1、Chapter NineRisk Management:Asset-Backed Securities,Loan Sales,Credit Standbys,and Credit DerivativesKey Topics The Securitization Process Securitizations Impact and Risks Sales of Loans:Nature and Risks Standby Credits:Pricing and Risks Credit Derivatives and CDOs Benefits and Risks Introduction Ma
2、ny issues such as credit risk and the burden of having to raise new capital to meet the funding needs of your customers and satisfy regulatory standards keep managers busy New tools such as securitizing loans,selling loans off balance sheets,issuing standby letters of credit,and participating in cre
3、dit derivative contracts can help with risk management Not only have these tools attempted to control risk more effectively,but they have also opened up new sources of fee income As the great credit crisis of 2007-2009 emerged we also learned that these new risk-management tools carry significant li
4、mitations,including unexpected risks and extreme complexity,that can overwhelm unprepared financial institutions and wreak havoc with the financial systemSecuritizing Loans and Other Assets Securitization of loans and other assets is a simple idea for raising new funds Requires a lending institution
5、 to set aside a group of income-earning,relatively illiquid assets,such as home mortgages or credit card loans,and to sell relatively liquid securities(financial claims)against those assets in the open market In effect,loans are transformed into publicly traded securities The lender whose loans are
6、securitized is called the originator These loans are passed on to an issuer,who is usually designated a special-purpose entity(SPE)The SPE is separated from the originator to help ensure that,if the originating lender goes bankrupt,this event will not affect the credit status of the pooled loans,sup
7、posedly making the pool and its cash flow“bankruptcy remote”EXHIBIT 91 The Heart of the Securitization ProcessSecuritizing Loans and Other Assets(continued)A credit rating agency rates securities to be sold so that investors have a better idea what the new financial instruments are worth Possible mo
8、ral hazard problem The issuer then sells securities in the money and capital markets,often with the aid of a security underwriter(investment banker)A trustee is appointed to ensure the issuer fulfills all the requirements of the transfer of loans to the pool and provides all the services promised in
9、vestors A servicer(who is often the loan originator)collects payments on the securitized loans and passes those payments along to the trustee,who ultimately makes sure investors who hold loan-backed securities receive the proper payments on time Investors in the securities normally receive added ass
10、urance they will be repaid in the form of guarantees against default Credit enhancer Liquidity enhancerEXHIBIT 92 Key Players in the Securitization Process:Cash Flows and Supporting Services That Make the Process Work and Generate Fee IncomeSecuritizing Loans and Other Assets(continued)The concept o
11、f securitization began in the residential mortgage market of the United States Three government-sponsored enterprises(GSEs)worked to improve the salability of residential mortgage loans The Government National Mortgage Association(GNMA,or Ginnie Mae)The Federal National Mortgage Association(FNMA,or
12、Fannie Mae)The Federal Home Loan Mortgage Corporation(FHLMC,or Freddie Mac)Unfortunately for Fannie Mae and Freddie Mac the long-range outlook for their growth and survival is questionable due to recent record defaults on many of the home loans they tradedSecuritizing Loans and Other Assets(continue
13、d)Beginning in the 1980s,with the cooperation of First Boston Corporation(later a part of Credit Suisse),a major security dealer,Freddie Mac developed a new mortgage-backed instrument in which investors were offered different classes of mortgage-backed securities with different expected payout sched
14、ules The collateralized mortgage obligation(CMO)CMOs typically were created through a multistep process in which home mortgage loans are first pooled together,then GNMA-guaranteed securities are issued against the loan pool and ultimately offered to investors around the globe These securities were p
15、laced in a trust account off the lenders balance sheet and several different classes of CMOs issued as claims against the security pool and the income they were expected to generateSecuritizing Loans and Other Assets(continued)Each class of CMO known as a tranche promises a different rate of return(
16、coupon)to investors and carries a different risk exposure The different security tranches normally receive the interest payments to which they are entitled The loan principal payments flow first to security holders in the top(senior)tranche until these top-tier instruments are fully retired Subseque
