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KAL_II Loan Servicing Valuation Manual
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Objective: This chapter describes the input fields for the economic data and the firm data. These are the second and third menu items.
Economic Data
The KAL_II Model allows two types of economic data:
Market or Interest Rate Forecast
General Inflation Rate Forecast
Firm Data
The KAL_II Model uses a wide variety of firm rates and firm factors in the evaluation of the cash flows. This section describes the rates and factors and the way their uses in the Model.
To use the KAL_II Model there are three sets of input data that you enter; the economic data, the firm data and the portfolio data. After you complete these sections, verify the input data and then execute the valuation. We present the analysis of the evaluation results in Chapter Five of this manual.
The first section is the Economic Data. In this section you develop a general economic forecast. The forecast includes estimates of future interest and inflation rates. We encourage you to develop different forecasts and save them in separate files. When you are evaluating portfolios, use each forecast to determine a value for that portfolio. Looking at the value under different scenarios will give you a better estimate of the risk you may be accepting.
Make the economic scenarios consistent with the financial (Firm) scenario. As you develop an economic scenarios, keep in mind the relationships between the economic and financial variables. If you think interest rates will rise in future years then maybe the discount rate should increase. If inflation increases, then the interest rate on earnings and charges might also increase.
Although the KAL_II Model provides the user the means to simulate future economic and financial conditions, the Model does not make recommendations about what will happen in the future.
The second input section deals with the financial structure
of the firm doing the simulation. Again, we encourage you to construct
different financial scenarios that you expect to occur in the future. In
forecasting we refer to this as "Best/Average/Worst" case scenarios.
The KAL_II Model provides a powerful tool to examine the effects on value
from different financial conditions. The Model uses two methods to determine
the financial rates and factors. First, each interest or inflation factor
in the Model can be a "specific" table composed of ten unique
rates over a thirty year period. Second, you can use each table as a "spread"
from an economic factor such as interest or inflation. As a result, a change
in a single interest rate will increase or decrease all the "spread"
rates by an equal amount.
The final input section defines the individual portfolio segment. The portfolio
segment is a sub-category of loans in portfolio. Because these loans exhibit
similar characteristics they are modeled as a distinct group. In KAL_II
you have a maximum of sixty different segments. It is possible to evaluate
each of these portfolio or group of portfolios using any combination of
economic and firm data files.
The most common segmentation methods are: loan type, investor and interest
rate.
We have provided input forms to help document the required data. After the hand written data is examined, and it appears correct, input the data to the program. When each section is complete, print the section and verify the data using the rates and factors screens (R&F). These screens provide insight into how the program has interpreted the data inputs. The screens are also helpful when verifying the valuation results.
The Model uses two methods of determining interest and
inflation factors, "spread" and "specific". First,
interest rates are set as a spread from the market index. Define this market
index as whatever you chose. The market index could represent the prime
bank rate or the short term money market rate. All rate tables defined
as "spread from market" are added to this market index. When
you change the index rate, all other spread rates will increase or decrease
by an equal amount. The second method defines each rate table as a specific,
unique table. You can define every rate in the program as a specific rate.
In our standard model example we set all rates as specific.
It is not necessary to chose one method or the other. You can use any combination
of spread and specific rates. The general inflation rate and market index
is a convenience for the user, you are not required to use the index. You
may wish to use a single inflation forecast rather than entering each specific
table separately. All other inflation rates are then set as a spread from
this general rate. Later in this chapter, we will define which rates, interest
and inflation, are tied to the general indexes.
Economic Data
Change Data
--> Name of Econ File
Inflation Forecast
Market Index
Quit Menu
This is the descriptive name for the set of economic data
that you define. The name may be up to sixty characters long. The name
will appear on the computer screen while you are working with this set
of data but does not appear until you have left this section of the program.
The name will also appear on the output reports.
It is helpful to specify a name that has some relationship to the characteristics
of the set of data that you are working with. A name such as ECO10-16 would
be an economic definition file developed on October 16. This file could
be kept and used with another portfolio segment.
The General Inflation Forecast is your expectation of
the level of price increases in the future. The program adds this forecast
to the individual inflation rate tables whenever you define that table
as a spread from the inflation index. This inflation forecast is used only
when it is explicitly defined by the user.
The program calculates the inflation rates on a monthly basis (Rate/12)
unless you set the program variable to have the rate compounded annually.
The annual growth feature is in the impound section of the Model.
The first step is to identify each period of time extending into the future
when the forecasted inflation rate will be constant. The program will extend
the last rate entered into the table for the entire period of the simulation.
