Considerations for

Program and Product Design

Session 2

Dec. 12, 3:30-5:30pm

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Options for structuring financial assistance

Other potential modes:

convening authority,

regulatory actions,

technology transfer,

intra-govt assistance

Cost points are highly dependent on details of initiative and move along continuum

Which is best platform to use?

• In current budgetary environment, zero & negative subsidy rate

credit programs have become attractive

• Regardless of forecast cost or FCRA subsidy rate, economic

benefits are conveyed to borrowers and/or lenders through

government loan programs, and there is cost and risk to taxpayers

– Negative subsidy rates arise from using Treasury rates as cost of capital

and from omission of administrative costs

• Common thread across federal credit activities is that subsidies are

intended to reduce price of credit and access to it

– Borrower subsides have effect of making prices appear lower, thereby

increasing both demand and quantity of loans provided

– Lender subsidies also increase quantity of loans provided at given

prices

Cost considerations and subsidies

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Congrats, you’re in charge of a new credit

program, now what?

5

• Division of essential lending functions between agency

and private partners

• Loan attributes

– Maturity, amortization and loan size

– Fixed vs. floating rates

– The wisdom of indexing

– Higher upfront fees or higher rates?

– Embedded options: prepayment, caps and floors, deferral,

forbearance, income-based repayment, consolidation, default

– How much choice is too much?

Program and product design choices

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• Other key considerations

– How much default risk is optimal? Should pricing be risk-based?

– Narrowly or broadly targeted?

– Product suitability

• Choices affect

– Success in meeting mission

– Gov’t costs and risks

– Borrower costs, risks and satisfaction

Program and product design choices

7

• Marketing

• Origination

• Servicing

• Funding

• Screening and monitoring

• Risk bearing

• Resolving defaults

The essential credit functions

8

• Critical decision: Which functions to perform in-house?

When to use a private partner?

– Choices have first-order impact on administrative costs, loan

performance, borrower satisfaction, goal attainment, etc.

– Apply principle of comparative advantage: who is best positioned

to perform the task most efficiently and effectively?

– Be cognizant of challenges of managing private partners

Managing essential credit functions

9

• Related decision: Guaranteed or direct lending?

– Guaranteed lending usually relies more on private partners

– But direct loan programs also use private partners

• We’ll delve into these issues more in Session 6

Managing essential credit functions

10

• Principle of matching maturity with investment horizon

• Right-sizing loans

– As small as possible to achieve purpose

• Effects on cost, performance and risk

– Longer maturity allows lower periodic payments

– Normally yield curve is upward sloping => rates charged

increase with maturity, reducing affordability

– Amortization can reduce default risk by forcing orderly

repayment. However, it decreases affordability by increasing

monthly payments

– A larger number of small loans diversifies portfolio risk

Loan attributes: Maturity, amortization, and size

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• Fixed rates: borrower perspective

– make cash flows more predictable for borrower

– may improve performance by avoiding affordability problems

when rates rise

– may leave borrower with above-market rate when rates fall

– typically higher rates than on floating rate loans

• Fixed rates from lender/gov’t perspective

– may leave lender with below-market rate when rates rise

– Can make the cash flows risky and increases cost if loan is

prepayable

• A guiding principle: Fixing a rate is not free. Do not set

fixed rate horizons to be unnecessarily long.

Loan attributes: Fixed vs. floating rates

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• Rates can be

– Fixed by statute

– An index rate plus a spread that is fixed by statute

– Set by guaranteed lenders (often with agency or statutory

restrictions)

– Set by agency (sometimes with statutory restrictions)

• Indexing links rates on new loans to current market

conditions

– E.g., 10-year Treasury + 2% on 10-year fixed rate loan

• Indexing ensures more uniform subsidies across cohorts

– Avoids cherry-picking by private sector when statutory rates are

above market rates

– Happens automatically when competitive lenders set rates

Loan attributes: The wisdom of indexing

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• Effects of higher upfront fees and lower rates

– Reduces implicit subsidy of high-risk borrowers by low-risk

borrowers

– May discourage some target borrowers because reduces

affordability

• Can mitigate by rolling fees into loan principal

• Budgetary note: Using higher rates as a substitute for explicit fees

can change budgetary treatment. Interest rates affect subsidy rate

calculations. Fees may be treated on cash basis as admin costs.

Loan attributes:

Higher upfront fees or higher rates?

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• Definition: An option provides the right but not the

obligation to buy or sell a security at a preset price.

– A call option gives the right to buy

– A put option gives the right to sell

– Options are valuable!

