of interest each month. They usually pay an interest rate that's higher than
a checking account, but lower than a money market account or a CD (Certificate of
Deposit). The accountholder can make deposits and withdrawals, but usually can't write
checks. Some savings accounts have a passbook, in which transactions are logged in a
small booklet that the customer keeps, while others have a monthly or quarterly
statement detailing the transactions. Some savings accounts charge a fee if the
customer’s balance falls below a specified minimum.
Besides the fact that the customer will be less likely to spend it, putting her money in a
savings account is safer because it is insured (up to $100,000) through the Federal
Deposit Insurance Corporation (FDIC). This means that even if the bank or credit union
goes out of business (which is very rare!) the customer’s money will still be there. The
FDIC is an independent agency of the federal government that was created in 1933
because thousands of banks had failed in the 1920s and early 1930s. Not a single
person has lost money in a bank or credit union that was insured by the FDIC since it
was constituted.
Interest on savings accounts is usually compounded daily and paid monthly. Sometimes,
but not always, banks charge fees for having a savings account. The fee may be low --
like a dollar a month -- or it may be higher or it could even be based on the customer’s
balance. Some of the characteristics of a savings account include:
• Fees and services charges on the account
• Minimum balance requirements (Some banks charge a fee only if the customer
doesn't keep a certain amount of money in her account at all times.)
• Interest rate paid on the balance
Each month, the bank (or credit union) sends the customer a statement of her account
either in the mail or by e-mail depending on her preferences. The statement will list all
the transactions as well as any fees charged to the account and interest that the money
deposited in the account has earned.
Checking Accounts
A checking account is the primary reason why many people use a bank. Probably no
other account offered has as many variables as a checking account.
With a checking account the customer can use checks to withdraw her money from the
account. She may use checks to pay bills, purchase products and services (at
businesses that accept personal checks), send money to friends and family, and many
other common uses. The customer can also use checks to transfer money into accounts
at other financial institutions. The customer has quick, convenient, and, if needed,
frequent-access to her money. Typically, the customer can make deposits into the
account as often as she may choose. Many institutions enable the customer to withdraw
Page 12 of 186
Foundation Course in Banking
or deposit funds at an automated teller machine (ATM) or to pay for purchases at stores
with her ATM card.
Some checking accounts pay interest; others do not. A regular checking account -
frequently called a demand deposit account - does not pay interest, whereas a
negotiable order of withdrawal (NOW) account does.
Institutions may impose fees on checking accounts, besides a charge for the checks the
customer orders. Fees vary among institutions. Some institutions charge a maintenance
or flat monthly fee regardless of the balance in the account. Other institutions charge a
monthly fee if the minimum balance in the account drops below a certain amount any
day during the month or if the average balance for the month drops below the specified
amount. Some charge a fee for every transaction, such as for each check the customer
writes or for each withdrawal made at an ATM. Many institutions impose a combination
of these fees.
Although a checking account that pays interest may appear more attractive than one that
does not, often checking accounts that pay interest charge higher fees than do regular
checking accounts.
Page 13 of 186
Foundation Course in Banking
Express -- Designed for people who prefer to bank by ATM, telephone or personal
computer, this account usually boasts unlimited check writing, low minimum balance
requirements, and low or no monthly fees. The catch? The customer pays fees for using
a teller. These accounts are especially popular with students and younger customers
who are on the go and don't want to spend a lot of time on banking transactions.
Lifeline -- These "no-frills" accounts for low-income consumers are typically products
with monthly fees ranging from zero to $6; require a low, if any, minimum deposit and
balance; and allot a certain number of checks per month. Many banks, thrifts and credit
unions offer such accounts. Lifeline accounts are required by law in Illinois,
Massachusetts, Minnesota, New Jersey, New York, Rhode Island and Vermont. In those
states, minimum terms, fees and conditions are set by law, not by individual banks.
Page 14 of 186
Foundation Course in Banking
Federal Deposit Insurance Corporation (FDIC) insures the money in a money market
account.
Interest on money market accounts is usually compounded daily and paid monthly.
Interest rates paid by money market accounts can vary quite a bit from bank to bank.
That's because some banks are trying harder to get people to open an account with
them than others -- so they offer higher rates. Another difference that is sometimes
found with money market accounts is that the more money a customer has in the
account the higher the interest rate she gets.
Like a basic savings account, money market accounts let the customer withdraw her
money whenever required. However, the customer usually is limited to a certain number
of withdrawals each month. Banks will usually charge a fee (typically around $5) if the
customer doesn’t maintain a certain balance in her money market account. There may
also be a fee (typically around $5-10) for every withdrawal in excess of the maximum
(usually six) the bank allows each month.
Page 15 of 186
Foundation Course in Banking
PRODUCT DIFFERENTIATORS
A list of features and services associated with a bank account are provided below:
Features
Interest Rate: If the account pays interest, what is the rate currently? Usually Banks
signify this in terms of "Annual Percentage Yield", which makes it easier to compare
banks that compound their interest at different frequencies.
Convenience: How close is the nearest branch? How long are the lines when you go?
Is the bank open when you need them, or do they open late and close early as many
banks do?
FDIC membership: Is the Bank a member of the Federal Deposit Insurance
Corporation? If so, all deposits will be insured up to $100,000.
Size: Is the bank large or small? Some people feel more comfortable with a larger bank,
while others believe small banks can offer better customer service.
Minimum deposit: What is the minimum deposit required to open an account (if any)?
Limitations: Are there any limitations imposed on the account? (For example, the
number of checks or transactions per month)
Availability of Funds: How soon after you make a deposit are you able to withdraw
against those funds? Different banks have different rules.
Services
• Direct deposit
• ATMs
• Banking by telephone
• Online banking
• Credit cards
• Debit cards
• Overdraft protection
• Canceled checks
• Loans and mortgages
• Stock and mutual fund trading
• Retirement planning services
• Small business services
Page 16 of 186
Foundation Course in Banking
Fees
Banking fees have risen significantly in recent years. The average price of maintaining a
bank checking account is currently about $200 a year. Here are the most common fees
that are charged for maintaining & running a Bank account.
Maintenance fees: Banks charge a small fee for providing the customer with their
service. The fee for a checking account might be waived, if the customer uses direct
deposit for her paychecks, if she is a shareholder of the bank or if she limits her bank
branch visits and/or transactions.
Low-balance penalty: Most big banks offer "free" checking if the customer maintains a
substantial balance, typically $2,000 to $4,000. There is a low-balance penalty in case
the the balance goes below the required amount. The calculation could be based on the
average daily balance, the lowest balance in the month, or the balance on a certain day
of the month, so that she can work the system to her advantage. Sometimes, if the
customer buys CDs from the bank (which yield higher rates than the checking account
does), the bank might include that amount in its minimum balance requirement.
ATM surcharges, "Foreign" ATM fees: Many of the Banks charge the customer for
ATM usage. Also, the customer can use ATMs of other banks at an additional fee from
the Bank that owns the ATM.
Returned check: Banks charge a penalty to customers who deposit bad checks.
Page 17 of 186
Foundation Course in Banking
Bounced check: Banks charge an insufficient funds fee (NSF) if the customer doesn’t
have enough funds in her account to cover the checks she has written. To help
customers avoid this fee, banks also provide overdraft protection (described below).
Overdraft Protection: Banks can provide overdraft protection to a customer’s account.
This is done by charging a high rate of interest on the overdrawn money. This is
beneficial to the customers in the cases of a check bounce as well as in cases when the
account balance goes below zero or the low-balance limit.
Check printing: Some banks offer free checks for first-time customer, customer with a
large minimum balance, senior citizens, students, and certain others. Other Banks
charge for providing check leaves.
Per-check charges: Some accounts include a certain number of checks per month and
charge extra for more.
Cancelled check return fees: If the bank doesn't include cancelled checks along with
the monthly statement, they may charge a fee for any cancelled checks a customer
requests.
Closed account: Some banks charge a fee if the customer closes an account that
hasn't been open for a sufficiently long time (such as one year).
ACCOUNT PROCESSING
S te p 1 Cu stom e r co m e s to B ra nch Re p
Cu stom e r
S TART fo r a /c O pe n ing
S e nd Inform a tio n to
Bra nch Fra u d De te ction (S S N, Colle ct Che ck
Ce ntra l Re po sito ry
Addre ss V e rifica tion ) O rde r De ta ils
EN D
Page 18 of 186
Ex te rna l
S yste m s S S N a nd Addre ss Che ck Orde ring
V e rifica tion S yste m S yste m
Foundation Course in Banking
Account Management
Page 19 of 186
Foundation Course in Banking
Transaction Pro
Customer
Page 20 of 186
Foundation Course in Banking
financial institutions process checks, they encode the amount of the check in magnetic
ink at the bottom of the check.
Check Clearing
Check Clearing refers to the movement of a check from the depository institution at
which it was deposited back to the institution on which it was written and the
corresponding movement of funds in the opposite direction.
Banks in large cities often form associations called clearinghouses for exchanging
checks drawn against the members. A clearinghouse may have fewer than a dozen
members, but these banks are usually the largest in the area. Clearinghouse members
group the checks of other member banks, exchange them at a specified time each day,
and settle accounts with each other. Clearinghouses can often collect and process
locally drawn checks faster and more efficiently than do intermediary services, such as
correspondent banks and the Federal Reserve’s check collection network.
Financial institutions clear and settle checks in different ways depending on whether the
checks are “on-us” checks (checks deposited at the same institution on which they are
drawn) or interbank checks (the payer and payee have accounts at different financial
institutions). On-us checks do not require interbank clearing or settlement. Interbank
checks can clear and settle through direct presentment, a correspondent bank, a
clearinghouse, or other intermediaries such as the Federal Reserve Banks.
Financial institutions can also clear checks through a Federal Reserve Bank or an
independent clearinghouse, where they have formed voluntary associations that
establish an exchange for checks drawn on those financial institutions. Typically,
financial institutions participating in check clearinghouses use the Federal Reserve’s
National Settlement Service to effect settlement for checks exchanged each business
day. There are approximately 150 check clearinghouse associations in the United
States. Smaller depository institutions typically use the check collection services of
correspondent banks or the Federal Reserve Banks.
The following diagram depicts the typical interbank check clearing and settlement
process through a Federal Reserve Bank or clearinghouse. The solid lines depict the
flow of information and the dashed lines represent the flow of funds.
In step 1 the consumer uses a check to pay a merchant for goods or services. The
merchant, after authorizing the check, accepts the check for payment. At the end of the
day, the merchant accumulates the checks and deposits them with its financial institution
for collection (steps 2 and 3). Depending on the location of the paying institution, the
funds may not be immediately available. For deposited checks payable at other financial
institutions, the merchant’s financial institution uses direct presentment for processing or
sends the checks to a Federal Reserve Bank, clearinghouse, or correspondent bank
(steps 4 and 6). The check or an electronic presentment file is sent to the consumer’s
financial institution, and the financial institution’s account at the correspondent,
clearinghouse, or Federal Reserve Bank is debited (steps 5 and 7).
Page 21 of 186
Foundation Course in Banking
Correspondent Banks
Most banks maintain accounts at other banks for the purpose of collecting checks. A
correspondent bank accepts checks from the bank with which it has a relationship and
processes those checks the same way it processes those for its depositors. It credits the
depositing bank’s account and forwards the checks to the bank on which they were
drawn.
Page 22 of 186
Foundation Course in Banking
checks are returned or “bounced” each year, according to the Federal Reserve. This is
0.6 percent of total check volume. The average value per returned check is $701.
A check may be returned for a number of reasons.
• Insufficient funds in the check writer’s account;
• An improper endorsement or date;
• An error in the magnetic ink code imprinted on the check when the check was
first deposited;
• An alteration in the handwritten information on the check that is not initialed by
the check writer;
• A stop-payment order issued on the check;
• A hold placed on the check writer’s account.
If a bank refuses to honor a check, the check must be returned to the bank where the
check was first deposited within a certain period specified by law.
Page 23 of 186
Foundation Course in Banking
A check writer may request a stop payment in person, by telephone, or in writing. Many
banks require written confirmation of a telephone request. The order should specify the
check number and the exact dollar amount. Banks usually charge a fee, which varies
from bank to bank, for this service.
Electronic Checks
An electronic check is a transaction that starts at the cash register with a paper check for
payment, but the payment is converted to an electronic debit, which is processed via the
ACH network. Thousands of retailers are offering this service, and hundreds of
thousands of checks are being converted everyday from paper checks to electronic
checks.
This new electronic check conversion service offers retailers, financial institutions and
consumers an efficient new method to handle payments at the point of purchase. The
consumer still hands a check to the retailer – but the retailer hands the check back after
capturing payment information, obtaining authorization from the customer and stamping
the check VOID. Then the payment flows through the national automated clearing
house network (ACH) to the check writer’s account.
Specifically, here’s how an electronic check payment flows:
• The customer hands the retailer the check intended to pay for the purchase.
Currently, only checks drawn on consumer accounts can be converted.
• The retailer determines that the check is eligible for conversion and then runs the
check through a magnetic ink character recognition (MICR) reader.
Page 24 of 186
Foundation Course in Banking
• MICR encoded information, the routing number, account number and check
serial number, is captured by the MICR reader. In addition, the retailer keys in
the payment amount and the name of the retailer is either keyed in or added by
the reader.
• The retailer may choose to run the payment information, including the retailer’s
name, through an internal or external database to authorize, verify or guarantee
the payment, to determine if the routing number can be used for ACH payments,
or to determine if the customer’s address is on file.
• After the customer information is recorded and if used, approval by the database
is obtained, the terminal prepares a written authorization, which is then signed by
the customer. The authorization must contain specific information specified in
the NACHA Operating Rules, which are the rules under which the ACH Network
operates.
• The retailer or its processor formats the payment information as an ACH debit
entry.
• The payment is included in a batch of ACH entries transmitted to the retailer’s
bank. The bank transmits the batch of payments to the ACH Network, which
routes each payment to the bank on which the converted check is drawn.
Page 25 of 186
Foundation Course in Banking
Page 26 of 186
Foundation Course in Banking
• The paying bank posts the check (debit) to the customer’s account, and the
customer receives information about the payment on their statement.
ACH
Stat Network
Consumer Receives
Check Information Consumer’s (Paying) Bank
on Statement (RDFI) Posts ACH Entry to
Consumer’s Account
The Electronic check service has several benefits both for the consumer writing it
and for the financial institution processing it. Some of the major benefits are
• It results in faster and less paper-intensive collection of funds.
• It helps to improve efficiency in the deposit process for retailers and their
financial institutions.
• It stems the growth of paper check processing.
• It benefits consumers by speeding checkout, providing more information about
the transaction on their account statement, and removing the consumer from any
negative file much quicker
• It enhances collection of checks that bounce for NSF or uncollected funds
because collection can be started more quickly than with paper checks.
Page 27 of 186
Foundation Course in Banking
Page 28 of 186
Foundation Course in Banking
CREDIT CARDS
Credit Cards have become one of the most ubiquitous things in today’s world and the
preferred mode of payment for all kinds of transactions. As a substitute to money; credit
cards offer to the user a huge amount of flexibility, ease of handling and an option to buy
things from the convenience of your residence. To the various other participants like the
issuers, acquirer’s etc. credit cards have become one of the biggest items of revenue
and profitability. At the risk of overemphasizing the obvious, suffice it to say that credit
cards have now become as integral a part of our everyday existence as money and the
importance is increasing everyday.
Page 29 of 186
Foundation Course in Banking
Page 30 of 186
Foundation Course in Banking
Application Processing
Application Processing verifies the information provided in the Credit Card application,
determines the credit worthiness of the applicant using credit scoring methods and
Credit Bureau reports, approves the card and sets up the account for the customer.
Transaction Processing
The cardholder makes a purchase and pays for it using the credit card. The merchant
sends the credit card transaction to the acquirer, who passes the financial transaction
information to the issuer. The issuer posts the information to the cardholder's account.
The issuer will pay the merchant for the cardholder's purchase. The issuer will settle the
financial transaction by electronically purchasing the cardholder's charges from the
merchant, the acquirer or their banks. The issuer periodically sends a statement to the
cardholder asking for payment of full or partial balance. The cardholder repays the loan
along with any interest or fees assessed.
Page 31 of 186
Foundation Course in Banking
Settlement – Settlement is the second phase of the credit card monetary cycle. It is the
process adopted between the merchant and the credit card company. The card issuer
reimburses the money to the merchant for the merchandise supplied/shipped to the
cardholder.
Core data processing – To collect the amount due from the cardholder, the credit card
company has to keep track of the cardholder's transaction, balance and credit limit. It
has to keep a log of all the monetary activities of the cardholder. In the case of partial
payment or non-payment, the cardholder will be charged an interest on the accumulated
balance. This is where credit card companies derive their major source of income. When
a cardholder makes huge purchases and pays over a period of time, the interest on her
balance increases proportionately. This process of core data processing is mostly
handled by independent organizations such as First Data Resources (FDR). Every
issuing bank prepares files, which contains all monetary, non-monetary transactions on
each business day.
Collections & Recovery – Collections & Recovery helps collectors to obtain payments
on cardholder accounts and fraud accounts. They help the credit grantors in controlling
their bad-debt portfolios and increase recoveries.
Page 32 of 186
Foundation Course in Banking
Page 33 of 186
Foundation Course in Banking
LOANS OVERVIEW
Banks traditionally raise funds from communities through deposits and savings accounts
and make revenues by lending it to people to buy homes & cars, to put children through
education, as well as to start and expand businesses.
These loans generally take care of immediate cash requirements for an interest charge;
the repayment is usually in the form of periodic (Monthly, Quarterly etc.) payments.
Some of the classifications for loans can be made based on term, amount or usage of
collateral.
• Long term or Short-term credit: ‘Term’ refers to the duration of time within which the
loan needs to be repaid. Long-term credit refers to loans like mortgages, auto loans
etc. which typically have longer repayment periods. Examples of short-term credit
include credit cards and working capital loans.
• Open ended or Close ended loans: Close ended loans are when the amount of loan
and the term are decided and fixed, as against open ended loans wherein the
borrower takes as much loan as required against an upper limit on the amount. In
this case, interest is charged on the outstanding balance. Examples for open ended
Page 34 of 186
Foundation Course in Banking
loans are credit cards and home equity line of credit7, while examples for close
ended loans are auto loans and mortgages.
• Secured or Unsecured debt: A secured loan is the case in which the repayment of
the loan is "secured" by a specific property (also called collateral). The lender can
acquire this property in case the borrower fails to repay the loan.
There are many type of loans designed to meet specific requirements of people and
businesses. The leading loans made to consumer in terms of number and volumes are
mortgages, auto loans, credit card debt and student loans.
• Working capital lines of credit for the ongoing cash needs of the operations
• Corporate Credit cards: higher-interest, unsecured revolving credit
• Short-term commercial loans: with a term of one to three years
• Longer-term commercial loans: term greater than three years, generally secured by
real estate or other major assets
• Equipment leasing: when businesses want assets that they don't want to buy outright
• Letters of credit: for businesses engaged in international trade
KEY PLAYERS
Key players in Loans process include the Borrower, Broker, Lender, Credit Rating
agency, Insurance agency, Securitiser, Government entities and the investor.
Player Function
Borrower Borrower is the entity that requests and obtains a loan; this
could either be an individual or a corporate.
7
Home Equity Lines of Credit (HELOC): HELOC refers to the loans provided with home as the
collateral. This is different from mortgage loans, which are for the purpose of purchase or
construction of a home. The borrower is allowed to borrow amounts as per requirement (against a
limit) and the interest is usually charged on the daily balance.
Page 35 of 186
Foundation Course in Banking
Insurance Agencies Insurance Agencies are risk intermediaries who reduce the
risk for the lenders by providing insurance. These include
collateral insurance, default insurance, and title insurance.
Investors Investors are FI’s who provide capital (funds) to the lenders.
Investors provide capital by purchasing whole loans or
securities backed by loans in the secondary market.