If there is only one entry, the program will extend this entry for thirty
years. We recommend you complete the full 360 month period for each table
of data inputs. In the following example we have shown three different
ways to enter the inflation rate for servicing cost growth. We will refer
to this example during the remainder of the manual.
ZERO Base Rate
You can chose to use the spread feature by setting all the
specific tables to the current respective inflation rates, setting the
keys to point to the general inflation rate and setting the general rate
to zero. Alter the base rate of zero to show what effects increases in
the general rate will have.
The General Inflation Rate is set in the economic section
of the program. If you do not use the spread feature of the program then
enter (360,0.00000) in the table.
The following inflation variables can be set as either a spread from the
general index or as a specific table rate:
Servicing Cost Growth
Extra Income Growth
Insurance Impound Growth
Tax Impound Growth
The servicing cost growth inflation factor affects several other factors indirectly. These factors all use the same method, spread or specific, as the servicing cost growth. These factors are not set independently:
Servicing Cost Growth
Servicing Cost - Annual
Delinquent Cost - Monthly
Foreclosure - Hard Cost
Payoff Cost - Per Loan
30 Day Collection Cost - Per Loan
Inflation does not affect the conversion cost because we assume that these cost all occur in the first monthafter you purchase the portfolio.
Inflation Forecast Screen {S212}
Inflation Rate
Thru Annual
Month Rate
60 0.040000
90 0.050000
360 0.040000
In the first column, enter the number of the month through
which the rate will be constant. The numbers in this column have to be
increasing. To stop entering, press {ESC}. In the second column, enter
the forecasted inflation rate as a decimal in annual terms (e.g. 1% as
.01).
In the above example, the rate is set to 4% for the first 60 months (5
Years) and to 5% for the following 30 months (2.5 Years). The rate is then
set to 4% for the remainder of the 360 Months. The program would have extended
the last rate in the table. We do not, however encourage this as it may
become unclear what rate you intended to enter. To be certain of the results,
always enter 360 as the last month.
You can verify that you entered the data as you intended by checking the
general factors screen (Chapter 7). This screen will show the monthly multiplier
for 360 Months.
Step One - INFLATION FORECAST
Let's assume an inflation rate of 6% for the next 30 years. If we do not enter any
rate in the servicing cost table then servicing cost would then grow by .5% a month
(6% annual) for the next 30 years. Try this now with the program.
Enter the following into the economic inflation table
Month Rate
360 0.06000
Next, go to the miscellaneous section (Chapter 4) and set the key to growth to "1".
To see the inflation rate correctly extended, go to the factors and rates section
of the program (Chapter 7) and call up the servicing cost screen. Screen {S6-11P}
is a picture of the screen.
Loan Portfolios
Service Cost Multiplier Factor
1 1.00500 16 1.08307 31 1.16721 46 1.25788
2 1.01003 17 1.08849 32 1.17304 47 1.26417
3 1.01508 18 1.09393 33 1.17891 48 1.27049
4 1.02015 19 1.09940 34 1.18480 49 1.27684
5 1.02525 20 1.10490 35 1.19073 50 1.28323
6 1.03038 21 1.11042 36 1.19668 51 1.28964
7 1.03553 22 1.11597 37 1.20266 52 1.29609
8 1.04071 23 1.12155 38 1.20868 53 1.30257
9 1.04591 24 1.12716 39 1.21472 54 1.30908
10 1.05114 25 1.13280 40 1.22079 55 1.31563
11 1.05640 26 1.13846 41 1.22690 56 1.32221
12 1.06168 27 1.14415 42 1.23303 57 1.32882
13 1.06699 28 1.14987 43 1.23920 58 1.33546
14 1.07232 29 1.15562 44 1.24539 59 1.34214
15 1.07768 30 1.16140 45 1.25162 60 1.34885
Each month for the next five years (60 months) has a cost multiplier factor. The first month is equal to 1/12 of the annual rate (6%) or .5%. Each month is then multiplied by this rate.
Step Two - SPREAD FROM FORECAST
Suppose we decide to have servicing cost be 3% over the
next five years and then have the rate change to equal the inflation index.
Set the servicing cost table (Chapter 4-Growth & Other Tables), to:
Month Rate
60 -0.03000
360 0.00000
The key to servicing cost is still "1".
Now, for the first five years the servicing factor will be 1.0025 (3%/12)
in the first sixty months and then return to 1.0050 for the final 300 months.
Step Three - SPECIFIC INFLATION TABLE
As the last part of this example we will enter a specific
inflation rate for the servicing cost growth.
