Chapter Nine Risk Management AssetBacked Securities Loan Sales
Chapter Nine Risk Management: Asset-Backed Securities, Loan Sales, Credit Standbys, and Credit Derivatives Mc. Graw-Hill/Irwin Copyright © 2010 by The Mc. Graw-Hill Companies, Inc. All rights reserved.
9 -2 Key Topics • The Securitization Process • Securitization’s Impact and Risks • Sales of Loans: Nature and Risks • Standby Credits: Pricing and Risks • Credit Derivatives and CDOs • Benefits and Risks of Credit Derivatives Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
9 -3 Securitization of Loans The Pooling of a Group of Similar Loans and Issuing Securities Against the Pool Whose Return Depends on the Stream of Interest and Principal Payments Generated by the Loans Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
9 -4 The Heart of the Securitization Process Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
9 -5 Securitization Process • Originator – Bank or Lender Who Makes the Loan • Issuer – Special Purpose Entity That Issues the Securities • Credit Rating Agency – Rates the Securities • Security Underwriter or Investment Banker Helps Issue Securities • Trustee – Makes Sure Issuer Fulfills All Their Obligations • Servicer- Collects Payments on the Securitized Loans Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
9 -6 Key Players in the Securitization Process Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
9 -7 Advantages of Securitization • Diversifies a Bank’s Credit Risk Exposure • Creates Liquid Assets Out of Illiquid Assets • Transforms These Assets into New Sources of Capital • Allows the Bank to Hold a More Geographically Diversified Loan Portfolio • Allows the Bank to Better Manage Interest Rate Risk • Allows the Bank to Generate Fee Income Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
9 -8 Problems with Securitization • May Not Reduce a Bank’s Capital Requirements • Prepayment Risk • May Increase Competition for the Best Quality Loans • May Increase Competition for Deposits • Credit Crisis of 2007 -2009 showed that the “bankruptcy remote” SPE arrangements can get into trouble if the underlying loans go bad • GSEs: Ethical Controversies Around Fannie Mae and Freddie Mac Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
9 -9 Promised Fees and Payments on Securitized Loans • Coupon Rate Promised to Investors Who Buy Securities • Default Rate on the Pooled Loans • Fees to Compensate for Servicing Loans • Fees Paid to Advise on Setting Up Securitization Process • Fees Paid for Providing Liquidity Enhancement • Residual Income For Security Seller, Trust or Credit Enhancer Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
9 -10 Types of Securitized Assets • Residential Mortgages – the beginnings of securitization • • ▫ The role of GSEs (GNMA, FHLMC) ▫ Riskier CMOs Home Equity Loans Automobile Loans (CARs) Commercial Mortgages Small Business Administration Loans Mobile Home Loans Credit Card Receivables Truck Leases Computer Leases Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
9 -11 Regulators’ Concerns About The Soundness and Safety of Lenders and Financial System • Risk of Having to Come Up with Large Amounts of Liquidity Quickly to Make Payments To Investors Holding Securities • Risk of Agreeing to Serve as Underwriter for Securities that Cannot be Sold • Risk of Acting as Credit Enhancer and Underestimating Need for Loan Reserves • Risk that Unqualified Trustees Will Fail to Protect Investors • Risk of Loan Servicers Being Unable to Satisfactorily Monitor Loan Performance and Collect Monies Owed • In light of the credit crisis, also focus on the impact of securitization on the remaining portfolio of loans that are not securitized Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
9 -12 Quick Quiz • What does securitization of assets mean? • What kinds of assets are most amenable to the securitization process? • What advantages does securitization offer lending institutions? • What are the most important risks associated with the securitization process (from the lending institution and the regulators’ perspectives)? Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
9 -13 Loan Sales Selling Loan Contracts Held by an Institution in Order to Raise New Cash Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
9 -14 The Impact of Loan Sales Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
9 -15 Servicing Rights The Selling Bank Can Generate Fees for Agreeing to Keep Records, Collect Monies Owed and Help Enforce the Terms of a Group of Loan Contracts and Passing the Proceeds on to the Loan Buyers Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
9 -16 Types of Loan Sales • Participation Loans ▫ Where an Outside Party Purchases a Loan. They Generally Have No Influence Over the Loan Terms • Assignments ▫ Ownership of the Loan is Transferred to the Buyer of the Loan. The Buyer Has a Direct Claim Against the Borrower. • Loan Strip ▫ Short-Dated Pieces of Longer Term Loans, Maturing in a Few Days or Weeks Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
9 -17 Reasons Behind Loan Sales • Way to Rid the Bank of Lower-Yielding Assets to Make Room for Higher-Yielding Assets when Interest Rates Rise • Way to Increase Marketability and Liquidity of Assets • Way to Eliminate Credit and Interest Rate Risk • Way to Generate Fee Income • Purchasing Bank can Diversify Loan Portfolio and Reduce Risk Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