Page 36 of 186
Lenders Foundation Course in Guarantee
Banking
Underwriting
s
Borrowers Process
Pre-qualification
Brokers
Credit
Bureau
Services
Loan
Loan Closed
Approved
Appraisa
l
Services
Sale in In
secondary Lenders’
market portfolio
• After the underwriting process, the interest rate and other terms are
negotiated between the borrower and the lender, necessary paperwork executed
and the amount granted to the borrower. This process is called ‘closing’ of the loan.
• Once the loan is closed, it can be either retained in the lender’s portfolio, in
which case the lender continues to ‘own’ the loan. Alternately, certain types of loans
Page 37 of 186
Foundation Course in Banking
are put for sale in secondary market. In this case, the loans are sold to another entity
so that the lender has money to make more loans.
Page 38 of 186
Foundation Course in Banking
MORTGAGES
Mortgages are loans given to consumers for the purpose of purchase, construction or
repair of real estate.
Mortgages were started in the 1930s by insurance companies in the US, primarily with
the hope of gaining ownership of properties if the borrower failed to make the payments
on it. It wasn't until 1934 that mortgages, in their current form, came into being. The
Federal Housing Administration (FHA) played a critical role in this process. In order to
help pull the country out of its economic depression, the FHA initiated a new type of
mortgage aimed at the folks who couldn't get qualify for mortgages under the existing
programs.
At that time, only four in 10 households owned homes, against the current
homeownership levels of close to 70%. Mortgage loan terms were limited to 50 percent
of the property's market value, and the repayment schedule was spread over three to
five years and ended with a single lump sum payment that clears the total outstanding.
Total
mortgages $5,201.1 $5,712.5 $6,316.6 $6,890.3 $7,600.8 $8,486.0
Page 39 of 186
Foundation Course in Banking
Multifamily
residential 300.1 331.5 369.1 405.0 453.3 498.4
MORTGAGE PRODUCTS
There are many types of mortgages in the market. These are designed to suit various
requirements of the borrowers including the length of mortgage, capability for initial
payment, the other financial obligations.
Mortgages can be broadly classified into Conventional and Government Insured Loans.
Conventional Loans can be further classified into conforming and non-conforming loans.
Mortgages
Conventional
Government
Non-Conforming Conforming
VA FHA RHS
Page 40 of 186
Foundation Course in Banking
Urban Development, the Veterans Administration (VA), and the Rural Housing Service
(RHS), which is a branch of the U.S. Department of Agriculture. These agencies do not
typically originate loans (except for low income and other specific borrowers) directly but
guarantee/insure loans originated by others provided they meet their underwriting
norms.
• The FHA loans offer a mortgage-financing program that insures home loans.
The financial requirements for FHA loans are relaxed compared to traditional
commercial loans. So an individual with an adverse credit limit who is not eligible
for a prime mortgage could be eligible for a FHA loan. Also, the interest rates
charged on a FHA loan are lower than those for conventional loans. However the
FHA loan requires an upfront mortgage insurance payment to be paid, thus
leading to higher closing costs. Also, there are limits on FHA loan amount that
vary based on the state & county and these limits are lower than those for
conventional loans. Based on their requirements, individuals would need to
decide between going for a FHA loan (lower interest rates, lower down payment)
or a sub prime loan (lower closing costs, higher loan limits).
o FHA requirements reduce the debt-to-income ratio from 28/36 to 29/418.
o FHA loans also require a low down payment of 5 percent or less
• VA loans are designed for qualified veterans and offer more relaxed standards
for qualification than either FHA loans or traditional loans. For example in 2002,
loans can be for amounts up to $240,000 and require no down payment.
• RHS offers both guaranteed loans through approved lenders and direct loans
that are government funded. These are offered to low-income families, living in
rural areas or small towns for purchase, construction or repairing homes.
Conventional Loans - A conventional loan is one that is not insured by the Federal
Housing Administration (FHA) or guaranteed by the Veterans Administration (VA). These
are further classified into conforming and non-conforming loans.
• Conforming loans comply with the loan size limitations, amortization periods,
and underwriting guidelines set by Freddie Mac and Fannie Mae in secondary
market. Conforming loans may be sold to the Freddie Mac or Fannie Mae
(Government-sponsored enterprises or GSEs), which, in turn, securitize,
package, and sell these loans to investors in the secondary market.
8
28/36 refers to total monthly mortgage payment being less than 28% of monthly income AND
total monthly debt payment less than 36% of monthly income.
Page 41 of 186
Foundation Course in Banking
Conventional
75%
VA
3% FHA Jum bo
14% 8%
•
Non-conforming loans (like “Jumbo Loans”) are not eligible for purchase by a GSE,
but can be sold in the secondary market as whole loans, or can be pooled,
securitized, and sold as private-label mortgage-backed securities. Non-
conforming loans comprise Jumbo loans, subprime loans and “Alt” A loans.
• Jumbo loans are the loans in which the loan amount is above the limit set by
Freddie Mac & Fannie Mae. This limit changes annually based on the single-
family home price survey done by the Federal Housing Finance Board. For
example in 2002, a conforming loan limit was $300,700. Loans that are above
that limit are called Jumbo loans. Jumbo loans have interest rates higher by
about 0.25 percent to 0.50 percent than the conventional loans.
• Subprime loans are loans given to borrowers with poor credit history whose
credit characteristics do not meet the requirements of Fannie Mae & Freddie
Mac. These loans typically have higher down payment and higher interest rates.
• "Alt” A mortgage loan is provided to borrowers who have good job stability, good
income, but their credit scores don't fit the "A Credit" guidelines. This could either
be due to a short credit history or due to a slight derogatory hit on the credit
scores such as a 30-day late payment.
Page 42 of 186
Foundation Course in Banking
Fixed-Rate Mortgage (FRM) - This mortgage comes with an interest rate that will never
change over the entire life of the loan irrespective of changes in the market rates and
economic trends. So, a mortgage with a rate of 7 percent that calculates a payment of
$1,247 per month for a 20-year term would imply a monthly payment of $1,247 during
the entire duration. However, there could be a change in the property tax and any
insurance payments included in the monthly payment. The term of the fixed rate
mortgage is usually 15, 20 or 30 years.
In a FRM, the lender requires a premium for the commitment to keep interest rates
fixed over the term of the loan. Longer the term of the loan, greater the premium. In
an ARM, since the borrower takes the risk of fluctuating interest rates, the lender
usually charges an initial rate, lower than the initial rate of an FRM of the same
tenure. Such a rate is called the teaser rate of the ARM.
The major advantage of ARMS is that if interest rates decline and the borrower
does not qualify for a refinance, an ARM will automatically adjust itself to a lower
rate. The disadvantage could be in the rare case when interest rates decline too
sharply, so as to fall below the limit set by the ARM cap (the lifetime cap or the
periodic cap or both). In that case, the ARM interest rate stays above the interest
rate of the FRM. The reverse holds good for rising interest rates, where the rates
may rise beyond the lifetime cap of the ARM, making the ARM rates lower than
those of comparable FRMs.
All Conventional and Government loans (with the exception of VA loans) are available as
ARMs.
Page 43 of 186
Foundation Course in Banking
Hybrid Loans - Hybrid loans combine features of a fixed rate mortgage (FRM) and an
adjustable rate mortgage (ARM). The hybrid loan’s interest rate and monthly payments
are fixed over a specified period of time beyond which the loan will convert into and stay
as an ARM for the remainder of the loan term. The initial rate may be fixed for 3, 5 7 or
even 10 years beyond which the ARM takes over. The ARM adjusts every 6 to 12
months. The longer the initial rate stays fixed, the higher will be the rate but the initial
rate of a Hybrid loan is usually lower than that of a 30 year FRM. The initial interest rate
will be higher than an ARM since the rate remains fixed for much longer than that of a
normal ARM. A normal ARM would offer a fixed rate for say 6 to 12 months.
The 7/23 loans may also be considered a form of Hybrid loans. These loans remain fixed
for the first 7 years, then adjust once and remain at that rate for the remaining 23 years.
Balloon Mortgage - A balloon mortgage offers an initial fixed interest rate for five to
seven years and then requires a "balloon" payment. The balloon payment is the final
payment of the loan and pays off the entire balance.
Graduated Payment Mortgages (GPMs) - A GPM would have a fixed interest rate with
monthly payments that gradually increase by predetermined amounts during the early
years of the loan and then level off, say after 5 years. A GPM would be useful for
borrowers who expect their incomes to increase significantly over a period of time.
However, GPMs carry the risk of having the loan principal to actually increase during the
early years when payments are low and inadequate to meet the entire interest payment.
Reverse Mortgages - Reverse mortgages pay money to the borrower as long as the
borrower lives in her/her home. These loans are designed for people aged 62 and above
who own their homes and need an inflow of cash. The loan is against the equity of home
and isn't paid off until the borrower sells or moves out of the home.
The payment can be a single lump sum, regular monthly payments, or a as a "creditline"
account that lets the borrower decide when and how much of the available cash is paid.
Against this, the lender gets an equivalent amount of ‘equity’ in the home, which they
can claim once the home is liquidated after the borrower does or moves away. All types
of Conventional and Government loans (except VA loans) are available with ARM
options.
80-10-10 Financing
When the mortgage amount is more than 80 percent of the purchase price of the home,
lenders require the borrowers to take insurance on the extra amount. It is called PMI
(Private Mortgage Insurance) and the borrower pays for the premium. The cost varies
but it can be equivalent of an additional 1/2 to 1 percent of the loan amount per year.
Furthermore, this cost is not tax-deductible. With 80-10-10 financing, the borrowers
Page 44 of 186
Foundation Course in Banking
make cash down payment of 10 percent of the purchase price. They take out two
mortgages: a new first mortgage for 80 percent of the price and 10 percent second
mortgage. Often the first and second mortgages are from the same lender.
The interest rate on the second mortgage will be about 2 percent higher than the going
rate on first mortgages. This allows the borrowers to save money spent on the PMI.
Bridge Loans - Borrowers who plan to take a new home before selling their current one
can go in for a bridge loan to span the gap between the two transactions.
Bridge loans can either be structured to completely pay off the old home's mortgage or
to add the financial obligation of the new home to the existing mortgage. Typically, the
loan is structured with a short term (often one year) and hefty prepaid interest (perhaps
six month's worth).
Most often, a bridge loan is used to pay off the existing mortgage, with the remainder
(minus closing costs and prepaid interest) going toward the down payment on the new
home. If after six months the old home has not sold, the borrower begins making
interest-only payments on the loan. When the home sells, the bridge loan is paid off. If it
sells within the first six months, any unearned interest payments will be credited to you.
Definition
Concept
Interest This determines the amount of interest paid on the mortgage loan. The
Rate interest rates for loans of different terms are discussed in Appendix C.
Closing These are the costs, which are incurred by the borrower in order to
costs obtain the mortgage. These may include points, taxes, settlement
agent fees and more. The various costs that are a part of closing costs
are discussed in Appendix C.
Down The down payment is the contribution of the borrower towards the
payment home purchase or construction and is to be paid initially while taking
the loan. The down payment can be anywhere from three to twenty
percent of the home's value.
Down payments can be lower for some special, first-time buyer loans,
Page 45 of 186
Foundation Course in Banking
and veterans or those on active military service can obtain loans with
no down payment at all.
Amortization A mortgage payment has two parts (if we exclude insurance and
taxes), the interest and the principal. The sum of these two make the
EMI. A mortgage payment received is first applied to the interest and
then to the principal. This causes the principal balance outstanding to
decrease. For the next installment, the interest portion of the payment
decreases since interest is always computed on the principal balance
outstanding and the principal balance outstanding decreases with each
Page 46 of 186
Foundation Course in Banking
Prepayment Prepayment penalty is the charge or a fee for paying all or part of the
penalty loan before payment is due. These are usually expressed as a percent
of the outstanding balance at time of prepayment, or a specified
number of months of interest.
Foreclosure Foreclosure is the process by which the lender takes possession of the
borrower’s home and sells it in order to get its money back in case of
payment defaults. The other options available for borrowers in case of
default include:
• Special forbearance – This is the process by which the
borrower can set up another repayment plan with the lender to
fit their current financial situation. Sometimes, if the borrower
has recently lost a job or another source of income, the lender
might be willing to temporarily reduce or suspend the payments.
• Mortgage modification – The borrower might have the option
of refinancing the amount owed or extend the term of the loan.
• Partial claim – In some cases where the borrowers meet
special qualification criteria, HUD could provide an interest free
loan in order to close on the default.
• Pre-foreclosure sale – The borrower can sell the property in
order to pay off the mortgage if the appraised value of the
property is at least 70 percent of the amount owed. There are
certain requirements for this including the fact that the sale
price has to be at least 95 percent of the appraised value.
• Deed-in-lieu of foreclosure - As foreclosure damages the
borrower’s credit record, the borrowers may be able to "give"
the property to the lender in order to avoid the credit problems
associated with regular foreclosure. Here again, there are
requirements that the borrower must meet in order to qualify for
this option.
Mortgage If the interest rates go down after the borrower has taken a mortgage,
Refinance they can go in for a refinancing option. The borrower can use
refinancing to reduce the interest rate on their mortgage, leading either
Page 47 of 186
Foundation Course in Banking
MORTGAGE MARKET
There are various players who participate in the functioning of the mortgage banking.
The two obvious players are the borrower and lender. Traditionally lenders have
managed all the required functions of prospecting a customer, providing the loan,
servicing the loan, and managing the risk by themselves. However, as the market
matured, the functions of origination, servicing, risk management and funding are
unbundled and managed by different specialized entities.
Risk
Risk
Intermediaries
Intermediaries
Borrower
Borrower Originator
Originator Servicer
Servicer Investor
Investor
Settlement
Settlement
Providers
Providers
Originators perform the role of accessing the prospect’s credit worthiness and deciding
on the best product to suit their needs and ability to pay. These are the entities that
actually provide the mortgage loans. The borrower can directly contact an originator or
go through an intermediary like a broker or a correspondent lender.
Risk intermediaries provide insurance to make the loan process more viable. There are
private insurance entities that provide Private Mortgage Insurance (PMI), Flood
Insurance, Title Insurance, Hazard Insurance, etc. Some example include,
• Private Mortgage Insurance (PMI) is provided in cases where the borrower makes a
low down payment. In this case, the norm of 80% for the Loan to Value (LTV) ratio is
exceeded. The insurance is provided for the amount over and above the value that
meets the LTV ratio of 80%.
• Flood Insurance is provided to protect against losses due to floods.
• FHA, VA, and RHS are the government-backed agencies that provide insurance in
mortgages.
Settlement Services Providers provide various services required for underwriting and
closing a loan. These services include Credit Reporting 9, Property Appraisal, and Loan
Closing.
Loan Servicing firms provide the servicing of a loan – collecting the monthly payments,
reporting to the investors, and handling the cases of delinquency. Some of the mortgage
origination firms outsource the servicing function to focus on origination. Also, some
firms purchase pools of loan after origination and manage the servicing function.
Secondary Market
As noted earlier, banks raise deposits and use the money to provide loans & mortgages.
So the ability of a bank to provide loans is limited by the extent to which it can raise
deposits. This on an aggregate scale also limits the total demand the mortgage market
can manage.
In order to increase this limit, the concept of secondary market was introduced. In the
secondary market, investors looking for investment avenues purchase loans from the
lenders. This provides lenders with additional cash to make more mortgages.
9
Refer to Appendix A on Credit Rating Agencies
Page 49 of 186
Foundation Course in Banking
Once the lender originates a mortgage loan, they may either retain the loan in their
portfolio or sell it in the secondary market. In secondary market, they can sell whole
loans or package it with other loans and exchange for Mortgage Backed Securities 10
(MBS).
The loans are ‘pooled’ into groups with similar characteristics – could be region,
seasoning (time elapsed since the loan started), credit rating of the borrowers etc. These
loan pools are used as collateral against which securities are issued. These securities
(MBS) provide an ownership in the underlying pool of loans.
There are various types of MBS that are available in the market for investors.
There also other more evolved form of MBS including Collateralized Mortgage Obligation
(CMO), Z-bonds, PAC bonds, Reverse floaters etc. Details on these can be found in
Appendix – B.
10
Security: A security is an instrument with a financial value. Securities are by definition tradable
and can be bought or sold in an exchange.
11
Yield: Yield is the return on any investment, calculated as the amount of interest paid divided by
the price. This is usually expressed as an Annual Percentage Rate.
Page 50 of 186
Foundation Course in Banking
(Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). Some
private institutions also package loans and issue securities. These securities are known
as “private label” mortgage securities.
Key players
The key players in the secondary market are Fannie Mae, Freddie Mac, and Ginnie
Mae.
The Federal National Mortgage Association (FNMA or Fannie Mae) has its genesis
in the Reconstruction Finance Corporation (RFC), which was created in 1935. In 1938 a
wholly owned subsidiary, the National Mortgage Association of Washington was formed,
which was soon renamed the FNMA. This was the first federal attempt to establish and
assist a national mortgage market. From its beginning until 1970, Fannie Mae only
purchased FHA/VA mortgages. In 1970, Congress, in the same bill, which created the
Federal Home Loan Mortgage Corporation, authorized Fannie Mae to purchase certain
other mortgages. These “conventional” mortgages now represent the bulk of the loans
purchased by Fannie Mae.
Page 51 of 186
Foundation Course in Banking
The Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac) supports
conventional mortgage lending by purchasing and securitizing Mortgage Banking loans.
It was created to provide secondary market facilities for members of the Federal Home
Loan Bank System, but its charter was later modified to include all mortgage lenders.
Freddie Mac was the first issuer of mortgage backed securities based on conventional
mortgages in 1971 when it sold participation certificates backed by mortgages
purchased from savings and loan associations. Freddie Mac performs the following
functions:
Page 52 of 186
Foundation Course in Banking
The Government National Mortgage Association (GNMA or Ginnie Mae) Ginnie Mae
came into being in 1968, when Congress enacted legislation to partition Fannie Mae into
two separate corporations: a residual Fannie Mae and the new Ginnie Mae. After that
partition, Ginnie Mae offered the special assistance and loan liquidation functions
formerly provided by Fannie Mae, as well as a mortgage-backed securities program.
Ginnie Mae is located in the Department of Housing and Urban Development (HUD).
Since GNMA is only in the fee business of providing guaranteed MBS in exchange for
mortgage loans and due to its focus on only FHA/VA and other government guaranteed
loans, it is the smallest of the three entities.
Page 53 of 186
Foundation Course in Banking
MORTGAGE PROCESSES
Mortgage banking involves four major areas of activities: Loan Production, Pipeline and
Warehouse management, Secondary marketing, and Servicing.
Secondar
Pipeline
y Servicin
Loan Manageme g
Marketin
Production nt
g
Loan Production
Mortgage loan production consists of origination, processing, underwriting, and closing.
Page 54 of 186
Foundation Course in Banking
• Wholesale sources for loans include loans purchased from bank correspondents12 or
other third-party sellers. These mortgages close in the third party’s name and are
subsequently sold to the bank. The wholesale production of mortgage loans allows
banks to expand volume without increasing related fixed costs.
The Underwriting Process is used to decide on going ahead with mortgage as well as
the acceptable terms to go ahead. Each lender has its own Underwriting process. Also,
to ensure loans made are eligible for sale to the secondary market, most lenders apply
underwriting and documentation standards that conform to those specified by the GSEs
or private label issuers.
After the underwriting unit approves a loan, the loan is properly closed and settled.
Closings may be performed by an internal loan-closing unit or by title companies or
attorneys acting as agents for the bank. The individual who performs the closing,
whether bank employee or agent, obtains all required documents before disbursing the
loan proceeds. Obtaining all front-end documents, (e.g., note, preliminary title insurance,
mortgage assignment(s), insurance/guaranty certificate), is the responsibility of the
closing function.
12
Correspondent lenders: These lenders provide the loan to the borrower and then sell the loan
soon afterwards (usually with 30 – 45 days).
