Off-Balance-Sheet Banking Class # 9

Lecture Outline Purpose: To understand what is reported off of the balance sheet, why items are not reported on the balance sheet, and what risks off-balance sheet accounting poses. Off-Balance-Sheet Accounting Introduction Off-Balance-Sheet Items Loan commitment agreement Letters of credit Futures, forward contracts, swaps, and options When issued securities Loans sold More on Loan Sales

Accounting Introduction Off-Balance-Sheet Accounting Introduction

How did Citigroup perform in the crisis?

Can this be Citi’s Balance Sheet? Of course not, this is Coca Cola! Liabilities

Can this be Citi’s Balance Sheet?

Off-Balance-Sheet (OBS) Assets/Liabilities What are off-balance-sheet assets/liabilities? Contingent assets and liabilities that affect the future, rather than current, shape of an FI’s balance sheet. Contingent They are not assets/liabilities yet They are promises to issue assets or take on a new liability if an event occurs In accounting terms, they usually appear “below the bottom line”, frequently just as footnotes in the financial statements

Off-Balance-Sheet (OBS) Assets/Liabilities (Continued) A commitment to add an asset (Ex: loan) to the balance sheet if a contingent event occurs. OBS Liability: A commitment to add a liability to the balance sheet if a contingent event occurs. Examples: Loan Commitment (Asset): Bank commits to give a company a loan in the future Bank Guarantee (Liability): Bank guarantees against the default of a loan. The bank assumes responsibility for the loan in the case of default.

Growth in Off-Balance-Sheet Items $14.4 Trillion

Reasons for growth in OBS Activities Increased volatility, giving rise to demand for risk management by companies Banks’ scope for tailoring financial instruments Banks’ interest in saving capital and avoiding reserve requirements Some government assistance, such as the US government sponsorship of the securitized mortgage market (to allow risks to be diversified where banks were confined to one area) Position value vs Notional amount

Banks with large OBS exposure in the Crisis Lehman Brothers Bear Stearns Merrill Lynch Citigroup CIT Group Freddie Mac Fannie Mae - Bankrupt - “Acquired” - “Acquired” - Bailed out - Bankrupt (after bailout) - Conservatorship

Is OBS accounting Bad? Insolvency Risk To get a true picture of FI insolvency we need to consider both on and off balance sheet risk On Balance sheet Assets Liabilities and Equity Market value of Assets 100 Market value of Liabilities 90 Equity 10 Including off balance sheet activity, reduces the equity piece and brings the bank closer to insolvency On & Off Balance sheet Assets Liabilities and Equity Market value of assets 100 Market value of Liabilities 90 Market value of contingent claim assets 50 Equity 5 Market Value of contingent claim liabilities 55 150

TYPES OF OBS INSTRUMENTS

Types of OBS Activities Schedule L : In 1983 banks began to submit “Schedule L,” on which they listed notional size and variety of their OBS activities, as a part of their quarterly reports. FDIC: Schedule L Non-Schedule L: Settlement risk Affiliate Risk

Types of Schedule L OBS Activities for U.S. Banks Loan commitment agreement Letters of credit Futures, forward contracts, swaps, and options When issued securities Loans sold

1. Loan Commitment Definition Risks Expected Return

1. Loan Commitment Definition Definition – a contractual commitment to make a loan up to a stated amount at a given interest rate in the future. Most loans to businesses and consumers are structured as lines of credit, in which the borrower may decide at any time during the life of the loan to borrow. Banks often charge a fee for making funds available (up-front fee) and also for the unused balance of the commitment at the end of the period (back-end fee). The difference between the amount actually borrowed and the amount committed is not on the balance sheet.

