Chapter 09 - Risk Management: Asset-Backed Securities, Loan Sales, Credit Standbys, and Credit Derivatives

CHAPTER 9 RISK MANAGEMENT: ASSET-BACKED SECURITIES, LOAN SALES, CREDIT STANDBYS, AND CREDIT DERIVATIVES Goal of This Chapter: The purpose of this chapter is to learn about some of the newer financial instruments that financial institutions have used in recent years to help reduce the risk exposure of their institutions and, in some cases, to aid in generating new sources of fee income and in raising new funds to make loans and investments. Key Topics in This Chapter The Securitization Process Securitizations Impact and Risks Sales of Loans: Nature and Risks Standby Credits: Pricing and Risks Credit Derivatives and CDOs - Benefits and Risks

Chapter Outline I. Introduction II. Securitizing Loans and Other Assets A. Nature of Securitization B. The Securitization Process C. Advantages of Securitization D. The Beginnings of Securitization The Home Mortgage Market 1. Collateralized Mortgage Obligations CMOs 2. Home Equity Loans 3. Loan-Backed Bonds E. Examples of Other Assets That Have Been Securitized F. The Impact of Securitization upon Lending Institutions G. Regulators Concerns about Securitization Ill. Sales of Loans to Raise Funds and Reduce Risk A. Nature of Loan Sales B. Participation loan, Assignment loan and Loan Strip C. Reasons behind Loan Sales D. The Risks in Loan Sales IV. Standby Credit Letters to Reduce the Risk of Nonpayment or Nonperformance A. The nature of standby letter of Credit (Contingent Obligations) B. Types of Standby Credit Letters C. Advantages of Standbys D. Reasons for Rapid Growth of Standbys E. The Structure of SLCs F. The Value and Pricing of Standby Letters G. Sources of Risk with Standbys H. Regulatory Concerns about SLCs I. Research Studies on Standbys, Loan Sales, and Securitizations

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Chapter 09 - Risk Management: Asset-Backed Securities, Loan Sales, Credit Standbys, and Credit Derivatives

V. Credit Derivatives: Contracts for Reducing Credit Risk Exposure on the Balance Sheet A. An Alternative to Securitization B. Credit Swaps C. Credit Options D. Credit Default Swaps (CDSs) E. Credit-Linked Notes F. Collateralized Debt Obligations (CDOs) G. Risks Associated with Credit Derivatives VI. Summary of the Chapter Concept Checks 9-1. What does securitization of assets mean?

Securitization involves the pooling of groups of earning assets, removing those pooled assets from the banks balance sheet, and issuing securities against the pool. As the pooled assets generate interest income and repayments of principal the cash generated by the pooled earning assets flows through to investors who purchased those securities. 9-2. What kinds of assets are most amenable to the securitization process?

The best types of assets to pool are high quality, fairly uniform loans, such as home mortgages or credit card loans. 9-3. What advantages does securitization offer lending institutions?

Securitization gives lending institutions the opportunity to use their assets as sources of funds and, in particular, to remove lower-yielding assets from the balance sheet to be replaced with higheryielding assets. 9-4. What risks of securitization should the managers of lending institutions be aware of?

Lending institutions often have to use the highest-quality assets in the securitization process which means the remainder of the portfolio may become more risky, on average, increasing the banks capital requirements. 9-5. Suppose that a bank securitizes a package of its loans that bears a gross annual interest yield of 13 percent. The securities issued against the loan package promise interested investors an annualized yield of 8.25 percent. The expected default rate on the packaged loans is 3.5 percent. The bank agrees to pay an annual fee of 0.35 percent to a security dealer to cover the cost of underwriting and advisory services and a fee of 0.25 percent to Arunson Mortgage Servicing Corporation to process the expected payments generated by the packaged loans. If the above items represent all the costs associated with this securitization can you calculate the percentage amount of residual income the bank expects to earn from this particular transaction?