Page 55 of 186
Foundation Course in Banking
HUD, Freddie Mac, Fannie Mae, Ginnie Mae, and most private investors require the
lender to have a quality control unit that independently assesses the quality of loans
originated or purchased. The quality control function tests a sample of closed loans to
verify that underwriting and closing procedures comply with laid down policies or
practices, government regulations, and the requirements of investors and private
mortgage insurers. The unit confirms property appraisal data and borrower employment
and income information. It also performs fraud prevention, detection, and investigation
functions. It also checks for compliance with various regulations.
Pipeline Management
When a consumer submits a loan application, a mortgage bank normally grants the
consumer the option of “locking in” the rate at which the loan will close in the future. The
lock-in period commonly runs for up to 60 days without a fee. If the consumer decides
not to lock-in at the current established rate, the loan is said to be “floating.”
Interest rate fluctuations affect mortgage pipeline activities. Changes in rates influence
the volume of loan applications that the bank closes, the value of the pipeline
commitments, and the value of commitments to sell mortgages in the secondary market.
Warehouse loans are closed mortgages awaiting sale to a secondary market investor.
Uncertainty regarding the delivery of a warehouse loan to an investor is limited to a
determination of whether the loan meets investor underwriting, documentation, and
operational guidelines. As a result, 100 percent of warehouse loans are normally sold
forward into the secondary market. A mortgage bank normally holds a loan in the
warehouse account for no more than 90 days.
Page 56 of 186
Foundation Course in Banking
Hedging the price risk associated with loans awaiting sale: The overall objective of this
function should be to manage the operation’s price risk and minimize market losses.
Secondary Marketing
A bank’s secondary marketing department, working with origination management, is
responsible for developing, pricing, selling, documenting, and delivering mortgage
products to investors. A bank must consistently demonstrate reliable performance in
underwriting, documenting, packaging, and delivering quality mortgage products to
remain in good standing with secondary market participants.
A bank can sell mortgages in the secondary market as an individual (whole) loan or as
part of a pool of loans. Banks that originate a substantial number of mortgage loans
normally pool them to sell because it produces a higher price and reduces transaction
costs.
Investors
Mortgage Secondary Market
Originators Conduits
• Pension Funds
• Commercial • Fannie Mae
• Insurance
Banks • Freddie Mac companies
• Thrifts • Ginnie Mae • Commercial Banks
• Mortgage • Private Investment • Thrifts
brokers Conduits
• Fannie Mae
Investor
Sell loans
Sell whole
Originate loans to
loans investors
Secondary
Swap loans for Market
pass-throughs Conduit
Pool loans into
Sell MBS to
Mortgage
Investors
Hold in Backed
portfolio Securities
Page 57 of 186
Foundation Course in Banking
Loans also may be “swapped” for pass-through certificates issued by investors. In this
transaction, the bank gives up a portion of the interest income on the loan (generally
0.25 percent) in return for a more liquid asset and more favorable risk-based capital
treatment. The bank retains servicing of the loans, which back the certificate.
To fulfill its delivery responsibilities, the banks obtain all mortgage documents for its
investors. Front-end documents are obtained before, or at, closing. Post-closing
documents such as mortgages, assignments, and title policies must be recorded by local
authorities or issued by the title company. Post-closing documents may normally be
received up to 120 days after closing.
Servicing
Servicing revenue is a primary source of income for many banks engaged in mortgage
banking. To be successful, the servicer must comply with investor requirements and
applicable laws, have strong internal controls, and manage costs. Loan servicing
involves several areas of responsibility:
• Cash management
• Investor accounting and reporting
• Document custodianship
• Escrow account administration
• Collection
• Other real estate owned (OREO)
• Loan setup and payoff
• Customer service
Page 58 of 186
Foundation Course in Banking
Page 59 of 186
Insuranc Foundation Course in Banking
e & Tax
Mortgag payment
e s Investor
Investor Investor
paymen
Cash
Cash Escrow
Escrow Accountin s
ts Accountin
Managem
Managem Administra
Administra gg
ent
ent tion
tion &&
Delinquen
Delinquen OREO
OREO Reporting
Reporting
cy
cy (Real
(Real
Managem
Managem Estate
Estate
ent
ent
((Collectio
Collectio liquidatio
liquidatio
ns))
ns n)
n)
Document
Document
Quality Control
Quality Control
Customer Service
Customer Service
• Servicers process borrowers’ loan payments and remit principal and interest to
investors according to the specifications.
• Servicing adjustable-rate mortgage loans requires ensuring that the interest rate
adjustments are properly performed and documented, and that customers are
notified in accordance with investor guidelines.
• A servicer’s investor reporting responsibilities involve preparing monthly reports to
investors on principal and interest collections, delinquency rates, foreclosure actions,
Page 60 of 186
Foundation Course in Banking
Other real estate owned (OREO) administration consists of managing and disposing of
foreclosed properties.
Loan setup and payoff consists of inputting information into the automated servicing
system and processing loan payoffs.
• The loan setup involves inputting information regarding the borrower, the type of loan
and repayment terms, and the investor into the servicing system.
• The function also involves sending a letter to the borrower introducing the company’s
services and includes the first payment coupon.
• Loan payoff involves the functions to be carried out once a loan is completely repaid,
including recording the mortgage satisfaction and returning the original note to the
borrower.
Other servicing arrangements that are important to mortgage servicing include data
processing systems and outside vendors and subservicers.
Page 61 of 186
Foundation Course in Banking
A servicer may employ outside vendors and subservicers to perform various servicing
tasks such as making real estate tax and insurance payments, performing lock-box13
services, conducting property inspections, and performing custodial duties for loan
documents.
13
Lock-box services involve collecting all the payment checks mailed to a particular mailbox
address and depositing them into an account.
Page 62 of 186
Foundation Course in Banking
Fair Lending
These regulations prohibit discrimination in lending and other services on basis of age/
location/ color/ religion etc and provide for
The key laws that form a part of the Fair Lending Regulations are:
Equal Credit Opportunity Act (ECRA): This Act prohibits discrimination with respect to
any aspect of a credit transaction on the basis of race, color, religion, national origin,
sex, marital status, age etc. Hence the mortgage origination firms need to record data on
all applications processed so that this can be verified.
Fair Housing Act: This Act makes it unlawful for any lender to discriminate in its
“residential real estate-related” activities against any person because of race, color,
religion, sex, handicap, familial status, or national origin.
Home Mortgage Disclosure Act (HMDA): HMDA is a disclosure law to provide the
public with information that will help show whether financial institutions are serving the
housing credit needs of the neighborhoods and communities in which they are located.
Mortgage firms need to collect and disclose data on applicant and borrower
Page 63 of 186
Foundation Course in Banking
characteristics so that disparate lending patterns can be identified and reviewed for
compliance with HMDA goals.
Fair Credit Reporting Act (FCRA): FCRA indicates that consumer reporting agencies
generating and transmitting customer data need to have permissible reasons for
generating or using the data. Since Mortgage origination firms typically are users of this
data and they need to follow guidelines on when they can ask for customer data. These
organizations also need to maintain data justifying the use of customer data & also
consent from the customer to obtain this data (credit reports etc.).
Truth In Lending Act (TILA): TILA ensures that credit terms are disclosed in a
meaningful way so that consumers can compare credit terms more knowledgeably. This
serves to protect consumers against inaccurate and unfair credit billing practices. TILA
provides tolerance limit for errors in calculating annual percentage rates or charges as
well as guidelines for making disclosures on various transactions (high value, low value,
variable rate, fixed rate mortgages).
Restitution: Financial institutions that violate certain provisions of the TILA law might be
required to reimburse borrowers for faulty disclosures. This could be for
understatements of the annual percentage rate (APR) or finance charge disclosures
resulting from a clear and consistent pattern or practice of disclosure errors, a gross
negligence or a willful violation of the Act.
OTS Mortgage Regulations: These provide that sufficient disclosures regarding the
interest rate and the adjustments (in case of ARMs) need to be provided before the
processing fee is paid for a mortgage. The information to be disclosed includes the fact
that the interest rate may change, the index or formula for these adjustments, and the
breakup of interest rate & principal. This is applicable only to Thrifts14.
Real Estate Settlement Procedures Act (RESPA): RESPA requires lenders, mortgage
brokers, or servicers of home loans to provide borrowers with pertinent and timely
disclosures regarding the nature and costs of the real estate settlement process.
signed on or after July 29, 1999, that require the automatic termination of PMI after the
borrower reaches 22% equity in the home, based on the original property value.
Apart from terminating PMI, it also established disclosure and notification requirements,
and requires the return of unearned premiums.
Consumer Leasing Act (CLA): CLA assures that meaningful and accurate disclosure of
lease terms is provided to consumers before entering into a contract. This enables
consumers to easily compare one lease with another, as well as compare the cost of
leasing with the cost of buying on credit or the opportunity cost of paying cash.
Electronic Fund Transfer Act: EFTA framework establishing the rights, liabilities and
responsibilities of consumers who use electronic fund transfer (EFT) services and
financial institutions that offer these services.
Flood Disaster Protection Act: FDPA requires federal financial regulatory agencies to
adopt regulations prohibiting their regulated lending institutions from making, increasing,
extending or renewing a loan secured by improved real estate or a mobile home located
or to be located in a SFHA (Special Flood Hazard Areas) in a community participating in
the NFIP unless the property securing the loan is covered by flood insurance.
Fair Debt Collection Practices Act: This is designed to eliminate abusive, deceptive
and unfair debt collection practices for a consumer loan taken for personal, family or
household purposes.
Page 65 of 186
Foundation Course in Banking
Due to the interest rate cuts in 2000 and later, there has been a boom in mortgage
refinances, which accounted for most of mortgage originations in till end 2003.
There has been a consolidation of mortgage firms with multiple mergers and
acquisitions. The top 10 originators accounted for 61% of originations in 2001 as against
21% of originations in 1990.
Along with the consolidation, there has been an unbundling of Mortgage activities with
vertical disintegration into Originating firms, Servicing firms, and Investors. There also
has been consolidation in the servicing space wherein the market share of the top ten
firms rose from over 11 percent in 1990 to over 49 percent in 2002, while the market
share of the top 25 firms rose from 17 percent to nearly 62 percent during the same
period. The scale economies achieved through automation of servicing operations have
allowed the most efficient lenders to increase the size of their servicing portfolios.
There has also been an increase in the securitization of loans in the market providing
greater liquidity to the lenders. This has also led to a increase in the market size for
mortgages.
Increased regulations including TILA, RESPA etc. governing the mortgage processes
are causing additional load to the processes.
Page 66 of 186
Foundation Course in Banking
• Document Management Systems (Imaging & workflow software) for closing &
loan documentation
All the above are not available in a single system and most of these are off the shelf
products.
Loan Servicing Software provides the functionality required for servicing the loan. The
functionalities supported include
• Payment processing
• Escrow administration
• Accounting
• Status reporting
• Delinquency & collection
The processes for servicing are backend, standardized and rigid. Hence the applications
generally used are home grown systems giving almost all the above features.
Secondary Sales Systems are used in the sales of mortgage loans in the secondary
market. The functionality supported includes:
Page 67 of 186
Foundation Course in Banking
• Internet as the sourcing channel: Increasingly more and more mortgages are being
originated on the Internet. The players include full service providers like Countrywide,
WaMu, JPMC, IndyMac, as well as referral sites like lendingtree.com and
MortgageIT.com
• End to end automation: There are initiatives aimed at standardization of the common
business transactions in the mortgage industry. The initiatives by MISMO (Mortgage
Industry Standards Maintenance Organization) aim to provide a XML based
architecture for mortgage origination, servicing and secondary market transactions.
Page 68 of 186
Foundation Course in Banking
There are two financing options that the buyer can use Detroit, MI 6.55%
Dallas, TX 6.21%
Direct Lending
San Francisco, CA 6.68%
In direct lending loans are furnished directly from the
financing company. Buyer contacts the finance Rates apply to a $15,000 fixed-
company either through their website or otherwise for rate loan made to good credit
the disbursement of the loan. Buyer uses the loan quality borrowers.
proceeds from the financing company to pay the
dealership for the vehicle. Increasingly consumers are
using the Internet to arrange for vehicle loans.
Dealer Financing
This is the most common type of financing option used. In this case, the buyer and a
dealer enter into a contract wherein the dealer finances the automobile to the buyer. The
dealership may retain the contract, but usually sells it to an assignee (such as a bank,
finance company or credit union), which services the account and collects the payments.
The other option commonly used by buyers is leasing. Apart from this, hire purchase and
refinancing are also used to a smaller extent.
Car Leasing
This is the option wherein the borrower pays monthly payments towards using the
automobile for the term of the lease. At the end of the lease the lessee returns the
vehicle to the leasing company such that it meets the agreed standards on wear and
tear.
The options available with car leasing are similar to the ones available with financing.
However, the monthly payments associated with a lease are normally lower than for a
purchase. This is because the borrower only pays for the depreciation on the car. At the
Page 69 of 186
Foundation Course in Banking
end of the lease term, the lessee needs to turn in the car or purchase the car at the
agreed price.
Hire Purchase agreement is simply a contract where the 'owner' of the automobile
allows the 'hirer' the right to possess and use the automobile in return for regular
payments. When the final payment is made, the title to the car is transferred to the
borrower.
Using this kind of loan, a buyer cannot buy any kind of a car. Many car models are
excluded. Generally the most popular, high demand vehicles and new models are not
included. In most cases, vehicles must be taken from dealer stock, limiting the choice of
vehicle options. The length of loan term also affects the rate offered. Most interest-free
financing offers require short terms of 24 to 36 months. This results in significantly higher
monthly payments.
Virtual Check
Some banks also provide the option of getting a blanket loan for the purchase of a
specific automobile. This is known as virtual draft or a virtual check and can be used like
a check to procure a vehicle after negotiating with the dealer. This again can be
considered a kind of direct lending.
Auto Refinance
This is a loan that settles the borrower’s existing car loan. The auto refinancing process
is very similar to refinancing a mortgage. Normally, people refinance so that they can
receive loans at a reduced interest rate thereby reducing the total interest costs and the
monthly payments.. The new lender pays off borrower’s existing car loan and the title to
her automobile is turned over to the new lender. This is not used as often as in
mortgages as the value of the collateral – the car – decreases with time unlike the case
of a home and hence the interest rates on a loan for cars are higher than those for a new
car.
Page 70 of 186
Foundation Course in Banking
The term of new auto loans can be from 3 to 7 years while used car loans normally have
shorter terms depending on the type and age of the vehicle being purchased. Interest
rates charged for vehicle loans can vary based on the term, the lender and the credit
rating of the purchaser. Auto loans are available under both - fixed and variable interest
rates. Variable-rate auto loans aren't widely available, and where available are likely to
be based on the prime-lending rate.
Page 71 of 186
Foundation Course in Banking
Page 72 of 186
Foundation Course in Banking
Page 73 of 186
Foundation Course in Banking
Payoff methods. There are different formulas for calculating finance payoff amounts.
The payoff amount will depend on the method the lender uses to compute interest on the
loan. These methods include
Term 48 months
APR 9.00%
Page 74 of 186
Foundation Course in Banking
over the loan term. The Simple Interest method is usually the least expensive
way of computing the finance charge, and an early payoff will usually be less
expensive than under the other methods of computing interest. It is always less
than under the Rule of 78 method.
• Rule of 78 Method - For some loans, lenders "precompute" the interest. That is,
they compute the amount of interest that will accrue based on the entire loan
amount. That interest becomes part of the total amount owed. With this kind of
loan, the borrower is contractually obligated to repay the principal plus all the
precomputed interest. However, the borrower receives a rebate of the portion of
interest paid that is considered "unearned," or this unearned amount is deducted
when the payoff amount is calculated. Under this method, when the borrower
pays off the loan early, even if each payment is made on the due date or within
any grace period, she usually will pay more interest than under the other
methods described in this section. This "overpayment" results because the
lender earns the interest faster, so that less of each payment during the earlier
months of the loan reduces the principal balance. Therefore, the early payoff will
Rule of 78 Method
Example:
Term 48 months
APR 9.00%
Additional payments do not reduce the loan balance in the month paid. If an additional
$1,000 is paid at the end of the first month, it is treated as prepayment of the monthly
payments due at the end of months 2 and 3. If the remaining payments are made on time
or within the grace period, there is no savings of the full-term projected interest because
the amount of interest in each payment is precomputed. If the loan is prepaid after 24
payments, the balance will be $54.81 higher than it would be under the Constant Yield
(Actuarial) method. This method does not provide any benefits for prepayments.
Page 75 of 186
Foundation Course in Banking
be higher than under the other methods, assuming that all payments are made
on time.
Term 48 months
APR 9.00%
•
Daily Simple Interest method - The Daily Simple Interest method enables lenders
to accrue interest on loans daily by applying a periodic rate to the outstanding
balance. Under this method, the lender's calculations and the borrower’s paying
habits determine the amount of total interest due and the amount of the final
payment.
For example, if the borrower makes any periodic payment before its due date (for
example, on the 12th when the scheduled due date is the 15th) and then makes
each subsequent payment on the same date every month, she will pay less
interest and should get a rebate after her last payment. This advantage occurs
because the loan balance declines more rapidly and less interest accrues daily.
In contrast, if the payments are made after the scheduled due date (for example,
on the 18th of the month when the scheduled due date is the 15th), even if they
are made during a grace period, she'll end up paying more and will owe an
additional amount after the last scheduled payment. Depending on state law, the
borrower may or may not be subject to late charges for payments after any grace
period in addition to the interest that has accrued.
Page 76 of 186
Foundation Course in Banking
PLAYERS INVOLVED
Auto Dealers Dealers sell new and used cars and are most common
origination points for auto loans. Dealers provide buyers with
options from various lenders and insurance firms. In some
cases, they also provide financing.
Lenders Lenders provide the financing for the purchase of the vehicle.
They can be Banks, Credit Unions, Online Direct Lenders &
Auto Finance Companies. Lenders have different Financing
products to offer to customers & Auto dealers based on their
requirements. Lenders sometimes sell their loan portfolios to
other lenders for servicing. Their funding sources include debt
and sales of receivables in Securitizations.
Servicers Servicing is about managing the payments from the buyers and
providing reports to the investors. Servicers can also resell their
loans to other servicing agents.
Credit Rating Credit Rating Agencies help Lenders to decide the interest rate
Agencies on auto loans by providing them with a credit report on each
borrower.
KEY CONCEPTS
Concept Definition
M.S.R.P The total Manufacturer's Suggested Retail Price. This may not
include the accessories and other items that are added to a
typical car purchase such as security systems, Vehicle
Identification Number (VIN) etching, etc.
Page 77 of 186
Foundation Course in Banking
Factory invoice The invoice from the manufacturer to the dealer that is
supposed to be their purchase price. It is not the dealer’s actual
cost because of holdbacks, advertising fees, gasoline charges,
dealer discounts, rebates, and other such dealer incentives.
Prepayment Penalty A fee that some loans charge if the loan is paid off before the
end of the term.
Simple Interest Also known as "flat rate interest," simple interest is calculated
Loans only on the initial amount of the loan by multiplying the principal
balance by the rate of interest andthe term of the loan. This
number is then divided by the number of months of the loan for
the amount of interest to be paid each month.
Trade-in allowance The amount of money taken off the purchase price of the new
car in case the buyer does a trade-in of her old car.
Upside-down Loan An upside down loan is a situation wherein the amount owed by
the borrower is more than the value of the car. In this case,
selling off the vehicle cannot close the loan, as the money
realized on selling will not be sufficient to close the loan.
Credit Insurance Optional insurance that pays the scheduled unpaid balance if
the borrower dies or scheduled monthly payments if she
becomes disabled.
Guaranteed Auto Optional protection that pays the difference between the amount
Protection (GAP) owed on the vehicle and the amount received from the
insurance company if the vehicle is stolen or destroyed before
the repayment of the loan. This is necessary as the vehicle
depreciates very fast in the initial stages of a loan.
