KAL_II Loan Servicing Valuation Manual


Chapter 1 - Overview

A. Introduction to Loan Servicing Valuation

A.1 LOAN SERVICING SIMULATION

The KAL_II Servicing Simulation Model simulates the daily, monthly, and annual cash flows generated from servicing mortgage loans. The Model uses these cash flows to determine the present value of the loan servicing rights. Many valuation models available today will do this type of analysis. In this introduction we will explain why our model will help you do a better and more complete evaluation of a servicing portfolio.

There are two primary components of loan servicing value: the earnings on the net interest margin and the net operating income. Our Model focuses on these two components and simulates as closely as possible the different revenues and expenses that contribute to each component. We adjust the resulting cash flow for the amortization of the original investment. Finally, the Model applies the marginal tax rate to the pre-tax income. The firm's projected after-tax discount rate determines the present value of the net cash flow.

In the post debt analysis the Model subtracts the interest on the debt and the repayment of the debt from the pre-debt cash flows. The remaining cash flow is evaluated based on the firms projected equity discount rate.

A.2 LOAN SERVICING COST

One of the most important variables in any servicing valuation is the servicing cost. Rather than use a single "Cost per Loan" our Model divides servicing cost into a normal component and a marginal component. The normal component is the servicing cost of the loan before any prepayment, delinquency, foreclosure, or setup costs. Our Model recognizes that different types of loans may have different normal servicing costs. For example, adjustable rate loans may cost more to service than fixed rate loans. Government loans may cost more than conventional loans. Each loan type could have its own normal servicing cost.

The marginal servicing cost is the additional cost required to service this loan based on the loan's special activity during the month. This activity could be a delinquency, a payoff, or additional special handling. The Model adds the marginal cost to the normal cost to produce a total unit servicing cost for each unique segment of loans. We define a loan segment as a group of loans that exhibit similar characteristics and costs.

The KAL_II Model uses this schedule of different normal and marginal costs to determine a total servicing cost for each portfolio segment. The Model determines the servicing cost by multiplying the unit costs by the number of loans serviced during the month.

For example, you tell the Model how much it costs to service a loan in foreclosure and the Model calculates the total monthly foreclosure cost. You determine the unit foreclosure cost by dividing the loans in foreclosure by the total foreclosure cost for the period. When you change the foreclosure ratios, the Model automatically changes the servicing costs, the cash flows, and the present value. We use this type of marginal cost structure for each of the major servicing functions.

With our Model you calculate a monetary value for the benefits of cost reduction in different servicing departments.

When you evaluate servicing portfolios, the cost per loan automatically reflects the portfolio's unique prepayment pattern, delinquency ratios, remittance pattern, and marginal servicing costs.

A.3 LOAN DELINQUENCIES

The second major improvement the KAL_II Model offers is the ability to see how different delinquency patterns ultimately affect the portfolio value and the cash flows. Other models assign a fixed P&I constant for the entire life of the loan, regardless of delinquencies, foreclosures or changes in the borrowers' payment habits. The KAL_II Model simulates the daily mortgagor collections and the daily investor remittances. This reflects both the timing of the regular payments and the effects of changing delinquency ratios. When you lower the delinquency ratios there will be more cash available to earn interest. If you encourage the mortgagors to pay earlier in the month, there will be more cash available to earn interest. The simulation tells us not only the amount of the cash balance but also how the different cashiering and delinquency patterns affect this balance.

A.4 MARKOV CHAIN

The KAL_II Model uses several other important concepts to determine the cash flows. We use the name Markov often in our literature. Markov was a Russian mathematician who died early in this century. His basic premise, the Markov Chain, was that the probability of a second event occurring is often dependent on the probability of a first event occurring. For example, a loan which is one month delinquent cannot become three months delinquent. It must first become two months delinquent.

Let's say that a one month delinquent loan is in "category one." From category one there are only three events that can occur:

1. The loan becomes two months delinquent

2. The loan pays off

3. The loan becomes current.

What we need to determine is the probability of each event occurring. By definition, the sum of the three probabilities must always equal one.

Extending our example, a loan that is two months delinquent (Category or Status #2) can only:

1. Become three months delinquent

2. Pay off

3. Become current

The probabilities for the second set of events will be different and dependent on the first set of events.

A.5 LOAN STATUSES

To complete our example we would continue to define "Statues" for each delinquency period. We would then define the probabilities for each event in each delinquency status. Remember, the probability of the loan moving on to the next status is independent of the loan's prior delinquency history. The Model uses this matrix or transition table, to determine what the delinquency ratios will be in each month during the life of the loan portfolio. We can adjust these probabilities to generate any delinquency pattern in any month of the loan life.

