1 Laying Off Credit Risk: Loan Sales versus Credit Default Swaps Christine Parlour, UC-Berkeley Andrew Winton, University of Minnesota FDIC/JFSR Conference: Issues in Securitization and Credit Risk Transfer September 2008

2 Background: Credit Risk Transfer Loan sales: Drucker/Puri (2007) –Loan sales volume $176 billion in –Sold loans are from larger, riskier, higher leverage borrowers. Credit default swaps (CDS): Minton/Stulz/Williamson (2008) –Banks’ total notional CDS outstanding $5,526 billion in 2005 (Net protection only $489 billion (10% of loans); further analysis suggests only 2% of loans hedged. –Banks that use CDS tend to be largest banks (23 of those > $1 billion). –Banks that use CDS also make use of loan sales. Questions: –How do loan sales, CDS compare as risk transfer methods for banks? –Do loan sales, CDS undermine monitoring of borrowers?

3 Related Literature - Theory Loan sales and monitoring –Gorton/Pennacchi (1995): undermine monitoring unless reputation concerns cause bank to hold part of loan. –Parlour/Plantin (2008): loan sales tend to undermine monitoring, may be offset by increasing loan size. CDS and monitoring –Arping (2004), Duffie/Zhou (2001): if observable, using CDS shorter than loan maturity enhances monitoring. –Morrison (2005): CDS unobservable, so undermine monitoring. Securitization and monitoring –Chiesa (2008): securitization of portfolio w/proper capital regulations maintains monitoring incentives. –Jiangli, Pritsker, Raupach (2008): securitization allows more effective credit risk transfer than loan sales.

4 Overview of This Paper Simple single-period model. –Entrepreneur needs loan to finance firm. –Bank makes loan, gets info about borrower, faces capital shock. –Bank can lay off risk through loan sale or CDS to uninformed investor. –Holder of loan can “monitor” (enforce control rights), prevent entrepreneur moral hazard. Key point: loan sales transfer loan control rights, CDS do not.

5 Overview (Continued) When firm’s base credit risk is high, only loan sales are used. Risk transfer is efficient, but too much monitoring. –Uninformed loan buyers monitor. When base credit risk is lower, outcome depends on cost of bank’s capital shock. –High capital cost: all loans sold/hedged, so risk transfer efficient. Also Either loan sales, CDS coexist, no monitoring, Or firm borrows more, only loan sales used, too much monitoring. –Low capital cost: only lower quality loans get sold/hedged, so risk transfer inefficient. Also Either CDS coexists w/loan sales, and no monitoring, Or firm borrows more, only loan sales used, right loans get monitored.

6 Overview (Continued) Loan sales restrictions cause bank to use CDS or do loan participation; either undermines monitoring. We consider repeated game setting (bank long-lived, entrepreneurs, investors not). –Defaults are noisy signal bank has not monitored. –Can sometimes maintain first-best with CDS: bank uses CDS to hedge risk, but monitors when appropriate. Eventually, defaults occur, revert to inefficient equilibrium. –First-best outcomes more likely to occur when firm’s credit risk low, impact of monitoring high, or bank’s discount rate low.

7 Single-Period Model Entrepreneur needs loan ≥ 1 to finance firm. –Project returns R > 1 if successful, C < 1 otherwise. –If project “simple” (probability θ), then Pr[Success] = p+Δ –If project “complex” (probability 1−θ), entrepreneur can choose simple project or riskier one w/private benefit B > 0, Pr[Success] = p. –Assume parameters such that choose riskier project if allowed. Competitive bank makes loan w/repayment R ℓ. Bank learns whether project complex or not. –Bank “type” = p+Δ or p (reflects entrepreneur’s choice). Bank faces capital shock: cost β(R ℓ −C) if risk unhedged. (Correlated lending opportunity arises.)

8 Model (Continued) Bank can sell loan to uninformed investor, execute CDS w/uninformed investor, or keep loan risk. –Loan sale transfers cash flows, control rights of loan. –CDS pays off R ℓ −C if loan defaults; no control rights transferred. –Competitive markets, so loan price, CDS cost = expected values. Holder of loan can monitor (enforce terms, force simple project to be chosen). Monitoring costs b > 0. Assume monitoring socially optimal. Firm succeeds or fails; holder of loan receives payment, CDS pays off if firm failed.

9 Equilibria Given Loan Face Value R ℓ Proposition 1. Suppose R ℓ −C ≤ b/Δ. Then neither bank nor loan buyer will monitor. –If capital costs high enough (β > (1−θ)Δ), have equilibrium “(p,n)” where bank always sheds risk, loans sales and CDS can coexist. –If capital costs low (β ≤ Δ), have equilibrium “(s,n)” where only bank type p sheds risk, loan sales and CDS can coexist. Intuition: condition makes monitoring unattractive even if know entrepreneur is choosing risky project. –In (p,n), given investor beliefs, bank type p+Δ prefers to pool, hedge risk rather than bear (high) capital cost. –In (s,n), given investor beliefs, bank type p+Δ prefers to separate, bear (low) capital cost rather than pool at low-quality prices.

10 Equilibria Given R ℓ (Continued) Proposition 2. Suppose R ℓ −C > b/Δ. Then bank type p will monitor if retain loan risk. –If capital costs high enough, credit risk R ℓ −C not too high, equilibrium (p,n) can exist. –If R ℓ −C high enough, have equilibrium “(p,m)” where bank always sheds risk through loan sales, loan buyer monitors. –If capital costs low and R ℓ −C not too high, have equilibrium “(s,m)” where only bank type p sheds risk through loan sales, loan buyer monitors. Intuition: now, credit risk may be high enough that loan buyer would monitor (depends on beliefs). If so, loan sale dominates CDS. Again, can get pooling or separating.