– Sometimes valued using “options or derivative pricing models”

• Most “embedded options” in loans benefit borrowers

– Many government credit products are actually complex financial

derivatives

– Private lenders recover cost through higher interest rates or fees

– Options increase the subsidy rates on gov’t loans

Embedded options

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• Valuable option to borrowers with fixed-rate loans

– Allows flexibility in timing of loan repayments

– Can take advantage of reductions in market interest rates by

refinancing

• Costly option for gov’t or private lenders

– Particularly risky on long-term loans with no prepayment penalty

– 30-year fixed rate mortgages

• S&L crisis; near-bankruptcy of Fannie Mae in 1980s

– Student loans

• Tends to benefit sophisticated borrowers at the expense

of less knowledgeable borrowers

Embedded options: prepayment

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• Caps put a ceiling on floating rates

– E.g.,1-year Treasury + 3% with a cap of 10%

– Useful for reaping some of the cost-saving benefits of floating

rates while protecting borrowers from very high rates

– Caps increase loan cost and hence subsidy rates

• Floors put a lower bound on the floating rate paid

– E.g., 1-year Treasury + 3% with a floor of 4%

– Protects lender against low revenues when rates fall

– Floors decrease loan cost and subsidy rates

Embedded options: caps and floors

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• All these options affect the timing and/or size of cash

flows to the benefit of borrowers

• Hence they increase subsidy rates and/or the rates

charged by private lenders on guaranteed loans

• When other options have significant effects, statistics on

default rates and recovery rates provide a very

incomplete picture of loan performance and cost

Embedded options: deferral, forbearance, income-

based repayment, consolidation, and default

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19

Student Loan Consolidation Option:

Historical Experience

From Lucas and Moore (2012), “The Student Loan

Consolidation Option”

Consolidation Volume and Estimated Cost

(1998 – 2005)

Consolidat

ion Year

Consolidation

Volume

(billions of $)

Consolidation

Cost

(billions of $)

Consolidation

Cost (dollars

per $100)

1998 5.6 0.0 0.17

1999 12.3 0.5 4.01

2000 10.2 -0.6 -5.44

2001 15.5 0.6 4.16

2002 26.4 2.3 8.86

2003 39.3 7.4 18.73

2004 43.8 7.0 15.92

2005 55.3 4.2 7.60

• Options benefit borrowers by increasing flexibility

• But offering too many options can hurt borrowers more

than it helps them

– Cost of option paid for in higher rates

– Harder to comparison shop when different loans have different

options

• E.g., No points and 4% rate versus 1% in points and 3.75% rate

– Cross-subsidies to borrowers who understand how to use

options well from those who are unable to use them optimally

• E.g., Home mortgage prepayment option less useful if you don’t

qualify for refinancing

How much choice is too much?

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How much default risk is optimal? Should pricing be risk-based?

21

Low-risk borrowers

likely to obtain

credit privately

Collection is expensive.

Default harms borrowers.

High-risk group is better

candidates for grants.

Sweet spot has

moderate risk

• Risk-based pricing reduces cross-subsidies

• Broad eligibility

– Maximizes access to credit and other benefits

– More likely to be target inefficient and displace private lending

– Is including low-risk borrowers to offset high-risk borrowers a

good idea?

• e.g., to reduce overall default rates, to provide negative subsidy

rates to accommodate high-risk borrowers, to increase importance

of program to policymakers,…

• May have political advantages

• Diversification benefits at program level, less important at aggregate

federal level

• Likely at odds with directive to only serve borrowers that cannot

obtain private funding

Narrow or broad eligibility?

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• No watchdog agency with job of overseeing federal

credit products

– This leaves responsibility with Congress and Agencies

• Exception is that CFPB oversees reverse mortgages

• Growing concerns about adverse effects of excessive

indebtedness

– For individuals and for the broader economy

• My Uber driver and the FHA

– E.g., student loans, mortgages

Product suitability

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The Landscape

The Market Dramatic changes in financial institutions

Changes in borrower expectations

Technology Automation in origination underwriting and servicing

Data and risk management

Realities: Funding The SBA: Business Modernization, Re-engineering

What Money?

