GFMI Final: Chapters 12, 7, 13 and Highlights 14-18 Chapter 12: Commercial Banks financial statements analysis a) Financial

Statements of Commercial Banks Financial information on commercial banks is reported on two basis documents: 1. Report of condition: balance sheet of a commercial bank reporting information at a single point in time 2. Report of income: Income statement of a commercial bank reporting revenues, expenses, net profit or loss, and cash dividends Financial statements of commercial banks must be submitted at the END of each QUARTER

Retail Bank: A bank that focuses its business activities on consumer banking relationships Wholesale bank: A bank that focuses its business activities on commercial banking relationships Correspondent Bank: Bank that provides services to another commercial bank Balance Sheet Structure : Assets, Liabilities and Owners Capital Assets: 1. Cash and due from depositary institutions: currency and coin needed to meet customer withdrawals a. Vault cash b. Deposits at the Fed c. Deposits at other financial institutions d. Cash items in the process of collection 2. Investment securities (earning assets) a. Fed funds sold (Short returns vary directly with changes in interest rates) i. >90% of transactions have maturity < 1 day b. Repos (Short returns vary directly with changes in interest rates) i. Collateralized federal funds transactions c. US treasury and agency securities (Short returns vary directly with changes in interest rates) i. L/T T-bonds and US ii. T-bonds, municipals, MBS and most other securities offer somewhat higher expected returns than short-maturity investments iii. US treasury securities and Government national mortgage association bonds are fully backed by the US government and thus carry no default risk iv. Municipal securities held by commercial banks are generally high-rated, investment grade securities, issued by municipalities as either general obligation or revenue bonds. Interest paid on these is exempt from Fed tax. d. MBS

e. Other debt securities f. Equity securities 3. Loans and Leases (earning assets) a. Major asset item on Balance Sheet generates largest flow of revenue income b. Least liquid items and major source of credit and liquidity risk for most banks. c. Loan classifications: i. Commercial and Industrial (C&I) 1. Used to finance a firms capital needs, equipment purchases, and plant expansion 2. Can be made at fixed or floating rates 3. Secured loan = asset backed 4. Unsecured loan = gives the lender only a general claim on the assets of the borrower should default occur ii. Loans secured by real estate 1. Primarily mortgage loans and some revolving home equity loans 2. Resi-mortgages greatest iii. Individual or consumer loans 1. Personal and auto loans 2. Credit cards iv. Other loans 1. Loans to nonbank financial institutions 2. State and local governments 3. Foreign banks 4. Sovereign government d. Lease: used as alternatives to loans when the bank as owner of a physical asset, allows a customer to use an asset in return for periodic lease payments. 4. Other assets : These accounts are usually a small a. Premises and Fixed Assets b. Other real estate owned c. Intangible assets (goodwill and mortgage servicing rights) d. Deferred taxes, prepaid expenses, mortgage servicing fees receivable. Liabilities: consist of various types of deposit accounts and other borrowings used to fund the investments and loans on the asset side of the balance sheet. Liabilities vary in terms of their maturity, interest payments, check-writing privileges, and deposit insurance coverage. a) Deposits: are transaction accounts held by individuals, corporations, partnerships and governments that pay no explicit interest. a. NOW accounts: negotiable order of withdrawal accounts are similar to demand deposits but pay interest when a minimum balance is maintained b. MMDAs: money market deposit accounts with retail saving accounts and some limited checking account features c. Other Savings deposits: All savings accounts other than MMDAs

d. Retail CDs: Time deposits with a FV < $100,000 e. Wholesale CDs: Time deposits with a FV >= $100,000 b) Loan commitments: Contractual commitment to loan to a firm a certain maximum amount at given interest rate and terms a. Also defines the length of time over which the borrower has the option to take down this loan b. In return the bank may charge an upfront fee: the fee charged for making funds available through a loan commitment c) Commercial Letters of Credit and Standby letters of Credit a. Commercial l LC: Contingent guarantees sold by an FI to underwrite the trade or commercial performance of the buyers of the guarantee b. Standby LC: Guarantees issued to cover contingencies that are potentially more severe and less predictable than contingencies covered under trade related or commercial letters of credit d) Loans solds: Loans originated by the bank and then sold to other investors that can be returned to the originating institution a. Sold with: Recourse: the ability to put an asset or loan back to the seller should the credit quality of that asset deteriorate e) Derivative Securities: Futures, forward, swap and option positions taken by the FI for hedging or other purposes a. Contingent credit risk is likely to be present when banks expand their positions in futures, forward, swap and option contracts b. Option contracts can be sold over the counter (OTC). These are normally susceptible to default risk f) Other fee-generating activities a. Trust services i. Holds and manages assets for individuals and corporations ii. Individuals trusts represent about 50% of all trust managed by commercial banks b. Processing services i. Data processing services e.g. accounts receivable and accounts payable ii. Lock box services iii. Personal services: moving funds from savings accounts that earn interest to transaction accounts that do not earn interest as firms need to make payments. c. Correspondent Banking i. Provision of banking services to other banks that do not have the staff or resources to perform the services themselves ii. E.g. check clearing and collection, foreign exchange trading, hedging services, and participation in large loan and security issuances

