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

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When you price an opportunity in PrecisionLender, Andi may suggest lowering the LTV if you are short of your target ROE. This article explains why reducing the LTV increases the ROE.

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"). 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 ROE when you are pricing a loan, since:

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

Together, these two effects drive ROE higher.

LTV is a ratio of the loan amount to the value of the assets collateralizing it. Let's consider an example in which a $1 million real estate loan collateralized by a building appraised at $1,250,000 has an 80% LTV. The lower the LTV, the lower your risk of loss, since the collateral mitigates some of your exposure in the event of default. If we price this Opportunity in PrecisionLender and accept Andi's suggestion to reduce LTV, you will see that we now meet our target. To meet the target, the loan amount decreases to $887,960. Note that if you click in the collateral box, there is a pin icon next to the Opportunity name. PrecisionLender assumes your collateral value is set, and “pins” that value to the loan amount. You can choose to “unpin” the collateral value by clicking the pin icon.

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, so your Collateral Types and Recovery Factors are likely different than those you see here. 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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