In the growth table section (Chapter 4)set the servicing cost growth to
:
Month Rate
60 0.04000
90 0.05000
360 0.04000
In the miscellaneous section , set the key to servicing
growth equal to "2". The program will ignore the inflation table
and use the specific rate table.
This is a general forecast of interest rates expected to occur in the future. We call the rate a "Market Index" because it can represent any interest rate you desire. The index does not represent a single, unique rate. Everyone looks at different interest rates. Consider the following rates that may be important to you:
1. Bank Prime Rate
2. Short Government Rate
3. Long Term Government Rate
4. Cost of Funds (S&L's, Banks)
The question which immediately arises is "Which rate
should I use for the Market Index?" It depends on your corporate environment.
If you are a bank then you might consider the prime rate as your "base"
rate. If you are an S&L then the cost of funds might be a better base
rate. The point is that you decide what rate to use as a base and then
allow all other interest rates to fluctuate with the base rate.
You could decide to use a ZERO base rate. By changing your base rate to one percent all other spread rates would increase by exactly one percent. In this case the market index has no meaning other than as an index.
Other interest rates in the model can be chosen to be a spread or be a "changing" spread (either positive or negative) from the "Market Index".
Suppose the market index is set to 7% the first year,
8% the second year and 9% for the remainder of the analysis. Select the
impound earnings rate to be an a spread from the market index. A -2% spread
from market for 360 months would give an impound rate of 5% the first year,
6% the second year and 7% for the remainder of the analysis.
Changing Spread - A -1% spread could be chosen for the first year and a
-2% spread for the remainder of the analysis. This would give a impound
rate of 6% the first year, 6% the second year and 7% for the remainder
of the analysis.
The use of the market index allows you to quickly alter
the interest variables for a new interest rate scenario. If you use the
specific rate tables, then each table must be updated separately for each
new interest rate scenario. Decide what types of analyses will be run.
You can construct a single portfolio valuation using individual loan tables.
A simulation of your entire servicing operation makes better use of the
spread option.
The market index is set in the economic section of the
program. If you are not going to use the index then set it to zero (360
0.00000).
The following variables can be set as a spread from the index:
Cost of Advances
Impound Earnings
Pay on Impounds
Reinvestment Rate
ARM Index
Debt Rate
The following factors cannot be set as a spread from the index:
After Tax Discount Rate
Equity Discount Rate
Marginal Tax Rate
Interest Rate Forecast
Thru Annual
Month Rate
12 0.070000
240 0.080000
360 0.090000
Identify each period of time extending into the future
when your forecast of market Interest Rates will remain the same.
In the first column, enter the number of the month through which the rate
will be constant. Naturally, numbers in this column have to be increasing.
To stop entering, press. In the second column, enter the Interest Rate
as a decimal (e.g. 1% as .01). The last entry in the Table will be extended
for the duration of the Analysis.
In the following example the last rate entered (9%) will be extended to
the end of the analysis.
Verify the market rate table in the factors and rates section on "General
Factors - i. Market Rate".
We discussed earlier the need for a consistent economic
and financial scenario. As an introduction to the development of these
scenarios we present suggested relationships between different economic,
firm and portfolio variables. In tomorrow's economy these variables may
interact differently. If you feel things interact differently, change the
guideline. The chart is a reminder that there is a need to be consistent.
Factors which generally move in the same direction:
Interest Rates
Inflation Rates
Discount Rate
Equity Discount Rate
Reinvestment Rate
Interest Earning Rates
Debt Rate
Principal Balances held from payoffs
Impound Balances
Ancillary Income Earnings
Servicing Costs
Factors which may decrease as interest and inflation move upward:
Prepayment patterns
Delinquency ratios
Foreclosure Ratios
P&I Advances
Factors which may show little effect as interest and inflation change:
Principal and Interest Constant
Impound Payment Rate
Service Fees
Amortization Expense
Fixed Costs
Within this scenario, we divide the effects into direct
effects and indirect effects. An increase in the general price indicator
will have an almost immediate effect on demands for higher wages and the
cost of supplies. It will have an indirect effect on delinquencies as property
values appreciate and the risk of foreclosure decreases due to the inflated
property values. When you build your scenario keep all the factors in mind.
Lowering your discount rate without adjusting any other variables is an
inconsistent approach to raising the value of the portfolio.
The greatest risk in the valuation process is creating
value which does not exist. If you bid low today you can always bid again
tomorrow. You can't send back tomorrow what you shouldn't bought today.
