Risk Management in Financial Tools - Securitization, Loan Sales, and Credit Derivatives

1. Chapter Nine Risk Management: Asset-Backed Securities, Loan Sales, Credit Standbys, and Credit Derivatives

2. 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

3. Introduction • Many 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 credit 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 limitations, including unexpected risks and extreme complexity, that can overwhelm unprepared financial institutions and wreak havoc with the financial system

4. Securitizing Loans and Other Assets • Securitization of loans and other assets is a simple idea for raising new funds • Requires a lending institution 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 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, supposedly making the pool and its cash flow “bankruptcy remote”

5. EXHIBIT 9–1 The Heart of the Securitization Process

6. Securitizing 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 moral 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 investors • 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 assurance they will be repaid in the form of guarantees against default • Credit enhancer • Liquidity enhancer

7. EXHIBIT 9–2 Key Players in the Securitization Process: Cash Flows and Supporting Services That Make the Process Work and Generate Fee Income

8. Securitizing Loans and Other Assets (continued) • The concept of 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 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 traded

9. Securitizing Loans and Other Assets (continued) • 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 schedules • 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 placed in a trust account off the lender’s balance sheet and several different classes of CMOs issued as claims against the security pool and the income they were expected to generate

10. Securitizing Loans and Other Assets (continued) • Each class of CMO – known as a tranche – promises a different rate of return (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 • Subsequently 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 shorter maturities • Reduces their reinvestment risk exposure • Attractive to risk-averse investors

11. EXHIBIT 9–3 The Structure of Collateralized Mortgage Obligations (CMOs)

12. Securitizing Loans and Other Assets (continued) • Examples of Types of Securitized Assets • Residential Mortgages – the beginnings of securitization • The 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 Leases

13. EXHIBIT 9–4 Securitization Activities of FDIC-Insured Depository Institutions, 2010

14. Securitizing Loans and Other Assets (continued) • 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

15. Securitizing 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 2007–2009 credit crisis • Regulators today are looking closely at • 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 loans • The risk of agreeing to serve as an underwriter for asset-backed securities that cannot be sold • The risk of acting as a credit enhancer and underestimating the need for loan-loss reserves • The risk that unqualified trustees will fail to protect investors in asset-backed instruments • The risk of loan servicers being unable to satisfactorily monitor loan performance and collect monies owed lenders and investors

16. Sales 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 report 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 seller’s books for some time

17. Sales 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 buyers • 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 of the debtor

18. Sales of Loans to Raise Funds and Reduce Risk (continued) • Types of Loan Sales • Participation Loans • When 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 • Two of the most popular forms of loan sales are participation loans and assignments

19. EXHIBIT 9–5 The Impact of Loan Sales

20. EXHIBIT 9–6 Assets Sold With Recourse and Not Securitized by FDIC-Insured Depository Institutions, 2010

21. Sales 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 interest rate risk • Way to generate fee income • Purchasing bank can diversify loan portfolio and reduce risk

22. Sales 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 loans • Loans purchased from another bank can turn bad just as easily as one from their own bank • Loan sales are cyclical

23. Standby 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 against default and to reduce the borrower’s 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 include • Performance guarantees • A financial firm guarantees that a project will be completed on time • Default guarantees • A financial firm pledges the repayment of defaulted notes when borrowers cannot pay

24. Standby Credit Letters to Reduce the Risk of Nonpayment or Nonperformance (continued) • Key Advantages to Issuing SLCs • Letters of credit earn a fee for providing the service (usually around 0.5 percent to 1 percent of the amount of credit involved) • They aid a customer, who can usually borrow more cheaply when armed with the guarantee, without using up the guaranteeing institution’s scarce reserves. • Such guarantees usually can be issued at relatively low cost because the issuer may already know the financial condition of its standby credit customer • The probability usually is low that the issuer of an SLC will ever be called upon to pay

25. Standby Credit Letters to Reduce the Risk of Nonpayment or Nonperformance (continued) • Standbys have become important financial instruments for several reasons • The spread of direct finance worldwide, with some borrowers selling their securities directly to investors rather than going to traditional lenders • The risk of economic fluctuations has led to demand for risk-reducing devices • The opportunity standbys offer lenders to use their credit evaluation skills to earn additional fee income without the immediate commitment of funds • The relatively low cost of issuing SLCs – they carry zero reserve requirements and no insurance fees

