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Chapter 09 - Risk Management: Asset-Backed Securities, Loan Sales, Credit Standbys, and Credit Derivatives CHAPTER 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 their risk exposure 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 Securitization’s 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 and Disadvantages of Securitization D The Beginnings of Securitization—The Home Mortgage Market Collateralized Mortgage Obligations (CMOs) Home Equity Loans 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 III Sales of Loans to Raise Funds and Reduce Risk A Nature of Loan Sales B Forms of Loan Sales Participation Loan Assignments 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 Performance Guarantees Default Guarantees C Advantages of Standbys 9-1 Chapter 09 - Risk Management: Asset-Backed Securities, Loan Sales, Credit Standbys, and Credit Derivatives 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 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 and removing those pooled assets from the lender’s balance sheet After that, the pool is usually designated as a special-purpose entity (vehicle) and turned into collateral for issuing asset-backed securities This process refers to as securitization of assets As the pooled assets generate interest income and repayments of principal, the cash generated flows through to investors who purchased these 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 to the 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 higher-yielding assets The lending institution can create liquid assets out of illiquid, expensive-to-sell assets Also, this helps diversify the lender’s credit risk exposure It permits lenders to hold a more geographically diversified loan portfolio, perhaps countering local losses with higher returns available from loans from different geographic areas with more buoyant economies Securitization is also a tool for managing interest rate risk and possibly credit risk, depending on the quality of the packaged loans Securitization opens avenues for lending institutions to earn added fee income from servicing the packaged loans Lenders can also benefit from the normal positive interest-rate spread between 9-2 Chapter 09 - Risk Management: Asset-Backed Securities, Loan Sales, Credit Standbys, and Credit Derivatives the average yield on the packaged loans and the coupon (promised) rate on the securities issued against those loans, capturing residual income 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 bank’s capital requirements There is a risk of having to come up with large amounts of cash in a hurry to make payments to investors holding asset-backed securities and cover bad loans The managers must be aware of the risk of agreeing to serve as an underwriter for asset-backed securities that cannot be sold Also, they must ensure that the appointed trustees are capable of protecting the investors of asset-backed instruments 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? The bank’s estimated residual income should be about: Gross Loan Yield 13% - 9-6 Servicing Fee 0.25% - Security Interest Rate 8.25% = - Expected Default On Packaged Loans 3.5% - Underwriting and Advisory Fee 0.35% Expected Residual Income 0.65% What advantages 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 Loan sales remove both credit risk and interest rate risk from the lender’s balance sheet and may generate fee income up front 9-3 Chapter 09 - Risk Management: Asset-Backed Securities, Loan Sales, Credit Standbys, and Credit Derivatives 9-7 What are the risks of using loan sales as a significant source of funding for banks and other financial institutions? The lenders 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 The regulators might require higher capital requirements from the lender The lender may have done a poor job of evaluating the borrower’s financial condition.Buying such a loan, obligates the purchasing institution to review the condition of both, the lender and the borrower In some cases, the seller of loan will give the benefit of recourse to the loan purchaser in case the sold loan becomes delinquent This arrangement forces both the buyer and seller to share the risk of loan default 9-8 What is loan servicing? Loan servicing involves monitoring borrower compliance with a loan’s 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 9-10 What are standby credit letters? Why have they grown so rapidly in recent years? Standby credit letters are promises of the issuer to a lender to pay off an obligation of its customer, in case that customer cannot pay It can also be in the form of a guarantee that a project of the customer will be completed on time The standby credit agreements have grown substantially in the recent years 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, increasing number of borrowers have asked banks to provide a credit guarantee The opportunity standbys offer lenders to use their credit evaluation skills to earn additional fee income without the immediate commitment of funds 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 any other financial institution known as the “issuer”, 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 9-4 Chapter 09 - Risk Management: Asset-Backed Securities, Loan Sales, Credit Standbys, and Credit Derivatives 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 issuer’s contingent obligation will become an actual liability, due and payable This may cause a liquidity squeeze for the issuer Also, the beneficiary, that has to collect the letter must be sure that 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 ways to reduce risk exposure from the standby credit letters they have issued, such as: Frequently renegotiating the terms of any loans extended to customers who have SLCs, so that loan terms are continually adjusted to the customer’s changing circumstances and there is less need for beneficiaries to press for collection Diversifying SLCs issued by region and by industry to avoid concentration of risk exposure Selling participations in standbys in order to share risk with other lending institutions 9-14 Why were credit derivatives developed? What advantages they have over loan sales and securitizations, if any? 