The last category or status is called "Off_Books." We assume that loans moving into this status have completed foreclosure. This category tells the Model how many loans have completed foreclosure during the month.

The first step in using the Model is to define your loan delinquency statuses. A loan status may cover from one to as many as 24 months of delinquency. You determine the length of a status by the period of time during which the marginal servicing costs remain constant. The Model combines contiguous months with similar marginal servicing costs into a single "condensed" status. You may wish to set the status length equal to your normal delinquency reporting schedule. This helps project what your delinquency ratios might be during each future month.

A.6 TRANSITION TABLES

Transition Tables define the loan delinquency statuses and the cost to service each status for every month of the loan life. You can alter the month-to-month delinquency patterns to reflect seasonal or economic delinquency patterns. You can change the cost to service each status to determine the financial effects of an improvement in operating cost. These tables help construct a forecast of operating and financial conditions.

A.7 ADVANTAGES OF THE KAL_II SERVICING VALUATION MODEL

B. USES FOR THE KAL_II MODEL

There are four principal functions that the Model performs. The first and most often used is the determination of the present value of a loan servicing portfolio. This is often called the "Bid Price". Once we establish the value, we then look at the cash flow from the portfolio. Our Model has the ability to add portfolios at different months in the future. This means that you can simulate an entire year's production, acquisitions, and sales. The result is a forecast of your annual anticipated cash flow. Next, you can use the Model to determine the cost to service the individual loan segments. This information is very helpful when you must determine what type of loans to originate or acquire. Finally, the Model has the ability to forecast your operational goals and objectives. You can simulate your anticipated operating conditions for the next five years. Additions, deletions and the cost to service each segment can be defined in the Model. The result is a realistic operational plan.

The KAL_II Model is unique in the ability to do all these functions using the same input data. The savings to you are in the administrative cost of planning and forecasting.

B.1 PRESENT VALUE OF LOAN SERVICING

The Model provides many relevant investment ranking criteria:

Purchase Price (including conversion cost)
Expected Loan Life
Payback Period
Net Present Value
Internal Rate of Return
Modified Internal Rate of Return
Break-even price (the maximum value of the portfolio)
Economic Duration

These criteria are available for each segment and the combined portfolio. The results are shown for both a Pre-Debt and After-Debt analysis.

B.2 CASH FLOWS

KAL_II presents the servicing cash flows in a useful and descriptive manner. Many cash flows are reported on a daily basis. You will be able to answer complex questions about the effects of different financing structures, loan servicing costs, and delinquency patterns. Changes in each area directly affect the cash flows.

It is possible to view the daily P&I collections and advances, daily investor remittances, and daily changes in the impound accounts. The Model also calculates the average P&I balances, the average P&I advance and the largest advance made during any month for the life of the portfolio.

B.3 ADMINISTRATIVE SERVICING COST ANALYSIS

The simulation helps you investigate cost reduction by showing how additional expenditures in key servicing departments can reduce the servicing cost per loan. The normal servicing costs are shown separately from the delinquency, foreclosure, payoff and conversion costs in order to allow for the additional costs associated with each of these functions. Cost savings in separate loan administration functions are translated into changes in portfolio value and net income.

The program provides computer screens, printed reports, and computer files. You can analyze the monthly earnings from a portfolio segment or from a group of segments.

The output reports group the costs according to normal servicing costs and delinquent servicing costs, payoff costs, foreclosure costs, P&I advance interest, and impound interest. The earnings statement also shows the amortization of the portfolio purchase price and the income tax payments.

B.4 STRATEGIC PLANNING

The Model will help you develop a loan servicing strategy that supports your strategic business goals by simulating a wide variety of different servicing strategies. You can use a "What-If" approach to investigate the different buy and sell decisions that occur on a daily basis in the purchased servicing markets.

You can enter multiple portfolio acquisitions at future dates and show the effects of these additional portfolios on the budgeted income statements. Portfolio sales can also be included any time within the next five years. This feature is essential in the development of a long range strategic plan.

The program provides a five year budget which gives monthly details of servicing revenues, servicing costs, amortization schedules, interest schedules, and income tax charges. In addition, the program takes the current fixed costs, amortization and interest charges of the firm into consideration when determining the budget.