Page 78 of 186
Foundation Course in Banking
Loan Origination
The borrower goes to the lender directly (Direct Lending) or through a dealer (Indirect
Lending). The borrower decides on the automobile, she wants to purchase & asks dealer
about the loan options available. The dealer makes a commission on the loan (by
regulation the commission cannot be more than 3%).
The borrower fills a loan application and hands it to the dealer. The application typically
Credit
Indirec Burea
t u
Lendin Insuranc
Credi
g e
t
Agencie
Apprais s
Applicatio al
Collateral
n Agency
Appraisal
Lender
Notificatio
Direct n
Lendin
Loan
g
Approv
ed
Documen
t
Verificati
Sub Loan on
Prime Turndown
Lender
has information including the name, Social Security number, date of birth, current and
previous addresses and length of stay, current and previous employers and length of
employment, occupation, sources of income, total gross monthly income, and financial
information on existing credit accounts. Based on these and additional information like
loan amount required and down payment willing to be paid, a pre-qualification is done.
Some lenders also allow the borrower to have a co-signee in the loan. A co-signer
assumes equal responsibility for the contract, and the account history will be reflected on
the co-signer’s credit history as well.
Dealers typically sell the contract to a lender, such as a bank, finance company or credit
union. The dealership submits the credit application to one or more of these potential
lenders to determine their willingness to purchase the contract from the dealer.
Page 79 of 186
Foundation Course in Banking
The lender passes the loan application through its underwriting process. It contacts a
credit rating agency to check the creditworthiness of the borrower. Credit rating Agency
generates a credit report (containing the credit score) of the borrower based on her past
debt history. The level of sophistication ranges from simply using the generic credit
score or bankruptcy score on the credit bureau to implementing customized scorecards
that have been developed and tested with the lender’s own credit applications. Some of
the scorecards, called regional scorecards are also designed for particular markets.
Appraisal Service providers help in determining the value of the collateral in the loan, in
the case of a used car. For some cases a manual review is done. After the underwriting
process, the lender decides whether it is willing to buy the contract, notifies the
dealership of its decision and, if applicable, offers the dealership a wholesale rate at
which the assignee will buy the contract, often called the “buy rate.”
Dealers also route the borrowers application to different Insurance Agencies. To protect
their interest in the collateral, most automobile lenders require physical damage
insurance coverage equal to the loan amount, with the lender named as loss payee on
the policy.
Dealers collect all the necessary documents (salary slips, car insurance, residence
proofs etc.) form the borrower for all the verifications. After the underwriting process, the
interest rate and other terms are negotiated between the borrower and the lender
through the dealer, necessary paperwork executed and the amount granted to the
borrower. This process is called ‘closing’ of the loan.
In case the Loan is turned down (due to bad credit history), the lender might forward the
loan application to a sub-prime lender, for a fee (the sub-prime lender pays the fee).
Sub-prime lenders are financial institutions that give credit to borrowers with bad credit
history on a high interest rates.
Once the loan is closed, it can be either retained in the lender’s portfolio, in which case
the lender continues to ‘own’ the loan. Alternately, certain types of loans are put for sale
in secondary market. In this case, the loans are sold to another entity so that the lender
has money to make more loans.
Loan servicing
Lenders can service the loans themselves or sell them to a servicing firm. In cases
where third-party servicers are employed, the fee paid is traditionally a percentage fee
which ranges from 1% for prime quality pools to 3.5% for sub-prime pools. In certain
arrangements, the fee can also be charged on a monthly dollar-per-contract basis.
Typical servicing duties in car loans include the following
Page 80 of 186
Foundation Course in Banking
Managing security interest - Monitoring insurance coverage for lease vehicles. Some
companies have systems to track continuance of coverage and notify borrowers of any
lapses. Many lenders also have backup insurance in case the obligors’ insurance
policies lapse. Some lenders pay for or require the borrower to pay for vendor single
interest (VSI) coverage at time of financing. This protects the lender for the outstanding
loan amount in case of a skip, or if the car is repossessed and there is uninsured
damage to the vehicle. Other lenders will self-insure (through special-loss reserves), or
will force-place insurance. Many companies, however, have moved away from force-
placing insurance due to recent lawsuits over the excessive premiums that were
charged.
Delinquencies and losses are especially acute in the sub-prime segment. Sub-prime
companies generally call delinquent obligors within the first 10 days of delinquency, with
some companies calling as early as the first day.
Page 81 of 186
Foundation Course in Banking
the vehicle or damage it. Most auto finance companies auction repossessed vehicles to
used-car dealers, some remarket the vehicles on either their own used car lots or on the
lots of unaffiliated dealerships. The major benefit of this method is in higher recovery
proceeds. This results from selling vehicles to the end user at retail prices, versus selling
them to other dealers at auction prices.
Lenders might also use a backup servicer in case of sub-prime loans. There could be an
active backup servicer that can serve as an independent reviewer of monthly servicing
reports and adherence to performance criteria. The backup servicer could also step in as
a successive servicer in case there are performance issues with primary servicer.
Secondary marketing
Auto loans Asset Backed Securities (ABS) are securities whose underlying securities are
Auto loans. However, auto leases, agricultural machinery loans, and car dealer floor-
plan securitizations are also often included under the umbrella of Auto ABS.
With close to $190 billion outstanding at the end of 2001, auto ABS makes up the
second largest non-residential ABS sector. The primary players in the origination of
these securities are
•
The captive finance firms – This market is dominated by wings of the big three
automakers GM, Ford, & DiamlerChrysler
• Commercial banks
Auto loan lenders create a pool of loans and sell it to a bankruptcy-remote special
purpose subsidiary. This subsidiary then establishes a separate Special Purpose Entity
(SPE), usually a trust, and transfers the receivables to the SPE in exchange for the
Page 82 of 186
Foundation Course in Banking
proceeds from securities issued by the SPE. The SPEs are used as bankruptcy-remote
vehicles that hold collateral on behalf of investors and administer the distribution of cash
flows. This is helpful to the investors as even if an issuer becomes bankrupt, the trust,
which is a separate entity continues to pay the proceeds to investors.
SPEs issue securities, most of which are sold to investors (Pension Funds, Insurance
Companies and Commercial Banks) in public offerings or private transactions.
The vast majority of loans in auto securitizations are dealer-financing loans, although
some securitizations contain direct loans as well. Further information can be found in
Appendix E.
AUTO LEASES
Leasing continues to be an important segment of the automobile finance market,
accounting for nearly one-third of all new retail vehicle sales over the past two years.
Once, leasing was a way to finance new high-end luxury cars; however, recently it has
become a common financing method for all types of automobiles, including used
vehicles. Leasing owes its popularity to the rapid increase in new car prices in the late
1980s and the 1990s, as leases allow consumers to drive cars that ordinarily would be
too expensive to purchase and puts them in new cars every few years.
Both individuals and businesses use leases to finance their vehicle acquisition.
Consumers lease which we focus on here is defined as a lease of personal property to
an individual to be used primarily for personal, family, or household purposes for a
period of more than 4 months and with a total contractual obligation of no more than
$25,000.
In a typical consumer auto lease transaction, the lessor purchases a vehicle from the
manufacturer or dealer and leases it to the consumer. The consumer, or lessee, pays
the lessor for the right to use the vehicle during the term of the lease. The lessee’s
Page 83 of 186
Foundation Course in Banking
monthly payment is a function of four variables, each of which is determined at the time
the contract is written
• The net capitalized cost of the vehicle: The net capitalized cost of the vehicle
is the negotiated purchase price plus fees and taxes, less any down payment.
• The residual value of the vehicle: This represents an estimate of a leased
vehicle’s resale value at the end of a lease, typically figured as a percentage of
the manufacturer’s suggested retail price.
• The term of the lease: Lease terms can vary from 12–60 months, typically in
increments of six or 12 months.
• The money factor: The money factor is analogous to an annual percentage rate
(APR) on a retail auto loan in the sense that it essentially represents a financing
charge. The money factor on a lease contract can be converted to an
approximate APR by multiplying by 2400. This approximate APR is not directly
comparable with auto loan APR’s since it is applied to an average rather than an
amortizing balance; however, it does allow consumers to differentiate among
lease offers.
The table above provides a numerical example of the calculation of a lessee’s monthly
payment, which is equal to the sum of:
• The difference between the net capitalized cost and the residual value, divided by the
lease term, and
• The sum of the net capitalized cost and the residual value, multiplied by the money
factor.
The first part of this equation represents the principal component of the monthly
payment, while the second part represents the “interest” portion.
Page 84 of 186
Foundation Course in Banking
Benefits of leasing
Leasing provides multiple benefits to all the parties involved in the transaction -
consumers, manufacturers, and finance companies.
Consumers
• In most instances, leasing results in a lower monthly payment for consumers
because, under a lease contract, consumers pay only for that portion of the
vehicle actually being used (i.e. the depreciation of the vehicle over the life of the
lease contract). As a result of the lower monthly payments, consumers are able
to get more car for their money and drive a new car every two to four years,
depending on the term of the lease contract.
•
Most leases require little or no down payment, and, in most states, sales tax is
charged on the monthly payment rather than on the initial vehicle price (as is the
case with auto purchases).
• An additional benefit to leasing is low maintenance costs and other used
vehicle headaches, since by selecting a lease term that coincides with the length
of the manufacturer’s warranty, most major repairs and maintenance will be
covered.
• At lease termination, the lessee has the option to purchase the vehicle or return
it to the leasing company and, therefore, the lessee is not required to remarket or
sell the used vehicle. Moreover, the lessee can obtain a new vehicle by “rolling
over” the lease.
Page 85 of 186
Foundation Course in Banking
Finance firms - Auto leasing benefits finance companies by providing higher finance
charges than traditional auto loans — primarily because rent charges on a lease are
calculated from the adjusted capitalized cost over the life of the contract, whereas
interest on an auto loan is based on the amortizing balance of that loan.
Lease Types
The two main kinds of leases are close-ended and open-ended leases.
Closed-end lease ("walk-away" lease) - A lease in which the lessee is not responsible
for the difference if the actual value of the vehicle at the scheduled end of the lease is
less than the residual value. The lessee may however be responsible for excess wear,
excess mileage charges and for other lease requirements.
Open-end lease - A lease agreement in which the amount owed at the end of the lease
term is based on the difference between the residual value of the leased property and its
realized value. The lease agreement may provide for a refund of any excess if the
realized value is greater than the residual value.
In this case, the liability of the lessor is limited by the three-payment rule. According to
this rule, assuming the lessee has met the mileage and wear standards, the residual
value is considered unreasonable if it exceeds the realized value by more than 3 times
the base monthly payment (called the "three-payment rule").
On the other hand, if the lessee believes that the amount owed at the end of the lease
term is unreasonable and refuses to pay, she cannot be forced to pay the excess
amount unless the lessor brings a successful court action and also pays reasonable
attorney's fees.
Single-payment
Page 86 of 186
Foundation Course in Banking
A single-payment lease is a lease agreement that requires a single large payment made
in advance rather than periodic payments made over the term of the lease. Because the
lessor is making this payment in advance, this lump-sum payment should be less than
the sum total of periodic payments over the term of the lease.
Multiple-payment
A multiple-payment lease is a lease agreement in which the lessor makes payments
periodically, usually monthly. Most leases are multiple-payment leases.
In all the leases, the lessee is responsible for the vehicle’s maintenance and insurance
for the duration of the lease. However, as most lease terms coincide with the
manufacturer’s warranty, maintenance is a minor concern for the lessee. At the maturity
of the lease, lessees typically have an option to purchase the vehicle for the stated
residual value. If the actual retail value of the vehicle is greater than the contractual
residual value, the lessee is likely to purchase the vehicle. Otherwise, the lessee will
return the vehicle to the dealership from which it was leased, and the dealer will have the
option to purchase it. The dealer will compare the vehicle’s stated residual value to
wholesale used auto prices in making a purchase decision. If the dealer also chooses
not to buy the vehicle, the lessor takes possession and assumes responsibility for
vehicle disposition and residual value realization.
Key Concepts
Concept Definition
Page 87 of 186
Foundation Course in Banking
Acquisition A charge included in most lease transactions that is either paid up-
fee front or is included in the gross capitalized cost. It usually covers a
variety of administrative costs, such as the costs of obtaining a credit
report, verifying insurance coverage, checking the accuracy and
completeness of the lease documentation, and entering the lease in
data processing and accounting systems. This may also be called a
bank fee, an administrative fee, or an assignment fee.
Gross cap cost
Assignee A third party that buys a lease agreement from a lessor. The lessee
- Reductions
becomes obligated to the assignee, and the assignee generally
assumes the=responsibilities
Adjusted of
capthe lessor, although some obligations
cost
may remain with the lessor. An assignee may be a lessor for purpose
- Residual value
of Regulation M when the assignee has substantial involvement in the
lease. = Depreciation
Regulation M,+ a part
Rentof the Consumer Leasing Act, ensures that
lessors provide all relevant information on the lease to lessees to
prevent any malpractices.
= Total forIt calculating
also specifies,
Base the content of information
to be disclosed, how it needs to be segregated, and that it needs to
monthly payments
be provided before the start of the lease.
÷ Lease term in months
Residual The estimated wholesale value of a leased vehicle at the end of the
Value =
lease term. This Base the
is what monthly
lessorpayment
believes the vehicle will be worth
when it is returned to them. Excessive mileage or wear and tear is not
factored into the residual value.
Base The portion of the monthly payment that covers depreciation, any
monthly amortized amounts, and rent charges. It is calculated by adding the
payment amount of depreciation, any other amortized amounts, and rent
charges and dividing the total by the number of months in the lease.
Monthly sales/use taxes and other monthly fees are added to this
base monthly payment to determine the total monthly payment.
Page 88 of 186
Foundation Course in Banking
Sales/use Sales/use taxes are the mandatory additional sales taxes collected by
taxes vehicle dealers and leasing companies on all vehicle sales, rental and
leases. These vary from state to state and often from county to
county and are assessed on both leased and purchased vehicles.
There are often differences in what amounts are taxed and when the
taxes are assessed. In a lease, sales/use taxes may be assessed on
(1) The base monthly payment
(2) Any capitalized cost reduction, and
(3) In a few states, the adjusted capitalized cost.
In most states, the sales/use tax on the base monthly payment is paid
monthly; in some states, however, the tax is due at lease inception.
Sales/use taxes on the capitalized cost reduction and the adjusted
capitalized cost are usually due at lease inception.
Payoff Also known as "purchase price." At the end of the lease, if the lessee
Amount intends to purchase the vehicle, the payoff amount includes:
• The specified purchase amount of the vehicle, as stated in the
lease agreement
• Outstanding property taxes, as applicable in the state
• Any outstanding monthly payments
• Any official fees or state taxes due
Page 89 of 186
Foundation Course in Banking
The Gap The gap is the difference between the early termination payoff
amount -the top line in the graph - and the insured value of the
vehicle - the bottom line in the graph - at any point in time during the
Gap
Insured
Value
Number of months
lease.
An example:
A car is totaled in an accident halfway through the lease. The
adjusted lease balance is $16,000. The insurance company estimates
the book value of the car to be $15,000, and the lessee has a $500
deductible; the insurance company pays $14,500. The difference
between the $16,000 owed on the lease and the $15,000 insured
value is “the gap.”
If there is no gap coverage, the lessee is responsible for the $1,000
gap and the $500 deductible. In case gap coverage exists, it will
cover the gap and the lessee is only responsible for the $500
deductible.
Many lessors will “waive” gap liability and the lessees wouldn’t have
to pay anything extra to have gap coverage. This type of gap
coverage is “paid for” in the fees the lessor charges. Other lessors
might not waive the gap liability but may offer gap coverage at an
additional charge (usually in the $400–$500 range).
Key Players
Lessors
The major players in the auto lessor market include the captive finance subsidiaries of
major auto manufacturers, banks, and independent leasing companies. The captives
have traditionally dominated auto leasing with more than two-thirds of the market;
however, banks and independents have been gaining market share.
Page 90 of 186
Foundation Course in Banking
Most car firms have businesses selling certified used cars and this provides the captives
good cost advantage when they dispose off the vehicles after leases. Due to this, the
captives are typically more aggressive in setting residual values on leased vehicles to
make monthly payments more competitive, a practice referred to as subvention.
The technologies used for generating & underwriting loans typically include the following:
• Automated Underwriting
Page 91 of 186
Foundation Course in Banking
The key functions in Loan Servicing where IT systems are used include:
Reporting tools
Reporting for Lender Activity – view summaries of loan applications and contracts-in-
transit from electronically connected financing sources.
Reporting for Credit Bureau Activity - review how many credit reports dealership has
requested through a B2B network by credit bureau provider and credit score.
User Activity – view the number of applications submitted, credit reports pulled, and
additional activities by DealerTrack user within the dealership.
Page 92 of 186
Foundation Course in Banking
For Leasing
This is primarily in the fields of Point-of-sale, Web enabled Forms and interfaces that
automate Lease Origination.
• ProMaxOnline
• DealerSuite (ADP)
Page 93 of 186
Foundation Course in Banking
• DealerTrack
• Fiserv
• Lending Tree
• Reynolds & Reynolds
• First American CMSI
• Digital Insight.
Recent IT Trends
Electronic Networks
These are B2B networks that automate the Loan origination process by connecting the
lenders and various dealers. Some of the key B2B networks include DealerTrack.
Page 94 of 186
Foundation Course in Banking
Truth-in-Lending Act
The principal disclosures required under the Truth-in-Lending Act for retail finance
transactions include the terms of repayment, the amount financed, the total finance
charge and the annual percentage rate.
Page 95 of 186
Foundation Course in Banking
Regulation M: Regulation M
applies only to "consumer The specific content of disclosures required under Regulation M
leases" defined as contracts includes:
meeting each of the following
elements: • Description of property • Early termination
conditions and penalties
• Amount due at lease
signing or delivery • Maintenance
• The lease is for the use
responsibilities
of personal property, • Payment schedule and
such as an automobile; total amount of periodic • Purchase option
payments
• The lease has a term of • Statement referencing
more than four months; • Disclosure of other "non-segregated”
anticipated charges during disclosures
• The contractual normal execution of the
obligation does not • The right of appraisal
lease agreement
exceed $25,000. • Liability at the end of the
• Total of payments
lease term
• Payment calculation
Regulation M mandates that a • Fees and taxes
specific set of terms in any • Lease term • Insurance and warranties.
lease contract be disclosed so
that all the legal and financial
obligations between the lessor and the lessee are clear.
Page 96 of 186
Foundation Course in Banking
STUDENT LOANS
Education spending worldwide is over $2 trillion and it is a $750 billion market in the
United States. Of this, Higher education is a $250 billion market in the United States.
Education is a big industry in the U.S with more money being spent on education than in
any other industry with the exception of healthcare.
Student loans are available to students entering higher education to help them meet
their educational expenses. Once the student’s course has finished - and they are
earning enough money - they can start to pay back the loan.
Federal funding for post-secondary education began in 1944 with the Serviceman's
Readjustment Act. There are three categories of federal student aid:
Grants – This is financial aid that students don’t have to repay. To be eligible, the
student must be an undergraduate student, and the amount of aid received depends on
the need determined by parental /self contribution, cost of attendance and enrollment
status (full time or part time).
Maximum amounts available vary yearly as determined by Congress. During the 2003-
2004 school year, the amounts for Pell grant15 ranged from $400 to $4,050. Besides
financial need, the amount of a Pell grant also depends on costs to attend school, the
student's status as a full- or part-time student, and the student's plans to attend school
for a full academic year or less. Pell grant funds are paid directly to the student by the
school at least once each semester, trimester, or quarter.
Campus based programs like the Federal Supplemental Educational Opportunity Grant
(FSEOG), Federal Work-Study (FWS), and Federal Perkins Loan programs are
administered directly by the financial aid office at each participating school. Federal
funds for these programs are given to the schools and distributed to students at the
schools' discretion. Amounts students can receive depend on individual financial need,
amounts of other aid the student receives and the total availability of funds at the school.
