1

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

Key Topics
The Securitization Process

Securitizations Impact and Risks

Sales of Loans: Nature and Risks Standby Credits: Pricing and Risks Credit Derivatives and CDOs
McGraw-Hill/Irwin Bank Management and Financial Services, 7/e

Benefits and Risks of Credit Derivatives

2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

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

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e

2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

The Heart of the Securitization Process

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e

2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

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
McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

Key Players in the Securitization Process

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e

2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

Advantages of Securitization
Diversifies a Banks 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

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e

2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

Problems with Securitization

May Not Reduce a Banks 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
McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

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
McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

10

Types of Securitized Assets

Residential Mortgages the beginnings of securitization Home Equity Loans Automobile Loans (CARs) Commercial Mortgages Small Business Administration Loans Mobile Home Loans Credit Card Receivables Truck Leases Computer Leases
The role of GSEs (GNMA, FNMA, FHLMC) Riskier CMOs

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e

2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

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
McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

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)? McGraw-Hill/Irwin
Bank Management and Financial Services, 7/e

2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

13

Loan Sales

Selling Loan Contracts Held by an Institution in Order to Raise New Cash

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e

2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

14

The Impact of Loan Sales

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e

2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

15 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

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e

2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

16

Types of Loan Sales

Participation Loans
Where an Outside Party Purchases a Loan. They Generally Have No Influence Over the Loan Terms Ownership of the Loan is Transferred to the Buyer of the Loan. The Buyer Has a Direct Claim Against the Borrower.
Short-Dated Pieces of Longer Term Loans, Maturing in a Few Days or Weeks
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

Assignments

Loan Strip

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e

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
McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

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
McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

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
McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

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
McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

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
McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

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
McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

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
McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

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
McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

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
McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

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
McGraw-Hill/Irwin Bank Management and Financial Services, 7/e 2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

27

Types of Credit Derivatives Credit Swaps Credit Options Credit Default Swaps Credit Linked Notes Collateralized Debt Obligations

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e

2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

28

Credit Swaps
Two Lenders Agree to Swap a Portion of Their Customers 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

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e

2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

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

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e

2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

30

Credit Default Swaps

Aimed at Lenders Able to Handle Comparatively Limited Declines in Value But Who Want Insurance Against Serious Losses

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e

2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

31

Credit Linked Notes

Fuses Together a Normal Debt Instrument with a Credit Option Contract to Give Borrower Greater Payment Flexibility

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e

2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

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

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e

2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

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
2008 The McGraw-Hill Companies, Inc., All Rights Reserved.

McGraw-Hill/Irwin Bank Management and Financial Services, 7/e