Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Chapter
10
The purpose of this chapter is to learn about some of the newer
Financial instruments that bankers have used in recent years to help
Reduce the risk exposure of their banks and, in some cases, to aid in
Generating new sources of fee income and in raising new funds to
Make loans and investments.
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Types of Securitized Assets
 Residential Mortgages
 Home Equity Loans
 Automobile Loans
 Commercial Mortgages
 Small Business Administration Loans
 Mobile Home Loans
 Credit Card Receivables
 Truck Leases
 Computer Leases
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Marketing Loan Contracts Held by an
Institution in Order to Raise New Cash
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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.
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Short-Dated Pieces of a Longer-Term
Loan, Entitling the Purchaser to Fraction of the Expected Loan Income
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

A Financial Instrument that Guarantees
Performance or Insures Against Default in
Return for Payment of a Fee. It is a
Contingent Obligation
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Reasons for Growth of SLCs
 Rapid Growth of Direct Financing Worldwide
 Perception Among Banks and Their Customers that the
Risk of Economic Fluctuations Has Increased
 Opportunity SLCs Offer Banks to Use Their Credit
Evaluation Skills to Earn Fee Income
 The Relatively Low Cost of Issuing SLCs
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Financial Contracts Offering Protection to a Designated Beneficiary in Case of Loan
Default
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

Types of Credit Derivatives
 Credit Swaps
 Credit Options
 Credit Default Swaps
 Credit Linked Notes
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.

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
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.