11 Welfare Corollary 1. If equilibrium is –(p,n), risk transfer is efficient but monitoring is too low. –(p,m), risk transfer is efficient but monitoring is too high. –(s,n), risk transfer is inefficient and monitoring is too low. –(s,m), risk transfer is inefficient but monitoring is efficient.

12 Equilibrium Choice: High Capital Costs By choosing debt face value R ℓ and thus credit risk R ℓ −C, entrepreneur influences equilibrium. Break-even credit risk is –Decreasing in base chance of success p, impact of monitoring Δ, collateral value C; –Increasing in probability of moral hazard 1−θ, cost of monitoring b, cost of capital β. Proposition 4. If capital costs high (β > Δ), only pooling equilibria feasible. –If break-even credit risk for (p,n) sufficiently low and monitoring costs high relative to expected monitoring gains, entrepreneur chooses (p,n). –Otherwise, chooses (p,m), possibly increasing loan amount to do so.

13 Equilibrium Choice: Low Capital Costs Proposition 5. Suppose capital costs low: β ≤ (1−θ)Δ. –If break-even credit risk for (s,m) sufficiently low and monitoring costs high relative to expected monitoring gains, entrepreneur chooses (s,n), otherwise (s,m). –If break-even credit risk for (s,m) intermediate in size, entrepreneur chooses (s,m). –If break-even credit risk for (s,m) sufficiently high, entrepreneur chooses (p,m) (separating equilibria are not feasible).

14 Equilibrium Choice: Intermediate Capital Costs Proposition 6. Suppose capital costs medium: (1−θ)Δ < β ≤ Δ. –If break-even credit risk for (p,m) sufficiently low, there is indeterminacy between (s,n), (s,m), and (p,n) equilibria. Entrepreneur chooses (p,n) if monitoring costs high relative to expected monitoring gains, otherwise chooses (s,m) or (p,m) depending on investor beliefs. –If break-even credit risk for (p,m) intermediate and monitoring costs high relative to expected monitoring gains, entrepreneur chooses (p,n). –Otherwise, chooses (p,m), possibly increasing loan amount to do so.

15 Loan Sale Restrictions Suppose loan includes anti-assignment clause to limit sales. –Might think this improves monitoring incentives. –But actually may encourage bank to use CDS to offset risk, undermining monitoring by bank. Or bank may use loan participation to unload all or part of risk while maintaining control rights. –Participating bank can’t monitor (no control rights). –Originating bank has little or no incentive to monitor. So loan sales restrictions exacerbate lack of monitoring if bank has access to alternative credit risk transfer modes.

16 Multiperiod Model and Bank Reputation Suppose bank exists for infinite number of periods. –In each period, new entrepreneur seeks loan, new investors interact w/bank in loan sales and CDS markets. –Bank discounts future profits at δ, 0 < δ < 1. Can reputation concerns give bank incentive to monitor even if use CDS to offset risk? This would be first-best outcome: bank transfers risk but still monitors efficiently. –Requires that bank earn higher discounted profits by monitoring than shirking. –So investors need some way of detecting shirking, –And some way of punishing bank for shirking.

17 Reputational Equilibria Consider “trigger-strategy” equilibria (Green/Porter, 1984): –Investors, entrepreneur start out believing bank will monitor rather than shirk. –If firm defaults, believe bank shirked for sure; revert to single-period equilibria from then on. –Bank keeps any surplus over single-period equilibrium. (Perhaps banks w/reputation are relatively few.) Comment: default is noisy signal: –Bank may shirk and yet loan pays off, or bank may monitor and loan defaults. –But defaults more likely if bank shirks, less likely if bank monitors.

18 Incentive Compatibility Let S * denote single-period surplus (welfare under first- best less welfare under single-period equilibrium). Incentive compatibility condition becomes Keeping S * fixed, this is more likely as –Base probability of success p increases, –Impact of monitoring Δ increases, –Discount factor δ increases, –Cost of monitoring b decreases.

19 Incentive Compatibility (Cont’d) Proposition 8 examines this with endogenous S *. These comparative statics results continue to hold if –Single-period equilibrium is pooling (i.e., (p,n) or (p,m)), so capital costs high or break-even credit risk high; –Single-period equilibrium is (s,m) with higher than break-even leverage, so capital costs low, net benefits of monitoring high; –Single-period equilibrium is (s,m) or (s,n) with break-even leverage and p, Δ, δ sufficiently large relative to θβ. Here, S * is increasing in expected capital costs for “high” bank type, which decrease with p, Δ, and increase with θβ. Thus, reputational equilibrium more likely as credit quality or impact of monitoring sufficiently high. –But even then, defaults will eventually occur, cause this to break down.

20 Conclusion CDS most active when borrower credit risk low. When credit risk high, loan sales likely (see Drucker/Puri, 2007): –Loan sales dominate in single-period setting; –Reputational equilibria w/CDS harder to sustain in repeated setting. Suggests that, if CDS available due to speculative demand, may be detrimental for high credit risk borrowers. –Cost of undermining monitoring outweighs risk-sharing benefits. –Consistent w/evidence in Ashcraft and Santos (2007). For future, reputational equilibria worth more attention.