Not all schools participate in all three programs. Unlike the Federal Pell Grant Program,
which provides funds to every eligible student, the campus-based programs provide a
certain amount of funds for each participating school to administer each year.
Federal Supplemental Educational Opportunity Grants (FSEOG) are gift aid
for undergraduates with exceptional financial need. Pell Grant recipients with the
lowest Expected Family Contribution (EFC) will be the first to get FSEOGs, which
don't have to be paid back. The students can get between $100 and $4,000 a
year, depending on when the application is made, the financial need, and the
15
The two federal grants given for eduation are (a) Federal Pell Grant: Assists undergraduate
students with financial need who are attending an eligible public or private postsecondary school.
And (b) Federal Supplemental Education Opportunity Grant: Assists undergraduate students with
financial need who are attending an eligible public or private postsecondary school.
Page 97 of 186
Foundation Course in Banking
funding available at the school. These grants are awarded only to undergraduate
students who have not earned a bachelor's or a professional degree.
If a student is eligible, her school will credit her account, pay her directly (usually
by check), or use a combination of the two. The school must pay the student at
least once per term (semester, trimester, or quarter).
Loans – This is borrowed money that a borrower must repay with interest. The borrower
can be an undergraduate or graduate student. Parents may also borrow to pay the
educational expenses of their dependent undergraduate students. Maximum loan
amounts depend on the student’s grade level in school.
Page 98 of 186
Foundation Course in Banking
Student
Loans
Federal
Loans Private
Loans
FFELP FDLP
benefits like a student who is in school at least half time is not required to make any loan
payments while they are in school.
The interest rates for the loans are capped (The Interest rates were capped at 8.25% in
2003) and taxpayers subsidize all federal student loans so that borrowers pay below-
market interest rates. Federal loan guarantees also lower the cost of borrowing for
higher education by making federal student loans available to any eligible borrower.
The interest rate on the majority of FFELP loans are floating, and reset only once a year
— effective from July 1 to June 30. The index for the interest rates is usually the 91-day
US Treasury bill (For ex, it was 91 T-bill + 1.7% in school and + 2.3% during repayment)
The interest rate on these loans change annually but is capped at a maximum rate of
8.25%.
rate on these loans also changes annually 2002-03 4.06% (1.760 + 2.3%, cap 8.25%)
and is capped at a maximum rate of
8.25%. During the 2002 fiscal year almost 2001-02 5.99% (3.688 + 2.3%, cap 8.25%)
$12 billion in unsubsidized FFELP loans 2000-01 8.19% (5.893 + 2.3%, cap 8.25%)
were made. Undergraduate students can
borrow up to $46,000 and the loan limit 1999-00 6.92% (4.621 + 2.3%, cap 8.25%)
The amount students can borrow each year for Stafford Loans depends on whether they
are dependent students or independent students. An independent student is at least 24
years old, married, a graduate or professional student, a veteran, an orphan, a ward of
the court, or someone with legal dependents other than a spouse. A student who does
not meet any of the criteria for an independent student is a Dependant student. The total
debt outstanding that can be had from all Stafford Loans combined is
• $23,000 as a dependent undergraduate student
• $46,000 as an independent undergraduate student (only $23,000 of this amount
may be in subsidized loans)
• $138,500 as a graduate or professional student (only $65,500 of this amount
may be in subsidized loans). The graduate debt limit includes any Stafford Loans
received for undergraduate study.
Depending on the loan amount, the term of the loan can be extended from 12 to 30
years.
• 10 years for less than $7,500;
• 12 years for $7,500 to $10,000;
• 15 years for $10,000 to $20,000;
• 20 years for $20,000 to $40,000;
• 25 years for $40,000 to $60,000; and
• 30 years for $60,000 and above.
The reduced monthly payment may make the repayment easier for some borrowers.
However, by extending the term of a loan the total amount of interest paid is increased.
In certain circumstances (for example, when one or more of the loans was being repaid
in less than 10 years because of minimum payment requirements), a consolidation loan
may decrease the monthly payment without extending the overall loan term beyond 10
years. In effect, the shorter-term loan is being extended to 10 years. The total amount of
interest paid will increase unless you continue to make the same monthly payment as
before, in which case the total amount of interest paid will decrease.
The interest rate on consolidation loans is the weighted average of the interest rates on
the loans being consolidated, rounded up to the nearest 1/8 of a percent and capped at
8.25%.
Thus, the key benefits of a consolidation loan include the following:
• Replacing payments on multiple loans with a single payment on the consolidation
loan
• Access to alternate repayment plans, such as extended repayment, graduated
repayment, and income contingent repayment. Although these plans may be
available to unconsolidated loans, the term of an extended repayment plan
depends on the balance of the loan, which is higher on a consolidation loan
• The ability to lock in the interest rate, including the ability to lock in the lower in-
school interest rate during the grace period.
• When a borrower consolidates during the grace period, the borrower has to begin
repayment immediately and loses the remainder of the grace period, including
possibly interest benefits on subsidized loans
• The borrower may lose some of the favorable loan forgiveness provisions on the
Perkins loan when it is included in the consolidation loan
• Extending the repayment term may increase the total interest paid over the
lifetime of the loan.
• Current laws allow a borrower to consolidate loans only once. So if interest rates
go down, a borrower who has already consolidated will not be able to take
advantage of the lower interest rates.
The overall limits for all subsidized and unsubsidized loans (including a combination of
FFELPs and Direct Loans) are given below:
and parents take Private student loans to pay for all college expenses, from tuition to
every day college expenses such as off campus living expenses, school supplies, travel,
etc. Both Public and Private Sector Lenders provide Private Loans.
Most borrowers typically take a combination of different loans to meet their
requirements. The calculation below illustrates a couple of scenarios that require the
borrowers to opt in for a combination of loans.
Loan Repayment
There are various kinds of repayment options to the borrowers of education loans. Lets
take a look at the repayment options for FFELP and FDLP loans separately.
The FFELP loan program generally offers following repayment options:
• The Standard Repayment Plan: Borrower pays a fixed amount each month—at
least $50—for up to 10 years, not including deferment and forbearance periods.
The length of her repayment period depends on the loan amount.
• The Graduated Repayment Plan: Borrower’s payments will be lower at first and
then increase, usually every two years. The length of the repayment period will
generally range from 12 to 30 years, depending on the loan amount. Borrower’s
monthly payments will never increase to more than 1.5 times what she’d pay
under the Standard Repayment Plan. She will repay a higher total amount of
interest, though, because the repayment period is longer than under the
Standard Repayment Plan.
• The Income Sensitive Repayment Plan: Borrower’s monthly payment is based on
her yearly income and her loan amount. As her income rises or falls, so do her
payments. Each payment must at least equal the interest accrued (accumulated)
on the loan between scheduled payments.
• The Extended Repayment Plan is available only to FFEL borrowers who received
the first loan on or after October 7, 1998, and who have FFELs totaling more
than $30,000. Under this plan, borrower’s payments will be fixed or graduated
(lower at first and then increased over time) over a period of up to 25 years.
The repayment plans with the Direct Loan Program are on similar lines:
• The Standard Repayment Plan: Same as in the case of FFELP loan.
• The Extended Repayment Plan: Borrower repays the loan over a period that is
generally 12 to 30 years, depending on the loan amount. Her monthly payment
might be lower than under the Standard Repayment Plan, but she will repay a
higher total amount of interest over the life of her loan because the repayment
period is longer. The minimum monthly payment is $50.
• The Graduated Repayment Plan: Same as in the case of FFELP loan.
• The Income Contingent Repayment Plan: Borrower’s monthly payment is based
on her yearly income, family size, interest rate, and loan amount. As her income
rises or falls, so do her payments. After 25 years, any remaining balance on the
loan will be forgiven, but she’ll have to pay taxes on the amount forgiven.
Apart from these custom repayment options, two other options available for postponing
repayment of student loans are deferments and forbearances. These options can be
availed of before the loan goes into default. Once the loan is default, the borrower is no
longer eligible for deferments and forbearances.
Deferment
During deferment, the lender allows the borrower to postpone repaying the principal of
the loan for a specific period of time.
Most federal loan programs allow students to defer their loans while they are in school at
least halftime. For Perkins Loans and Subsidized Stafford Loans, no interest accrues
during the deferment period because the federal government pays the interest. For other
loan programs, such as the unsubsidized Stafford loan, the interest still accrues during
the deferment period. Students can postpone the interest payments on such loans by
capitalizing the interest. It needs to be noted that capitalizing the interest adds it to the
loan principle, increasing the size of the loan.
Deferments are commonly granted for
• Students who are enrolled in undergraduate or graduate school,
• Disabled students who are participating in a rehabilitation training program,
• Unemployment and
• Economic hardship
These deferments are for the FFELP and FDSLP loans and not for Perkins loan.
Deferments are not granted automatically, the borrower needs to submit an application
and provide documentation to support the request for a deferment.
Forbearance
During forbearance, the lender allows the borrower to postpone or reduce the payments,
but the interest charges continue to accrue. The federal government does not pay the
interest charges on the loan during the forbearance period. The borrower must continue
paying the interest charges during the forbearance period.
There are limits on the length of forbearance and they are typically granted in 12-month
intervals for up to three years.
Forbearances are granted at the lender's discretion, usually in cases of extreme financial
hardship or other unusual circumstances when the borrower does not qualify for a
deferment.
KEY PLAYERS
Federal Government The U.S. Department of Education (ED) administers the federal
student loan programs. As discussed later, it also serves as the
lender under certain loan programs.
Borrower This means the student or the parent—the person who receives
the student loan and is responsible for repaying the loan.
Lender This is the entity that lends the money for your student loan.
Most schools have developed working relationships with single
lenders or multiple lenders (a.k.a. "preferred" lenders). Schools
often provide a list of lenders. A lender can be:
• A bank.
• A savings and loan association.
• A school.
• A credit union.
• A pension fund.
• An insurance company.
• A consumer finance company.
• The federal government.
Third Party Firms like Nelnet Loan Services Inc. provide services in Loan
Origination & Origination. They originate all types of student loans. These firms
Servicing Firms also buy loans from other lenders and service them during their
full term. Services include: payment processing, accounting,
reporting, delinquency reporting etc.
KEY CONCEPTS
School A school needs to be certified by the Department of Education as
Concept Definition
an eligible school to participate in the FFELP OR the FDLP loan
Free Application programs.
The Schools
form used by thehave the option
students of going
to apply in for anneed-based
for financial FFELP or
for Federal an FDLP program. A school, may be one of the following
aid. As the name suggests, no fee is charged to file a FAFSA
Student Aid • Common College
(FAFSA)
• University
Promissory Note The legal and binding
• Graduate contract signed between the lender and the
college
borrower (student/parents) stating that the borrower will repay the
loan •as agreed
Professional
upon incollege
the terms of the contract.
• Vocational /Technical college
Student Aid A report sent to a student by the government 4 – 6 weeks after
Report (SAR) • Correspondence
submitting a FAFSA. The college
report informs the student of the
Expected Family Contribution (EFC) and the financial aid for which
the student is eligible. College financial aid offices use the report
information to build a financial aid package for a student.
Disbursement The release of loan funds to the school for delivery to the borrower.
This is first credited to the student's account for payment of tuition,
fees, room and board and other school charges. Any excess funds
are then paid to the student in cash or by check. Also, unless the
loan amount is under $500, the disbursement will be made in at
least two equal installments.
Default The failure to repay a loan in accordance with the terms of the
promissory note. A loan becomes default when the borrower fails
to pay several regular installments on time (i.e., payments overdue
by 270 days).
Forbearance These are adjustments to the repayment terms when the borrower
is having financial difficulty. It must be explicitly applied for and
usually runs for 6 to 12 months. Forbearance provisions vary by
loan type and are at lender’s discretion. Key differences between
deferment and forbearance are
• Interest accrues and may be capitalized on all loans during
forbearance, including loans that were formerly subsidized
• Interest rate goes up .6% on variable rate Stafford's during
forbearance
Lender’s Request The letter that the lender sends to the guarantee agency (GA) after
Assistance (LRA) a student fails to repay the loans properly. After getting this letter
the GA tries to persuade the student to pay up the loan.
Notice Of Default If the student doesn’t repay even after the GA’s persuasion then
(NOD) the lender sends a Notice of default to the GA. On receipt of a
NOD, the guarantor gives the guarantee money to the lender and
informs the Department of Education and the NSLDS for necessary
updation and action.
Cohort Default The percentage of loan borrowers who default before the end of
Rate the academic fiscal year following the fiscal year in which they
entered repayment on their loans.
Loan Forgiveness Under certain circumstances, the federal government will cancel all
Programs or part of an educational loan. This practice is called Loan
Forgiveness. The qualification criteria are
• Student performs certain volunteer work;
• Student performs military service;
• Student teaches or practices medicine in certain types of
communities; or,
• Meets other criteria as specified by the forgiveness
program.
LOAN PROCESS
Loan Repayment
Loan
Disbursement
Student Lender
IOI
Loan
Application Choice of
Disbursement
School & Sign
Financial Lender
US Dept Edu Aid Promissory Note
Eligibility
Approval
SAR
School Lender Guarantor
Promissory
IOI – Indication of Interest Note
SAR – Student Aid Report
Obtaining a federal student loan begins when a student files the Free Application for
Federal Student Aid (FAFSA). The information supplied on the FAFSA is analyzed to
estimate what is the expected family contribution (EFC) toward higher education costs.
The Student submits Application (FAFSA) to US Department of Education. This
application contains the financial contribution of the family along with the list of schools
applied to.
There are three regular formulas for the calculation of EFC16 (A) for the dependent
student, (B) for the independent student without dependent(s) other than a spouse, and
(C) for the independent student with dependent(s) other than a spouse.
The US Department of Education then creates a Student Aid Report (SAR) and sends it
to the borrower & all the schools mentioned in FAFSA. The SAR serves to indicate a
student’s expected financial contribution (EFC), which is required by school’s financial
aid professionals to calculate Financial Aid Eligibility.
Based on the SAR, School financial aid professionals compare the EFC to the total cost
of attendance for a school and fashion the financial aid package that typically includes
16
EFC = Total Student & Parent Income (Taxed + Untaxed) + Contribution from Assets –
Allowances against Income. Factors such as number of family dependents, number of children in
college, etc. is also included in the calculation.
Page 111 of 186
Foundation Course in Banking
grants and loans. Schools send Financial Aid Award Letter to the prospective students
and families outlining the type and amount of Financial Aid for which they qualify.
Based on this letter, student selects the school and the loan type, best suited for him.
Schools have their list of preferred lenders. Student may choose any one of these or a
lender outside this list. Student may also apply for a loan through a student loan
origination and servicing firm associated with the school. These firms typically offer the
entire federal student loan options and have a list of lenders associated with them. The
student selects a lender based on parameters such as: loan amount, interest rate,
repayment options, lender servicing options, etc.
Loan Origination
After deciding on the Lender, student informs the school and signs a Master Promissory
Note (MPN) with the school, which the student gets from her lender. The school uses it
to apply for a guarantee against default. The guarantor is usually a state agency. The
guarantor approves the loan and directs the Lender to proceed with Loan disbursement.
When a student signs the Master Promissory Note, she is confirming her understanding
that the school may make new loans for her for the duration of student’s education (up to
10 years) without having her to sign another promissory note. Student is also agreeing to
repay the lender, all loans made to her under the terms of the MPN. The lender checks
all the documents and the loan amount is sent to the school. The school will disburse
student’s loan in at least two installments; no installment will be greater than half the
amount of the loan. The loan money must first be used to pay for tuition, fees, and room
and board. If loan funds remain, student will receive them by check or in cash, unless
the student give the school written permission to hold the funds until later in the
enrollment period.
Loan Servicing
Repayment generally begins six months after a student leaves school. FFELP and FDLP
borrowers have several repayment options, including equal monthly installments,
payments that gradually rise over the loan term, and payment amounts linked to the
borrower’s income. FFELP and FDLP borrowers may also consolidate student loans into
a single monthly payment with a single lender.
If the borrower fails to make payments for nine months, the loan is in default and the
lender presents a claim for partial payment (98 percent of the outstanding balance) to
the guaranteeing agency. Once the guaranteeing agency determines that the claim is
valid, the loan is purchased from the lender and the guaranteeing agency applies to the
U.S. Department of Education for partial reimbursement (95 percent of the claim value).
Some lenders manage the servicing process for their borrowers in-house, while others
contract this work out to third party loan servicers who receive payments, track balances
and keep in contact with the borrowers.
The servicing activity is similar to the process followed in other loans and the activities
include - collecting payments, answering customer service phone calls, reporting and
collecting delinquent accounts.
FDLP Loan
The process here works in the same fashion as in the case of a FFELP loan, with the
exception being that no lender or state guarantee agency is contacted. The federal
government raises the loan funds through its regular Treasury bill auctions.
The US Department of Education calculates EFC, creates a Student Aid Report (SAR)
and sends it to the borrower & all the schools mentioned in FAFSA.
School Financial Aid Office compares the expected family contribution to the total cost of
attendance for a school and in case of extreme financial needs fashion a FDLP loan
package. Schools send Financial Aid Award Letter to the prospective students. The
student selects a school & signs the Lender Promissory Note with the school, which in
turn is forwarded to the US Department of Education.
Loan Origination
Upon receiving the promissory note, the Loan proceeds are sent directly to the school by
the US Department of Education.
Loan Servicing
Repayment generally begins six months after a student leaves school. The servicing
process is similar to that followed for FFELP loans. Direct Loan Servicing Centre does
loan Servicing; performing the same servicing functions as in other loans.
Private Loans
In case of private loans, student, guarantor and the lender are the only players involved
working for the disbursement of the loan. US Department of Education does not figure in
the picture. Most private loans are unsecured loans. The Process works as:
• After the FAFSA is processed, school will send student a financial aid award
notice detailing the amounts and types of federal and school-based aid for which
the student is eligible.
• The difference between the student’s total financial aid and the school’s cost of
attendance is the amount parents or students may be eligible to borrow as
Private Loan.
• The student applies to lenders for the private loans with a loan application
containing personal & financial information.
• After submitting a completed loan request, the Lender will perform a credit check
through a credit rating agency and notify student of the credit status.
• Based on loan term & interest rates offered by the lenders, the student selects a
lender.
• The lender provides the borrower with a promissory note.
• The student signs the Lender promissory Note with the school, which acts as a
school certification & submits it to the Lender.
• The loan is approved and upon completion and signing of the approved loan
application, lender sends the Loan proceeds to the school.
SECONDARY MARKET
Some lenders sell their student loans to investors through a student loan secondary
market. By purchasing loans, secondary markets ensure that there is always a ready
supply of capital available to assist other students. In 2002, student loan providers raised
over $50 billion in new capital from the private sector to meet the growing demand for
student loans. Sallie Mae is the biggest player in Secondary Market. Apart from Sallie
Mae, there are state sponsored Secondary Market Players and private educational
finance companies like Nelnet and EdSouth.
Security Issuers
Student-loan ABS issuers have distinct origination and funding strategies. Sallie Mae
and Brazos Student Finance Corporation purchase FFELP collateral from a network of
diversified lenders. Supplemental lenders such as Chela Financial USA, Inc., and PNC
originate supplemental loans, primarily from students at private, four-year institutions.
Access Group provides one-stop shopping to professional school students, primarily law
students, originating both their FFELP and private supplemental loans.
Student loans have lower gross margins than credit card or home equity loans, but can
generate high gains on sale because of low expected losses and long maturities.
Although these characteristics make student loans prime candidates for securitization,
other factors have limited the value of student loan securitization to many banks. These
factors include complex security structures and investor reporting requirements. In
addition, many potential issuers and lenders have the ability to sell assets to Sallie Mae
and other secondary markets at attractive prices. Active securitizers, in addition to Sallie
Mae, generally include private non-profit specialized student loan lenders and for-profit
lenders with roots in the non-profit sector. Consequently, the student loan issuance has
been concentrated among few large players.