9 -18 Risks In Loan Sales • Best Quality Loans are the Easiest to Sell Which May Increase Volatility of Earnings for the Bank Which Sells the Loans • Loan Purchased From Another Bank Can Turn Bad Just as Easily As One From Their Own Bank • Loan Sales are Cyclical Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
9 -19 Standby Letters of Credit (SLCs) • Financial Instrument that Enhances the Credit Standing of a Borrower by Providing Guarantees of Performance or Insures Against Default in Return for Payment of a Fee. It is a Contingent Obligation ▫ Performance Guarantees – Guarantees a Project Will be Completed On Time ▫ Default Guarantees – Financial Institution Pledges Repayment of Defaulted Notes When Borrowers Cannot Pay Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
9 -20 Advantages of SLCs • Letters of Credit Earn a Fee for Providing the Service (0. 5 to 1 percent of the amount of credit involved) • They Aid a Customer Who Can Borrow More Cheaply When There is a Guarantee • Such Guarantees Can be Issued at Relatively Low Cost • Probability is Usually Low that an Issuer of SLC Will Ever Be Called On to Pay Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
9 -21 Reasons for Growth of SLCs • Rapid Growth of Direct Financing Worldwide • Risk of Economic Fluctuations has led to Demand for Risk-Reducing Devices • Opportunity SLCs Offer Lenders to Use Their Credit Evaluation Skills to Earn Fee Income Without the Immediate Commitment of Funds • The Relatively Low Cost of Issuing SLCs Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
9 -22 Structure of SLCs Three Essential Elements: • Commitment From Issuer • An Account Party – For Whom the Letter is Issued • A Beneficiary – Investor Concerned About Funds Committed to Account Party Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
9 -23 Sources of Risk with SLCs • Default Risk of Issuing Bank • Beneficiary Must Meet All Conditions of Letter to Receive Payment • Bankruptcy Laws Can Cause Problems for SLCs • Issuer Faces Substantial Interest Rate and Liquidity Risks Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
9 -24 Ways to Reduce Risk Exposure of SLCs • Frequently Renegotiating the Terms of Any Loans Extended to Customers • Diversifying SLCs Issued by Region and Industry • Selling Participations in Standbys in Order to Share Risk Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
9 -25 Regulatory Concerns About SLCs • Bank Examiners are Working to Keep Risk Exposure Under Control Leading to New Regulatory Rules: ▫ Banks Must Apply the Same Credit Standards to SLCs as for Loans ▫ Banks Must Count SLCs as Loans When Assessing Risk Exposure to a Single Customer ▫ Banks Must Post Capital Behind Most SLCs Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
9 -26 Credit Derivatives • Over-the-Counter Financial Agreements Offering Protection to a Designated Beneficiary in Case of Default on a Loan, bond, or Other Debt Instruments • Was One of the Fastest-Growing Markets, but the Credit Crisis Uncovered Problems with Recordkeeping and Possible Increasing Risk Exposure Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
9 -27 Types of Credit Derivatives • Credit Swaps • Credit Options • Credit Default Swaps • Credit Linked Notes • Collateralized Debt Obligations Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
9 -28 Credit Swaps • Two Lenders Agree to Swap a Portion of Their Customer’s Loan Payments • Can Help Each Lender Further Spread Out Their Risk • Variation is a Total Return Swap Where the Dealer Guarantees Parties a Specific Rate of Return Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
9 -29 Credit Options Guards Against Losses in Value of a Credit Asset or Helps Offset Higher Borrowing Costs Due to Changes in Credit Ratings of the Borrower Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
9 -30 Credit Default Swaps Aimed at Lenders Able to Handle Comparatively Limited Declines in Value But Who Want Insurance Against Serious Losses Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
9 -31 Credit Linked Notes • Fuses Together a Normal Debt Instrument with a Credit Option Contract to Give Borrower Greater Payment Flexibility Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
9 -32 Collateralized Debt Obligations • Contain Pools of High-Yield Corporate Bonds, Stocks or Other Financial Instruments Contributed by Businesses Interested In Strengthening Their Balance Sheets and Raising New Funds. Notes of Varying Grades are Sold to Investors Seeing Income From Pooled Assets • The Credit and Liquidity Crisis of 2007 -2009 has Exposed ▫ The Complexity of These Instruments ▫ Questionable Credit Ratings Assignments ▫ Huge Write-Downs of CDO Values Worldwide Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
9 -33 Risks of Credit Derivatives • Partners in Swap or Option Contract May Fail to Perform • Smaller Volume – Markets are Thinner and More Volatile • Legal Issues • Regulatory Concerns • Lessons of Credit Crisis: ▫ Securitized Assets and Credit Swaps are Complex Financial Instruments that are Difficult to Correctly Value and Measure in Terms of Risk Exposures ▫ Operate in Cyclically Sensitive Markets ▫ Contagion Effect Cannot be Stopped without Active Government Intervention Mc. Graw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The Mc. Graw-Hill Companies, Inc. , All Rights Reserved.
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