B.5 SUMMARY OF THE USES FOR KAL_II


C. INPUTS TO THE KAL_II MODEL

There are three distinct input sections for the Model. The first, the economy, is a forecast of future interest and inflation rates. The company section defines your company's unique financial conditions. Finally, the portfolio section defines each portfolio segment's characteristics.

C.1 THE ECONOMY

In this section of the Model you define the expected future economic environment. First, you project the inflation and the interest rate levels over the next thirty years. Next, you tie the other input variables to this forecast. It is also possible to set the interest and inflation variables separately. You can have ten distinct periods for each of the rates and factors used in the simulation.

We encourage you to develop different sets of economic assumptions about the state of the economy. Each set of assumptions can be saved and reused. The Model provides all the necessary file handling capability to do the data file operations.

By saving your assumptions, the simulation can be run with actual data after each future year is complete. You can compare actual results to expected results and determine whether your assumptions were valid. This process provides an invaluable learning experience for the people running the simulation.

You can develop a Three Market Scenario that allows for improving conditions, steady state conditions and worsening conditions. Use these patterns as the basis of your evaluations and your measurement of risk. A cash flow simulation is the ideal tool to help understand the riskiness of the purchase or sale of loan servicing.

C.2 THE FIRM

This section defines the financial characteristics of your Firm. To simulate accurately, you need to understand the nature of your Firm's financial structure and the operating characteristics of your loan servicing department. Your Firm may have particular areas of servicing expertise that provide it with an economic advantage over a competitor who is bidding on the same portfolio.

Every firm may value the cash flows differently, and may be willing to pay a different price for the same portfolio. Because of this, different companies may arrive at substantially different values for the same loan portfolio. Try different values in this section to determine which characteristics would give your firm an advantage when buying or selling loan servicing. The most important question to ask is "How can my firm better position itself to accomplish our specific goals?"

C.3 THE PORTFOLIO SEGMENT

Your servicing portfolio has different types of loans which may have different loan servicing requirements. These types include GNMA's, FNMA's, and your own portfolio. Each loan type may be further subdivided into geographic states, delinquency patterns, or interest rates.

The first step in the segmentation process is to determine which loans in the portfolio have similar characteristics. There should be as few segments as possible. Loan segments should have a significant difference in cost, delinquencies, or other measurable characteristics. With the Model you create a unique data file for each segment. It is possible to combine these files to find an optimum portfolio mix. You can also duplicate the loan data files for use in another valuation. This makes it unnecessary to reenter new loan characteristics each time you start a new valuation.

D. Outputs from the Model

D.1 PORTFOLIO SIMULATION

The final value of the simulation is determined by the effort you spend evaluating the portfolio segments. After you complete each segment evaluation, you can examine the results for that segment. When the group consolidation is run you will be certain that the results are correct.

The following annual reports are available in printed or data file format:

Loan Status and Delinquency Ratios
Earnings Report, Income Statement Format - Monthly and Annual
Cost per Loan - Monthly & Annual
Principal and Interest Float - Monthly and Annual
Impound Account Balances - Monthly and Annual
Debt Repayment Schedules
Portfolio Valuation Results - Before and After Debt Service

D.2 RATES AND FACTORS SCREENS

These screens provide you with a means to test the factors used as inputs to the Model. The Model presents each input factor for the entire life of the current loan segment. You can compare the financial ratios, interest rates and table variables to the desired input value. This verification process prevents the Model from using erroneous input data in the evaluation.

D.3 BACKUP SCREENS

Using the Backup Screens, you can examine the individual data items presented in the results schedules. It is possible to trace the Model's calculations from the original input screen through the financial statement analysis.

We designed the KAL_II simulation to be an instructional tool. The Model will help people who need to work with and understand the "Value of Loan Servicing." Outputs are easily verified using the backup screen system. You will find these screens very helpful when investigating valuation results that do not appear correct.

D.4 GROUP SIMULATION

After you have evaluated the individual portfolio segments and have verified the results using the Backup Screens, you can consolidate a group of portfolios. You define which segments to use in the group file definition. During this phase the model evaluates each portfolio segment individually, consolidates the cash flows, and does the present value calculation.

You can combine different portfolio segments to determine the optimum portfolio strategy for a particular firm. When you do this type of analysis, the ability to start and sell portfolios in the future is important.

The group section also includes a Five Year Budget Report. The budget determines the long range effects of adding or selling loan servicing. After you run the consolidation, you can examine the daily, monthly and annual cash account balances for the group of segments.

