Chapter 24 - Managing Risk off the Balance Sheet with Loan Sales and Securitization

SOLUTIONS MANUAL
Chapter Twenty-Four
Answers to Chapter 24
Questions:
1. Loan securitization has increased in olu!e as a result of the creation of an actie secondar"
!arket and the i!plicit and e#plicit goern!ent guarantees on pass-through securities. $he loan
sales !arket has suffered fro! credit risk e#posure% high infor!ation and !onitoring costs% and
costl" alidation and transactions costs. Loan sales hae onl" &een do!inant in loan categories
such as co!!ercial and industrial loans that are too large and heterogenous to package into
securities.
2. Loans sold without recourse !eans that after selling the loan the originator of the loan can
take it off the &alance sheet. 'n the eent the loan is defaulted% the &u"er of the loan has no
recourse to the seller for an" clai!s% transferring the credit risk entirel" to the &u"er. (or the
originator% it has co!pletel" eli!inated this loan fro! its &ooks. 'n the case of a sale with
recourse% credit risk is still present for the originator &ecause the &u"er could transfer ownership
of the loan &ack to the originator. $hus% fro! the perspectie of the &u"er% loans with recourse
&ear the least credit risk.
). Short-ter! loan sales usuall" consist of !aturities &etween one and three !onths and are
secured &" the assets of a fir!. $he" are usuall" sold in units of *1 !illion or !ore and are !ade
to fir!s that hae inest!ent grade credit ratings. Banks hae originated and disposed of short-
ter! loans as an effectie su&stitute for co!!ercial paper% which hae si!ilar characteristics to
short-ter! loans. $he accessi&ilit" of co!!ercial paper &" !ore and !ore corporations has
reduced the olu!e of these short-ter! loans for loan sales purposes.
4. Co!!ercial paper issuers are generall" &lue chip corporations that hae the &est credit
ratings. Banks !a" sell the loans of less creditworth" &orrowers% there&" raising re+uired "ields.
'ndeed% since co!!ercial paper issuers tend to &e well-known co!panies% infor!ation%
!onitoring% and credit assess!ent costs are lower for co!!ercial paper issues than for loan
sales. Moreoer% since there is an actie secondar" !arket in co!!ercial paper% &ut not for loan
sales% the co!!ercial paper &u"er takes on less li+uidit" risk than does the &u"er of a loan sale.
,. 'n a loan participation% the &u"er does not o&tain total control oer the loan% while in an
assign!ent% all rights are transferred upon sale% there&" giing the &u"er a direct clai! on the
&orrower. $ransactions costs are higher for loan assign!ents than for loan participations since
the loan !ust &e transferred ia a -nifor! Co!!ercial Code filing. Moreoer% current holders
of the loan !ust &e erified as well as an" i!pedi!ents to transfer% there&" further increasing
transactions costs upon loan sale under assign!ent. Monitoring incenties are higher and costs
are lower under loan assign!ents as opposed to loan participations. $his is &ecause the &u"er is
the sole holder of the loan and thus there is no free-rider pro&le!. Monitoring costs are lower
since the loan assign!ent &u"er need onl" !onitor the &orrower.s actiities% while the loan
participation &u"er !ust !onitor &oth the &orrower and the originating &ank. Risk e#posure is
greater under loan participations than under loan assign!ents since participations hae a
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Chapter 24 - Managing Risk off the Balance Sheet with Loan Sales and Securitization
/dou&le-risk0 e#posure. $he &u"er of the loan participation is e#posed to the credit risk of the
originating &ank 1still controlling the loan2 as well as the credit risk e#posure of the &orrower.
3. $he &u"ers of loans are4
i. 'nest!ent &anks 1since the" are often inoled with the initial transaction that leads to the
issuance of the de&t25
ii. 6ulture funds 1since the" inest in portfolios of risk" loans25
iii. 7ther do!estic &anks 1in order to circu!ent regional &anking and &ranching restrictions so
as to increase regional and custo!er diersification25
i. (oreign &anks 1to o&tain a presence in the -.S. !arket without incurring the costs of a &ranch
network25
. 'nsurance co!panies and pension funds 1to earn higher "ields% when per!issi&le25
i. Closed-end &ank loan !utual funds 1to earn fee inco!e on loan s"ndications25 and
ii. 8on-financial corporations 1to earn higher "ields2.
$he sellers of loans are4
i. Ma9or !one" center &anks 1to reduce capital re+uire!ents% diersif" the loan portfolio% reduce
resere re+uire!ents% and increase li+uidit"25
ii. (oreign &anks 1to reduce capital re+uire!ents% diersif" the loan portfolio% reduce resere
re+uire!ents% and increase li+uidit"25
iii. 'nest!ent &anks 1as !arket !akers25
i. S!all regional or co!!unit" &anks5 and
. the -.S. goern!ent and its agencies.