Income Statement: Shows the sources of interest income. Interest Income Interest Expense Provisions for loan leases Noninterest income and expenses Income before taxes and extraordinary items Net income for the banks earned on- and off balance sheet acitives

Interest Income Interest and fee income on loans and leases is the largest income-producing category Interest on investment securities held is also included as interest income. Interest income is recorded on an accrued basis Interest income is taxable, except for municipal securities and tax-exempt income from direct lease financing

Interest expenses 2nd largest category on banks income statement o Interest on deposits o NOW accounts o MMDAs and other savings o Foreign deposits o Wholesale CDs o Interest on Fed Funds o Other borrowed funds

Net Interest income = total interest total expenses Provisions for loan losses: Noncash, tax deductible expense Current periods allocation to the allowance for loan losses listed on the balance sheet

Non-interest income: Includes all other income received by the bank as a result of its on-and off- balance sheet activities Is becoming increasingly important as the ability to attract core deposits and high-quality loan applicants becomes more difficult.

Total Operating Income = Interest Income + Non Interest Income

Non-interest expense: Mainly consist of personnel expenses and are generally large relative to noninterest income. o Items include: salaries and employee benefits o Expenses of premises and fixed assets o Other operating expenses (deposit insurance premiums) o For almost all banks noninterest expense is > noninterest income

Income before taxes and Extraordinary Items = net interest income provisions Extraordinary Items: Events or transactions that are both unusual and infrequent Net income: Income before taxes and extraordinary items income taxes plus extraordinary items in the net income for the bank Direct Relationship b/w Income Statement and the Balance Sheet

NI = Banks net income An = Dollar value of the banks nth asset Lm =Dollar value fo the banks mth liability Rn = rate earned on the banks nth asset Rm = rate earned on the banks nth liability P = Provision for loans and losses NII = Non-interest income earned by the bank, including from off balance sheet activities NIE = Noninterest expenses incurred by the bank T = Banks taxes and extraordinary items N = Number of assets that bank holds M = number of liabilities the bank holds Time series analysis: Analysis of financial statements over a period of time Cross sectional analysis: Analysis of financial statements comparing one firm with others Impact of Market Niche and Bank Size on Financial Statements Bank size has traditionally affected the financial ratios of commercial banks, resulting in significant differences across size groups

Large banks relatively easy access to purchased funds and capital markets compared to small banks access is a reason for many of these differences

Chapter 7: Mortgage Markets

Mortgages: Loans to individuals or businesses to purchase a home, land, or other real property Backed by real property i.e. if the borrower defaults on a mortgage, the financial institution can take ownership of the property No set size or denomination for primary mortgages Primary mortgages generally involve a single investor Because single investors information on these borrowers is less extensive and unaudited

Securitized: Securities packaged and sold as assets backing a publicly traded or privately held debt instrument. Securitization allows financial institutions asset portfolios to: o Become more liquid o Reduce interest rate risk and credit risk o Source of free income o Helps reduce regulatory constraints such as cap requirements, reserve requirements, deposit insurance premiums on FI profits

Primary Mortgage Market

Four basic categories of mortgages are issued by financial institutions: 1. 2. 3. 4. Home Multi-family dwelling Commercial Farm

Mortgage Characteristics
Fees Size Interest rate FI must identify if borrower qualifies

All mortgage loans are backed by a special piece of property that serves as collateral to the mortgage loan> Lien: A public record attached to the title of the property that gives the financial institution the right to sell property if the mortgage borrower defaults Down payment: A portion of the purchase price of the property a financial institution requires the mortgage borrower to pay up-front.