Do-it-yourself: Data Analysis, Benchmarks, Tools, Guidelines

The Landscape

A Practical Approach to Building a New

Credit Program

1 Review the Objectives, Performance, and Outcomes (Session 1)

2 Define the borrower need in financial terms

3 Identify the financial reasons that conventional lenders won't do it

4 Choose the platform: grant, direct loan, guaranty

5 Design the product: pricing, structure, term, volume

6 Assess feasibility: cost, risk, staff size and skillsets, systems

7 If not feasible, revise pricing, structure, term, and/or volume until feasible

8 Determine how the financial benefits are shared: borrower, partner, agency

9 If not balanced, revise structure of the product cash flows

Steps in the Iterative Process

Product Design: Suitability for the Borrower

Inputs

Amount of

the Loan

Annual

Interest Rate

PMI if

applicable

(%)

Term in

Months

Monthly

Payment

Borrower

Credit Score

Maximum

Borrower LTV

Debt Service

to Income

Borrower

Annual

Income $

Borrower

Equity

Required %

Conventional Borrower 350,000$ 3.50% 360 $1,571.66 680 80.00% 30.00% 62,866$ 20.00%

Maximum

Amount of

the Loan

Annual

Interest Rate

PMI if

applicable

(%)

Term in

Months

Monthly

Payment

Borrower

Credit Score

Maximum

Borrower LTV

Debt Service

to Income

Borrower

Annual

Income $

Borrower

Equity

Required %

Target Borrower $350,000 3.50% 0.50% 360 $1,670.95 620 100.00% 55.70% 36,000$ 0.00%

Conventional Credit Product

Currently Available in the Market

The Credit Product that the Target

borrower needs

Product Design: Volume, Interest Rates, and

Fees

Loan Production Assumptions

250,000$ Totals # of Loans 70,000 Total $ of Loans

Enter s tarting year of model : 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025

# Of loans 500 1,500 5,000 7,500 10,000 10,000 10,500 8,000 7,500 9,500

$ Of Loans $ 125,000,000 $ 375,000,000 $ 1,250,000,000 $ 1,875,000,000 $ 2,500,000,000 $ 2,500,000,000 $ 2,625,000,000 $ 2,000,000,000 $ 1,875,000,000 $ 2,375,000,000

Interest rates and fees

Fed Funds LIBOR Prime Swap Other ST 6-Mo T Bills 10 Yr Treas Other LT

Today's rate (information only) 1.75

10 Yr Treas

2.25%

Fixed

Rate Forecast Starting Year2016 2017 2018 2019 2020 2021 2022 2023 2024 2025

Index Rate 1.75% 2.0000% 2.2500% 2.5000% 2.7500% 3.0000% 3.2500% 3.5000% 3.7500% 4.0000%

Fees Origination ServicingGuarantee

Fee Up Front

Guarantee

Fee OngoingOrigination Servicing

Other Up

Front

Other

Ongoing

3.00% 2.00% 1.00%

Amount of the loan ($)

Interest Rate Index (choose 1)

Index

Spread over Index

Fixed or Floating Rate (click on cell and select from drop-down list)

Agency Fees % Partner Fees %

$17,500,000

Principal Cash Flows: Sales, Delinquencies,

Losses, Recoveries, Prepayments

2016 2017 2018 2019 2020 2021 2022 2023 2024 2025

0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%

8.00% 8.2500% 8.5000% 8.7500% 9.0000% 9.2500% 9.5000% 9.7500% 10.0000% 10.2500%

Product Default Risk and Prepayment Characteristics

Age of loan in years: 1 2 3 4 5 6 7 8 9 10

Probabi l i ty of default: 0.25% 0.50% 1.00% 2.00% 1.50% 0.75% 0.25% 0.25% 0.25% 0.25%

Probabi l i ty of prepayment: 0.50% 1.00% 2.00% 3.00% 3.00% 3.00% 3.00% 3.00% 2.00% 2.00%

(Use this input for s tress testing) 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025

Additional probabi l i ty of default: 0.50% 0.50% 0.50% 0.50% 0.50% 0.50% 0.50% 0.50% 0.50% 0.50%

Year after default: 1 2 3 4 5 6 7 8 9 10

% of charge-offs recovered 5.00% 2.50% 1.25% 0.75% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%

(as a percentage of the loan amount outstanding at the time of charge-off)

Model Year: 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025

2.00% 3.00% 5.00% 5.00% 5.00% 5.00% 5.00% 5.00% 5.00% 5.00%

2016 2017 2018 2019 2020 2021 2022 2023 2024 2025

0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00% 0.00%

2016 2017 2018 2019 2020 2021 2022 2023 2024 2025

$ - $ - $ - $ - $ - $ - $ - $ - $ -

% of active loan portfol io sold in year

Del inquency losses

% of defaulted loans sold in year

Investor cap rate on loan sa les

Cents per $1 va lue of these loans

Agency loan loss reserve (% gross loans

owned by agency)

