Loan Structuring

🏦 Credit Analysis: Loan Structuring

The Story of Building a Safe Bridge 🌉

Imagine you want to build a bridge across a river. Before anyone gives you money to build it, they need to know: Will this bridge be safe? Will it last? Can you pay back the money?

Banks think the same way when giving loans! This is called Loan Structuring – making sure every loan is built like a strong, safe bridge.

🏠 Collateral Valuation

What is Collateral?

Think of collateral like a promise with a prize.

When your friend borrows your favorite toy, you might ask them to leave their favorite toy with you. If they lose yours, you keep theirs! That’s collateral.

Simple Example:

• You borrow $100,000 to buy a house
• The bank keeps the house as collateral
• If you can’t pay, the bank takes the house

How Banks Value Collateral

Banks don’t just guess what something is worth. They check very carefully!

Collateral Types & Values:
━━━━━━━━━━━━━━━━━━━━━━━━━
🏠 Real Estate    → 70-80% of market value
🚗 Vehicles       → 50-70% of market value
💰 Cash/Deposits  → 90-100% of value
📄 Stocks/Bonds   → 50-70% of market value
🏭 Equipment      → 40-60% of market value

Why less than 100%? Because if the bank has to sell it quickly, they might get less money. This safety cushion is called the haircut.

graph TD
    A["🏠 Property Worth $500,000"] --> B["Apply 80% Rule"]
    B --> C["Collateral Value: $400,000"]
    C --> D["Maximum Loan: $400,000"]

Real Life Example:

• Sarah wants a $400,000 loan
• She offers her house worth $500,000
• Bank values it at 80%: $400,000
• ✅ Loan approved because collateral covers the loan!

📜 Loan Covenants

What are Covenants?

Covenants are like rules of the game between you and the bank.

Imagine you lend your bike to a friend. You say: “Don’t ride in the rain, don’t lend it to anyone else, and bring it back clean.” These are your covenants!

Two Types of Covenants

1. Affirmative Covenants (DO THIS!) ✅ Things you MUST do:

• Keep insurance on your property
• Send financial reports every quarter
• Pay taxes on time
• Maintain your business

2. Negative Covenants (DON’T DO THIS!) ❌ Things you MUST NOT do:

• Don’t sell the collateral
• Don’t take more loans without asking
• Don’t pay too much in dividends
• Don’t change your business type

Financial Covenants (The Number Rules)

Banks set limits on your finances:

Common Financial Covenants:
━━━━━━━━━━━━━━━━━━━━━━━━━━━
📊 Debt-to-Equity Ratio    ≤ 3:1
💵 Interest Coverage Ratio ≥ 2:1
💰 Current Ratio           ≥ 1.5:1
📈 Minimum Net Worth       ≥ $1 million

Example: ABC Company has:

• Debt: $3 million
• Equity: $1.5 million
• Covenant: Debt-to-Equity ≤ 3:1

Current ratio: 3 ÷ 1.5 = 2:1 ✅ Safe!

If debt goes to $6 million: 6 ÷ 1.5 = 4:1 ❌ Covenant broken!

⚠️ Credit Risk Rating

What is Credit Risk?

Credit risk is the chance that someone won’t pay you back.

Like giving candy to friends – some always share back, some forget, and some… well, they eat it all and disappear! 🍬

The Rating Scale

Banks rate borrowers like grades in school:

Credit Risk Ratings:
━━━━━━━━━━━━━━━━━━━━━━
🌟 AAA/AA  → Super Safe (Best students!)
⭐ A/BBB   → Good (Reliable payers)
⚡ BB/B    → Risky (Need watching)
💀 CCC/D   → Dangerous (Might fail)

The 5 C’s of Credit

Banks check 5 things (all start with C!):

graph TD
    A[🔍 The 5 C's] --> B["💰 Character"]
    A --> C["💵 Capacity"]
    A --> D["💎 Capital"]
    A --> E["📦 Collateral"]
    A --> F["🌍 Conditions"]

1. Character – Will they WANT to pay? (History, reputation)
2. Capacity – Can they AFFORD to pay? (Income, expenses)
3. Capital – Do they have SAVINGS? (Net worth)
4. Collateral – What can we TAKE if they don’t pay?
5. Conditions – Is the ECONOMY good? (Market conditions)

Example Rating:

• Company XYZ wants a loan
• Great payment history → Character ✅
• Strong cash flow → Capacity ✅
• Low savings → Capital ⚠️
• Good collateral → Collateral ✅
• Stable industry → Conditions ✅
• Final Rating: BBB (Good, some concerns)

💲 Loan Pricing and Spreads

What is Loan Pricing?

The interest rate is like paying rent to use someone else’s money!

The Building Blocks of Loan Price

Your Interest Rate:
━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━
🏛️ Base Rate (what bank pays)    4.0%
⚠️ Risk Premium (your risk)     +2.0%
🏢 Operating Costs              +0.5%
💰 Profit Margin                +0.5%
━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━
📊 Your Total Rate               7.0%

What is a Spread?

The spread is the difference between what the bank pays for money and what they charge you.

