McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Chapter Twenty-five Loan Sales and Asset Securitization

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Basic Descriptions of Loan Sales Loan sale –Occurs when an FI originates a loan and subsequently sells it Pass-through securities –mortgages or other assets originated by an FI are pooled and investors are offered an interest in the pool Collateralized Mortgage Obligations (CMOs) –similar to pass-through in that CMOs are securities backed by pools of mortgages or other assets originated by an FI, but CMOs assign varying combinations of risk and return by repackaging the pool Mortgage-Backed Bonds (MBBs) –a bond issue backed by a group of mortgages Loan sale –Occurs when an FI originates a loan and subsequently sells it Pass-through securities –mortgages or other assets originated by an FI are pooled and investors are offered an interest in the pool Collateralized Mortgage Obligations (CMOs) –similar to pass-through in that CMOs are securities backed by pools of mortgages or other assets originated by an FI, but CMOs assign varying combinations of risk and return by repackaging the pool Mortgage-Backed Bonds (MBBs) –a bond issue backed by a group of mortgages

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Loan Sales Loan sales and asset securitization –the packaging and selling of loans and assets backed by securities issued by an FI Correspondent banking –A relationship between a small bank and a large bank in which the large bank provides services Highly leveraged transaction (HLT) loan –a loan that finances a merger and acquisition, a leveraged buyout results in a high leverage ratio for the borrower Bank loan sale –sale of loan originated by a bank with or without recourse to an outside buyer Loan sales and asset securitization –the packaging and selling of loans and assets backed by securities issued by an FI Correspondent banking –A relationship between a small bank and a large bank in which the large bank provides services Highly leveraged transaction (HLT) loan –a loan that finances a merger and acquisition, a leveraged buyout results in a high leverage ratio for the borrower Bank loan sale –sale of loan originated by a bank with or without recourse to an outside buyer

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Types of Loan Sales Contracts Two basic types: –Participations the buyer is not a party to the underlying credit agreement so the initial contract between loan seller and borrower remains in place after the sale the buyer can exercise only partial control over changes in the loan contract’s terms –Assignments the transfer of all rights on sale the transfer of U.S. domestic loans normally associated with a Uniform Commercial Code filing Two basic types: –Participations the buyer is not a party to the underlying credit agreement so the initial contract between loan seller and borrower remains in place after the sale the buyer can exercise only partial control over changes in the loan contract’s terms –Assignments the transfer of all rights on sale the transfer of U.S. domestic loans normally associated with a Uniform Commercial Code filing

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved The Loan Sale Market Traditional Short-Term Segment –banks sell loans with short maturities (90 days or less) that are secured by assets of the borrowing firm LDC Loan –loans made to a less developed country, such as certain Asian, African, and South American countries HLT Loan Sales –leveraged loan market, differs according to whether distressed or nondistressed –vulture fund - a specialized fund that invests in distressed loans Traditional Short-Term Segment –banks sell loans with short maturities (90 days or less) that are secured by assets of the borrowing firm LDC Loan –loans made to a less developed country, such as certain Asian, African, and South American countries HLT Loan Sales –leveraged loan market, differs according to whether distressed or nondistressed –vulture fund - a specialized fund that invests in distressed loans

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Buyers and Seller of HLTs The Buyers –Investment banks, vulture funds, other domestic banks, foreign banks, insurance companies and pension funds, closed-end bank loan mutual funds, and nonfinancial corporations The Sellers –major money center banks, small regional or community banks, foreign banks, and investment banks The Buyers –Investment banks, vulture funds, other domestic banks, foreign banks, insurance companies and pension funds, closed-end bank loan mutual funds, and nonfinancial corporations The Sellers –major money center banks, small regional or community banks, foreign banks, and investment banks

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Secondary Market for Less Developed Country Debt (LDC) Since mid 1980’s, many large commercial and investment banks in the New York and London began trading in LDCs –Mexico and Brazil crisis in late 1980’s –Asian crisis in 1997/1998 –economic crisis in southeast Asia, South America, and Russia in the late 1990’s Trading takes place in the high-yield (or junk bond) departments of participating banks Brady bond –a bond that is swapped for an outstanding loan to an LDC Since mid 1980’s, many large commercial and investment banks in the New York and London began trading in LDCs –Mexico and Brazil crisis in late 1980’s –Asian crisis in 1997/1998 –economic crisis in southeast Asia, South America, and Russia in the late 1990’s Trading takes place in the high-yield (or junk bond) departments of participating banks Brady bond –a bond that is swapped for an outstanding loan to an LDC