1. Loan Commitment Basic Example Sample Loan Commitment Terms Amount = 200M Term = 1 year Fees: 12 bps up front fee 8 bps back end fee Loan Commitment Terms Amount Length – (term) Fees Parties Fees = (0.0012)(200M) = $240,000 Fees = (0.0008)(30M) = $24,000 1m $30M 2 m $50M 7 m $20M 11 m $70M $30M unused 0 m 12 m $240,000 $24,000

1. Loan Commitment Risks Exposure Interest rate risk Takedown risk Aggregate takedown risk Credit Risk

1. Loan Commitment Interest Rate Risk Interest rate risk – look at commercial paper Negative Margin

1. Loan Commitment Interest Rate Risk Interest rate risk – look at the repo rate Negative Margin

1. Loan Commitment Interest Rate Risk Interest rate risk – look at a floating rate (Libor +1%) Have we eliminated interest rate risk? Positive Margin

1. Loan Commitment Interest Rate Risk Look at their profits (margin) Super Risky Is this risk-free?? Risky Cash Flow – not constant This is an example of basis risk

1. Loan Commitment Aggregate Takedown Risk When the supply of credit is limited (in a crisis), companies tend to takedown their loan commitments simultaneously, which can severely stress banks’ balance sheets March 2008 – Sept 2009 Government Lending Facilities: Government lending facilities during the crisis were basically a general loan commitment to the financial sector. We can see that financials drew down these commitments simultaneously during the crisis Imagine what trillions of dollars in loan take downs would do to the financial sector

1. Loan Commitment Takedown & Credit Risk Take-down risk: The borrower can “take-down” the entire allotment or any fraction at any time over the commitment period. Therefore, there is uncertainty regarding the amount the FI will have to pay out on the commitment at any given time. Back-end fees are intended to reduce this risk. Ex: February, 2002: Tyco Intl. draws down $14.4B in credit lines from banks after being shut out of the commercial paper market while wrapped up in an accounting scandal. Credit risk: Credit rating of the borrower may deteriorate over the life of the commitment. FIs will include an adverse material change in conditions clause which allows it to cancel or reprice the commitment, but this is usually an option of last resort due to legal fees, etc.

1. Loan Commitment Risk Summary Interest rate risk: Fixed rate – funding costs can increase or decrease bank margins Floating rate – Basis risk, the loan commitment reference rate may not mirror the company’s cost of funding (commercial paper rate) Takedown risk The company can take down any fraction of the loan at any time Aggregate takedown risk Under tight credit conditions many firms will likely simultaneously takedown loan agreements Credit Risk The credit quality of a company may deteriorate after the loan commitment is signed - adverse material change in conditions clause

Return on a loan commitment

How do you calculate a return? Stock: Dividend Paying Stock: Bonds: General:

1. Loan Commitment Return Bank requires the borrower to hold a fraction of the loan at the bank – usually in demand deposits Loan Commitment Return Loan Commitment Return LCR Reserve Req.

1. Loan Commitment Expected Return Calculation Strategy: Calculate loan amount & Interest Earned Calculate the fee income Calculate compensating balance Calculate the reserve requirement Calculate the interest expense

1. Loan Commitment Expected Return Example: USbank has issued a one-year loan commitment to Kamble Inc. for $2M with an up-front fee of 25 bps and a back-end fee of 10 bps on the unused portion. USbank Negotiates a 5% compensating balance to be held as non-interest bearing demand deposits. USbank can borrow and lend at 6% (cost of funding). The interest rate on the loan is 10% p.a. compounded annually. The Federal Reserve requires that 8% of demand deposits be held on reserve at the fed. Assume that the up front fee is held in cash. Calculate the expected return on the loan if Kamble is expected to take down 80% of the loan commitment immediately. Step #1 Calculate loan amount & interest earned Realized at t=0 but held in cash Step #2 Calculate fee income

1. Loan Commitment Expected Return Example: USbank has issued a one-year loan commitment to Kamble Inc. for $2M with an up-front fee of 25 bps and a back-end fee of 10 bps on the unused portion. USbank Negotiates a 5% compensating balance to be held as non-interest bearing demand deposits. USbank can borrow and lend at 6% (cost of funding). The interest rate on the loan is 10% p.a. compounded annually. The Federal Reserve requires that 8% of demand deposits be held on reserve at the fed. Assume that the up front fee is held in cash. Calculate the expected return on the loan if Kamble is expected to take down 80% of the loan commitment immediately. Step #3 Calculate the compensating balance Held in demand deposits Step #4 Calculate reserve requirements