According to the Institute for Higher Education Policy, the use of private student loans
has been rapidly increasing since the mid-1990s. Under the FFELP, students can only
borrow up to fixed loan amounts per academic year. Loan limits have not risen since
1992. As a result, more students are turning to private credit student loans to meet their
education financing needs.
The total volume of private loans exceeds the amounts awarded annually under the
Perkins Loan program, federal work-study, and the Federal Student Educational
Opportunity Grant program combined. Private loans help make school choice possible
for students who have exhausted all other sources of financial aid, including federal
student loans.
Sallie Mae
Sallie Mae is the largest private source of funding, delivery and servicing support for
education loans in the United States primarily through its participation in the Federal
Family Education Loan Program (‘‘FFELP’’). They provide a wide range of financial
services, processing capabilities and information technology to meet the needs of
educational institutions, lenders, students and their families, and guarantee agencies.
Their primary business is to originate and hold student loans, but the Company also
provides fee-based student loan related products and services and earns servicing fees
for student loan servicing and guarantee processing, and student loan default
management and loan collections.
Sallie Mae from time to time securitizes some of its student loan assets by selling
student loans to SLM Student Loan Trusts. The asset-backed securities are issued by
the Trusts.
Sallie Mae manages the largest portfolio of FFELP student loans, serving over 7 million
borrowers through their ownership and management of $79 billion in student loans, of
which $73 billion or 92 percent are federally insured.
• Automated Loan Origination This application gives lenders direct control over
the loan origination process and enables them to customize many of the services
they provide with features including on-line reporting, on-line loan application,
guarantee, disbursement, and servicing data, and on-line loan counseling.
• Format Standardization A system that facilitates the electronic exchange of
data files among lenders, guarantors, and those who service the loans
• An online financial aid package tool This application automatically generates
different financial aids (grants, loans) available to students and informs them
online.
• An electronic bill presentment and payment service for campus business offices
• A directory service To manage files across lenders, guarantors and servicers.
This includes E-Signature capabilities to generate considerable evidence in
support of the transaction.
• Operating System To track all of the Federal Family Education Loan Program
(FFELP) loan origination and guarantee activities that a Lender administers on
behalf of their customers.
Student Aid - The student aid program authorized under Title IV, is a part of the HEA
and provides grant aid, loans, and work-study assistance. It is aimed at expanding
educational opportunity.
As part of the Higher Education Act, the student loan program is periodically amended to
regulate the yields paid to the lenders – origination fee chargeable.
AGRICULTURAL LOANS
Agricultural Loans are the loans granted to finance the agricultural industry. These are
loans given to individuals towards acquisition of work animals, farm equipment and
machinery, farm inputs (i.e., seeds, fertilizer, feeds), poultry, livestock and similar items.
It also includes construction and/or acquisition of facilities for production, processing,
storage and marketing; and efficient and effective merchandising of agricultural
commodities.
Bank credit has played an important role in farm activities throughout U.S. history. The
financing supplied by banks over the years has been essential to many individual farm
operators and to the development of new agricultural technologies and techniques. The
structural reorganization of Federal Agricultural lending institutions in the early 90’s
strengthened the market and helped in increasing agricultural loans among the farmers.
TYPES OF LOANS
The types of Agricultural loans available include
Operating Loans
Operating loans are loans made for general operating expenses such as labor, feed,
seed, fertilizer, grove caretaking, repairs, veterinary costs and small capital purchases.
These loans are granted for generally, one year or within an operating business cycle.
Operating loans require crop liens in addition to other underlying security.
Equipment Loans
Equipment loans are made for purchases of machinery, equipment, vehicles, and
breeding stock. The loan term extends up to 10 years.
Brokers
Brokers help borrowers in disbursement of the loan. They help in the preparation of the
Loan Application. A well-thought-out and detailed application is one of the most
important items a borrower can bring to a lender. This application will serve as the basis
for borrower’s financial details.
Lenders
Lenders for Agricultural Loans include:
Page 118 of 186
Foundation Course in Banking
The six insurance companies (AEGON USA, Citigroup Investments AgriFinance Group,
Lend Lease Agri-Business, Metropolitan Life, MONY Life Insurance, and Prudential)
currently active in farm lending account for about 85 percent of the industry's farm
mortgages and generally have high total assets and large farm mortgage portfolios.
They have virtually pulled out of the small- to medium-sized farm mortgage market in
favor of loans to agribusiness, timber, and specialty enterprises. These companies
Commercial Banks
In spite of continuous and rapid changes faced by the banking industry during the last
two decades, commercial banks retain the lead market share among lenders to the farm
sector. Though individual banks may specialize their agricultural loans (by type of crop,
farm size, etc.), banks as a group are important lenders to all segments of the farm
economy. They make loans to small and large farms, to agribusiness firms, and for both
farmland and production purposes. At the end of 2001, the commercial banking system
held 32 percent of outstanding farm real estate debt and 51 percent of outstanding non-
real estate farm debt. Most of this debt was in medium-sized farm loans.
Other lenders include parents financing their children into agriculture, landlords
providing self-financing for their tenant farmers, and captive lenders. Captive lenders,
such as equipment dealers, seed companies, and retailers normally provide limited-
purpose credit to enhance market penetration for their primary products, such as farm
machinery and seed.
Guarantors
Generally, a Collateral acts as a guarantee against default but for loans with high loan to
value ratio, lenders require a guarantee. Farm Service Agency and other state funded
institutions are the major guarantors of agricultural loans. FSA provides lenders (e.g.,
banks, Farm Credit System institutions, credit unions) with a guarantee of up to 95
percent of the loss of principal and interest on a loan. Farmers and ranchers apply to an
agricultural lender, which then arranges for the guarantee. The FSA guarantee permits
lenders to make agricultural credit available to farmers who do not meet the lender's
normal underwriting criteria.
PROCESS
Origination
The process begins with a preparation of a Loan proposal. A detailed business proposal
is one of the most important items required for the loan disbursement. The proposal
should include a description of the business, the amount of funds requested, and the
purpose of the funds. The proposal should also include a description of collateral and the
sources of repayment. This proposal will serve as the basis for financing application.
Usually, a broker helps the borrower with the preparation of this. The borrower submits
this application for approval to the lender.
Lender checks the documents submitted by the borrower, gets credit rating from the
credit rating agencies and property appraisal for collateral. In case of insufficient
collateral or loans with high loan to value ratio, commercial banks require a guarantee by
• Be a citizen of the United States (or legal resident alien), which includes Puerto
Rico, the U.S. Virgin Islands, Guam, American Samoa, and certain former Pacific
Trust Territories.
• Have an acceptable credit history as determined by the lender.
• Have the legal capacity to incur the obligations of the loan.
• Be unable to obtain a loan without a guarantee.
• Not have caused FSA a loss by receiving debt forgiveness on more than 3
occasions.
• Be the owner or tenant operator of a family farm after the loan is closed. For an
Operating Loan, the producer must be the operator of a family farm after the loan
is closed.
• Not be delinquent on any Federal debt.
The borrower and lender complete the guaranteed application and submit it to the
guarantor. The guarantor reviews the application for eligibility, repayment ability,
security, and compliance with other regulations. It approves and obligates the loan. The
lender receives a conditional commitment indicating funds have been set aside, and the
loan may be closed. The borrower and lender negotiate prices, loan term and interest
rates before the final approval. The lender closes the loan and advances funds to the
borrower. After this, the guarantor issues the guarantee.
In cases where the lender is Farm Credit System, Farm Credit System Insurance
Corporation provides guarantee.
Lenders usually retain operating and equipment loans and continue to service them but
loan, which extend for more than 10 years (real-estate loans) are sold to other lenders
for servicing. These include: Washington Mutual, Countrywide credit industries, Bank of
America, Southtrust mortgage Corp.
Lenders are responsible for servicing the entire loan in a reasonable and prudent
manner, protecting and accounting for the collateral, and remaining the mortgagee or
secured party of record.
The lender’s responsibilities regarding borrower supervision include, but are not limited
to the following:
• Ensuring loan funds are not used for unauthorized purposes.
Lenders in some cases sell their loans to Farmer Mac17 to replenish their funds.
Servicing
Servicing for these Farm Loans is separated into Field Servicing and Central Servicing.
Field Servicing is the responsibility of the lender and consists of: Monitoring taxes and
insurance, inspecting collateral, requesting annual financial statements for loans greater
then $500,000 and, in cases of default and collections, acting as contact with the
borrower.
Central Servicing, which is performed by an institution under contract to Farmer Mac,
consists of billing and collecting installment payments, accounting and reporting to the
pool trustee and handling collection/foreclosure/bankruptcy and sale, if needed.
SECONDARY MARKET
The Secondary Market here operates in much the same way as in other Loans.
Secondary Market Conduits purchase qualified loans from lenders, thereby replenishing
their source of funds to make new loans. They fund their loan purchases by issuing debt
or securities backed by pools of loans and selling them into the capital markets. Farmer
Mac is the major player in the securitization process.
Farmer Mac
Congress created Farmer Mac to establish a secondary market for high-quality
agricultural and rural housing mortgages. Authorized by the Agricultural Credit Act of
1987, Farmer Mac is a federally chartered institution that was privately capitalized and is
privately owned. Farmer Mac operates as an independent entity within the Farm Credit
System (FCS) and is regulated by the Office of Secondary Market Oversight within the
Farm Credit Administration. As a government-sponsored enterprise (GSE), Farmer Mac
can access a $1.5-billion direct line of credit to the U.S. Treasury, but only if certain
17
More information on Farmer Mac follows later in the chapter.
Page 122 of 186
Foundation Course in Banking
conditions are met. In addition, the securities of this publicly traded corporation have full
government agency status in capital markets.
Farmer Mac is modeled after the secondary markets for home mortgages operated by
Freddie Mac and Fannie Mae. Farmer Mac fulfills its statutory mission by guaranteeing
timely payment of principal and interest on qualified farm and rural housing mortgages or
mortgage-backed securities, or by purchasing loans from retail lenders that own stock in
the corporation. Farmer Mac purchases are financed with funds obtained from the sale
of notes and bonds on the national money market or by selling Farmer Mac-guaranteed
mortgage-backed securities to investors.
The Farmer Mac (often referred to as Farmer Mac I) and Farmer Mac II markets are
meant to serve very different farm clientele. The underwriting standards associated with
Farmer Mac I limit participation to financially healthy farmers. Farmer Mac II, in contrast,
benefits borrowers eligible for certain USDA-guaranteed loans. These borrowers include
farmers who are unable to obtain commercial credit at affordable rates because of
financial problems or lack of creditworthiness.
The various guarantee types of loan volume held by Farmer Mac include:
Swaps: Through a swap, a seller exchanges loans for a Farmer Mac guaranteed
security as an alternative to selling them outright or pledging them as collateral.
Long-Term Standby Purchase Commitment (LTSPC)
: Under an LTSPC, the seller passes the credit risk of qualified loans or groups of loans
to Farmer Mac in exchange for payment of an annual guarantee fee.
Agricultural Mortgage Backed Securities (AMBS): Farmer Mac’s cash window allows
lenders to sell qualified new or existing loans directly to Farmer Mac. Farmer Mac may
issue agricultural mortgage-backed securities from these loans, which may be retained
in portfolio by Farmer Mac or sold directly to investors.
RECENT TRENDS
According to the recent market scenario, Commercial Banks enjoy the largest market
share in farm credit. In the mid-1980s, with U.S. agriculture in a deep recession, the
financial condition of FCS deteriorated, and FCS lost market share to banks. Farm
Service Agency’s share in loan originations decreased drastically during the same
period. FCS has the second largest share in the market closely followed by individuals
and other lenders.
System debt resulting from federal financial assistance provided to the System under the
1987 Act.
The Farm Credit System Reform Act of 1996 includes numerous provisions that provide
regulatory relief for the FCS.
There is now a process of choice for the retail-banking customer; which delivery channel
to use and for which banking transaction. The retail banking industry today is using
delivery channels, which range from branch banking, telephone banking, ATM banking,
Internet banking to mobile banking and interactive TV.
The retail banking industry today is using delivery channels, which range from branch
banking, telephone banking, ATM banking, Internet banking to mobile banking and
interactive TV.
BRANCH BANKING
Throughout much of the last decade, retail banks have re-engineered their organizations
to improve efficiency and move customers to lower cost, automated channels, such as
ATMs and Internet Banking. However, banks are now realizing that one of their best
assets for building profitable customer relationships is the branch — branches are in fact
a key channel for customer retention and profit growth.
Today 70% of customers use more than one contact channel, but as channels
proliferate, customers remain loyal to branches—51% of customers say they prefer
Teller Operations
Cash advances
Consumer and mortgage loan payments
Currency and coin orders
Deposits, including commercial deposits
Fee collection
Foreign currency exchange
Payments
Stop payments
Transfers
Wire transfers
Withdrawals
Customer & Account Teller applications usually offer the following types of features
Service and functions:
Branch-office locator
Customer and account setup
Customer and account inquiries
Customer identification
Multiple transactions for single customer
Interfaces to third-party fraud and signature
verification applications
Interfaces to check-order vendors
Transactions
Functions of a Branch
The branches of a bank are generally authorized by regulators to perform all the normal
banking functions, which a bank is permitted to perform.
Accepting Deposits
o Demand Deposits
o Time Deposits
Lending Money
o Whole-sale Lending
o Retail Lending
Remittances
o Mail transfers, Telegraphic transfers, electronic funds transfer, Demand
Drafts etc
Safety Lockers Facility
ATM BANKING
The U.S. payments system is going through a period of rapid change. Paper checks are
increasingly giving way to electronic forms of payment, which themselves are being
transformed as new products, new players, and new industry structures arise. Some of
the most dramatic changes are being seen in the automated teller machine (ATM) and
debit card industry.
Installation of ATMs has been particularly rapid in recent years. ATM growth was 9.3
percent per year from 1983 to 1995 but accelerated to an annual pace of 15.5 percent
from 1996 to 2002. Much of the acceleration is due to placing ATMs in locations other
than bank offices. These off-premise ATMs accounted for only 26 percent of total U.S.
ATMs in 1994, but now account for 60 percent.
On the debit card side of the industry, growth has been extremely rapid in point-of-sale
(POS) debit card transactions. With an annual growth rate of 32 percent from 1995 to
2002, POS debit is the fastest growing type of payment in the United States. Today it
accounts for nearly 12 percent of all retail noncash payments, a fivefold increase in just
five years.
Automated Teller Machines (ATMs) have made banking available 24 hours a day, 7
days a week. ATM banking is also considerably cheaper than other methods of
payment, such as issuing cheques or doing transactions over the counter inside the
bank. A banking customer gets access to an ATM by means of a card, which is issued
when she opens a bank account such as a checking account or a savings account.
Banks can substitute cheaper ATM transactions for more expensive human teller
transactions because their customers are willing to use the machines, which are more
convenient because more banks are placing machines on the network.
ATMs were the first electronic banking service to be introduced to consumers. ATM and
debit card transactions take place within a complex infrastructure. To the consumer and
merchant, they appear to be seamless and nearly instantaneous. But, in fact, a highly
complex telecommunications infrastructure links consumers, merchants, ATM owners,
and banks. The common attribute of all ATM and debit card transactions is that the
transaction is directly linked to the consumer’s bank account—that is, the amount of a
transaction is deducted (debited) against the funds in that account. An ATM card is
typically a dual ATM/debit card that can be used for both ATM and debit card
transactions. Many ATM/debit cards offer the consumer both types of debit card
transactions, online and offline.
Apart from the monthly service fee that is charged on a customer’s bank accounts, she
may also be charged a fee for every transaction done at an ATM. But it is a lot cheaper
to bank at an ATM than it is to do your banking at a teller inside the bank. This is the
banks' way of encouraging consumers to use ATMs. Fees vary between banks and
according to the type of transaction. For cash withdrawals and cash deposits, the fees
depend on the amount involved in the transaction, while there tend to be set fees for
account payments and money transfers, irrespective of the amount involved. Mini
statements and balance inquiries are generally free if you use your bank's own ATM
network (it doesn't have to be the ATM outside your specific branch), but a fee is
charged for these transactions at the ATMs of other banks because your bank will have
to pay the other bank because you used the other bank's ATM.
There are three types of ATM systems: proprietary, shared/regional, and
national/international.
A proprietary system is operated by a financial institution that purchases or
leases ATMs, acquires the necessary software or develops it in-house, installs the
system and markets it, and issues cards of its own design (proprietary systems are
less prevalent today).
A shared/regional system is a network that comes into being when customers
of one or more financial institutions have access to transaction services at ATMs
owned or operated by other financial institutions. A common type of sharing is the
joint venture with other financial institutions, featuring common access and
cooperative control.
A national/international system is also a network, one that enables an ATM
machine in New York to connect with another in Los Angeles. Through service
agreements with regional and proprietary networks, national networks link ATM
machines coast to coast.
INTERNET BANKING
Internet banking enables a customer to do banking transactions through the bank's
website in the Internet. This is also called virtual banking, or net banking, or anywhere
banking.
For banks, the biggest advantage is reduced operational costs, compared to any other
form of banking distribution channel. Against $1.07 for branch banking, it costs only
$0.13 in Internet banking. It is still cheaper than ATM where the cost is around 0.30
cents. The additional advantage is that the bank need not invest in infrastructure and
staff management. Internet banking essentially encompasses two broad aspects, “PC
Banking” and “Internet Banking”.
“PC Banking” allows an owner of personal computers to access account information
using a modem connection to a traditional bank or financial service provider’s corporate
computer network. This access allows consumers to transfer funds within an established
bank, to pay bills, and to transact other traditional financial services without entering a
traditional branch office.
“Internet banking” is similar to “PC banking” in that it allows the delivery of traditional
financial services to customers through a home PC. What differentiates “Internet
banking” from “PC banking” is the nature of the financial institution delivering the
services to customers, and the importance of the public Internet to the provision of these
products to the customers. Traditional banks have historically used private networks to
deliver services to customers through personal computers or via the telephone. Internet
banks may not possess a physical branch network at all. Instead, these entities may
operate secure network servers in a variety of locations, with only a small number of
human personnel to handle customer queries. Internet banks may deliver financial
services to customers from almost any location, and to almost any location, thus posing
potentially onerous tasks for regulatory authorities.
Although bankers still talk of "relationships," their services have been unbundled. Each
service must stand alone as a profit center. This results in higher costs for banking
services formerly provided as either part of the relationship or subsidized by other high-
margin services. As a result of the banking industry's intense competition, rapid rate of
product development, evolving technology, and continuing consolidation, most Banking
businesses have started to offer several fee based services which were earlier being
provided as part of the overall relationship with a customer. These fee based services
today account for a substantial portion of a Bank’s revenue.
Bank Management sets fees and charges for banking services to ensure that the bank is
adequately compensated for the services it provides. When setting fees and charges,
Bankers take into consideration the possible exposure to loss, which may be incurred for
providing the service, the effort required of the Bank and the amount of time required
performing the service properly. Some of the more common fee based services being
offered by Banks to retail customers today are described in this section. Although most
of these services are related to Payments they can broadly be categorized under the
following broad headings
COLLECTION SERVICES
Lockbox
Using lockbox banking is a cash flow improvement technique in which the Bank has its
Clients' payments delivered to a special post office box instead of the business address.
The difference between this special post office box and a regular post office box is that
only the Bank’s Clients' payments are delivered to the box. Instead of the Client picking
up the payments, the bank's couriers have a key to the post office box, and they remove
its contents and deliver the payments to the bank. The bank opens the payments and
then processes the payments for deposit directly into the Client’s bank account.
Depending on the nature of the business, the contents of the Clients’ lockbox can be
removed and processed once a day, or more often if required.
The Client can establish lockboxes in several different post offices or cities. A basic rule
is that lockboxes should be set up nearest to the Client’s customers to reduce the
amount of time between the customers' mailing their payments and the deposit into the
Clients’ bank account.