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Chapter 09 - Risk Management: Asset-Backed Securities, Loan Sales, Credit Standbys, and Credit Derivatives

The banks estimated residual income should be about: Gross Loan Yield 13% Security Interest Rate 8.25% Servicing Fee .25% Expected Default On Packaged Loans 3.5% Expected Residual Income .65% Underwriting and Advisory Fee .35%

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What advantages do sales of loans have for lending institutions trying to raise funds?

Loan sales permit a lending institution to get rid of less desirable or lower-yielding loans and allow them to raise additional funds. In addition, replacing loans that are sold with marketable securities can increase the liquidity of the lending institution. 9-7. Are there any disadvantages to using loan sales as a significant source of funding for banks and other financial institutions? The lender may find themselves selling off their highest quality loans, leaving their loan portfolio stocked with poor-quality loans which can trigger the attention of regulators who might require higher capital requirements for the lender. 9-8. What is loan servicing?

Loan servicing involves monitoring borrower compliance with a loans terms, collecting and recording loan payments, and reporting to the current holder of the loan. 9-9. How can loan servicing be used to increase income?

Many banks have retained servicing rights on the loans they have sold, earning fees from the current owners of those loans. They generate fee income by collecting interest and principal payments from borrowers and passing the proceeds along to loan buyers.

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Chapter 09 - Risk Management: Asset-Backed Securities, Loan Sales, Credit Standbys, and Credit Derivatives

9-10. What are standby credit letters? Why have they grown so rapidly in recent years? Standby credit letters are promises of a lender to pay off an obligation of one of its customers in case that customer cannot pay. It can also be a guarantee that a project of customer is completed on time. There are several reasons that standby credit agreements have grown. There has been a tremendous growth in direct financing by companies (issuance of commercial paper) and with growing concerns about default risk on these direct obligations banks have been asked to provide a credit guarantee. Another reason for their growth is the ability of the bank to use their skills to add fee income to the bank. Another reason is that these have a relatively low cost for the bank. Finally banks and customers perceive that there has been an increase in economic fluctuations and there has been increased demand for risk reducing devices. 9-11. Who are the principal parties to a standby credit agreement? The principal parties to a standby credit agreement are the issuing bank or other institution, the account party who requested the letter, and the beneficiary who will receive payment from the issuing institution if the account party cannot meet its obligation. 9-12. What risks accompany a standby credit letter for (a) the issuer and (b) the beneficiary? Standbys present the issuer with the danger that the customer whose credit the issuer has backstopped with the letter will need a loan. That is, the issuers contingent obligation will become an actual liability, due and payable. This may cause a liquidity squeeze for the issuer. The beneficiary that has to collect on the letter must be sure it meets all the conditions required for presentation of the letter or it will not be able to recover its funds. 9-13 How can a lending institution mitigate the risks inherent in issuing standby credit letters?

They can use various devices to reduce risk exposure from the standby credit letters they have issued, such as: 1. Frequently renegotiating the terms of any loans extended to customers who have SLCs so that loan terms are continually adjusted to the customers changing circumstances and there is less need for beneficiaries to press for collection. 2. Diversifying SLCs issued by region and by industry to avoid concentration of risk exposure. 3. Selling participations in standbys in order to share risk with other lending institutions. 9-14. Why were credit derivatives developed? What advantages do they have over loan sales and securitizations, if any?

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Chapter 09 - Risk Management: Asset-Backed Securities, Loan Sales, Credit Standbys, and Credit Derivatives