1. Loan Commitment Expected Return Example: USbank has issued a one-year loan commitment to Kamble Inc. for $2M with an up-front fee of 25 bps and a back-end fee of 10 bps on the unused portion. USbank Negotiates a 5% compensating balance to be held as non-interest bearing demand deposits. USbank can borrow and lend at 6% (cost of funding). The interest rate on the loan is 10% p.a. compounded annually. The Federal Reserve requires that 8% of demand deposits be held on reserve at the fed. Assume that the up front fee is held in cash. Calculate the expected return on the loan if Kamble is expected to take down 80% of the loan commitment immediately. Step #5 Calculate interest expense Return: Amount Earned =160,000+5,000+400=165,400 Amount Committed =1,600,000 – 80,000 + 6,400 + 0 =1,526,400 Return

1. Loan Commitment Expected Return Example: What if the up-front fee was reinvested? What if USbank paid 3% on the compensating balance? What if the compensating balance is held as a CD paying 5% Up-font Fee = ($2M)(0.0025)=(5000)(1.06)1 =5,300 Return Amount Earned =160,000+5,300+400=165,700 Interest Exp = ($80,000-6,400)(0.03) =$2,208 Amount Committed =1,600,000 – 80,000 + 6,400 + 2,208 =$1,528,608 Return Interest Exp = ($80,000)(0.05) =$4,000 RR= $0.00 Return Amount Committed =1,600,000 – 80,000 +4,000+ 0 =$1,524,00

Crux Bank has entered into a 2-year loan commitment for $2M with Powell Inc. The loan has a 7% interest rate compounded annually. Crux charges a 30 bps up-front fee and a 20 bps back-end fee on the unused portion. Crux has also negotiated a 10% compensating balance to be held in demand deposits, which pay 4% interest. The Fed’s reserve requirement on demand deposits is 8%. Assume that Crux Bank invests the up-front fee at 8% (their cost of funding). Calculate the expected loan commitment return if Powell is expected to take down $1M immediately and .6M in 15 months. Solution

Crux Bank has entered into a 2-year loan commitment for $2M with Powell Inc. The loan has a 7% interest rate compounded annually. Crux charges a 30 bps up-front fee and a 20 bps back-end fee on the unused portion. Crux has also negotiated a 10% compensating balance to be held in demand deposits, which pay 4% interest. The Fed’s reserve requirement on demand deposits is 8%. Assume that Crux Bank invests the up-front fee at 8% (their cost of funding). Calculate the expected loan commitment return if Powell is expected to take down $1.2M after 7 months.

What are we not considering? The bank has funding costs – they would need to pay 10% (for example) on the $1.6M they lend out (not considered) Risk free loan – we have not taken into account the risk that the company will default on their loan. Assume that the loan is repaid at the end of the loan commitment The return is actual a combination of returns on 2 loans over different horizons 2 year and .75 year – we are combining them

Mid Lecture Summary Introduction to OBS Accounting What they are and why they are reported off the balance sheet Growth in OBS activity Introduction to Schedule L OBS items Loan Commitments What they are How to calculate the expected return of loan commitment

Lecture Outline Off-Balance-Sheet Items Loan commitment agreement Letters of credit Futures, forward contracts, swaps, and options When issued securities Loans sold More on Loan Sales – good bank bad bank if there is time

2. Letters of Credit Commercial Letter of Credit Standby Letter of Credit

2. Letters of Credit: Commercial Letter of Credit (CLC) Definition: A bank’s guarantee (in exchange for a fee) against the default of a firm on its payment for goods that the firm bought from a seller.

