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Why does my return change when I change Loan-To-Value (LTV)?

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Note:

This article discusses calculations related to Collateral. If you don't see the option to add Collateral to your opportunity, your administrators might have enabled Facility Ratings instead. To learn more, visit Using Facility Ratings.

 

When you price an opportunity in PrecisionLender, Andi may suggest lowering the LTV if you are short of your target. LTV is a ratio of the loan amount to the value of the assets collateralizing it. This article explains why reducing the LTV increases the return.

In short, a lower LTV means a smaller exposure relative to the value of the underlying collateral in the event the borrower defaults (often referred to as “Loss Given Default" or "LGD"). The lower the LTV, the lower your risk of loss, since the collateral mitigates some of your exposure in the event of default. Loan loss reserves are charged and capital is allocated to a loan based on the size of the LGD.  This lower LGD translates into a better return when you are pricing a loan, since:

  • a smaller loan loss reserve is required (making the numerator larger in the return calculation); and
  • less capital needs to be held against the loan (making the denominator smaller in the return calculation).

Together, these two effects drive your return higher.

In the product set-up in the Administration section within PrecisionLender, each type of collateral has a defined Recovery Factor, which represents the present value of the recovered collateral (after time and expenses), in the event of a default, as a percentage of the nominal collateral value. In the Administration section, you can view a product's Recovery Factor by clicking "Products," then the product name, and then "Collateral Types" at the top of the screen.  Recovery Factor is reflected as a percentage. This percentage will be used by PrecisionLender in the calculation of LGD. Considering an example: collateral with a Recovery Factor of 35% and an appraised value of $1.25 million would provide $437,500 of loss mitigation. The $1,000,000 loan exposure less the $437,500 of collateral mitigation results in $562,500 LGD. The LGD is the value to which loan loss reserve percentages and capital allocation rates are then applied, since this is in effect the unsecured portion of the loan. Remember, PrecisionLender is customized for your institution, and your Collateral Types and Recovery Factors have been set up by your Administrators. If you’d like to follow the math in detail, check out the link to our article “How does the math work?” below.

 

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