E. FACTORS USED - CASH FLOW CALCULATIONS

E.1 Amortization Schedules

Loan Balance

Average Maturity

Average Loan Age

Amortization Period

E.2 Cash Flow Schedules

Mortgagor Collections

Investor Remittances

Impound Remittances

E.3 Rates and Factors Forecasts

Inflation Rates

Interest Rates

Prepayment Rates

Delinquency Forecast

Foreclosure Forecast

E.4 Net Impound Earnings

Property Tax Impound/Loan

Growth in Property Tax

Insurance Impound/Loan

Growth in Insurance

Average P&I Float/Loan

Portion Impounds Usable

Earnings Rate Forecast

Rate Paid on Impounds

Advance Interest Rate

E.5 Revenues

Service Fee Rate

Dollar Service Amount

Other Income/Loan/Year

Optional Insurance

Late Fee Income

Fee Collection Rate

E.6 Administrative Expenses

Servicing Cost Forecast

Growth in Servicing Cost

Marginal Servicing Costs

Delinquency Cost

Current Fixed Costs

Cost of Advances

E.7 Foreclosure Cost

Cost to Service

Hard Cost to Foreclose

Hard Cost Recovered

Service Fees Lost

P&I Lost

Interest Lost

E.8 Purchase Price Amortization

Conversion Cost

Portfolio Purchase Price

Method of Amortization

E.9 Present Value

Marginal Tax Rate

After Tax Discount Rate

Equity Discount

Reinvestment Rate

E.10 Expected After Tax Income

Marginal Tax Rate

Purchase Price Amortization

Debt Interest Rate

Debt Service

F. SIMULATION DEMONSTRATION

HOW TO USE THIS SECTION The following is a brief synopsis of how to obtain the Simulation Output:

F.1 THE NUMBER OF MONTHS TO SIMULATE

At this point you should have entered all the inputs and have used the Rates and Factors screens to verify that the program has calculated the inputs correctly, It is now time to run the simulation. The program will simulate for any number of months between 1 and 360. The ONLY time the valuation screens should be used is when the simulation is run for the entire life of the portfolio.

The computer time taken to run the simulation will vary depending on the type of computer used. It is helpful to run the simulation for short periods, 24 months, if the results are only needed for the early months of the simulation. This may happen if you are only interested in testing the effects of certain input fields.

F.2 RUNNING THE PORTFOLIO SIMULATION

When you are certain that the model has all the inputs entered as you intended then it is time to run the simulation for the full 360 months or until the last loan in the portfolio is due to terminate. This will make the output fields in the valuation screens take the whole life of the portfolio into consideration. We cannot emphasis strongly enough that the Valuation Screens are only meaningful if the analysis is run for the entire life of the portfolio!

F.3 PRINTING THE REPORTS

When you have completed the simulation and have verified the results using the Backup Screens, then you should print the output reports you desire.

F.4 RUNNING THE GROUP SIMULATION

The last phase of the simulation process is the Group Simulation. The group screens are very similar to the portfolio screens. At this point you must decide which portfolios to consolidate into a group. The group need not represent the current servicing portfolio. It may represent an ideal portfolio grouping or an anticipated future portfolio grouping.

F.5 FIVE YEAR BUDGETED FORECAST

Many users will be interested in developing Five Year Budgets using the Group Simulation Section. The last command line in the Group Section is where the Five Year Plan is calculated. You must simulate for at least five years in order to see the complete Budget Forecast.

G. STEPS TO PERFORM CASH FLOW SIMULATION OF LOAN SERVICING

G.1 Develop your Economic, Firm, and Portfolio Data.

1. Decide on an economic forecast

2. Define the financial structure of your firm

3. Segment your loan servicing portfolio

4. From your economic forecast, determine the following:

Inflation Rates, Interest Rates, Discount Rates, Prepayment Rates.

5. From your operational financial information develop the following tables:

Servicing Cost

Remittance Requirements and schedules

Cashiering Schedules.

G.2 Setup the system hardware and data files.

1. Start each simulation from a unique subdirectory.

2. Setup the System Environment - CRT, printer, reports.

3. Define your input data edit checks.

G.3 Enter the data to the KAL_II Model.

1. Input the economic data. Print and save the definition.

2. Input the firm data. Print and save the definition.

3. Input the portfolio segment data. Print and save the definition.

4. Input the group file definitions. Print and save the definition.

G.4 Simulate each of the individual portfolio segments.