2. Letters of Credit: CLC Basic Example Armani has an account with Intesa Citi (issuer) Accepts the CLC and guarantees Barneys Payment Barneys (Applicant) applies for a CLC Intesa accepts the guarantee

2. Letters of Credit: CLC Basic Example Citi extends a loan to Barneys OBS asset or liability? Letters of credit are considered OBS liabilities

2. Letters of Credit: Example Suppose Citi issues a three-month letter of credit on behalf of Barneys, to back a $500,000 purchase order to Armani in Italy. Citi charges an up-front fee of 100 basis points for the letter of credit. How much up-front fee does the bank earn? What risk is Citi exposed to from the letter of credit? Up-front fee earned = $500,000 x 0.0100 = $5,000 Default Risk – The risk that Barneys does not pay Interest rate risk – if Barneys survives, the rate on the loan may not properly reflect economic conditions or credit risk Recovery Risk – if Barneys files for bankruptcy, Citi may not receive the full value of its claim from the bankruptcy estate

2. Letters of Credit: Example Suppose Citi issues a three-month letter of credit on behalf of Barneys, to back a $500,000 purchase order to Armani in Italy. Citi charges an up-front fee of 100 basis points for the letter of credit. How could Armani realize its income today if 3m Libor is 1.5%? Once Intesa accepts the letter of credit, it becomes a bankers acceptance and can be sold for its discounted value.

Santander bank in Chile issues a commercial letter of credit on behalf of RioTinto mining for the purchase of $12M in mining equipment from Caterpillar a US manufacture of heavy equipment. The transaction will take place in 10 months. Santander charges RioTinto a 500 bps upfront fee for the letter of credit. 10 month LIBOR is currently 5%. Calculate the upfront fee How can caterpillar receive payment today – how much will they receive?

2. Letters of Credit: Standby Letters of Credit (SLCs) Definition: are issued to cover contingencies that are potentially more severe and less predictable. Examples include default guarantees to back issues of commercial paper and performance bond guarantees whereby, for example, a real estate development will be completed in some interval of time. Not surprisingly, property-casualty insurers are also in this business. Without credit enhancement, many firms would not be able to borrow in the credit market or would have to borrow at a higher funding cost. Firms also get credit enhancement to boost their rating Same thing as a CLC but guarantees more severe less predictable events

3. Derivatives Contracts Forwards/Futures Options Swaps

3. Derivative Contracts Definition Options, Futures, Forwards and Swaps The cash flows from an option future/forward or swap are contingent on the price of an underlying asset. Derivatives use by FIs Hedging – interest rate risk, price risk, etc. Dealers – FIs make the market for OTC derivatives and charge transaction costs (J.P. Morgan Chase, Bank of America, and Citigroup) In 2009 over 1060 banks used derivatives with JP Morgan, Goldman Sachs and Bank of America accounting for 80% of the 201,964 derivatives held

3. Derivative Contracts Risks Counterparty risk The risk that counterparties are unable or unwilling to comply with the terms of the contract Counterparty risk is more of a problem when one counterparty is deeply in the money and the other is deeply out of the money on the contract. Counterparty risk is more of a problem in the OTC market – contracts are settled at maturity more likely that one counterparty will be deeply indebted to the other

4. When Issued Securities

4. When Issued Securities Definition & Examples Definition: Agreements to trade a security that has not been issued yet AOL IPO Treasury Auctions

4. When Issued Securities Definition & Examples Treasury Auctions Sell 5,000 T-bills for $860/bond Federal Reserve announces allotment of T-Bills to bring to auction Auction Results Winning bidders Price Quantities Thursday Friday Tuesday

4. When Issued Securities Risks Cannot get enough T-bills in the auction to satisfy the when- issued agreement Being obligated to buy T-bills at a higher price than what they promised to sell them for in the when-issued agreement Cash flow from when issued securities are contingent on some event (the auction results in this case). Therefore, they are held off balance sheet

5. Loan Sales With Recourse Without Recourse

5. Loan Sales (with Recourse) Sale with recourse: The buyer has the option to sell the loan back at a prearranged price if the borrower’s credit quality deteriorates. This generates risks for the selling bank, but the bank can sell the loan at a higher price with recourse than without recourse. Banks that sell loans often continue to service the loan (that is, collect checks), and they receive a servicing fee. Sale without recourse: Buyer purchases the loan without the option to sell it back.

