Chapter Nine
Risk Management Using Asset-Backed
Securities, Loan Sales, Credit
Standbys, and 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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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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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
Diverse 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
• Not Available for All Banks
• May Increase Competition for the Best
Quality Loans
• May Increase Competition for Deposits
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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
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Residential Mortgages
Home Equity Loans
Automobile Loans
Commercial Mortgages
Small Business Administration Loans
Mobile Home Loans
Credit Card Receivables
Truck Leases
Computer Leases
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Regulator Concerns About Securitization
• 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
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Loan Sales
Selling Loan Contracts Held by an
Institution in Order to Raise New
Cash
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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
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Reasons Behind Loan Sales
• Way to Rid the Bank of Low Yield
Securities
• Way to Increase 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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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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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 Guarantees
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
• 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
Financial Contracts Offering
Protection to a Designated
Beneficiary in Case of Loan Default
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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
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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
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