ROYAL BANK OF MIDWEST – QUESTIONS
In your report use the guide for reports found on the course website and incorporate the answers to questions 1 to 5 below. The available data is in the Excel spreadsheet on the course website. Note that the data is contained in two sheets.
Q. 1. Mary is concerned over how she should use credit ratings in making these loans. She has gathered sample data on credit rating and loan delinquencies which are provided for your use. Loans delinquent beyond 90 days are likely candidates for foreclosure. Mary believes that the bank is willing to accept a minimum credit score that has an expected foreclosure rate of ten percent.
a. What is the relationship between days delinquent and credit scores? Use simple regression. Determine and interpret the coefficient of determination.
b. What credit score is expected to yield an average delinquency of 90 days?
c. If Mary used that credit score as a minimum for extending these subprime loans, what proportion of loans to individuals with that score would you expect to be 90 or more days delinquent?
d. Assuming that Mary gets the bank to enter the Subprime market, what minimum credit score would you recommend accepting? Why?
Q. 2. Mary is wondering whether or not the success seen by her competitors is the result of recent increases in housing prices. She has heard rumors that the Federal Reserve is likely to tighten monetary policy and wonders what the implications are for her success in this market. Mary has provided you with data on historic home price changes in her area along with data on price level (CPI) changes, and interest rates. Using this data, how concerned should Mary be over possible changes in Federal Reserve policy? In making your recommendations, it is suggested that you do the following:
a. Find the relationship between home price change and interest rates using simple regression.
b. Find the relationship between home price change and inflation using simple regression.
Q. 3. Mary believes that the ten percent required down payment will protect the bank from a loss of principal. However, should the loan default, the funds are likely to be tied up, without interest income for six to nine months. The funds could have been used to fund a prime loan at around six percent interest with a default rate of well under one percent. Mary is wondering whether or not the two percent premium paid on the performing loans will cover the expected loss from the nonperforming loans. She expects a potential default rate around 3-5 percent. The average home loan is about $200,000.
Q. 4. Mary wants to sell some of these subprime loans on the developing secondary market. However, she also wants the bank to retain some in their asset portfolio to add income and make the stockholders happy. She wants an evaluation of the associated risks and a recommendation on whether or not to hold or sell. What are the possible gains and losses to the bank after December 2006?
Q. 5. Finally, Mary is concerned over the potential ethical dilemma of lending substantial amounts of funds to customers who have demonstrated an inability to manage their finances, or to not lend to them and deny an opportunity to move forward on home ownership. Is it ethical or not to extend loans in the subprime market?