Non-Schedule L Risks

Non-Schedule L OBS Risks Settlement Risk FIs receive much of their payments by wire transfer CHIPS wire transfer system processes transactions at the end of the day Bank X can send a fund transfer to Bank Z at 11 AM, but the cash settlement takes place at the end of the day. If Bank Z promises funds to Bank Y later in the day, but Bank X fails to deliver its promised funds, Bank Z can be in a serious net funding deficit position.

Non-Schedule L OBS Risks Affiliate Risk A holding company is a corporation that owns the shares (usually 25% +) of other corporations Many FIs operate in this capacity Citigroup is a One Bank Holding Company that owns all of the shares of Citibank JPMorgan Chase is a multibank holding company that owns many banks nationwide The failure of one affiliated firm imposes affiliate risk on other banks within the holding company structure for two reasons:

Non-Schedule L OBS Risks Creditors of the failed affiliate may lay claim to the surviving bank’s resources on the grounds that operationally the bank isn’t really a separate entity from its affiliate Regulators have tried to enforce a source of strength doctrine in recent years for large MBHC failures The resources of sound banks may be used to support failing banks – courts have generally prevented this from occurring

Lecture Summary Off-balance Sheet Accounting Item: What it is Why it is important Growth in OBS activity Item: Loan Commitment – return Letters of credit Commercial Standby Derivatives contracts When-Issued Securities Loan Sales

MORE ON LOAN SALES

Types of Loan Sales Contracts Participations Limited control rights – syndicate members purchase a piece of the loan but the lead arranger maintains the loan rights. Dual risk exposure – if the lead arranger fails, the participation may become a secured claim rather than a loan sale Monitoring Costs – syndicate members rely on the lead arranger to monitor Participations Lead Arranger JP Morgan Dual risk exposure- 1. exposed to the risk that the borrower defaults 2. exposed to the risk that the lead arranger defaults

Types of Loan Sales Contracts Appointments All rights transferred on sale of loan Currently form the bulk of the market (90% +) Lead Arranger JP Morgan

Good Bank – Bad Bank Bad Loans SPV off–balance – sheet Bank is tasked with selling crappy loans Why would anyone want this job? The bank instantly looks better after selling bad loans What stops management from just giving these loans away Management compensation is tied to the bank’s equity value

Good Bank – Bad Bank Example: Mellon Bank Creates Grant Street National Bank (GSNB) Mellon wrote-down the face value of $941 M in real estate loans and sold them to GSNB for $577 M. GSNB was an SPV funded by bond issues and common /preferred stock Managers of the bad bank GSNB were given equity (jr. preferred stock). This was an incentive mechanism to maximize value in liquidating the loans purchased from Mellon (i.e. doing better than $577 M)

Good Bank – Bad Bank Why loan sales at the bad banks are value enhancing: Bad bank enables bad loans to be worked out by loan workout specialists Good bank’s reputation and access to deposit and funding markets are improved when bad loans are gone Bad bank does not have short-term deposits, so it can follow an optimal strategy for bad assets – it isn’t concerned about liquidity Contracts for managers are created to maximize incentives to generate good value The structure reduces information asymmetries about the value of the good bank’s assets, increasing attractiveness to risk-averse investors

Why do Banks Sell Loans? Credit and liquidity risk management If sold without recourse, removed from balance sheet. Fee income Capital costs Meet capital requirements by reducing assets. Reduce reserve requirements

Lecture Summary Off-Balance-Sheet Accounting Introduction Off-Balance-Sheet Items Loan commitment agreement (Return) Letters of credit Futures, forward contracts, swaps, and options When issued securities Loans sold More on Loan Sales – good bank bad bank