Lockbox banking accelerates the payment and deposit portion of the Clients’ cash
conversion period in two different ways. First, lockbox-banking cuts down on any postal
delays caused by having the Clients’ customers' payments delivered to your business
address. Mail delivered to the Client’s place of business entails some extra sorting so
that the mail gets into the hands of the correct carrier, not to mention the added time it
takes the carrier to actually deliver it to the Client’s address. Second, using a lockbox
shortens the amount of time necessary to process the Clients’ customers' payments, by
having the Clients’ bank open the payment envelopes and deposit them directly into the
Clients’ bank account. Since the payment processing is done at the bank, the Clients’
customers' payments are received and deposited all within the same day. If the Client
were to do this work himself it can delay the deposit of the payments anywhere from one
to two days (depending on how long it takes you to process the customers' payments for
deposit, and to actually make the deposit at the bank).
PAYMENT SERVICES
Bank Drafts
A Bank Draft is an instrument, comparable with a cheque, signed by a drawer to a
drawee requesting payment for a fixed amount at a future time to a named beneficiary
(third party).
Bank drafts are a safe and convenient method of paying. Paying through a bank draft
means the Client’s money stays in her account until the day her payment is due. The
Client will never need to worry about remembering to make her payment, nor will she be
concerned with late payment charges or lost payments due to unpredictable mail
service. And in addition to the convenience, the Client can save costs related to checks
and postage.
Risks involved
Drafts may be lost or stolen
If fraud occurs, there is no recourse to claim lost money
Drafts are not easily replaceable
It is costly to sort out queries on lost or stolen drafts
Most banks charge the person requesting the draft to pay a fee. If the item is of low
value, this fee could be more than the value of the draft.
Money Orders
A Money Order is a financial instrument, issued by a bank or other institution, allowing
the individual named on the order to receive a specified amount of cash on demand.
Money Orders are a convenient, safe and economical alternative to personal and bank
cheques. It is often used by people who do not have checking accounts.
Overdrafts
An overdraft is an instant extension of credit from a lending institution. For example, if a
customer has an overdraft account, her bank will cover checks, which would otherwise
bounce. The customer is required to pay interest on the outstanding balance of the loan
much like any other loan. It is essentially a loan linked to a current account. The loan
amount varies in that the customer can draw as much as she needs up to the agreed
limit. It is an ideal solution for those unforeseen expenses.
The amount that the customer can borrow depends on how much she may need and
how fast she can repay it. The Bank reviews the amount every year with a view to either
increasing or decreasing it, depending on how well the customer has managed it.
An overdraft facility can be renewed on an annual basis and the customer only pays for
what she uses.
Overdraft protection
This is a checking account feature in which a person has a line of credit to write checks
for more than the actual account balance. Instead of getting charged for bouncing a
check, overdraft protection will in effect provide the account holder with an instant loan.
The interest rate will be extremely high, but if it is paid off quickly it is usually much less
expensive than the bounced check fee.
Check Coverage
Check Coverage automatically transfers available funds from the customer’s designated
savings or money market accounts to cover checking account overdrafts. Check
Coverage also gives the customer immediate access to checks deposited at the ATM,
up to daily cash withdrawal limit, if she has available balances in your savings, money
market accounts, or CDs and allows customers to write checks against the deposits
made on the same day.
Certified Check
It is a special kind of Check issued by a Bank for which the bank guarantees payment.
This is issued by a bank, which certifies that the maker of the check has enough money
in her account to cover the amount to be paid. The bank sets aside the funds so that the
check will remain good even if other checks are written on the particular account. Like a
cashier's check, a certified check guarantees that it is immediately good since it is
guaranteed by the bank and the recipient does not have to wait until it "clears."
Cashier's Check
It is a check, which cannot bounce because its face amount is paid to the bank when it is
issued, and the bank then assumes the obligation. The check is received as cash since
it is guaranteed by the bank and does not depend on the account of a private individual
or business. Cashiers' checks are commonly used when payment must be credited
immediately upon receipt for business, real estate transfers, tax payments and the like.
Travellers Cheques
A travelers cheque is a form of negotiable instrument, which entitles the check’s holder,
provided the Terms relating to the travelers cheque, have been properly followed, to
payment of the check’s face value on presentation of the cheque for payment by the
holder. The face value of a travelers cheque is the amount specified in a particular
currency on the cheque as payable to the cheque holder. The customer may request
travelers checks in a wide range of currencies and for a range of predetermined
amounts.
A travellers' cheque is the equivalent to cash but is more secure in that the person using
them will be refunded if they are stolen. The have a value in the currency they were
issued.
The Investment Advisory Services programs in Banks are generally designed keeping in
mind needs of customers who seek distinct financial solutions, information and advice on
various investment avenues. Banks have dedicated financial consultants at their branch
offices who provide need based advisory services to the customers. These financial
consultants design and implement a unique asset allocation strategy for each customer
that is determined based on the customer’s investment objectives, which could be any of
the following
Capital Appreciation
Reliable Income
Wealth preservation
These financial consultants periodically review the customer’s portfolio to help the
customer weather economic and market changes, and also leverage possible growth
opportunities.
In addition to providing these Investment Advisory Services, Banks also cater to the
needs of customers by providing tailor made solutions through the various products they
have on offer. These products / services may include one or more of the following
Bonds – The financial consultant would advise to invest in a broad array of fixed
income products including U.S. Treasury and Federal Agency bonds, corporate
bonds, municipal bonds and mortgage backed securities.
Mutual Funds – The financial consultant can recommend mutual funds selected
by the Bank’s mutual fund research team using a proprietary mutual fund screening
and selection model.
Managed Mutual Fund Portfolios - Through the bank’s managed mutual funds
portfolio program, the consultant determines asset allocation strategy that best
matches with the customer’s long term needs and attitudes toward risk, and
structures a professionally managed mutual fund portfolio.
FEDWIRE
Fedwire stands for Federal Reserve Wire Network. It is a high-speed electronic
communications network that links the Federal Reserve Board of Governors, the 12
Federal Reserve Banks and the 24 branches, the U.S. Treasury Department, and other
federal agencies. Fedwire enables transfer of funds throughout United States. It is used
by Federal Reserve Banks and Branches, the Treasury and other government agencies,
and some 9,500 depository institutions.
A Fedwire is an electronic transmission. The transmission contains inter-bank codes that
are changed continually, a reference number, the names of the sending and receiving
banks, the transfer amount, and the name and account number of the sending account
holder and the receiving account holder.
Fedwire is used for all large dollar time-sensitive payments and funds transfers between
reserve banks. The following diagram depicts a typical FEDWIRE transaction.
Customer A
Customer B
Bank A Bank B
Debit Bank
Credit Bank
Payment A Account
B Account
Request
Inter District
Reserve Fund
CHIPS
CHIPS means Clearing House Interbank Payment System. CHIPS, Clearing House
Interbank Payments System, is the premier bank-owned payments system for clearing
and settling large value payments. CHIPS is a real-time, final payments system for U.S.
dollars that uses bi-lateral and multi-lateral netting for maximum liquidity efficiency.
CHIPS is the only large value system in the world that has the capability of carrying
extensive remittance information for commercial payments. CHIPS processes over
267,000 payments a day with a gross value of over $1.37 trillion. It is a premier
payments platform serving the largest banks from around the world, representing 22
countries worldwide.
OTHER SERVICES
Maintenance fees: Some Banks may charge a small annual fee for maintaining the
customer’s account. Certain other Banks may not charge any maintenance fee at all.
The maintenance fee might also vary from customer to customer for the same Bank.
A customer might even be able to get a free checking account, if she uses direct
deposit for your paychecks, if she is a shareholder of the bank or if she limits her
bank branch visits and/or transactions.
Low-balance penalty: While most Banks offer "free" checking if the customer
maintains a substantial balance (the customer is though paying the opportunity cost
of tying up her money in a low- or no-yield account while the bank lends it out at a
hefty interest rate) some other Banks might charge a penalty if the account balance
falls below a pre-defined threshold. The threshold limit might be based on the
account’s average daily balance, the lowest balance in the month, or the balance on
a certain day of the month, so it is up to the customer to satisfy the threshold criterion
so that there is no low-balance penalty for her account.
ATM surcharges, "Foreign" ATM fees: Banks may also charge their customers for
ATM usage. Mostly if the customer is using an ATM, which is not owned by the
Bank, the Bank charges a surcharge, part or all of which is paid by the Bank to the
Bank owning the ATM.
Returned check: A Bank may also charge a Customer for a check that has been
presented by this Customer, if the check bounces.
Bounced check: If a Customer has written a check for an amount, which cannot be
covered by the available funds in the customer’s account, an insufficient funds fee
(NSF) will usually be imposed by the Bank. The only recourse to this is if the
Customer gets an overdraft protection.
Check printing: Some banks offer free checks for first-time account holders,
account holders with a large minimum balance, senior citizens, students, and certain
others. Most of the other Banks, however, charge a small fee for making checks
available to the customers.
Per-check charges: Some Bank accounts include a certain number of checks per
month and charge a fee for the number of checks used above the free check limit.
Closed account: Some banks charge a fee if the Customer closes an account that
hasn't been utilized for a sufficiently long time (usually two years).
Safe box holders may visit the Bank vault at any convenient time during the Bank’s
business hours, with their safe boxes being at their full disposal. The Bank disregards
the contents of the safe box, its rights not applying to such contents. In providing this
Service, the Bank charges fees for holding safe boxes in accordance with the applicable
fee schedule and depending on their size.
Typical items that can be protected in a safe deposit box with a Bank include, but are not
limited to:
Lease Agreements
Birth Certificates
Confidential Items and Documents
Income Tax Records
Insurance Policies
Jewelry
Loan Documents
Property Deeds
Stock Certificates
Savings Bonds
Trust Documents
REGULATORY REQUIREMENTS
Regulations
The Federal Reserve Board has implemented TILA through two key regulations:
Regulation Z – This explains how to comply with the consumer credit parts of the law.
Regulation Z applies to each individual or business that offers or extends consumer
credit if four conditions are met:
The credit is offered to consumers.
Credit is offered on a regular basis.
The credit is subject to a finance charge (i.e. interest) or must be paid in more
than four installments according to a written agreement.
The credit is primarily for personal, family or household purposes.
If credit is extended to business, commercial or agricultural purposes, Regulation Z does
not apply.
Regulation M – This includes all the rules for consumer leasing transactions. Regulation
M applies to contracts in the form of a bailment or lease where the use of personal
property by a person primarily for personal, family or household purposes. The lease
period must exceed four months, and the total contractual obligations must not exceed
$25,000, regardless of whether the lessee has the option to purchase the property at the
end of the lease term.
Other Agencies
In addition to the Federal Reserve Board, other federal agencies may have regulations
for certain special lines of business. For example, the Department of Transportation has
certain Truth In Lending Act regulations applicable to airlines. The Veterans
Administration, the Department of Housing and Urban Development, the Federal Home
Loan Bank Board and the National Credit Union Administration are also involved in the
enforcement of the Truth In Lending Act. The Truth In Lending Act is designed to reduce
confusion among consumers resulting from the different methods of computing interest.
It does not require creditors to calculate their credit charges in any particular way.
However, whatever alternative they use, they must disclose certain basic information so
that the consumer can understand exactly what the credit costs.
Home Mortgages
One of the biggest lending transactions any individual is likely to enter is borrowing to
purchase a home. These transactions have become more complicated in recent years.
The Federal Reserve Board and the Federal Home Loan Bank Board have published a
book entitled "Consumer Handbook on Adjustable Rate Mortgages" to help consumers
understand the purpose and uses of adjustable rate mortgage loans. Regulation Z
requires that creditors offering adjustable rate mortgage loans make this booklet, or a
similar one, available to consumers.
Disclosure
Disclosure is generally required before credit is extended. In certain cases, it must also
be made in periodic billing statements. Regulation M includes similar rules for disclosing
terms when leasing personal property for personal, family or household purposes, if the
obligations total less than $25,000.
There are five terms that are considered to be "material" disclosures required by TILA.
While other disclosures are required, these are deemed to be so important that a failure
to give any one of them gives you the right to rescind the loan transaction
1. Finance Charges - This is perhaps the most important disclosure made. The
"finance charge" is defined as the cost of credit over the life of the loan,
expressed as a dollar amount. This includes, not only interest, but also any other
charge that is required as a condition of receiving credit. Examples include:
"points", document preparation fees and other fees, which are excessive,
compared to their purpose (like excessive fees for notaries, appraisals, credit
reports, title examinations, etc.).
2. Annual Percentage Rate - This is the measure of the cost of the credit, which
must be disclosed on a yearly basis. APR is the cost of credit expressed as a
percentage. For example, a loan with an interest rate of 17% may have an APR
of 25% (all finance charges are rolled into the APR).
3. Amount Financed - This is the amount that is being borrowed in a consumer loan
transaction, or the amount of the sale price in a credit sale that is expressed as a
dollar amount. It is calculated by taking the principal amount of the loan and
subtracting those amounts that are financed as part of the principal that are
considered part of the finance charge. For example: you take out a $100,000
note and deed of trust on your home. The 5 points ($5,000) charged on this loan
are financed and are therefore included in the $100,000 principal on the note.
However, since the five points are defined as part of the finance charge, they are
subtracted from the $100,000 in determining the amount financed ($100,000-
$5,000 = $95,000).
4. Total of Payments - This includes the total amount of the periodic payments by
the borrower/buyer that is expressed as a dollar amount. It represents the total
dollar cost of the loan to you, assuming all payments are made on time. The total
of payments is calculated by adding up all payments disclosed in the schedule of
payments.
5. Total Sales Price - This is the total cost of the purchase on credit, including the
down payment and periodic payments.
Evidence of compliance with the Truth In Lending requirements must be retained for at
least two years after the date of disclosure. Disclosures must be clear and conspicuous
and must appear on a document that the consumer may keep.
Generally, the FCRA does not apply to commercial transactions, including those
involving agricultural credit.
Bank as a User
Few banks are consumer-reporting agencies. Most banks are users of information
obtained from them. As a user, a bank must identify itself to the consumer-reporting
agency and certify that the information requested will be used as specified in the act and
for no other purpose. A written blanket certification may be given by the bank to cover all
inquiries to a particular consumer-reporting agency. Banks also rely on information from
sources other than consumer reporting agencies. As a user, a bank must disclose
different information depending on its source.
Banks may disclose orally the information required under the FCRA. However, in certain
cases when the credit is denied, the bank must make additional written disclosures to
the consumer (Regulation B). The required disclosures for both the FCRA and
Regulation B may be provided on the same disclosure form, but they are independent
and one cannot substitute for the other.
Option 2 allows data taken from the MICR line of the original check or an electronic
image of the original check to be sent to a recipient in lieu of the original check, so long
as there is an agreement between the parties to allow it. [These "agreements" may be
between multiple parties, rather than individual bank to individual bank. For example,
there may be a network agreement, or clearinghouse rules that constitute the
"agreement.]
Obviously, the efficiency of the payment system will not be greatly enhanced if parties in
the chain insist upon paper. If a recipient demands paper, a substitute check must be
created and couriers will be needed to transport the item from point A to point B. If an
image can instead be exchanged, it can be digitally transported, with resulting savings in
time and money.
If a bank must produce a substitute check (because the next person in the chain refuses
to agree to accept an image), it will incur costs as a result, so it is anticipated that an
institution required to produce a substitute check will want to be compensated with a fee.
Check 21 is applicable to all deposit accounts.
While Check 21 applies to all deposit accounts, there are special protections built into
the Act for consumers. One protection is a notice/disclosure that consumer depositors
must be given. The second protection consists of an expedited process for recrediting
the account of a customer who makes a covered claim relating to a substitute check.
The law mandates that the notice to consumer customers cover two areas: the legal
equivalence of a substitute check and a description of what the consumer’s expedited
recrediting rights are in the event of certain problems with substitute checks.
The second component of the consumer protection measures in Check 21 is an error
resolution/ investigation procedure, which revolves around substitute checks, and
problems that a consumer may experience with them. Its goal is to resolve errors in a
speedy manner so that the customer is not wrongly without the use of disputed funds for
an extended period of time. In order for the procedure to apply:
It must be a consumer making a claim for expedited recredit;
The claim must be in connection with a substitute check
Not an image, not a copy, not an original;
The bank must have charged the consumer's account for a substitute check that was
provided to the consumer;
The consumer must make a claim in good faith;
The claim must be made before the end of the 40-day period beginning on the later
of l) the date on which the statement was mailed or delivered; or 2) the date on which
the substitute check was made available;
The customer must have suffered a loss; and
The production of either the original check or a better copy of the original must be
necessary to determine the validity of the claim;
The claim must relate to one of the following two grounds:
• The check was not properly charged to the consumer's account; or
• The consumer has a warranty claim with respect to the substitute check.
Multi-channel Integration
Multi-channel integration is garnering the attention of a growing number of banks.
Although it is far from becoming a mainstream exercise, it is moving away from the
early-adopter phase to being a feasible initiative for most banks to undertake. The
question is not if but when. Second-wave adopters are moving gradually, due to the
complexity and cost of integration. Many of these banks are gaining additional fortitude
to move forward by relying on third-party solution providers. Internet banking and call
center platforms are proving to be ripe targets for integration.
Banks are increasingly convinced that Internet banking's ROI can extend beyond simple
cost-to-serve equations and direct revenue models. Driven by enhancements in Internet
banking's user-friendliness, Internet banking's ROI now encompasses generating
revenues indirectly by improving customer satisfaction with Internet banking, which in
turn, has proven to translate into greater customer retention and higher balances. Banks'
demands also include lowering cost-to-serve through self-service features with broad
appeal (e.g., check image access and e-statements) and customer support features that
not only improve customer service representatives' effectiveness but also their efficiency
(e.g., online chat).
In the world of multichannel banking, customers can check account balances on the
Web, replenish cash from an ATM, or talk to a call center to see if a check has cleared.
Customers are embracing multiple channels and banks are responding by connecting
channels to employees, wherever they may be located. The employees can access and
share up-to-date information, thereby providing better customer service.
In addition to gaining a unified view of the customer, a multichannel approach helps a
bank present itself to the customer as a single organization rather than a series of
separate channels. Customers then can feel at ease switching from one channel to
another depending on their needs, knowing their needs will be met, regardless of which
channel they choose.
There is a growing portfolio of channels that retail banks are using to provide their
customers access to required information, such as Branch offices, Wireless devices
Internet or intranet, ATMs, POS terminals, Kiosks and Call centers.
BANCASSURANCE
Bancassurance in its simplest form is the distribution of insurance products through a
bank's distribution channels. In concrete terms bancassurance describes a package of
financial services that can fulfill both banking and insurance needs at the same time. It
takes various forms in various countries depending upon the demography and economic
and legislative climate of that country. Demographic profile of the country decides the
kind of products bancassurance shall be dealing in with, economic situation will
determine the trend in terms of turnover, market share, etc., whereas legislative climate
will decide the periphery within which the bancassurance has to operate.
The motives behind bancassurance also vary. For banks it is a means of product
diversification and a source of additional fee income. Insurance companies see
bancassurance as a tool for increasing their market penetration and premium turnover.
The customer sees bancassurance as a bonanza in terms of reduced price, high quality
product and delivery at doorsteps. Actually, everybody is a winner here.
By leveraging their strengths and finding ways to overcome their weaknesses, banks
could change the face of insurance distribution. Sale of personal line insurance products
through banks meets an important set of consumer needs. Most large retail banks
engender a great deal of trust in broad segments of consumers, which they can leverage
in selling them personal line insurance products. In addition, a bank’s branch network
allows the face-to-face contact that is so important in the sale of personal insurance.
Another advantage banks have over traditional insurance distributors is the lower cost
per sales lead made possible by their sizable loyal customer base. Banks also enjoy
significant brand awareness within their geographic regions, again providing for a lower
per-lead cost when advertising through print, radio and/or television. Banks that make
the most of these advantages are able to penetrate their customer base and markets for
above-average market share.