--> Name of Firm File
After Tax Discount
Cost of Advances
Equity Discount
Fixed Costs, Interest, Amortization
Impound Earnings
Methods of Amortization
Pay on Impounds
Reinvestment Rate
Tax Rate
Use of Bank Balances
Quit this menu
This is the Change Data Screen for the firm section. The
screen lists all the inputs that are available for a single firm. You can
use different firm files to value the same portfolio data file.
This is the descriptive name of the set of firm data that you are defining. The name will appear on the screen while working with this set of data. The name will also appear on the output reports. This helps the to remember what portfolio or firm file you are using. Specify a name that has some relationship to the characteristics of the set of data that you are working with.
TITLE The name may be up to 60 characters long.
AFTER TAX DISCOUNT RATE
The after-tax discount rate is the rate used by the firm to determine the value of the future cash flows. It is often described as the "Weighted Average Marginal after-tax Cost of Capital". It is also called the firm's minimum required rate of return on investments.
That is quite a description of the data field. The discount
rate is certainly one of the most used and abused variables in any valuation
analysis whether it is loan servicing or corporate capital budgeting. There
is no single right answer. The choice of the discount rate depends on the
management of the firm. We have offered a brief description and an example
showing how you might calculate the discount rate. This is not the only
method.
We define the rate as follows:
The weighted average cost is the percent cost of capital
weighted by the dollar amount of each source of capital. The sources would
include short term debt, long term debt, preferred stock, common stock
and stockholder equity.
The marginal cost of capital is the cost of new sources of funds. If you
raise new funds through bank borrowings then the marginal cost of capital
is the bank borrowing rate.
The after tax cost of capital assumes that the effects of income tax have
been considered.
The program uses the after-tax discount rate in the pre-debt analysis to
determine the present value of the stream of future cash flows which result
from the loan servicing operations. We present the results of the evaluation
in Chapter 5.
The decision about which rate to use often centers on the marginal versus the average cost of capital. The average after tax cost may be 9.5% but new financing will cost only 8.5%. Which rate do we use for our analysis.
Discount Rate Example
For our example let's assume the following facts:
Debt-to-Equity Ratio is 90%
Marginal Cost of Debt is 12%
Tax Rate is 33%
Equity Discount is 25%
The Weighted Average Marginal After-Tax Cost of Capital is:
Debt Tax Equity Weight
12% X 33% = 8.0% X .90 = 7.2%
25.0% X .10 = 2.5%
------
W A M A-T C O C 9.7%
It may be that the firm's discount rate will vary over
time. In this case, build the table according to the expected future changes
in the discount rate.
There are many factors which could significantly affect the discount rate:
Debt to equity ratio - As the firm retires debt the discount
rate could change. The interest on the debt is deductible and therefore
the use of debt tends to lower the cost of capital. However, most firms
maintain a constant debt-to-equity ratio. As one source of debt is retired
new debt is used to maintain the same D/E ratio.
In the model we assume that the debt to equity ratio is constant during
the period of the analysis. We recognize that the debt used to finance
the investment will retire sooner than the investment is amortized. The
discount rate, however, should not change unless the company decides to
change the debt to equity ratio of the firm.
Marginal Tax Rate - One of the principle advantages of the use of debt
is the deduction of the interest payments. If the firm's marginal tax rate
changes (Loss carry-forwards) then the discount rate could change.
Risk - The greater the risk of the investment the higher the discount rate
should be.
Liquidity - If an investments is highly liquid, we can often use a lower
discount rate.
Maturity - A positive sloped yield curve might indicate that the discount
rate should also be increasing over time in relation to the yield curve.
Investment Strategy - A starting point is the average return for the firm's
overall portfolio of investments. The overall investment strategy of the
firm could also change to allow for a change in the required discount rate.
The discount rate is obviously a topic for extended discussion among the
executive management of the firm. A wealth of literature is also available
about the determination of the firm's discount rate. Look to professional
guidance when selecting an appropriate discount rate. An article written
by John W. Heamon on this topic is presented in the MBA Guide on "Evaluating
Servicing Portfolios".
After Tax Discount
Thru Annual
Month Rate
360 0.080000
Identify each period of time extending into the future
when the discount rate will remain constant. In the first column, enter
the number of the month through which the rate will be constant. Naturally,
numbers in this column have to be increasing. To stop entering, press {ESC}.
In the second column, enter the forecasted rate as a decimal (e.g. 50%
as .50)
The Cost of Advances is the rate paid by the firm to borrow
funds used to make advances to investors when the borrower's payments have
not been received. You must select which method to use to determine the
cost of advances; the actual rate or the spread from the market index (interest
rate forecast). After the selection is made, the rate table will automatically
follow the computer screen.