:. $he three leels of ta#es faced &" ('s when !aking loans are5 a2 capital re+uire!ents on loans
to protect against default5 &2 resere re+uire!ents on de!and deposits for funding the loans5 and
c2 deposit insurance to protect the depositors. 'f the loans are securitized% ('s end up onl"
sericing the loans. ;s a result% no capital is re+uired to protect against default risk. <oweer%
resere re+uire!ents and deposit insurance will &e reduced if lia&ilities are also reduced. 'f the
cash proceeds fro! the loan sales are used to inest in other assets% then the ta#es will still
re!ain in place.
=. >hen a loan is sold without recourse% the &ank is relieed of the resere re+uire!ent on that
loan. >hen sold with recourse% the resultant lia&ilit" created su&9ects the &ank to a resere
re+uire!ent. ;ll things &eing e+ual% the presence of the resere re+uire!ent should induce &anks
to sell loans without recourse.
?. 'f &ank loans% along with other assets are !arked to the !arket% this would !ake the loans
look and trade !ore like securities% thus !aking the loans !ore trada&le.
1@. $he sale or securitization of a loan conerts a long ter! asset on the &alance sheet into cash%
thus reducing the !aturit" and increasing the li+uidit" of the assets.
11. Mortgage &acked &onds differ fro! collateralized !ortgage o&ligation in two ke" wa"s.
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Chapter 24 - Managing Risk off the Balance Sheet with Loan Sales and Securitization
CM7 help &anks and thrifts re!oe !ortgages fro! their &alance sheets% MBBs nor!all"
re!ain on the &alance sheet. ;lso% CM7s hae a direct link &etween the cash flows on the
underl"ing !ortgages and the cash flow on the &ond ehicles% while with MBBs the relationship
is one of collateralization% so that the cash flows on the !ortgages &acking the &ond are not
necessaril" used to !ake interest and principal pa"!ents on the MBB.
12. 'n the process of inter!ediation on &ehalf of its custo!ers% the (' assu!es risk e#posure.
$he (' can reduce that risk e#posure &" altering its product &ase% there&" affecting the portfolio
!i# o&tained in the course of inter!ediation. <oweer% this is likel" to &e +uite costl" in ter!s of
custo!er good will and loss of &usiness. Securitization ena&les ('s to !anage risk e#posure &"
changing their portfolio !i# without alienating custo!ers. $hat is% custo!ers are still sericed
and the (' continues to inter!ediate. Balance sheet alterations are !ade su&se+uent to and
independent of the inter!ediation actiit". $hus% the (' can !ake portfolio changes and still
fulfill the franchise of the inter!ediar".
'nterest rate risk e#posure is reduced &" !atching the durations of assets and lia&ilities.
Securitization ena&les the (' to acco!plish this since the (' can deter!ine which loans to
package and sell off. Credit risk e#posure is !ini!ized &" selling loans without recourse.
(oreign e#change rate risk e#posure is reduced &" !atching the foreign currencies in which the
assets and lia&ilities are deno!inated. Securitization allows the (' to sell off un!atched assets.
(inall"% securitization reduces li+uidit" risk% since the (' does not hae to fund the asset.
1). Bu"ers of CM7s incur prepa"!ent risks depending upon the class of tranches the" hae
purchased. Aurchasers of $ranche ; incur the !ost risk &ecause all prepa"!ents will &e passed
on to the!. Arepa"!ents usuall" occur when interest rates are low and thus posing high
reinest!ent risks to this group of &u"ers. 7n the other hand% $ranche C purchasers are protected
fro! prepa"!ent until $ranche B is e#hausted and as a result are less likel" to incur prepa"!ents
unless interest rates reach so low as to create a&oe-aerage leels of refinancing.
Pro!e"s:
1. a. 'f the &ank sells with recourse% it should e#pect4
1.@= # 1@!2BC1 - 11D11E.@=,2
)
2FD.@=,G E 1@!D11 E @.@=,2
)
H *?.=:2) !illion
&. 'f the &ank sells without recourse% it should e#pect4
1.@= # 1@!2BC1 - 11D11E.@=:,2
)
2FD.@=:,G E 1@!D11 E @.@=:,2
)
H *?.=@?) !illion
c. 'f sold with recourse and e#pected pro&a&ilit" of default is taken into account% it should
e#pect to receie4
1@.??,2 # *?.=:2)! H *?.=22?!% which is still higher than selling it without recourse. So% it
should sell it with recourse.