1. Review the rates and factor screens.

2. Simulate for the average life of the portfolio.

3. Test the valuation results using the backup screens.

4. Verify your results using the portfolio valuation schedules.

5. Run alternate economic and firm scenarios.

6. Save the results of the evaluation. Backup the data files.

G.5 Examine each of the output screens and determine that the factors listed below are correct:

1. Loan Status Screen - Balances and counts, delinquency ratios, prepayment pattern

2. Earnings Screen - Revenues, expenses, amortization, and taxes in annual, monthly, and dollars per loan.

3. Impound Screens - Average balance per loan, balances as a percent of the portfolio balance, beginning and ending balances, and impound remittance schedules.

4. Principal and Interest Balances - Average balance per loan, and balance as a percent of the portfolio balance.

5. Daily P&I Account - Cashiering and investor remittance schedules.

6. Portfolio Purchase Screen - Conversion cost, purchase price, and tax savings.

7. Valuation Screen - Payback, expected loan life, present value, net present value, internal rate of return, modified internal rate of return, break-even price, and duration.

G.6 Consolidate the group of portfolios that you have defined.

1. Select the group of portfolio segments to consolidate.

2. Define the length of the P&I advance account review

3. Run the consolidation for a short time period. Test and Verify the results

4. Run the consolidation for the maximum life of the loans in the consolidated

portfolio. Test and Verify the results

5. Prepare the presentation and evaluation of the results.

G.7 Present the results of the simulation.

1. Generate the monthly and annual reports.

2. Create the cost per loan reports.

3. Generate the data for the graphical presentation.

G.8 Evaluate the results of the simulation.

1. Investment Criteria Analysis - Purchase, Sell, Retain, Originate.

2. Post Debt Analysis - Effects of different financing structures.

3. Five Year Budget Analysis - Fixed cost analysis.

4. Daily Cash Flow Analysis - Bank account cash balances.

5. Portfolio Growth Planning - Loan counts and volumes.

6. Per Loan Analysis - Revenue, net interest margin, servicing costs, amortization.

G.9 Use the KAL_II Servicing Simulation Model to examine cash flow sensitivity to different rates and factors.

1. Develop the sensitivity analysis criteria.

2. Change the rates and factors to determine the cash flow and valuation sensitivity to each variable.

3. Alter the group file definitions in order to derive an optimum portfolio configuration.

4. Change the portfolio growth strategy to examine the effects of different levels of servicing volumes.

H. PRINTED REPORTS

H.1 HOW TO PRINT THE REPORTS

The Output Reports are generated whenever you select this item from the menu. The reports that are printed are determined by the selections you made in the System Section of the Main Menu. A copy of each Report is shown in Chapter 6, Printed Reports. In addition, the program will also generate the Monthly and Yearly spreadsheet files when ever this menu selection is chosen.

H.2 TYPES OF PRINTED OUTPUT

This section includes a brief overview of the different forms of printed output available from the system. A more detailed discussion is given in Section 2 of the Manual.

Remember, it is not always desirable to print the output of the program. The program will only generate Reports when you specifically request the individual report. When using the results to make decisions it is always important to retain a complete set of printed data.

H.3 BEGINNING THE SESSION

It is helpful to decide ahead of time what printed output is required. In every session different input variables may be used. Also, during a modeling session you might vary the inputs in many different sections of the program. As a result, there may be uncertainty concerning which inputs generated the last output values obtained. We suggest that before a final analysis is used to make decisions you print a complete set of the inputs used.

H.4 DURING THE SESSION

IMMEDIATE SCREEN OUTPUT - Input and Output Screens can be sent directly to a disk file using the {F2} key or immediately printed using the DOS {Shft}{PrtSc} facility.

INPUT SECTION REPORTS - Each input Section allows you to print that Section of Inputs directly on the Printer.

OUTPUT SECTION REPORTS - These Reports can be generated in the following ways:

PRINTER OUTPUT - The program will normally send the reports directly to the printer. Section 2 of the Manual gives detailed instructions on how to set up the Page Formats and Printer Setup

DISK FILE OUTPUT (WORD PROCESSING - ASCII Files) - By using a combination of Keys {F9} and {F10} you can direct the printed output to an ASCII file that can be formatted using your favorite word processing program. This is an ideal tool to use if you are creating a larger document which includes the graphic output or additional comments on the analysis.

H.5 ENDING THE SESSION

Each time you end a modeling session you should think through the purpose for the session and determine if you want to save a printed copy of the inputs and the Results. You may also want to save a copy of the data files used in the analysis. Imagine spending an afternoon calculating a value for a portfolio and then not remembering the next day what inputs were used to find the value of that portfolio. The KAL_II program will not let you exit accidentally. When the program asks you whether you want to EXIT, think about your Data Files!