Specific Table Rate (actual rate) - This would correspond to the situation
where you can set a long term fixed rate on your advance account borrowings.
If you use the actual rate, a change in the market index will not affect
this actual advance rate. The actual rate may change each time you select
a different interest rate scenario. If you are going to use many different
interest rates, it might be advisable to use the spread from market method
in your simulation.
Cost of Advances
Key to Cost of Advances : 1 (1=actual,2=spread)
Thru Annual
Month Rate
360 0.100000
1 - Actual Rate - Enter a "1" to input the cost of advances as an specific rate table.
2 - Spread from Market Index - Enter a "2" to input the advance rate as a spread from the market index. In this instance the funds are borrowed at some index over the current market rates.
Identify each period of time extending into the future
when the predicted rate of interest will remain the same. This table is
either an actual rate, "1", or a spread from market rate, "2".
In the first column, enter the number of the month through which the rate
will be constant. Numbers in this column must be increasing. To stop entering,
press {ESC}. In the second column, enter the forecasted rate as a decimal.
(e.g. 1% as 0.01)
The program uses the Equity Discount Rate to compute the
present value of cash flows after considering the debt service. It is the
minimum rate of return on investor capital provided by the stockholders
of the firm. The equity rate is only used in the after-debt analysis.
After-Debt Analysis - This analysis assumes that you service the debt before evaluating the cash flows. Instead of the "Discount Rate" discussed earlier the after-debt analysis uses the equity discount rate to calculate the present value of the portfolio cash flows. The purpose of this analysis is to examine the return on stockholder equity after the charges from all other forms of financing are taken into account.
Equity Discount
Thru Annual
Month Rate
360 0.150000
Identify each period of time extending into the future
when the predicted Equity discount rate will remain the same. In the first
column, enter the number of the month through which the rate will be constant.
Numbers in this column must be increasing. To stop entering, press {ESC}.
In the second column, enter the forecasted rate as a decimal. (e.g. 1%
as 0.01)
This section identifies all other costs of the firm not
directly related to a particular portfolio segment. However, the costs
are part of the overall servicing operation. This section gives you the
opportunity to enter those cost and expenses not allocated to a particular
portfolio. The program uses the data in this section only in the five year
budget projection.
These costs do not affect the present value of the cash flows!
Five Year Budget Summary - Costs not tied to a portfolio segment need to
be included in the calculation of the budget. The group section the program
uses these costs to determine a five year budget summary for the servicing
operation. This provides a starting point for the firm's budgeting process.
It is important to note that the fixed cost inputs are only used in the
calculation of the five year budget. They do not affect the present value
or any other investment ranking variable.
When Become Active - This field is found in the Amortization Factors screen
in the portfolio section. Using this switch, you can start the portfolios
at any time within the five years. This allows the firm to define an acquisitions
and sales strategy based on their future business projections. The program
evaluates the combined portfolio and calculates a five year schedule of
revenue, costs and expenses. The schedule is presented in the group section.
The revenues and costs of the different portfolios will be added at the
times specified by the Active switch.
Servicing Sales - It is possible with the KAL_II Model to simulate a purchase
of servicing in future years and a sale of servicing in future years. We
simulate the future purchase with the Active switch. We simulate a sale
by setting all the loans in a portfolio segment to pay off in a particular
month. When segmenting the whole portfolio, set aside those loans you expect
to sell at a future date and set a 100% prepayment to occur in the month
of the sale. Enter the price you expect to receive from the sale as the
service fee for that month.
We have provided an example in a later chapter of the manual that covers
this procedure in depth.
Group Simulation - It is necessary to run the group simulation in order
to view the Five Year Budget Summary.
Fixed Costs, Interest, Amortization
Year Existing ---Existing Debt--- Existing
Fixed Cost Principal Interest Amortization
1. 250000 0 0 0
2. 250000 0 0 0
3. 250000 0 0 0
4. 250000 0 0 0
5. 250000 0 0 0
Enter the dollar amount of existing annual fixed costs
which will be present whether this portfolio segment is included or not.
If the Firm plans to have a new facility, and additional rent in the next
year, this cost is shown as an addition to fixed costs in the year the
facility was put into use. This fixed cost also reflects the firm's administrative
overhead for servicing.
The amount is for the entire year, (e.g. the 12 months beginning at the
start of the analysis). This figure appears only in the "Budget Analysis"
report on group simulations.