2. a. Market alue of loan4
1.1@ # 2!2BC1 - 11D11E.122
1@
2FD.12G E 2!D11 E @.122
1@
H *1.::4 !illion
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Chapter 24 - Managing Risk off the Balance Sheet with Loan Sales and Securitization
&. $he prices of these loans are &eing +uoted at == cents and =? cents to the dollar. 'n the case
of the a&oe loan% it will translate into *1.:3 and *1.:= !illion% i.e.% a dealer is willing to &u"
such loans at *1.:3 !illion and sell the! loans at *1.:= !illion.
c. $his loan is categorized as distressed% since it is selling at prices &elow *@.?@ to the dollar.
't usuall" indicates lower than aerage li+uidit" and !ore default risk% !aking it a less trada&le
instru!ent.
). a. $he duration of the e#isting loan is4
@ E *1,!D*2@!1I2 H )., "ears HJ K#isting loan duration H 4.33: "ears
'f it purchases *, !illion of loans with an aerage duration of : "ears% its portfolio duration will
increase to *,!D*2@!1:2 E *1,!D*2@!14.33:2 H ,.2, "ears. 'n this case% the aerage duration
will &e a&oe , "ears 1of its lia&ilities2. $he (' !a" &e &etter off seeking another loan with a
slightl" lower duration.
&. $he (' should seek to purchase a loan of the following duration4
*,!D*2@!1X2 E *1,!D*2@!14.33: "ears2 H , "ears HJX H duration H 3 "ears.
4. a. Since BB rated co!!ercial loans hae a 1@@ percent risk weighting% the !ini!u! capital
re+uired on co!!ercial loans H *1@@! # 1.@ # @.@= H *= !illion.
&. Since there is an interaction &etween the de!and deposits and cash reseres held% the
answer re+uires soling the following% assu!ing the *= !illion is funded &" e+uit" and the
resere re+uire!ents are kept as cash4
*1@@! E 1@.1@ # LL2 H LL E =! HJ ?2! H .?LLHJ LL H ?2D.? H *1@2.22
c. ;ssets Lia&ilities
Cash 1@.22 Le!and deposits 1@2.22
1@@.@@ K+uit" =.@@
11@.22 11@.22
,. a. $here are 12@ +uarterl" pa"!ents oer )@ "ears. $he +uarterl" !ortgage pa"!ents are4
*2@@! H R # BC1 - 11D11E.1@D42
12@
2FD.1@D4G. $hus% R H *,%2:2%),=.3@.
&.
Muarter Balance Aa"!ent 1R2 'nterest Arincipal Re!aining
1(i#ed2 Aa"!ent Aa"!ent Arincipal
1 *2@@! *,.2:2! *,! *@.2:2! *1??.:2=!
2 1??.:2= ,.2:2 4.??) @.2:? 1??.44?
) 1??.44? ,.2:2 4.?=3 @.2=3 1??.13)
4 1??.13) ,.2:2 4.?:? @.2?) 1?=.=:@
c. $ranche ;4 ?ND4 # *,@ !illion H *1%12,%@@@ +uarterl"
$ranche B4 1@ND4 # *1@@ !illion H *2%,@@%@@@ +uarterl"
$ranche C4 11ND4 # *,@ !illion H *1%):,%@@@ +uarterl"
$otal interest pa"!ents4 *, !illion +uarterl"
Regular $ranche ; pa"!ents are *1.12, !illion +uarterl". 'f there are no prepa"!ents% then the
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Chapter 24 - Managing Risk off the Balance Sheet with Loan Sales and Securitization
regular O8M; +uarterl" pa"!ent of *,.2:2 !illion is distri&uted a!ong the three tranches. (ie
!illion is the total coupon pa"!ent for all three tranches. $herefore% *.2:2 !illion of principal is
repaid each +uarter% een if there are no prepa"!ents. $ranche ; receies all principal pa"!ents.
$ranche ; cash flows are *1.12, !illion E *.2:2 !illion H *1.)?: !illion +uarterl".
Muarter Balance Aa"!ent 1R2 'nterest Arincipal Re!aining
1(i#ed2 Aa"!ent Aa"!ent Arincipal
1 *,@! *1.)?:! *1.12,! *@.2:2! *4?.:2=!
2 4?.:2= 1.)?: 1.11? @.2:= 4?.4,@
) 4?.4,@ 1.)?: 1.11) @.2=4 4?.133
4 4?.133 1.)?: 1.1@3 @.2?1 4=.=:,
d. Muarterl" prepa"!ents on the entire !ortgage pool are *1@ !illion. $he" are credited
entirel" to $ranche ; until all principal is paid off. $he pa"!ents are distri&uted as follows4
Muarter Balance Aa"!ent 1R2 'nterest Arincipal Re!aining
1(i#ed2 Aa"!ent Aa"!ent Arincipal
1 *,@! *11.?):! *1.12,! *1@.=12! *)?.1== !