Other bank strengths are their marketing and processing capabilities. Banks have
extensive experience in marketing to both existing customers (for retention and cross
selling) and non-customers (for acquisition and awareness). They also have access to
Page 161 of 186
Foundation Course in Banking
MARKET LANDSCAPE
The retail banking services market in the US has been growing steadily with a growth of
∗
approximately 4% to US$1.2 billion in 2002.
The retail banking services market remains fragmented, with many small regional
players and the five largest companies accounting for only 35% of the total market value
in 2002.
Real estate loans remained the largest sector in the retail banking services market with a
growth rate of 18.5% over the 5-year review period of 1998-2002, from US$638.6 billion
in 1998 to US$757 billion in 2002 to capture approximately 63% of the market.
The retail banking services market is expected to grow approximately 11.1% from
US$1.3 billion in 2003 to US$1.4 billion in 2007.
Real estate loans are expected to remain the largest sector in the retail banking services
market with an expected growth of 9.5% over the forecast period from US$787.2 billion
in 2002 to US$862.3 billion in 2006, accounting for 61.6% of the total market value.
KEY PLAYERS
The following a list of the leading US Bank and thrift holding companies in terms of their
deposits.
3 J.P. Morgan Chase & Co. New York 326,492,000 304,753,000 293,650,000 279,365,000 241,745,000
4 Wells Fargo & Co. San Francisco 247,527,000 216,916,000 187,266,000 169,908,000 133,001,000
Statistics from report “Retail Banking Services in the USA 2003” by CMS Info
(www.cmsinfo.com)
Page 163 of 186
Foundation Course in Banking
14 Bank of New York Co. Inc. 56,407,686 55,386,576 55,711,190 56,376,046 55,750,348
The following table ranks the top 10 Retail Banks in the US on the basis of the size of
their assets. (As on March 2004, all figures in USD million)
• Bank One reported total assets of US$277.4 billion in 2002, up 3.7% from US$267.6
billion in 2001.
• Wells Fargo & Company reported a 13.6% increase in its assets over the previous
year, to US$349.3 billion in 2002 from US$ 307.6 billion in 2001, partly attributable to
the increased insurance revenues as a result of the purchase of insurance company
Acordia in 2001.
mega-mergers create, they will inevitably face even more intense competition and could
be forced to expand their own geographic reach.
US targets can be expensive. Bank of America’s decision to pay a 42% premium over
FleetBoston’s share price indicates that US banks are unlikely to sell themselves
cheaply, especially as signs of a global economic recovery emerge. The bar has been
raised for acquisition prices in the US, and this could create a strong deterrent to
European banks considering US partners, despite the favorable exchange rate they
enjoy today.
Citigroup appears to be the only large US bank currently looking for merger opportunities
in Europe. Due to the fragmented nature of the US market, most US players are
focusing on domestic consolidation as their immediate priority. Yet unless US regulators
increase the 10% limit on a bank’s market share of US retail deposits, expanding players
like Bank of America will find it difficult to pursue further large US mergers. As the
market evolves, US banks could choose instead to look to Canada for cross-border
deals.
Although there are several scoring methods, the score most commonly used by lenders
is known as a FICO because of its origins with Fair Isaac and Company. Fair Isaac is an
independent company that came up with the scoring method and software used by
banks and lenders, insurers and other businesses. According to FICO, the various
factors used to calculate credit scores can be grouped into five primary areas:
• Payment history
• Outstanding debt
• Number of years of credit usage
• Pursuit of new credit
• Types of credit in use
The scale runs from 300 to 850. The vast majority of people will have scores between
600 and 800. Credit score also influences the interest rate for loans and the difference in
the interest rates offered to a person with a score of 520 and a person with a 720 score
works out a substantial 3.45 percentage points.
500-549 5 percent
550-599 7 percent
600-649 11 percent
650-699 16 percent
700-749 20 percent
749-799 29 percent
Each of the three major credit bureaus (Experian, Equifax and TransUnion) worked with
Fair Isaac in the early 1980's to come up with the scoring method.
The three national credit bureaus have their own version of the FICO score, based on
their individual systems.
Each system is based on the original Fair Isaac FICO scoring method and produces
equivalent numerical results for any given credit report. Some lenders also have their
own scoring methods. Other scoring methods may include information such as your
income or how long you've been at the same job.
The issuer distributes the cash flow from the underlying collateral over a series of
classes, called “tranches” which make up the CMO issue. Each CMO is a set of two or
more tranches, each having average lives and cash flow patterns designed to meet
specific investment objectives.
Sequential pay structure: There are many kinds of CMO and one of the simplest is a
sequential pay or a pure vanilla CMO. This typically comprises three or four tranches
that mature sequentially. All tranches participate in interest payments from the mortgage
collateral, but initially, only the first tranche receives principal payments. It receives all
principal payments until it is retired. Next, all principal payments are paid to the second
tranche until it is retired, and so on.
Any collateral remaining after the final tranche is retired is called a residual. Sometimes,
the residual is also traded as a stand-alone security.
CMOs entail the same prepayment risk as mortgage pass-throughs. The risk of a
specific bond depends upon how it is structured and the underlying collateral. Many
different structures are used in practice, including
• Z-bonds
• PAC bonds
• IOs and POs
• Floaters and inverse floaters.
Cash flows for a CMO with three sequential pay bonds followed by a
single Z bond are depicted above. Note that interest payments made by
borrowers during the early years of the CMO are treated as principal
payments to the A, B and C bonds. Principal payments made by
mortgagors during the later years of the CMO are treated as payments
of accrued interest to the Z bond.
Planned amortization class (PAC): PAC bonds are a type of CMO bond. They are
designed to largely eliminate prepayment risk for investors. They do this by transferring
all prepayment risk to other bonds in the CMO. Appropriately, those other bonds are
called support or companion bonds.
PAC bonds offer a fixed principal redemption schedule that will be met so long as
prepayments on the underlying mortgage collateral remain within a specific range, which
is called a prepayment protection band.
Various related structures have been devised that offer a form of subordinate
prepayment protection. A PAC II bond is formed from the cash flows of support bonds
for regular PAC bonds. They offer a fixed principal redemption schedule so long as
prepayments remain within another, narrower, prepayment protection band. They are
more risky than PAC bonds, but offer higher yields. Continuing on the theme, PAC III
bonds are formed from cash flows of support bonds for PAC II bonds.
Targeted amortization class (TAC): TAC bonds are analogous to PAC bonds, but are
structured differently. They offer one-sided protection, shielding investors from high
prepayment rates up to a specified PSA. They do not protect against low prepayment
rates.
Interest only (IO) and principal only (PO): These bonds are obtained by stripping the
interest cash flows from the principal cash flows of mortgage collateral. The interest cash
flows form one bond, which is the IO. The principal cash flows form a second bond,
which is the PO.
Prepayment risk tends to be extreme for IO's and PO's, with one benefiting when the
other suffers. This is because
• Total payments to a PO are fixed—all that is uncertain is the timing of those
payments. Prepayments are desirable because the holder of the PO receives the
money earlier.
• Total payments to an IO are not fixed. Prepayments are undesirable because
they reduce future interest payments
Floater: A floater is a fixed income instrument whose coupon (interest rate) fluctuates
with some designated reference rate. The coupon rate is usually reset each time interest
is paid. A typical arrangement might be to pay interest at the end of each quarter based
on the value of 3-month Libor at the start of the quarter. The coupon rate is calculated as
the reference rate plus a fixed spread, which depends upon the issuer's credit quality
and specifics of how the instrument is structured.
Inverse Floater: If collateral for a CMO comprises fixed rate mortgages, they can be
structured by pairing offsetting floater and inverse floater tranches.
An inverse floater (or reverse floater) is a floater whose coupon fluctuates inversely with
its reference rate—increasing when the reference rate decreases and decreasing when
the reference rate increases. With each coupon payment, the floating rate is reset for the
next period according to the formula:
The multiplier is called the coupon leverage. Often, it is equal to 1, but not always. If it
exceeds 1, the instrument is called a leveraged inverse floater.
A typical structure for an inverse floater might have a maturity of five years, pay interest
quarterly, and offer a floating rate of 12% minus two times a reference rate of 3-month
USD Libor. There might also be a cap and/or floor for the floating rate.
Mortgage-Backed Bonds (MBB): MBBs are bonds issued by a Financial Institution that
have mortgages serving as collateral against the bonds. The MBB bondholders receive
a stated rate of interest that is not tied to the cash flows of the mortgage assets. The
issuance of MBBs does not remove the mortgage asset from the balance sheet and the
issuer retains all the liability for making payments to the investors. So, this is like any
other secured corporate debt with the exception that mortgage pools serve as the
collateral.
MBBs and pass-throughs are non-derivative products whereas CMOs are known as
derivative products.
There are various costs associated with a mortgage and we look at some of them in
detail here.
FRM Interest Rates – FRM interest rates vary with the term of the mortgage loan. The
rate usually is higher for greater terms. The interest rates for different months in 2003 is
presented below.
US National monthly averages 2003
APR Calculation – APR calculation is supposed to help out the borrower in comparing
the loan products of various lenders. But, the fact that there is no single way of
calculating the APR leads to some confusion. The costs that are used for APR
calculation are given below.
Closing costs – These are the costs that the borrower needs to pay while “closing” the
loan. Sometimes, these can also be included to the principal and be made a part of the
loan. Closing costs include the following:
• Appraisal fee-Is the fee paid to the property appraiser for providing the lender with a
reasonable estimate of property value for loan purposes. FHA and VA loans set a
maximum limit for the fee but conventional loan appraisers can determine their own
charges.
• Attorney/settlement fee-this is a charge for all the paperwork and research required
by the mortgage lender
• Credit report-the cost for reports on credit history so that the lender can verify credit
worthiness. Cost for reports range from $55 to $70.
• Points- fees the borrower pays the lender at the time the loan is closed, expressed
as a percent of the loan. So, 1 point equal to 1% of the loan. Typically higher points
Page 174 of 186
Foundation Course in Banking
paid will result in a lower interest rate on the loan of the same tenor. Points are used
as an additional pricing parameter to suit individual borrowers initial down payment
ability. Points comprise origination point and discount point(s)
o Origination point-a fee collected by the lender for obtaining a loan. On FHA
and VA loans, this cannot exceed 1% of the base loan amount; conventional
loans have no such limits.
o Discount point(s)-a one-time charge paid to reduce the interest rate on the
loan. The lower the interest rate, the higher the discount points will be.
However, depending on market conditions, a loan may or may not have
discount points.
• Sales commission-This is usually paid by the seller; this is the charge from the real
estate company or builder's representative who sold the property to the homebuyer.
For the real estate company, the charge is generally a percentage of the sales price;
builders may receive a straight fee per house.
• Survey-Charges for the survey, done by an engineer, shows the lot measurements
and all recorded or unrecorded easements or restrictions against the lot. This
ensures that the house and lot being sold are the same as the current deed.
• Title insurance-This protects the lender from title liens placed upon the new home.
Any claims that would cause problems with the lender's first lien on the property and
that was not detectable through the title search would be protected with this
insurance.
• Recording changes-This is the cost to record mortgage loan papers and the deed at
the county courthouse.
• Termite inspection-checks for wood damage or infestation of any kind from wood
destroying insects.
A grantor trust is the simplest auto ABS issuers, but is rarely used with newer
transactions. A grantor trust is a pass-through structure that requires a pro rata share of
principal and interest from the underlying collateral to be “passed-through” to investors.
Investors, also referred to as certificate holders, are entitled to all of the cash flows from
the auto loan receivables.
The absolute prepayment speed or ABS is the standard measure of prepayment rates in
the auto loan sector. This plays a role similar to the one played by CPR in MBS.
ABS = (100*SMM)/(100+SMM*(AGE – 1)
The ABS measurement differs from CPR, which measures prepayment as an
annualized percentage of the current pool balance.
Most prepayments on auto loans result from either defaults or trade-ins.
Borrowers rarely refinance existing car loans because interest rates tend to
be higher for used cars than new cars. A loan resulting from a refinancing
would be considered a used car loan. Thus, auto loan prepayments tend to
be fairly predictable and not highly correlated with interest rate changes.
Owner trusts are typically used when the cash flows of the assets must be “managed”
to create “bond-like” securities. Unlike a grantor trust, the owner trust can issue
securities in multiple series with different maturities, interest rates, and cash flow
priorities.
Prepayment Rate
The absolute prepayment speed or ABS is the standard measure of prepayment rates in
the auto loan sector. This plays a role similar to the one played by CPR in MBS.
ABS measures the monthly rate of loan prepayments as a percentage of the
original pool balance. ABS is defined by the formula below where SMM
refers to single monthly mortality, which measures the percentage of dollars
prepaid in a given month expressed as a percentage of the scheduled loan
balance.
ABS = (100*SMM)/(100+SMM*(AGE – 1)
The ABS measurement differs from CPR, which measures prepayment as an
annualized percentage of the current pool balance.
Most prepayments on auto loans result from either defaults or trade-ins.
Borrowers rarely refinance existing car loans because interest rates tend to
be higher for used cars than new cars. A loan resulting from a refinancing
would be considered a used car loan. Thus, auto loan prepayments tend to
be fairly predictable and not highly correlated with interest rate changes.
securities in multiple series with different maturities, interest rates, and cash flow
priorities.
Three methods have been used to transfer the beneficial interest in the segregated
leases to the securitization trust, each of which results in the transfer of the rights to the
cash flows from the segregated lease contracts and corresponding vehicles to the
securitization trust.
Undivided Trust Interests and Special Units of Beneficial Interests: The more
common method, used by Honda, Toyota, and World Omni, involves the creation of an
UTI and a SUBI.
The UTI represents a beneficial interest in all the unallocated assets of the origination
trust and is sold to an SPE. A separate portfolio within the origination trust is created
from the existing lease contracts and vehicle pool. A SUBI in the newly formed subset is
sold in a true sale to the securitization trust. After the sale, the “discrete portfolio” is no
longer part of the origination trust’s assets encumbered by the UTI. Multiple SUBIs may
be created from a single origination trust, as directed by the SPE, which represent
beneficial interests in unique asset pools as collateral for individual securitizations. Each
SUBI only has a claim on the assets associated with it and has no claim on any other
SUBIs, the remaining assets of the origination trust, or the UTI.
Sale/Leaseback Structure: The second method, used by Ford Credit and The
Provident Bank, involves a sale/ leaseback structure. For example, under Ford Credit’s
structure, unallocated leases represented by exchangeable beneficial certificates (EBC),
equivalent to the UTI, are segregated into individual trust certificates for each
securitization. Each of these trust certificates is then sold in a true sale to a Red Carpet
Lease (RCL) trust, an SPE created by Ford Credit for each securitization. Each RCL
trust then enters into a sale/leaseback transaction with the securitization trust. This
transaction is effected through the sale of the trust certificate to the securitization trust.
Leveraged Lease Structure: Some auto lease originators, including Provident Bank,
find themselves in a position where they are unable to take full advantage of the tax
benefits associated with the depreciation of the leased vehicles because they either
have more deductions than income or are subject to the alternative minimum tax. In
response, the concept of leveraged lease transactions was developed. A typical asset
backed leveraged lease transaction is very similar to a sale/leaseback structure, with the
exception that a portion of the purchase price of the lease contracts and related vehicles
is financed by equity investors and a portion with debt.
Leasing Financing
Up-front costs of leasing a vehicle may include Up-front costs of buying a vehicle
the first month’s payment, a refundable security may include the cash price or a
deposit, a capitalized cost reduction (like a down down payment, taxes, registration
payment), registration fees, taxes, and other fees, and other charges.
charges due at lease signing or delivery.
Capitalized cost reduction. A capitalized cost Cash price or down payment. The
reduction is the sum of any cash down payment, full cash price must be paid when
net trade-in allowance, or rebate that is you purchase the vehicle, unless
subtracted from the gross capitalized cost. The you obtain financing. If the vehicle
remainder is the adjusted capitalized cost of the is financed by either the seller or a
lease. A capitalized cost reduction reduces the third party, a down payment is often
monthly payment by (1) decreasing the amount required. The remaining cash you
of depreciation and any amortized amounts that must pay for the purchase or the
are a part of the monthly payment and (2) amount you must finance may be
decreasing the total rent charges by lowering reduced by a net trade-in allowance
the beginning lease balance (the adjusted or a rebate.
capitalized cost), thereby reducing the average
lease balance over the term.
Taxes. Several types of taxes may be due at Sales taxes. State and local sales
lease signing, depending on the taxation rules of taxes are typically assessed on the
the state and the policies of the lessor, such as full purchase price. However, if a
State sales tax on any capitalized cost reduction vehicle is traded as part of the
County or other local taxes State sales tax on purchase, sales tax may be
the adjusted capitalized cost State property tax assessed on only the purchase
on the vehicle. Instead of paying for these taxes price minus the trade-in value,
at lease signing, you may have the option of depending on state law. You may
having the lessor include them in the gross have the option of having the
capitalized cost, thereby increasing your creditor pay the sales tax and
monthly payment. include it in the amount financed,
thereby increasing your monthly
payment.
Other taxes. Several other types of
taxes may be due at purchase,
depending on the taxation rules of
the states, such as County or other
local taxes State property tax on the
vehicle. You may have the option of
Other charges. Several other types of charges Other charges. Several other types
may be assessed at lease signing, such as of charges may be assessed at
purchase, such as
• Vehicle license and registration fees
• Vehicle license and
• Vehicle title fee
registration fees
• Documentation fee
• Vehicle title fee
• Lessor acquisition fee.
• Dealership documentation
fee Credit application fee.
Optional insurance and services. You may be Optional insurance and services.
offered optional insurance products and other You may be offered optional
services when you lease a vehicle: insurance products and other
services when you purchase a
• Credit life and disability insurance
vehicle:
• Unemployment insurance
• Credit life and disability
• Gap coverage (may already be insurance
included)
• Unemployment insurance
• Vehicle maintenance services
• Gap coverage (usually not
• Vehicle service contract or mechanical included)
breakdown protection
• Vehicle maintenance
• Other services or insurance coverages. services
• Vehicle service contract or
mechanical breakdown
For any products or services you select, you
protection
may be able to purchase them from the lessor or
from a third party. If you purchase them from the • Other services or insurance
lessor, you may have the option of including coverages.
them in the gross capitalized cost (and paying a
For any products or services you
rent charge on them) or paying for them at lease select, you can purchase them from
signing. a third party or from the creditor. If
you purchase them from the
creditor, you may have the option of
including them in the amount
financed (and paying interest on
them) or paying for them at
purchase.
First monthly payment. Most leases (other First monthly payment. Most
than single-payment leases) require you to finance agreements require you to
make monthly payments in advance at the make monthly payments at the end
beginning of each monthly period. That of each monthly period. That
stipulation is why the first monthly payment is stipulation is why the first payment
typically due at lease signing. Some leases is not made at purchase.
require that the last monthly payment or several
of the last monthly payments of the term be paid
at lease signing.
In a special type of lease called a single-
payment lease, you pay a single large payment
at lease signing instead of making monthly
payments over the term of the lease.
Prior lease balance. The balance due under a Prior lease balance. The balance
previous lease agreement after the value of the due under a previous lease
previously leased vehicle has been credited. If agreement after the value of the
the lessor agrees to buy your previously leased previously leased vehicle has been
vehicle, you will have to pay any prior lease credited. If the seller agrees to buy
balance unless it is included in the gross your previously leased vehicle, you
capitalized cost. will have to pay any prior lease
balance unless it is included in the
amount financed.
Prior credit balance. The amount due under a Prior credit balance. The amount
previous finance agreement after the value of due under a previous finance
the vehicle traded in on the lease has been agreement after the value of the
credited. If you trade your previously financed vehicle traded in on the new finance
vehicle when you lease, you will have to pay agreement has been credited. If
any prior credit balance unless it is included in you trade your previously financed
the gross capitalized cost. vehicle when you finance another
vehicle, you will have to pay any
prior credit balance unless it is
included in the amount financed.