Credit derivatives were developed because not all loans can be pooled. In order to be pooled, the group of loans has to have common features such as maturities and cash flow patterns and many business loans do not have those common features. Credit derivatives can offer the beneficiary protection in the case of loan default and may help the bank reduce its credit risk and possibly its interest rate risk as well. 9-15. What is a credit swap? For what kinds of situations was it developed? A credit swap is where two lenders agree to swap portions of their customers loan repayments. It was developed so that banks do not have to rely on one narrow market area. They can spread out the risk in the portfolio over a larger market area. 9-16. What is a total return swap? What advantages does it offer the swap beneficiary institution? A total return swap is a type of credit swap where the dealer guarantees the swap parties a specific rate of return on their credit assets. A total return swap can allow a bank to earn a more stable rate of return than it could earn on its loans. This type of arrangement can also shift the credit risk and the interest rate risk from one bank to another. 9-17. How do credit options work? What circumstances result in the option contract paying off? A credit option helps guard against losses in the value of a credit asset or helps offset higher borrowing costs. A bank which purchases a credit option contract will exercise their option if the asset declines significantly in value or loses its value completely. If the assets are paid off as expected then the option will not be exercised and the bank will lose the premium they paid for the option. A bank can also purchase a credit option which will be exercised if their borrowing costs rise above a specified spread between their cost and a riskless asset. 9-18. When is a credit default swap useful? Why? A credit default swap is a credit option written on a portfolio of assets or a credit swap on a particular loan where the other bank in the swap agrees to pay the first bank a certain fee if the loan defaults. This type of arrangement is designed for banks that can handle relatively small losses but want to protect themselves from serious losses. 9-19. Of what use are credit-linked notes? A credit-linked note allows the issuer of a note to lower the coupon payments if some significant fact changes. For example, if more loans on which the notes are based default than expected, the coupon payments on the notes can be lowered. The lender has taken on credit-related insurance from the investors who have purchased the note.

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9-20. What are CDOs? How do they differ from other credit derivatives? A CDO is very similar to loan securitization, where the pool of assets can include high yield corporate bonds, stock, commercial mortgages, or other financial instruments, which are generally of higher risk than in the traditional loan securitization. Some CDO pools contain debt and other financial instruments from dozens of companies in order to boost potential returns and diversify away much of the risk. 9-21. What risks do credit derivatives pose for financial institutions using them? In your opinion what should regulators do about the recent rapid growth of this market, if anything? There are several risks associated with these instruments. One risk is that the other party in the swap or option may fail to meet their obligation. Courts may rule that these instruments are illegal or improperly drawn. These types of instruments are relatively new and the markets for these instruments are relatively thin. If a bank needs to resell one of these contracts they may have difficulty finding a buyer or they may not be able to sell it at a reasonable price. Regulators need to understand clearly the benefits and risks of these types of credit instruments and act to ensure the safety of the banks. Problems 9-1. GoodTimes National Bank placed a group of 10,000 consumer loans bearing an average expected gross annual yield of 7.5 percent in a package to be securitized. The investment bank advising GoodTimes estimates that the securities will sell at a slight discount from par that results in a net interest cost to the issuer of 8 percent. Based on recent experience with similar types of loans, the bank expects 3 percent of the packaged loans to default without any recovery for the lender and has agreed to set aside a cash reserve to cover this anticipated loss. Underwriting and advisory services provided by the investment banking firm will cost 0.5 percent. GoodTimes will also seek a liquidity facility, costing 0.5 percent and a credit guarantee if actual loans defaults should exceed the expected loan default rate, costing 0.6 percent. Please calculate the residual income for GoodTimes from this loan securitization. The estimated residual income for GoodTimes National Bank is: Gross Loan Yield 7.5% Liquidity Facility Fee 0.5% Security Interest Rate 8% Credit Enhancement Fee 0.6% Expected Default On Packaged Loans 3% Expected = Residual Income -5.1% Underwriting And Advisory Fee 0.5%

