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Chapter Nine

Risk Management: Asset-Backed


Securities, Loan Sales, Credit Standbys,
and Credit Derivatives
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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


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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

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The Heart of the


Securitization Process

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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
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Key Players in the Securitization Process

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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

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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

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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

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Types of Securitized Assets


• Residential Mortgages – the beginnings of
securitization
▫ The role of GSEs (GNMA, FNMA, 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

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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
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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)?
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Loan Sales

Selling Loan Contracts Held by an


Institution in Order to Raise New Cash

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The Impact of Loan Sales

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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

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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
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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

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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


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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
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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
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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


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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

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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
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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

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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

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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
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Types of Credit Derivatives


• Credit Swaps
• Credit Options
• Credit Default Swaps
• Credit Linked Notes
• Collateralized Debt Obligations

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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

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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

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Credit Default Swaps


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

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Credit Linked Notes

• Fuses Together a Normal Debt Instrument


with a Credit Option Contract to Give
Borrower Greater Payment Flexibility

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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

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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

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