McGraw-Hill/Irwin ©2008 The McGraw-Hill Companies, All Rights Reserved Chapter Nine Risk Management Using Asset-Backed Securities, Loan Sales, Credit Standbys.

9-2 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Key Topics in This Chapter The Securitization Process Securitization’s Impact and Risks Sales of Loans: Nature and Risks Standby Credits: Pricing and Risks

9-3 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 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

9-4 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Securitization of Loans Securitization involves: The pooling of groups of earnings assets, Removing those pooled assets from the bank’s balance sheet,and issuing securities against the pool. As the pooled assets generate interest income and repayments of principal the cash generated by the pooled earning assets flows through to investors who purchased those securities The best type of assets to pool are high quality, fairly uniform loans, such as home mortgages or credit card receivables

9-5 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Advantages What advantages does securitization offer lending institutions? Securitization gives lending institutions the opportunity to use their assets as sources of funds and, in particular, to remove lower-yielding assets from the balance sheet to be replaced with higher- yielding assets.

9-6 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Risks What risks of securitization should the managers of lending institutions be aware of? Lending institutions often have to use the highest-quality assets in the securitization process which means the remainder of the portfolio may become more risky, on average, increasing the bank’s capital requirements.

9-7 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 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

9-8 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Further 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

9-9 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Problems with Securitization May Not Reduce a Bank’s Capital Requirements. Lender use highest quality assets for securitization which means the remainder of the portfolio becomes more risky –requiring higher capital Prepayment Risk Not Available for All Banks May Increase Competition for the Best Quality Loans May Increase Competition for Deposits

9-10 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 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

9-11 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Problem Suppose a bank securitizes a package of loans that bear a gross annual interest yield of 13%. The securities issued against the loan package yield 8.25%. The default rate on the package is 3.5%. The bank agrees to pay the security dealer.35 % to cover the cost of underwriting and an advisory service fee of.25%. Calculate the residual income to the bank. Residual income = Gross loan yield – security interest rate – expected default on packaged loans – Underwriting and advisory fee – liquidity facility fee – credit enhancement fee = 13 – =.65%

9-12 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 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

9-13 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 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

9-14 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Loan Sales Selling Loan Contracts Held by an Institution in Order to Raise New Cash

9-15 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 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. Loan Strip –Short-Dated Pieces of Longer Term Loans

9-16 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Reasons Behind Loan Sales - advantages Way to Rid the Bank of Low Yield Securities and raise additional funds Way to Increase Liquidity of Assets by replacing loans sold with marketable securities Way to Eliminate Credit and Interest Rate Risk Way to Generate Fee Income Purchasing Bank can Diversify Loan Portfolio and Reduce Risk

9-17 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Loan sales What advantages do sales of loans have for lending institutions trying to raise funds? Loan sales permit a lending institution to get rid of less desirable or lower-yielding loans and allow them to raise additional funds. In addition, replacing loans that are sold with marketable securities can increase the liquidity of the lending institution.

9-18 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Loan sales Are there any disadvantages to using loan sales as a significant source of funding for banks and other financial institutions? The lender may find themselves selling off their highest quality loans, leaving their loan portfolio stocked with poor-quality loans which can trigger the attention of regulators who might require higher capital requirements for the lender.

9-19 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Loan servicing What is loan servicing? Loan servicing involves monitoring borrower compliance with a loan’s terms, collecting and recording loan payments, and reporting to the current holder of the loan.

9-20 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Loan Servicing Rights – Can increase income 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

9-21 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Loan servicing How can loan servicing be used to increase income? Many banks have retained servicing rights on the loans they have sold, earning fees from the current owners of those loans.

9-22 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 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

9-23 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Standby letters of credit What are standby credit letters? Standby credit letters are promises of a lender to pay off an obligation of one of its customers in case that customer cannot pay. It can also be a guarantee that a project of customer is completed on time.

9-24 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 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 – pays off obligation of a bank customer in case the customer cannot pay –Performance Guarantees – Guarantees a Project Will be Completed On Time –Default Guarantees – Financial Institution Pledges Repayment of Defaulted Notes When Borrowers Cannot Pay

9-25 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Standby LCs Who are the principal parties to a standby credit agreement? The principal parties to a standby credit agreement are the issuing bank or other institution, the account party who requested the letter, and the beneficiary who will receive payment from the issuing institution if the account party cannot meet its obligation.

9-26 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 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

9-27 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Reasons for Growth of SLCs Rapid Growth of Direct Financing Worldwide. Banks have been asked to provide a credit guarantee against default risk of commercial paper issued 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

9-28 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 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

9-29 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Standby LCs What risks accompany a standby credit letter for (a) the issuer and (b) the beneficiary? Standbys present the issuer with the danger that the customer whose credit the issuer has backstopped with the letter will need a loan. That is, the issuer’s contingent obligation will become an actual liability, due and payable. This may cause liquidity and interest rate risk for the issuer. The beneficiary that has to collect on the letter must be sure it meets all the conditions required for presentation of the letter or it will not be able to recover its funds.

9-30 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 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 Issuer Faces Substantial Interest Rate and Liquidity Risks as it may have to lend money to the defaulting customer – a contingent liability becomes an actual liability

9-31 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 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

9-32 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 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