2 )?.1== 11.?): @.==2 11.@,, 2=.1))
) 2=.1)) 11.?): @.3)) 11.)@4 13.=2?
4 13.=2? 11.?): @.):? 11.,,= ,.2:1
e. $he wa" the ter!s of the CM7 are structured% the aerage coupon rate on the three classes
e+uals the !ortgage coupon rate on the underl"ing !ortgage pool. <oweer% gien the !ore
desira&le cash flow characteristics of the indiidual classes% the (' !a" &e a&le to issue the CM7
classes at lower coupon rates. $he difference &etween the su! of all coupon pa"!ents pro!ised
on all CM7 tranches and the !ortgage coupon rate on the underl"ing !ortgage pool is the ('.s
sericing fee.
3. a. $he aerage pa"!ent is4 *2@%@@@%@@@ H R #BC1 - 11D11E.@?2
1@
2FD.@?G. $hus% R H
*)%113%4@1.=@.
&. *2@%@@@%@@@ H R #BC1 - 11D11E.@=,2
1@
2FD.@=,G. $hus% R H *)%@4=%1,4.1@.
:. a. $here are 1=@ !onthl" pa"!ents 11, "ears # 12 !onths2. $he O8M; !onthl" coupon rate
is =.,N - .,N H = percent per "ear% and the !onthl" O8M; pass-through pa"!ent is4 *1@!H
BC1 - 11D11E.@=D122
1=@
2FD.@=D12G # AM$ HJ AM$ H *?,%,3,.21.
$he present alue of the O8M; at a , percent !arket rate is4
A6 H *?,%,3,.21 # BC1 - 11D11E.@,D122
1=@
2FD.@,D12GH *12%@=4%:21.3).
&. ;ssu!e that the O8M; is onl" half a!ortized. $here is a lu!p su! pa"!ent at the
!aturit" of the O8M; that e+uals ,@ percent of the !ortgage pool.s face alue.
'f there is a ,@ percent a!ortization% the !onthl" O8M; pass-through pa"!ents are4
*1@! H AM$ # BC1 - 11D11E.@=D122
1=@
2FD.@=D12G E *,!D11 E .@=D122
1=@
HJ R H *=1%11,.?4
$he present alue of the O8M; at a , percent !arket rate is4
A6 H *=1%11,.?4 #BC1 - 11D11E.@,D122
1=@
2FD.@,D12G E *,!D11 E .@,D122
1=@
H *12%32)%@,1.),.
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Chapter 24 - Managing Risk off the Balance Sheet with Loan Sales and Securitization
=. a. $he !onthl" !ortgage pa"!ent% AM$% is 1the !onthl" interest rate is .1@D 12 H .@@=))24
*2@! H BC1 - 11D11E.1@D122
)3@
2FD.1@D12G # 1AM$2 HJ AM$ H *1:,%,14.)1
&. $he O8M;.s annual interest rate is @.1@ - @.@@44 - @.@@@3 H ?., percent. $he !onthl"
interest rate is @.@?,D12 H @.@@:?13: or @.:?13: percent.
c. $he !onthl" O8M; pa"!ent% AM$% is4 *2@! H BC1 - 11D11E.@?,D122
)3@
2FD.@?,D12G# AM$
HJ AM$ H *13=%1:@.=4
d. $he first !onthl" sericing fee% S(% is 1the !onthl" fee rate is .44ND12 H .@)3:N24
SF H 1.@@@)3:2*2@! H *:%))).
e. $he first !onthl" insurance pa"!ent% 'A% is 1!onthl" insurance rate is .@3ND12 H .@@,N24
'A H 1.@@@@,2*2@! H *1%@@@
?. Calculate the alue of 1a2 the !ortgage pool and 1&2 the O8M; pass-through in pro&le! = if
!arket interest rates increased ,@ &asis points. ;ssu!e no prepa"!ents.
a. $he !ortgage pool.s alue% A6% is 1the !onthl" discount rate is 1@.,ND12 H @.=:,N24 A6 H
*1:,%,14.)1 # BC1 - 11D11E.1@,D122
)3@
2FD.1@,D12G H *1?%1=:%),?
&. $he O8M;.s alue% A6% is 1the !onthl" discount rate is 1@ND12 H @.=)))N24
A6H *13=%1:@.=4 # BC1 - 11D11E.1@D122
)3@
2FD.1@D12G H *1?%13)%2@,.
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