Question

You are the consumer staples analyst for a large corporate and investment bank. The bank’s management has committed to shareholders to lift the bank ROE from the current 5% to 8% within a year and to 10% within 2 years.

Your institution can borrow money at the following maturity and cost:

Overnight 0.10% . 1-month 0.20% 3-month 0.25% 6-month 0.50%

1-year 0.75% . 3-year 1.50% . 5-year 2.00% . 7-year 2.50% 10-year 3.0%

You are looking at 2 loan applications for $200M each from Foodco and Safeco, two companies you know and cover for years, both of which have an established relationship with your bank. Foodco’s cost of borrowing in the market is UST +250 while Safeco’s UST+400. As Safeco is considered the riskier of the two, any loan towards Safeco will have to generate more loss reserves. Both loans will be senior secured and thus collateralized. Safeco pledges as collateral real estate holdings plus business receivables (50/50) while Foodco pledges delivery trucks plus $20M of cash deposits. The appraised value of the collateral covers the loan fully. For Foodco the loan reserve (based on its implied probability of default) is 30 basis points per annum while for Safeco is 60 basis points per annum. Both companies “leak” to you that they already have received bids from competitors in the neighborhood of 5.5% and 6.0% respectively for a 10yr loan. What do you do and why?

Answer 1

There are two applications made by two companies.

We shall discuss the application company-wise.

According to the data shared, the cost of borrowing to the bank for 10-year maturity is 3%.

So, looking into the risk profile the bank should lend on a case-to-case basis.

Safeco

As per the probability of default the bank would be required to provide 0.60% of the loan amount as a reserve for the possibility of default. The total reserve t be created in 10 years = 0.60% * 10 years = 6%.

So, Borrowing cost+ reserve cost + increase in ROE = minimum rate at which money to be provided = 3%+ 0.60%+ 3% = 6.6%

Foodco

As per the probability of default the bank would be required to provide 0.30% of the loan amount as a reserve for the possibility of default. The total reserve t be created in 10 years = 0.30% * 10 years = 3%.

So, Borrowing cost+ reserve cost + increase in ROE = minimum rate at which money to be provided = 3%+ 0.30%+ 3% = 6.3%

Both the loans are not in the bid range leaked by the companies. So, both the loans should not loaned below the above rate or should be rejected.