17、ntly principal payments then go to investors who purchased securities belonging to the next tranche until all securities in that tranche are also paid out,and so on down the“waterfall”until payments are made to investors in the last and lowest tranche The“senior”tranches of a CMO generally carry sho
18、rter maturities Reduces their reinvestment risk exposure Attractive to risk-averse investorsEXHIBIT 93 The Structure of Collateralized Mortgage Obligations(CMOs)Securitizing Loans and Other Assets(continued)Examples of Types of Securitized Assets Residential Mortgages the beginnings of securitizatio
19、nThe role of GSEs(GNMA,FNMA,FHLMC)Riskier CMOs Home Equity Loans Automobile Loans Commercial Mortgages Small Business Administration Loans Mobile Home Loans Credit Card Receivables Truck Leases Computer LeasesEXHIBIT 94 Securitization Activities of FDIC-Insured Depository Institutions,2010Securitizi
20、ng Loans and Other Assets(continued)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 bette
21、r manage interest rate risk Allows the bank to generate fee incomeSecuritizing Loans and Other Assets(continued)Securitization has increased regulators concerns about the soundness and safety of individual lenders and the financial system,especially in the wake of the 20072009 credit crisis Regulato
22、rs today are looking closely ata)The risk of having to come up with large amounts of liquidity in a hurry to make payments to investors holding asset-backed securities and cover bad loansb)The risk of agreeing to serve as an underwriter for asset-backed securities that cannot be soldc)The risk of ac
23、ting as a credit enhancer and underestimating the need for loan-loss reservesd)The risk that unqualified trustees will fail to protect investors in asset-backed instrumentse)The risk of loan servicers being unable to satisfactorily monitor loan performance and collect monies owed lenders and investo
24、rsSales of Loans to Raise Funds and Reduce Risk Loan sales are carried out today by financial firms of widely varying sizes Among the leading sellers of these loans are Deutsche Bank,JP Morgan Chase,the Bank of America,and ING Bank of the Netherlands Only a minority of U.S.depository institutions re
25、port regular and significant asset sales These are concentrated among residential mortgage credits and other miscellaneous loans extended primarily to the household sector Most loans sold in the open market usually mature within 90 days and may be either new loans or loans that have been on the sell
26、ers books for some timeSales of Loans to Raise Funds and Reduce Risk(continued)Usually the seller retains servicing rights on the sold loans,enabling the selling institution to generate fee income by collecting interest and principal payments from borrowers and passing the proceeds along to loan buy
27、ers Servicing institutions also monitor the performance of borrowers and act on behalf of loan buyers to make sure borrowers are adhering to the terms of their loans Most loans are purchased in million-dollar units by investors that already operate in the loan marketplace and have special knowledge
28、of the debtorSales of Loans to Raise Funds and Reduce Risk(continued)Types of Loan Sales Participation LoansWhen an outside party purchases a loanThey generally have no influence over the loan terms AssignmentsOwnership of the loan is transferred to the buyer of the loanThe buyer has a direct claim
29、against the borrower Loan StripShort-dated pieces of longer term loans,maturing in a few days or weeks Two of the most popular forms of loan sales are participation loans and assignmentsEXHIBIT 95 The Impact of Loan SalesEXHIBIT 96 Assets Sold With Recourse and Not Securitized by FDIC-Insured Deposi
30、tory Institutions,2010Sales of Loans to Raise Funds and Reduce Risk(continued)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 the marketability and liquidity of assets Way to eliminate credit and
31、interest rate risk Way to generate fee income Purchasing bank can diversify loan portfolio and reduce riskSales of Loans to Raise Funds and Reduce Risk(continued)The Risks in Loan Sales Best quality loans are the easiest to sell which may increase volatility of earnings for the bank which sells the
32、loans Loans purchased from another bank can turn bad just as easily as one from their own bank Loan sales are cyclicalStandby Credit Letters to Reduce the Risk of Nonpayment or Nonperformance Financial guarantees Instruments used to enhance the credit standing of a borrower to help insure lenders ag
33、ainst default and to reduce the borrowers financing costs Designed to ensure the timely repayment of the principal and interest from a loan even if the borrower goes bankrupt or cannot perform a contractual obligation One of the most popular guarantees is the standby letter of credit(SLC)SLCs may in