Think of it like a lemonade stand:

• You buy lemons for $1
• You sell lemonade for $3
• Your spread is $2!

graph TD
    A["Bank's Cost: 4%] --> B[+ Spread: 3%]
    B --> C[Your Rate: 7%]
    C --> D[Spread = Bank's Earnings!"]

Example:

• Prime Rate: 5%
• Your spread: 2.5%
• Your loan rate: 5% + 2.5% = 7.5%

Riskier borrowers = Higher spreads!

Risk Level → Spread
━━━━━━━━━━━━━━━━━━
AAA rated  → +0.5%
BBB rated  → +2.0%
B rated    → +5.0%

📈 Risk-Adjusted Return (RAROC)

What is RAROC?

RAROC stands for Risk-Adjusted Return On Capital.

It’s like asking: “For every dollar of risk I take, how much do I earn?”

Think of two piggy banks:

• Piggy Bank A earns $10 but might break easily
• Piggy Bank B earns $8 but is super strong

Which is better? RAROC helps decide!

The Simple Formula

RAROC = Net Income ÷ Economic Capital

Where:
• Net Income = What you earn after all costs
• Economic Capital = Money set aside for risk

Real Example

Loan to Company A:

• Interest earned: $50,000
• Operating costs: $10,000
• Expected losses: $5,000
• Net Income: $35,000
• Capital at risk: $200,000
• RAROC: 35,000 ÷ 200,000 = 17.5%

Loan to Company B:

• Interest earned: $80,000
• Operating costs: $15,000
• Expected losses: $25,000
• Net Income: $40,000
• Capital at risk: $400,000
• RAROC: 40,000 ÷ 400,000 = 10%

Winner: Company A! Even though Company B pays more interest, Company A gives better return for the risk taken.

graph TD
    A["Calculate RAROC"] --> B{RAROC > Hurdle Rate?}
    B -->|Yes ✅| C["Approve Loan"]
    B -->|No ❌| D["Reject or Reprice"]

📋 Loan Documentation

What is Loan Documentation?

Documentation is all the paperwork that makes a loan official and legal.

Like getting a permission slip for a school trip – everything needs to be written down!

Key Documents

Essential Loan Documents:
━━━━━━━━━━━━━━━━━━━━━━━━━━━━━
📝 Loan Agreement
    → The main contract (terms, rate, amount)

🔒 Security Agreement
    → Details about collateral

✍️ Promissory Note
    → "I promise to pay" document

🛡️ Guarantee Agreement
    → Someone else promises to pay if you can't

📊 Financial Statements
    → Proof of your financial health

💼 Board Resolution
    → Company's official approval to borrow

Why Documentation Matters

Story Time!

Tom’s Restaurant borrowed $100,000 but never signed the security agreement. When Tom couldn’t pay, the bank tried to take the restaurant equipment, but the court said NO – because there was no signed document!

Lesson: Every document must be:

• ✅ Complete (all blanks filled)
• ✅ Signed (by the right people)
• ✅ Dated (with correct dates)
• ✅ Legal (follows all laws)

✅ Loan Approval Process

The Journey of a Loan

Getting a loan is like going through airport security – many checkpoints, all for safety!

graph TD
    A["📥 Application"] --> B["📊 Credit Analysis"]
    B --> C["💰 Risk Assessment"]
    C --> D["📝 Committee Review"]
    D --> E{Decision}
    E -->|Approved ✅| F["📋 Documentation"]
    E -->|Rejected ❌| G["Inform Customer"]
    F --> H["💵 Disbursement"]

Step-by-Step Process

1. Application 📥

• Customer submits loan request
• Provides financial statements
• States purpose and amount needed

2. Credit Analysis 📊

• Bank reviews the 5 C’s
• Calculates ratios
• Checks credit history

3. Risk Assessment ⚠️

• Assign credit rating
• Calculate RAROC
• Evaluate collateral

4. Loan Committee Review 👥

• Present findings to committee
• Discuss risks and terms
• Vote on approval

5. Approval/Rejection ✅❌

• If approved: set final terms
• If rejected: explain reasons

6. Documentation 📋

• Prepare all legal papers
• Get signatures
• Perfect collateral (register it legally)

7. Disbursement 💵

• Release the funds
• Start monitoring the loan

Approval Authority Levels

Loan Amount → Who Can Approve?
━━━━━━━━━━━━━━━━━━━━━━━━━━━━━━
< $100,000    → Branch Manager
< $1 million  → Regional Manager
< $10 million → Credit Committee
> $10 million → Board of Directors

Example: XYZ Corp wants a $5 million loan:

1. ✅ Application submitted with financials
2. ✅ Analyst reviews: BBB rating
3. ✅ RAROC: 15% (above 12% hurdle)
4. ✅ Credit Committee approves
5. ✅ Legal prepares documents
6. ✅ CEO and CFO sign
7. ✅ Funds released!

🎯 Quick Summary

🌟 Remember!

Every loan is like building a partnership. The bank wants to help you succeed (so you can pay them back!), and all these steps make sure everyone is protected.

The Golden Rule: Good preparation = Smooth approval = Happy borrowing! 🎉