Enter the dollar amount of the annual principal repayment on existing debt that is scheduled within the next year (e.g. the 12 months beginning at the start of the analysis). This debt should be related to the servicing operation in general, such as a mortgage on a building or a facility. The debt you incur to purchase portfolios is added to this amount in the "Budget Analysis" report in group simulations.
Enter the dollar amount of the annual interest that is scheduled to be paid within the next year (e.g. 12 months from the start of the simulation). This amount is added to new interest in the budget summary in group simulations.
Enter the dollar amount of existing yearly amortization expense which is scheduled within the next year (e.g. 12 months from the start of the simulation). This amount is added to the new loan amortization in the "Budget Analysis" report in group simulations. This amortization should be unrelated to any of the portfolios in the evaluation.
During each month the mortgagee collects money from the
mortgagor. The mortgagee earns a service fee and collects late charges
from this money. The remainder of the of the money is remitted to the investor
who owns the loan behind the mortgage and to the escrow agents for the
loan. The mortgagee collects and accumulates the funds in a insured financial
institution. The mortgagee accumulates the money since it is expensive
and time consuming to remit funds to investors on a daily basis. The funds
are usually remitted once a month. We discuss the different remittance
requirements in Chapter 4.
The funds held by the mortgagee during the month are broken down into the
following categories:
Tax, hazard insurance and insurance premium impound balances
Principal and interest constant collected each month
Payoff amounts received each month
There is a separate remittance schedule for each category. The KAL_II Model
deals explicitly with each remittance and collection schedule. It is through
these collection and remittance schedules that the Model builds a simulation
of the daily cash flows.
Although the mortgagee does not carry these cash balances directly on the
balance sheet they can be used to the mortgagor's advantage in several
ways:
1. Offset to a short term debt
2. Offset to a warehouse funding account
3. Offset to a floating rate loan
4. Form of capitalization with a bank or S&L parent company
5. Offset lockbox and bank processing charges
In each of the above cases there will be a spread from a rate that the mortgagee will earn on these funds. The impound earnings rate is the imputed rate that the mortgagee expects to earn.
It could be appropriate to enter a negative spread from the market index if the impounds are used to offset a bank loan.
Key to Impound Earnings Rate : 2 (1=actual,2=spread)
Impound Earnings
Thru Annual
Month Rate
360 -0.010000
1 - Actual Rate - Enter a "1" to input the Impound
rate as an actual rate. This would correspond to the situation where you
were able to directly set a long term fixed rate on your Impounds.
2 - Spread from Market Index - Enter a "2" to input the impound
rate as a spread from the market interest index.
Identify each period of time extending into the future
when the predicted rate of interest will remain the same. In the following
example the Bank has allowed an Earnings rate of 1% under the current market
rate. If current market rate is 7% then the Impounds are earning 6%.
In the first column, enter the number of the month through which the rate
will be constant. Numbers in this column must be increasing. To stop entering,
press {ESC}.
In the second column, enter the forecasted rate as a decimal. (e.g. 1%
as 0.01)
When you purchase a portfolio there are two components
of the purchase price. The first is the "price". This is usually
defined as a percentage of the remaining loan balances. Since the time
between bid and acceptance can often be many months it is important to
the buyer not to offer a single dollar amount. Many of the loans that were
in the original portfolio offering would have paid off by the time the
actual transfer takes place. Therefore, we offer to pay a percentage of
the loan balance.
The second component of the portfolio price is the conversion
cost of the portfolio. "Conversion Costs" are all costs associated
with the transfer or acquisition of loan portfolios. This would include
GNMA transfer fees, labor, legal and accounting expenses, travel, rent,
custodial charges, freight, and any other day-to-day costs associated with
the transfer. It would also include the costs of the sale/purchase negotiation;
travel, entertainment and employee time.
Portfolios which are already on the books will not have conversion costs
associated with them. Usually, these costs have been absorbed. If transfer
costs from an existing portfolio have been previously capitalized then
enter these costs in the Fixed Costs Section previously covered. The portfolio
and group valuation screens present a detailed schedule of the purchased
price, conversion costs and amortization schedules for each.
The Model uses two methods of expensing the purchase price and conversion
cost; first year and amortized. Enter the amount of the purchase price
that you want to expense the first year. If you have a favorable tax situation
this earlier amortization may produce tax savings. The Model will calculate
the first year tax savings based on the percentages expensed the first
year.
Production Costs If the portfolios being valued are your own production
then the conversion cost would represent the net cost of production.
Break-even Price - In order to determine the total break-even price it
is necessary to add the first year conversion costs to the break-even price
for the portfolio. Often the present value will be higher than the break-even
price. This is because the conversion costs are not show as part of the
break-even price.