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 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 customer’s loan repayments It was developed so that banks 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 9-5 Chapter 09 - Risk Management: Asset-Backed Securities, Loan Sales, Credit Standbys, and Credit Derivatives 9-17 How 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 occurring due to a change in credit ratings A lending institution, which purchases a credit option contract, will exercise its 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 lender will lose the premium was paid for the option The lender can also purchase a credit option which will be exercised if its borrowing costs rise above a specified spread between the costs and riskless assets 9-18 When is a credit default swap useful? Why? A credit default swap is related to a credit option where a lender may seek of a dealer willing to write a put option 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 This type of swap is useful because, if the borrower defaults, then the dealer may pay the lender for the depreciated value of the loan or may pay an amount of money agreed to when the swap was arranged 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 factor changes For example, if more loans, 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 9-20 What are Collateralized Debt Obligations (CDOs)? How 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 credit derivatives pose for financial institutions using them? In your opinion what should regulators about the recent rapid growth of this market, if anything? Answer: There are several risks associated with the credit derivatives One risk is that the other party in the swap or option may fail to meet its obligation Courts may rule that these instruments are illegal or improperly drawn 9-6 Chapter 09 - Risk Management: Asset-Backed Securities, Loan Sales, Credit Standbys, and Credit Derivatives These types of instruments are relatively new and the markets for these instruments are relatively less If a bank needs to resell one of these contracts, it may have difficulty finding a buyer or it 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 GoodLife National Bank placed a group of 10,000 consumer loans bearing an average expected gross annual yield of percent in a package to be securitized The investment bank advising GoodLife estimates that the securities will sell at a slight discount from par that results in a net interest cost to the issuer of 4.0 percent Based on recent experience with similar types of loans, the bank expects 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 GoodLife will also seek a liquidity facility, costing 0.5 percent, and a credit guarantee if actual loan defaults should exceed the expected loan default rate, costing 0.6 percent Please calculate the residual income for GoodLife from this loan securitization Answer: The estimated residual income for GoodLife National Bank is: Gross Loan Yield 6% - Liquidity Facility Fee 0.5% Security Interest Rate 4% - - Credit Enhancement Fee 0.6% Expected Default On Packaged Loans 3% - Expected Residual Income -2.6% = 9-7 - Underwriting And Advisory Fee 0.5% Chapter 09 - Risk Management: Asset-Backed Securities, Loan Sales, Credit Standbys, and Credit Derivatives 9-2 Jasper Corporation is requesting a loan for repair of some assembly-line equipment in the amount of $10.25 million The nine-month loan is priced by Farmers Financial Corporation at a 6.5 percent rate of interest However, the finance company tells Jasper that if it obtains a suitable credit guarantee the loan will be priced at percent Lifetime Bank agrees to sell Jasper a standby credit guarantee for $10,000 Is Jasper likely to buy the standby credit guarantee Lifetime has offered? Please explain Answer: The interest savings from having the credit guarantee would be: [$10.25 mill ì 0.065 ì ắ] - [$10.25 mill ì 0.06 ì ắ] = $499,687.50 - $461,250.00 = $38,437.50 Clearly, the $10,000 guarantee is priced correctly and the standby credit guarantee will be purchased Jasper would only have to pay a percent coupon rate and $10,000 towards bank charges for the loan, instead of 6.5 percent 9-3 The Pretty Lake 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 Pretty Lake 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, 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? Answer: Tranche A has the shortest maturity and tranche D has the most prepayment protection b Every month principal and interest are paid on the outstanding mortgages, and some mortgages are paid in full These payments are passed through to Pretty Lake, 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? Answer: Tranche A: 25 million × (.045/12) = $93,750 Tranche B: 25 million × (.050/12) = $104,167 Tranche C: 25 million × (.055/12) = $114,583 Tranche D: 25 million × (.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? Answer: 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 9-8 Chapter 09 - Risk Management: Asset-Backed Securities, Loan Sales, Credit Standbys, and Credit Derivatives Tranche A will be affected by the reduction in principal d Why does Tranche D have a higher expected return? Answer: 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 company’s 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 bank’s commercial credit division faces in assessing this customer’s loan request is a management decision reached several weeks ago that the bank should gradually work down its leveraged 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 bank’s 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 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 one-quarter 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 Answer: In view of these reasonable objectives on the part of First Security National Bank’s 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 Security’s 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 9-9 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 onehalf 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 1/2 percent to percent of the amount of the standby guarantee, depending upon the bank’s 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 1/2 percent to percent fee would compare favorably in amount to the 1/8 to 1/4 percent spread over the Eurodollar rate or the 1/4 to 1/2 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 National’s 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 percent of the portfolio – the default rate it has projected The bank wants to lower the interest cost on the bonds in case the loan default rate rises too high Answer: 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 field’s 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 9-10 Chapter 09 - Risk Management: Asset-Backed Securities, Loan Sales, Credit Standbys, and Credit Derivatives c A bank holding company plans to offer new bonds in the open market next month, but knows that the company’s 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 company’s economics department has forecast a substantial rise in capital market interest rates The company’s 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 and further spread out the risk 9-11 ... Risk Management: Asset-Backed Securities, Loan Sales, Credit Standbys, and Credit Derivatives D Reasons for Rapid Growth of Standbys E The Structure of SLCs F The Value and Pricing of Standby Letters... Securities, Loan Sales, Credit Standbys, and Credit Derivatives 9-12 What risks accompany a standby credit letter for (a) the issuer and (b) the beneficiary? Standbys present the issuer with the... relationship by assessing a fee for issuing the standby letter of credit The fee for a standby letter of credit typically ranges from 1/2 percent to percent of the amount of the standby guarantee,
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