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9-2. Colburn Corporation is requesting a loan for repair of some assembly-line equipment in the amount of $9.5 million. The nine-month loan is priced by Farmers Financial Corporation at a 7.5 percent rate of interest. However, the finance company tells Colburn that if it obtains a suitable credit guarantee the loan will be priced at 7 percent. Lifetime Bank agrees to sell Colburn a standby credit guarantee for $10,000. Is Colburn likely to buy the standby credit guarantee Lifetime has offered? Please explain. The interest savings from having the credit guarantee would be: [$9.5 mill. * 0.075 * ] - [$9.5 mill. x 0.07 * ] = $534,375 - $498,750 = $35,625 Clearly, the $10,000 guarantee is priced correctly and will be purchased. Colburn would only have to pay a 7 percent coupon rate for the loan instead of 7.5 percent. 9-3. The Lake View Bank Corp. has placed $100 million of GNMA-guaranteed securities in a trust account off the balance sheet. A CMO with four tranches has just been issued by Lake View using the GNMAs as collateral. Each tranche has a face value of $25 million and makes monthly payments. The annual coupon rates are 4.5 percent for Tranche A, 5 percent for Tranche B, 5.5 percent for Tranche C, and 6.5 percent for Tranche D. a. Which tranche has the shortest maturity, and which tranche has the most prepayment protection? Tranche A has the shortest maturity and tranche D has the most prepayment protection. b. Every month principal and interest is paid on the outstanding mortgages, and some mortgages are paid in full. These payments are passed through to Lake View, and the trustee uses the funds to pay coupons to CMO bondholders. What are the coupon payments owed for each tranche for the first month? Tranche A: 25 million x (.045/12) = $93,750 Tranche B: 25 million x (.050/12) = $104,167 Tranche C: 25 million x (.055/12) = $114,583 Tranche D: 25 million x (.065/12) = $135,417 c. If scheduled mortgage payments and early prepayments bring in $5 million, how much will be used to retire the principal of CMO bondholders and which tranche will be affected? Total interest to be paid: $93,750 + $104,167 + $114,583 + $135,417 = $447,917 Amount applied to principal: $5,000,000 - $447,917 = $4,552,083 Tranche A will be affected by the reduction in principal.

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d. Why does Tranche D have a higher expected return? Tranche D has the longest maturity and the highest reinvestment risk and thus, should have the highest expected return. In addition, since prepayments are first applied to the other tranches, tranche D also carries the highest amount of default risk. 9-4. First Security National Bank has been approached by a long-standing customer, United Safeco Industries, for a $30 million term loan for five years to purchase new stamping machines that would further automate the companys assembly line in the manufacture of metal toys and containers. The company also plans to use at least half the loan proceeds to facilitate its buyout of Calem Corp., which imports and partially assembles video recorders and cameras. Additional funds for the buyout will come from a corporate bond issue that will be underwritten by an investment banking firm not affiliated with First Security. The problem the banks commercial credit division faces in assessing this customers loan request is a management decision reached several weeks ago that the bank should gradually work down its leverage buyout loan portfolio due to a significant rise in nonperforming credits. Moreover, the prospect of sharply higher interest rates has caused the bank to revamp its loan policy toward more short term loans (under one year) and fewer term (over one year) loans. Senior management has indicated it will no longer approve loans that require a commitment of the banks resources beyond a term of three years, except in special cases. Does First Security have any service option in the form of off-balance-sheet instruments that could help this customer while avoiding committing $30 million in reserves for a five-year loan? What would you recommend that management do to keep United Safeco happy with its current banking relationship? Could First Security earn any fee income if it pursued your idea? Suppose the current interest rate on Eurodollar deposits (three-month maturities) in London is 3.40 percent, while Federal funds and six-month CDs are trading in the United States at 3.57 percent and 3.19 percent, respectively. Term loans to comparable quality corporate borrowers are trading at one-eighth to one-quarter percentage point above the three-month Eurodollar rate or onequarter to one-half point over the secondary-market CD rate. Is there a way First Security could earn at least as much fee income by providing United Safeco with support services as it could from making the loan the company has asked for (after all loan costs are taken into account)? Please explain how the customer could benefit even if the bank does not make the loan requested. In view of these reasonable objectives on the part of First Security National Banks management, the bank should consider recommending that the leveraged buy-out portion of the request be handled by an offering of bonds or, perhaps, 5-year notes, with the bank issuing a standby letter of credit for a portion (though probably not all) of the bond or note issue. Armed with First Securitys standby credit agreement, United Safeco should be able to borrow through a security issue at a substantially lower interest rate. First Security could sell participations in the standby credit to share its risk exposure.