26. Standby Credit Letters to Reduce the Risk of Nonpayment or Nonperformance (continued) • SLCs contain three essential elements • A commitment from the issuer (often a bank or insurance company today) • An account party (for whom the letter is issued) • A beneficiary (usually a lender concerned about the safety of funds committed to the account party) • The key feature of SLCs is they are usually not listed on the issuer’s or the beneficiary’s balance sheet • This is because a standby is only a contingent liability • In most cases it will expire unexercised

27. EXHIBIT 9–7 The Nature of a Standby Credit Agreement (SLC)

28. Standby Credit Letters to Reduce 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 issuer’s fee for providing the guarantee is less than the value 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 if

29. Standby Credit Letters to Reduce the Risk of Nonpayment or Nonperformance (continued) • 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 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 institutions

30. Standby Credit Letters to Reduce the Risk of Nonpayment or Nonperformance (continued) • 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

31. Credit Derivatives: Contracts for 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 credit 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 market, followed by security dealers, insurers, and managers of hedge funds

32. Credit Derivatives: Contracts for Reducing Credit Risk Exposure on the Balance Sheet (continued) • 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

33. EXHIBIT 9–8 Example of a Credit Swap

34. EXHIBIT 9–9 Example of a Total Return Swap

35. Credit Derivatives: Contracts for Reducing Credit Risk Exposure on the Balance Sheet (continued) • Credit Options • Guards against losses in the value of a credit asset or helps to offset higher borrowing costs that may occur due to changes in credit ratings

36. EXHIBIT 9–10 Example of a Credit Option

37. Credit Derivatives: Contracts for Reducing Credit Risk Exposure on the Balance Sheet (continued) • Credit Default Swaps (CDSs) • Aimed at lenders able to handle comparatively limited declines in value, but wanting insurance against serious losses • In this case a lender may seek out a dealer willing to write a put option on a portfolio of bonds, loans, or other assets • There may be a materiality threshold • A minimum amount of loss required before any payment occurs • Credit default swaps were first developed at JP Morgan (now JP Morgan Chase) in 1995 • Today more than 90 percent of all credit derivatives are credit default swaps

38. EXHIBIT 9–11 Example of a Credit Default Swap

39. Credit Derivatives: Contracts for Reducing Credit Risk Exposure on the Balance Sheet (continued) • Credit-Linked Notes • Fuses together a normal debt instrument, such as a bond, plus a credit option contract, to give a borrower greater payment flexibility • Grants its issuer the privilege of lowering the amount of loan repayments it must make if some significant factor changes

40. Credit Derivatives: Contracts for Reducing Credit Risk Exposure on the Balance Sheet (continued) • Collateralized Debt Obligations (CDOs) • CDOs may contain pools of high-yield corporate bonds, stock, commercial mortgages, or other financial instruments • Notes (claims) of varying grade are sold to investors seeking income from the pooled assets • The claims sold are divided into tranches similar to those created for the securitization of home mortgages, from the most risky tranche offering the highest potential return to the least risky (“senior”) tranche with lowest expected returns • Regular CDOs have been surpassed by an explosion in synthetic CDOs • These instruments rest on pools of credit derivatives (especially credit default swaps) that mainly ensure against defaults on corporate bonds • Thus, creators of synthetic CDOs do not have to buy and pool actual bonds, but can create synthetic instruments and generate revenues from selling and trading them

41. Credit Derivatives: Contracts for Reducing Credit Risk Exposure on the Balance Sheet (continued) • Risks Associated with Credit Derivatives • Partners in swap or option contract may fail to perform • Smaller volume – Markets are thinner and volatile • Legal issues • Regulatory concerns • Lessons of recent Credit Crisis: • Securitized assets and credit swaps are complex financial instruments that are difficult to correctly value and measure in terms of risk exposures • These derivatives operate in cyclically sensitive markets • Contagion effect cannot be stopped without active government intervention

42. 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? Disadvantages? • What advantages do sales of loans have for lending institutions trying to raise funds? • What is loan servicing? • What are standby credit letters? Why have they grown so rapidly in recent years? Who are the principal parties to a standby credit agreement? • Why were credit derivatives developed? What advantages do they have over loan sales and securitizations, if any? • What risks do credit derivatives pose for financial institutions using them? In your opinion what should regulators do about the recent rapid growth of this market, if anything?