Borrowers that put up < 20% must purchase private mortgage insurance. Private Mortgage Insurance: Insurance contract purchased by a mortgage borrower guaranteeing to pay the financial institution the difference between the value of the property and the balance remaining on the mortgage. Mortgages are classified as either: 1. Federally insured 2. Conventional Federally Insured Mortgages: Mortgages originated by financial institutions with repayment guaranteed by either the Federal Housing Administration (FHA) or the Veterans Administration Conventional Mortgages: Mortgages issued by financial institutions that are not federally insured. Mortgage Maturity: Original maturity of either 15 or 30 years. Most mortgages allow the borrower to prepay all or part of the mortgage principal without penalty. Amortized: A mortgage is amortized when the fixed principal and interest payments fully pay off the mortgage by its maturity date. Balloon payment mortgage: Mortgage that requires a fixed monthly interest payment for a three-to five year period. Full payment of the mortgage principal (the balloon payment) is then required at the end of the period. Fixed rate mortgage: a mortgage that locks in the borrowers interest rate and thus the required monthly payment over the life of the mortgage regardless of how market rates change. Adjustable rate mortgage: a mortgage in which the interest rate is tied to some market interest rate. Thus, the required monthly payments can change over the life of the mortgage. During the height of the financial crisis, as interests rates were dropping to historic lows, virtually no ARMs were issued.

Discount points: interest payments made when the loan is issued (at closing). One discount point paid up front is equal to 1 percent of the principal value of the mortgage Other fees: Application fee Title search Title insurance Appraisal fee Loan Origination fee Closing agent and review Covers the issuers initial costs of processing the mortgage application and obtaining a credit report Confirms the borrowers legal ownership of the mortgaged property and ensures there are no outstanding claims against the property Protects the lender against an error in the title search Covers the cost of an independent appraisal of the value of the mortgaged property Covers the remaining costs to the mortgage issue for processing the mortgage application and completing the loan Cover the costs of the closing agent who actually closes the mortgage

fees Other costs

Any other fees.

Mortgage refinancing: occurs when a mortgage borrower takes out a new mortgage and uses the proceeds obtained to pay off the current mortgage. Involves the same details and steps as applying for a new mortgage. Amortization schedule: schedule showing how much the monthly mortgage split between principal and interest. For calculation of monthly mortgage payments see formula sheet. Other types of mortgages: Jumbo mortgages: Mortgages that exceed the conventional mortgage conforming limits Subprime mortgages: mortgages to borrowers who have weakened credit histories Alt-A mortgages: Mortgages that are considered more risky than a prime mortgage and less risk than a subprime mortgage Option ARMS: adjustable rate mortgages that offer the borrower several monthly payment options Minimum payment option o Lowest of the four and carries MOST RISK Interest only payment o Requires the borrower to pay only the interest on the loan during the initial period of the loan o Monthly payments increase after this period in order to be amortized so that the terms of the mortgage are met 30-year fully amortizing payment o Pay both Principal and Interest on loan 15-year fully amortizing payment o Similar to above but with a larger principal paid each month

Second mortgages: Loans secured by a piece of real estate already used to secure a first mortgage Home equity loan: loans that let customers borrow on a line of credit secured with a second mortgage on their homes Reverse-annuity mortgage: A mortgage for which a mortgage borrower receives regular monthly payments from a financial institution rather than making them. When the RAM matures (or the borrower dies) the borrower (or the estate of the borrower) sells the property to retire the debt.

Secondary mortgage markets

After FIs originate mortgages, they often sell or securitize them in the secondary mortgage market in 2010 over 55% of all resi mortgages were securitized in this fashion.

Secondary mortgage market was created by the Fed Government to help boost US economic activity during the great depression. Established Fannie Mae. Fed Housing Administration. Veterans Administration. Correspondent Banking: a relationship between a small bank and a large bank in which the large bank provides a number of deposit, lending and other services. Mortgage sale: sale of a mortgage originated by a bank with or without recourse to an outside buyer. Recourse: The ability of a loan buyer to sell the loan back to the originator should it go bad. Pass-through securities: MBS securities that pass through promised payments of principal and interest in ools of mortgages created by financial institutions to secondary-market participants holding interests in the pools GSE = government sponsored enterprise Timing insurance: a service provided by a sponsor of pass-through securities guaranteeing the bond holder interest and principal payments as the calendar date promised Collateralized mortgage obligations: a mortage backed bond issued in multiple classes or tranches Tranche: a bond holder class associated with a CMO Mortgage asset backed bonds: bonds collateralized by a pool of assets