Loan Life - If you are buying a portfolio that has a five year expected
life then you should set the amortization period for five years or less.
The Model uses five methods of amortizing the purchase price:
1. No Amortization - all the price is expensed
the first year.
2. Straight Line - The program assumes a even amortization
over the number of years specified in the "Years to Amortize"
field. If the number of years is ten, then 10% of the price is amortized
each year.
3. F.A.S. Method - The portfolio is amortized according to
the pre-tax Income pattern of the portfolio segment. If the portfolio generates
a cash flow pattern of ($30, $20, $20, $15, $10, $5) over the next six
years then 30% will be amortized the first year, 20% the second year, 20%
the third year, 15% the fourth year, etc. Currently, this is the most widely
accepted method.
4. Declining Balance Method - Declining
balance amortization is computed by applying a constant rate (the "Declining
Balance Factor" times the straight line amortization) to the remaining
unamortized balance. Since there will always be some fraction left to amortize,
the program will continue to use the declining balance formula until the
straight line depreciation amount is larger. At this point the program
will continue to use the straight line depreciation until the investment
is fully amortized.
5 Sum-Years-Digits The sum-of-the-years-digit method of calculating
amortization uses the "Years to Amortize" field. This is an accelerated
depreciation method that takes the sum of each of the years and amortizes
based on the weight of each year. The denominator is always the total of
the number of years to amortize. The numerator is equal to the remaining
life of the portfolio. If there are four years to amortize then the first
two years' amortization are:
Year One 4 / (1+2+3+4) or 4/10 or 40%
Year Two 3 / (1+2+3+4) 3/10 or 30%
Methods of Amortization
Fraction Purchase Price Expensed : 0.250000
Fraction Conversion Cost Expensed: 0.800000
Amortization of Purchase & Conversion: 1
(0 = None )
(1 = Straight Line )
(2 = F.A.S.B. Method )
(3 = Declining Balance)
(4 = Sum-Years-Digits )
Years to Amortize Over 10
The program will "expense", in the first year,
this fraction of the price paid for a portfolio. The rest of the purchase
price will be amortized using the method chosen below. Enter a percentage
between 0% and 100% expressed as a decimal between 0.000 and 1.000. In
the above example, 25% of the purchase price will be expensed in the first
year.
The program will "expense", in the first year,
this fraction of the conversion cost. The remainder of the conversion costs
will be amortized using the method chosen below. In the above example 80%
of the conversion cost will be expensed in the first year.
Enter the number of the type of amortization to be used for purchase and conversion costs.
0 - None - No amortization is allowed. All costs are expensed in the period of the purchase.
1 - Straight Line - assumes a even amortization over the number of years specified.
2 - F.A.S.B. Method - The portfolio is amortized according to the pre-tax income pattern of the portfolio segment.
3 - Declining Balance- A constant rate equal to some factor times the straight line amortization is used.
4 - Sum-Years-Digits - Sum of the Years digit method of calculating Amortization. The number of years to use will be based on the Years to Amortize field.
Years to Amortize
This is the number of years the amortization calculation will use to determine the relevant Method of Amortization. Be careful not to amortize over more years than the loan life.
Declining Balance Factor
(1.00 = Normal straight-line )
(2.00 = Double Declining Balance)
This field is used only in the declining balance method
(3). Enter a number between that tells the program what declining balance
factor you want to use in the calculation. If you enter a "2"
the program will use a double declining balance calculation.
Mortgagees may be required to pay interest on funds held
in the mortgagor's impound accounts. In this section you define the rate
to use for all impounds that require impound interest; tax, hazard insurance
and insurance premiums impound accounts.
You set this impound rate in several ways:
1. Firm Section - Spread or Specific
2. Portfolio Section - Spread or Specific Table
3. Portfolio Section - Firm File
There are two basic situations that the Model covers.
First, you are only evaluating loans located in impound interest states.
In this instance you set the impound rate in the firm section. More often,
the portfolio you are evaluating has loans located in many different states.
In this situation you set each portfolio segment to have a different impound
interest rate. We will discuss the portfolio inputs in the next chapter.
Key Rate Paid on Impounds : 1 (1=actual,2=spread)
Pay on Impounds
Thru Annual
Month Rate
360 0.000000
1 - Actual Rate - Enter a "1" to input the impound
rate as an actual rate table.
2 - Spread from Market Index - Enter a "2" to input the Impound
rate as a spread from the market index.