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Factors Encouraging and Deterring Future Loan Sales Growth Factors Encouraging Loan Sales –Generate current fee income –Reduce liquidity risk –Boost capital adequacy ratio –Reduce reserve requirements Factors Discouraging Loan Sales –Access to the Commercial Paper Market—enhanced under the Fin. Svc.’s Modernization Act of 1999—means selling loans is less important –Legal concerns: challenges are often incurred if the borrower incurs financial distress Factors Encouraging Loan Sales –Generate current fee income –Reduce liquidity risk –Boost capital adequacy ratio –Reduce reserve requirements Factors Discouraging Loan Sales –Access to the Commercial Paper Market—enhanced under the Fin. Svc.’s Modernization Act of 1999—means selling loans is less important –Legal concerns: challenges are often incurred if the borrower incurs financial distress

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Pass-Through Security The original use of securitization is a result of government-sponsored programs to enhance the liquidity of the residential mortgage market –GNMA (“Ginnie Mae”)—provides timing insurance - guaranteeing P&I at the date promised –FNMA (“Fannie Mae”)—creates the pass-throughs by buying and holding mortgages and issues bonds directly to finance those purchases –FHLMC (“Freddie Mac”)—similar to FNMA except that its major securitization involves thrifts The original use of securitization is a result of government-sponsored programs to enhance the liquidity of the residential mortgage market –GNMA (“Ginnie Mae”)—provides timing insurance - guaranteeing P&I at the date promised –FNMA (“Fannie Mae”)—creates the pass-throughs by buying and holding mortgages and issues bonds directly to finance those purchases –FHLMC (“Freddie Mac”)—similar to FNMA except that its major securitization involves thrifts

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Collateralized Mortgage Obligation (CMO) A CMO is repackaged cash flows from mortgages and pass-through securities A multiclass pass-through created with a number of different bond holder classes differentiated by the order in which each is paid off Class A,B, and C Bond buyers –A bonds have the shortest life, attractive to savings banks and commercial banks –B bonds, typically 5-7 years are attractive to pension funds and life insurance companies –C bonds, longest duration, pension funds and life ins. co. A CMO is repackaged cash flows from mortgages and pass-through securities A multiclass pass-through created with a number of different bond holder classes differentiated by the order in which each is paid off Class A,B, and C Bond buyers –A bonds have the shortest life, attractive to savings banks and commercial banks –B bonds, typically 5-7 years are attractive to pension funds and life insurance companies –C bonds, longest duration, pension funds and life ins. co.

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Mortgage -Backed Bond (MBB) Differ from pass-throughs and CMOs in two key dimensions: –MBBs normally remain on the balance sheet –cash flows on the mortgages backing the bond are not necessarily directly connected interest and principal payments on the MBB MBBs decrease the bank’s asset portfolio liquidity Differ from pass-throughs and CMOs in two key dimensions: –MBBs normally remain on the balance sheet –cash flows on the mortgages backing the bond are not necessarily directly connected interest and principal payments on the MBB MBBs decrease the bank’s asset portfolio liquidity

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Securitization of Other Assets The major use of pass-throughs, CMOs, and MBBs have led to the packaging of other loans such as: –automobile loans –credit card receivables (CARDs) –small business loans guaranteed by the Small Business Administration –commercial and industrial loans –student loans –mobile home loans –junk bonds –time share loans –adjustable rate mortgages The major use of pass-throughs, CMOs, and MBBs have led to the packaging of other loans such as: –automobile loans –credit card receivables (CARDs) –small business loans guaranteed by the Small Business Administration –commercial and industrial loans –student loans –mobile home loans –junk bonds –time share loans –adjustable rate mortgages

McGraw-Hill /Irwin Copyright © 2004 by The McGraw-Hill Companies, Inc. All rights reserved Benefits versus Costs of Securitization Benefits Costs________ New funding source Public/private credit risk Increased liquidity Overcollateralization Enhanced ability to manage Valuation and packaging interest rate risk Savings to the issuer on: reserve requirements deposit insurance premium capital adequacy requirements Benefits Costs________ New funding source Public/private credit risk Increased liquidity Overcollateralization Enhanced ability to manage Valuation and packaging interest rate risk Savings to the issuer on: reserve requirements deposit insurance premium capital adequacy requirements