bussiness report question

ROYAL BANK OF MIDWES T

(Middletown, December 2006) Owning a home is part of the American dream. Having a home creates

ties to the community, provides stability, and promotes civic pride. This desire for home ownership is so

much a part of the American culture that governments promote this ownership by providing significant tax

incentives. Mary Lloyd is Senior Vice President for Mortgage Lending at a medium sized bank, Royal

Bank , operating in the Midwest. Mary prides herself in her role of helping her customers realize this

American dream. She wants to help extend the opportunity of home ownership to her customers who

previously would not qualify for a home loan from Royal by convincing the bank management to enter into

the subprime home lending market.

Royal ha s been a fairly conservative banking institution, concentrating on commercial lending to local

business and low risk home loans. The home loans extended by Royal are to prime borrowers. These

borrowers have reasonably well established credit and borro w in loans conforming to Fannie Mae or

Freddie Mac criteria. Such loans can be packaged and sold through these government -sponsored

agencies. The risk to the bank is low, many of the loans are sold to other institutions and pension funds

while the bank e arns fees for processing the payments. Prime borrowers generally had credit scores of

640 or higher.

In managing the loan business for her bank, Mary sees her job as dealing with two significant problems.

Prior to extending a loan she must deal with adv erse selection. Once the loan is extended she needs to

provide sufficient incentives to reduce the moral hazard problem. Adverse selection results from

asymmetric information. The potential borrower knows more about their likely behavior and financial

condition than the bank. If the bank establishes a lending criteria that is significantly more lenient than its

competitors, the borrowers selected are more likely to be higher risk and less likely to maintain their

payments. Once the loan is extended the borrowers might expose the bank to unanticipated risk by

failing to maintain the property. Mary sees this moral hazard problem being reduced by requiring a

minimum down payment of10 percent of the property’s value. Since the first party to incur a loss, should

the property value decline, is the homeowner, they have an incentive to maintain the value. The adverse

selection problem is managed by screening the applicants. A potential borrower’s credit score has

proven to be a useful screening device.

Mar y has been frustrated by having a screening rule that only permits loans to highly qualified borrowers.

Since her bank only issues prime mortgage loans, she must turn away business from borrowers with 640

or lower credit scores. She has watched her compe titors enter the less than prime (subprime) market

with a high degree of success and seen many of the subprime borrowers succeed in making their housing

payments, improve their credit scores, and achieve their dream of home ownership. Mary believed that

these potential borrowers should not be denied the opportunity of home ownership just because of a few

late payments, difficulty in documenting their income and, perhaps, a prior bankruptcy. If they were given

the opportunity and provided financial counse ling to help them manage their incomes, they would become

good customers for the bank, provide an additional source of bank income, and become more productive

members of the community.

The subprime market developed in the late 1990s. These loans were des igned to provide potential

homeowners with less than perfect credit the opportunity to get back on their feet, improve their credit

rating, and ultimately refinance into a prime loan at lower rates. The initial subprime loans required a 20

percent down pa yment, had a fixed interest rate for the first two years that was generally 2 percent above

the prime, 30 -year fixed rate, and moved into an adjustable rate mortgage (ARM) after two years. Moving

into the 2000s, housing prices were rising, equity was bein g built up for the homeowners and the loans

were profitable. With the subprime loans improving bank profitability, banks and mortgage lending

institutions moved to make their loans more attractive. The down payment requirements dropped to 10

The authors would like to thank Fred Arnold for helpful information on the subprime mortgage market.

percent. In stitutions, in some cases, would issue loans for 100 percent of the property’s value (no down

payment). In order to provide additional loans, second loans were sometimes issued to subprime

borrowers to permit them to take acquired home equity out of the h ouse. While the latest movement

towards more lenient lending criteria has Mary a little worried, she still sees the subprime market as a

vehicle to help both her bank, with higher profits, and her customers, by providing them with the

opportunity of home ownership.

The subprime loans Mary wishes to make would require at least a ten percent down payment, have a

fixed rate for two years, include a prepayment penalty during the first two years, and become an

adjustable rate mortgage (ARM) after two years. To compensate for the added risk associated with these

loans, the fixed rate would be 2 percent higher than the bank’s traditional prime home mortgage loans.

The ten percent down would protect the bank in the case of foreclosure, and the future adjustable rate

would make the loan attractive on the developing secondary market for subprime loans. The ARM is

indexed relative to the 6 -mo LIBOR (London Interbank Offer Rate). Mary is comfortable with these

features. She believes that her borrowers would make their mortgage payment, reestablish a higher

credit score and be able to refinance after two years into a lower rate prime loan.

Required

Mary has some concerns over entering this market and has hired your consulting firm to help her resolve

these concer ns and recommend how she should proceed in this market. Please write a report using the

form recommended on the Gateway web site. (This case takes place in December 2006. While you

have future events in this industry available, you need to make your ca se on data available prior to

January 2007.)

In preparing your answer be sure to consider statistics concepts 4, 5, 6, and 8 and macroeconomics key

concepts 4, 6, 7, and 9.

The available data is in the E xc el spreadsheet found on the cou rse web site. Note that the data is

contained in two sheets.