 |
SunTrust "Banks" On Crystal
Ball For Assessing The Risk Of Commercial Loans
CUSTOMER OF THE MONTH (NOV. 1998)
|
SunTrust Banks, Inc., is a premier financial services company based
in the Southeastern United States. SunTrust provides a wide range
of services to meet the financial needs of its growing customer
base through approximately 700 full-service banking offices in Florida,
Georgia, Tennessee and Alabama. SunTrust's primary businesses include
traditional deposit and credit services as well as trust and investment
services. Through various subsidiaries the Company provides credit
cards, mortgage banking, credit-related insurance, data processing
and information services, discount brokerage and investment banking
services.
A small segment of SunTrust's commercial loan department is that
of lending to the construction industry. SunTrust has recently used
Crystal Ball to perform Monte Carlo Simulations on hotel construction
loans. This helps quantify the risks involved in evaluating these
types of loans. Formerly, bankers would do worst case and best case
analysis on construction loans when deciding on providing financing
or not. Using Crystal Ball, a method has been developed to obtain
a risk-adjusted return on investment. Using this finding and comparing
it to the bank's cost of funds helps decision-makers determine if
the profitability is worth accepting the risk of approving the loan.
There are five steps to analyzing hotel construction loans using
Crystal Ball. For this method, there is assumed to be a take-out
lender that will refinance the hotel construction loan provided
that a required debt service coverage, DSC, is achieved. These steps
involve:
- 1) Generating a pro-forma income statement on a spreadsheet
including calculations for debt service coverage,
- 2) Assign probability distribution functions to the average
daily rate obtainable by the hotel, average occupancy rate of
the hotel and the projected floating interest rate on the loan,
- 3) Run the simulation to determine the probability that the
DSC will fall with the level required by the take-out lender,
- 4) Calculate the expected return on investment, and
- 5) Compare the calculated ROI with the cost of funds to determine
if the spread is large enough to warrant accepting the loan.
Of the above steps, step 4 requires further explanation.
In calculating the expected return on investment the spreadsheet
"IF" function was utilized. For the cell calculating the expected
return, the following equation was used: E{R} = (Loan Amount) x
Interest Rate if the DSC was greater than that required by the take-out
lender, and E{R} = Liquidation Value - Loan Amount if the DSC failed
to meet requirements. The first equation is the expected profit
and the second is the expected loss. This of course makes the assumption
that there would be a liquidation if the DSC was inadequate, which
is not necessarily the case. However, this is the most conservative
approach. The "IF" function combines the two formulas above depending
on the level required by the debt service coverage upon each iteration
of the simulation. This gives the analysis the advantage that when
the simulation is complete, one single number for the expected ROI
"pops out". This makes it easy for the decision-makers to make a
determination by only focusing on one number.
|