Staffing Costs

# FTEs 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025

Marketing 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00 1.00

Origination 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00

Underwriting 2.00 3.00 5.00 8.00 8.00 8.00 8.00 8.00 8.00 8.00

Closing 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00 0.00

Servicing 1.00 1.00 1.00 2.00 2.00 2.00 3.00 3.00 4.00 4.00

Monitoring 3.00 4.00 5.00 5.00 5.00 5.00 5.00 5.00 5.00 5.00

Default Management 2.00 2.00 2.00 2.00 2.00 2.00 2.00 2.00 2.00 2.00

Administration 3.00 3.00 3.00 3.00 3.00 3.00 3.00 3.00 3.00 3.00

Total FTEs 12.00 14.00 17.00 21.00 21.00 21.00 22.00 22.00 23.00 23.00

Annual inflation rate for operating costs 2.00%

STAFFING COSTS 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025

Marketing 70,000 71,400 72,828 74,285 75,770 77,286 78,831 80,408 82,016 83,656

Origination - - - - - - - - - -

Underwriting 170,000 173,400 176,868 180,405 184,013 187,694 191,448 195,277 199,182 203,166

Closing - - - - - - - - - -

Servicing 50,000 51,000 52,020 53,060 54,122 55,204 56,308 57,434 58,583 59,755

Monitoring 225,000 229,500 234,090 238,772 243,547 248,418 253,387 258,454 263,623 268,896

Remediation 160,000 163,200 166,464 169,793 173,189 176,653 180,186 183,790 187,466 191,215

Administration 225,000 229,500 234,090 238,772 243,547 248,418 253,387 258,454 263,623 268,896

Total staff costs 900,000 918,000 936,360 955,087 974,189 993,673 1,013,546 1,033,817 1,054,493 1,075,583

Non-Staff Operating Costs and Staff

Production Benchmarks

NONSTAFF OPERATING COSTS 2016 2017 2018 2019 2020 2021 2022 2023 2024 2025

Marketing 100,000 102,000 104,040 106,121 108,243 110,408 112,616 114,869 117,166 119,509

Origination - - - - - - - - - -

Underwriting 160,000 163,200 166,464 169,793 173,189 176,653 180,186 183,790 187,466 191,215

Closing - - - - - - - - -

Servicing 35,000 35,700 36,414 37,142 37,885 38,643 39,416 40,204 41,008 41,828

Monitoring 135,000 137,700 140,454 143,263 146,128 149,051 152,032 155,073 158,174 161,337

Default Management 45,000 45,900 46,818 47,754 48,709 49,684 50,677 51,691 52,725 53,779

Administration 100,000 102,000 104,040 106,121 108,243 110,408 112,616 114,869 117,166 119,509

Total nonstaff operating costs 575,000 586,500 598,230 610,195 622,398 634,846 647,543 660,494 673,704 687,178

2016 2017 2018 2019 2020 2021 2022 2023 2024 2025

Total Operating Costs per year 1,475,000 1,504,500 1,534,590 1,565,282 1,596,587 1,628,519 1,661,090 1,694,311 1,728,198 1,762,762

2016 2017 2018 2019 2020 2021 2022 2023 2024 2025

Opex as % of Principal O/S No agency loansNo agency loansNo agency loansNo agency loansNo agency loansNo agency loansNo agency loansNo agency loansNo agency loansNo agency loans

Originations per FTE No FTEs No FTEs No FTEs No FTEs No FTEs No FTEs No FTEs No FTEs No FTEs No FTEs

Applications per underwriting FTE 250 500 1,000 938 1,250 1,250 1,313 1,000 938 1,188

Originations per closing FTE No FTEs No FTEs No FTEs No FTEs No FTEs No FTEs No FTEs No FTEs No FTEs No FTEs

Active loans per servicing FTE 496 1,977 6,907 7,113 11,926 16,596 14,229 16,446 13,802 15,696

Annual servicing cost per active loan $171.33 $43.86 $12.80 $6.34 $3.86 $2.83 $2.24 $1.98 $1.80 $1.62

STAFF PRODUCTIVITY AND STAFF STRESS BENCHMARKS

NON-STAFF OPERATING COSTS

Please write a paragraph or series of bullet points thinking

critically about the key program objectives of a federal

credit program with which you are familiar.

– How does that program contribute to the agency’s mission?

– Are sufficient data and metrics available to assess costs and

benefits? Are there additional metrics that could be helpful?

– If you could revise program objectives or intended outcomes,

would you? How?

Discussion: program contributions to

mission objectives and the use of metrics

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