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Chapter 09 - Risk Management: Asset-Backed Securities, Loan Sales, Credit Standbys, and Credit Derivatives

For the portion of the loan that calls for the purchase of new assembly-line equipment, management might seriously consider proposing a shorter-term loan for about one-third to one-half the total amount requested by Safeco. This loan would be secured by a pledge of the new equipment plus sufficient covenants to insure the maintenance of adequate liquidity and require bank approval before significant amounts of other forms of debt are undertaken. First Security could generate fee income from this relationship by assessing a fee for issuing the standby letter of credit. The fee for a standby letter of credit typically ranges from percent to 1 percent of the amount of the standby guarantee, depending upon the banks assessment of the degree of risk exposure in the guarantee. If First Security issues a standby letter of credit on behalf of United Safeco as described above, both parties should benefit. First Security, by issuing the standby credit agreement, does not have to tie up $30 million in reserves for an extended period of time as it would if it made the requested loan, particularly in a projected rising interest rate environment. The percent to 1 percent fee would compare favorably in amount to the 1/8 to percent spread over the Eurodollar rate or the to percent spread over the federal funds or CD rate that currently prevails in the market. Under the risk-based capital standards now in effect, the standby letter of credit will require the bank to hold capital in an amount equal to the capital requirement for the loan. Therefore, United Security National will have the same capital requirement for either transaction, the loan or the standby letter of credit. Also, as stated above, United Safeco should be able to issue bonds or notes at a more favorable rate with United Security Nationals standby letter of credit behind them. 9-5. What type of credit derivatives contract would you recommend for each of the following situations: a. A bank plans to issue a group of bonds backed by a pool of credit card loans but fears that the default rate on these credit card loans will rise well above 6 percent of the portfolio the default rate it has projected. The bank wants to lower the interest costs on the bonds in case the loan default rate rises too high. The best solution to this problem is to use credit linked notes. The interest payments on these notes will change if significant factors change. b. A commercial finance company is about to make a $50 million project loan to develop a new gas field and is concerned about the risks involved if petroleum geologists estimates of the fields potential yield turn out to be much too high and the field developer cannot repay. One possibility for solving this problem is to use a credit option. If the developer cannot repay the loan then the option would pay off. They would lose their premium if the developer can repay the loan but they are protected against significant loss.

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c. A bank holding company plans to offer new bonds in the open market next month, but knows that the companys credit rating is being reevaluated by credit-rating agencies. The holding company wants to avoid paying sharply higher credit costs if its rating is lowered by the investigating agencies. A credit risk option would be a good solution to this problem because it protects the bank from higher borrowing costs in the future. If the borrowing costs rise above the spread specified in the option contract, the contract would pay off. d. A mortgage company is concerned about possible excess volatility in its cash flow off a group of commercial real estate loans supporting the building of several apartment complexes. Moreover, many of these loans were made at fixed interest rates, and the companys economics department has forecast a substantial rise in capital market interest rates. The companys management would prefer a more stable cash flow emerging from this group of loans if it could find a way to achieve it. One possibility to solve this problem would be to enter into a total return swap with another bank. The other bank would receive total payments of interest and principal on this loan as well as the price appreciation on this loan. The original bank would receive LIBOR plus some spread in return as well as compensation for any depreciation in value of the loan. e. First National Bank of Ashton serves a relatively limited geographic area centered upon a moderate-sized metropolitan area. It would like to diversify its loan income but does not wish to make loans in other market areas due to its lack of familiarity with loan markets outside the region it has served for many years. Is there a derivative contract that could help the bank achieve the loan portfolio diversification it seeks? This bank could enter into a credit swap with another bank. This swap agreement means that the two banks simply exchange a portion of their customers loan repayments. The purpose of this type of swap agreement is to help the two banks diversify their market area with having to make loans in an unfamiliar area.

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