34、clude1.Performance guaranteesA financial firm guarantees that a project will be completed on time2.Default guaranteesA financial firm pledges the repayment of defaulted notes when borrowers cannot payStandby Credit Letters to Reduce the Risk of Nonpayment or Nonperformance(continued)Key Advantages t
35、o Issuing SLCs1.Letters of credit earn a fee for providing the service(usually around 0.5 percent to 1 percent of the amount of credit involved)2.They aid a customer,who can usually borrow more cheaply when armed with the guarantee,without using up the guaranteeing institutions scarce reserves.3.Suc
36、h guarantees usually can be issued at relatively low cost because the issuer may already know the financial condition of its standby credit customer4.The probability usually is low that the issuer of an SLC will ever be called upon to payStandby Credit Letters to Reduce the Risk of Nonpayment or Non
37、performance(continued)Standbys have become important financial instruments for several reasons1.The spread of direct finance worldwide,with some borrowers selling their securities directly to investors rather than going to traditional lenders2.The risk of economic fluctuations has led to demand for
38、risk-reducing devices3.The opportunity standbys offer lenders to use their credit evaluation skills to earn additional fee income without the immediate commitment of funds 4.The relatively low cost of issuing SLCs they carry zero reserve requirements and no insurance feesStandby Credit Letters to Re
39、duce the Risk of Nonpayment or Nonperformance(continued)SLCs contain three essential elements1.A commitment from the issuer(often a bank or insurance company today)2.An account party(for whom the letter is issued)3.A beneficiary(usually a lender concerned about the safety of funds committed to the a
40、ccount party)The key feature of SLCs is they are usually not listed on the issuers or the beneficiarys balance sheet This is because a standby is only a contingent liability In most cases it will expire unexercisedEXHIBIT 97 The Nature of a Standby Credit Agreement(SLC)Standby Credit Letters to Redu
41、ce the Risk of Nonpayment or Nonperformance(continued)In effect,the SLC issuer agrees for a fee to take on a risk that,in the absence of the SLC,would be carried fully by the beneficiary In general,an account party will seek an SLC if the issuers fee for providing the guarantee is less than the valu
42、e assigned to the guarantee by the beneficiary If P is the price of the standby,NL is the cost of a nonguaranteed loan,and GL is the cost of a loan backed by a standby guarantee,then a borrower is likely to seek an SLC ifStandby Credit Letters to Reduce the Risk of Nonpayment or Nonperformance(conti
43、nued)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 Ways to Reduce Risk Exposure of SLCs Frequently renegotiating the terms
44、 of any loans extended to customers Diversifying SLCs issued by region and by industry Selling participations in standbys in order to share risk with other lending institutionsStandby Credit Letters to Reduce the Risk of Nonpayment or Nonperformance(continued)Regulatory Concerns About SLCs Bank exam
45、iners are working to keep risk exposure under control leading to new regulatory rulesBanks must apply the same credit standards to SLCs as for loansBanks must count SLCs as loans when assessing risk exposure to a single customerBanks must post capital behind most SLCsCredit Derivatives:Contracts for
46、 Reducing Credit Risk Exposure on the Balance Sheet Securitizing assets,selling loans,and issuing standby credits may possibly reduce not only interest rate risk but also exposure to credit risk However,it may be more efficient to reduce credit risk with a somewhat newer financial instrument the cre
47、dit derivative An over-the-counter agreement possibly offering protection against loss when default occurs on a loan,bond,or other debt instrument Until the 2007-2009 credit crisis the credit derivatives market was one of the fastest growing in the world Bankers generally lead the credit derivatives
48、 market,followed by security dealers,insurers,and managers of hedge fundsCredit Derivatives:Contracts for Reducing Credit Risk Exposure on the Balance Sheet(continued)Credit Swaps Two lenders agree to swap a portion of their customers loan payments Can help each lender further spread out their risk
49、Variation is a total return swap,where the dealer guarantees parties a specific rate of returnEXHIBIT 98 Example of a Credit SwapEXHIBIT 99 Example of a Total Return SwapCredit Derivatives:Contracts for Reducing Credit Risk Exposure on the Balance Sheet(continued)Credit Options Guards against losses
50、 in the value of a credit asset or helps to offset higher borrowing costs that may occur due to changes in credit ratingsEXHIBIT 910 Example of a Credit OptionCredit Derivatives:Contracts for Reducing Credit Risk Exposure on the Balance Sheet(continued)Credit Default Swaps(CDSs)Aimed at lenders able