Identify each period of time extending into the future when the predicted rate of interest to be paid will remain the same. In the first column, enter the number of the month through which the rate will be constant. To stop entering, press {ESC}.
As the portfolio generates cash, the net cash inflows
are either returned to the shareholders or reinvested in the business or
some combination of the two. The Reinvestment Rate is the pre-rate at which
the generated cash inflows are reinvested. If the assumption is made that
all generated funds are used to purchase new portfolios then the reinvestment
rate is equal to the average return on all portfolios being serviced. If
the generated funds are put into long term securities then the reinvestment
rate is equal to the return on the securities. Finally, if the funds are
used to retire long term debt then the reinvestment rate is equal to the
rate paid on the debt.
The Model uses the reinvestment rate in two specific places:
1. MIRR Modified Internal Rate of Return - The nominal
IRR assumes funds are reinvested at the nominal IRR. The Modified Internal
Rate of Return (MIRR) assumes all funds generated by the investment are
reinvested at the reinvestment rate. As a result the MIRR is a function
of both the IRR and the MIRR. The MIRR is calculated for both the pre-debt
and post-debt analysis.
2. Debt Repayment Analysis - The reinvestment rate is used to determine
the interest earned on the bank balance used to accumulate the cash from
period to period. In the Post-Debt Analysis the cash flows are first used
to service the debt. The remaining cash flows are invested at the reinvestment
rate. (Chapter 5 Monthly Debt Repayment Analysis)
Reinvestment Rate
Key to Reinvestment Rate : 1 (1=actual, 2=spread)
Thru Annual
Month Rate
360 0.090000
Reinvestment Rate
In the first column, enter the number of the month through
which the rate will be constant. To stop entering, press {ESC}. In the
second column, enter the rate as a decimal (e.g. 10% as .10)
The Marginal Tax Rate is the combined federal and state
tax rate that is paid on income earned. When deciding what tax rate to
use it is important to consider the effects of other company operations.
The additional income from this portfolio investment may cause the marginal
rate to increase or decrease.
The marginal tax rate is used to determine the amount of tax paid, the
"tax shield" of interest and amortization, and the effective
after-tax cash flow.
Negative Taxes - When the cash flows become negative the program assumes
that you will receive a tax benefit form this situation. If you do not
receive this benefit, set the tax rate to zero for those years that the
cash flows are negative.
Tax Rate
Thru Annual
Month Rate
360 0.350000
In the first column, enter the number of the month through which the rate will be constant. Numbers in this column must be increasing. To stop entering, press {ESC}. In the second column, enter the rate as a decimal (e.g. 50% as 0.50)
Every day the firm deposits funds into the bank account
. These funds may be cash or checks. If the firm deposits cash then the
they receive immediate use of the funds. Checks, however, require a clearing
period called the clearing days or float time. During this period the firm
does not receive credit for the funds. In effect, the bank must receive
the cash from the cleared checks before the firm receives credit for, or
access to, the balance. In addition, the bank may charge the firm for the
bank's reserve requirement. The reserve requirement is a percentage of
the bank's total funds that the bank must keep on reserve due to state
or federal regulatory requirements.
The bank may charge for their services indirectly by not allowing the access
to a percentage of the daily balance. In this instance the firm will negotiate
with the bank about the usable funds. Also, different types of bank accounts
may have different requirements.
Fees - Finally, the bank may charge the firm fees, in addition to the reserves,
that represent a decrease in the bank balance usable. These fees could
represent the costs of handling the daily transactions through the account.
Tax & Insurance - The handling of the T&I account balance is almost
identical to the P&I account balance. The accounts differ in the size
and number of transactions that pass through the bank each day. The bank
is inclined to charge less for accounts that handle fewer and larger transactions.
The T&I accounts have relatively fewer withdrawals over a year's time.
Fraction of T&I Bank Balances Usable: 0.880000 Fraction of P&I Bank Balances Usable: 0.970000
Enter the fraction of bank balances from the principal
and interest payments which are available for investment. The program will
compute earnings on this fraction of the deposit.
Enter the fraction as a decimal (e.g. 96% as .96). Values are entered as
a fraction of the total balance; i.e. 0.970000 means that 97% of the balances
were available. The program will compute earnings on this fraction of the
deposit.
Enter the fraction of bank balances from the tax and insurance
payments which are available for investment. The program will compute earnings
on this fraction of the deposit.
Enter the fraction as a decimal (e.g. 97% as 0.97). Values are entered
as a fraction of the total balance; i.e. 0.970000 means that 97% of the
balances were available. The program will compute earnings on this fraction
of the deposit.