©2007, The McGraw-Hill Companies, All Rights Reserved 24-1 McGraw-Hill/Irwin Chapter Twenty-four Managing Risk with Loan Sales and Securitization

©2007, The McGraw-Hill Companies, All Rights Reserved 24-2 McGraw-Hill/Irwin Basic Descriptions of Loan Sales Loan sale Pass-through securities Collateralized Mortgage Obligations (CMOs) Mortgage-Backed Bonds (MBBs) Loan sale Pass-through securities Collateralized Mortgage Obligations (CMOs) Mortgage-Backed Bonds (MBBs)

©2007, The McGraw-Hill Companies, All Rights Reserved 24-3 McGraw-Hill/Irwin Loan Sales Loan sales and asset securitization Correspondent banking Highly leveraged transaction (HLT) loan Bank loan sale Loan sales and asset securitization Correspondent banking Highly leveraged transaction (HLT) loan Bank loan sale

©2007, The McGraw-Hill Companies, All Rights Reserved 24-4 McGraw-Hill/Irwin Types of Loan Sales Contracts Two basic types: –Participations –Assignments Two basic types: –Participations –Assignments

©2007, The McGraw-Hill Companies, All Rights Reserved 24-5 McGraw-Hill/Irwin The Loan Sale Market Traditional Short-Term Segment LDC Loan HLT Loan Sale The Buyers –vulture fund - a specialized fund that invests in distressed loans Traditional Short-Term Segment LDC Loan HLT Loan Sale The Buyers –vulture fund - a specialized fund that invests in distressed loans

©2007, The McGraw-Hill Companies, All Rights Reserved 24-6 McGraw-Hill/Irwin 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

©2007, The McGraw-Hill Companies, All Rights Reserved 24-7 McGraw-Hill/Irwin 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 –Brazil’s rapid economic recovery, Mexico’s upgraded credit rating, Russia’s debt restructuring early 2000’s Trading takes place in the high-yield (or junk bond) departments of participating banks Brady bond 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 –Brazil’s rapid economic recovery, Mexico’s upgraded credit rating, Russia’s debt restructuring early 2000’s Trading takes place in the high-yield (or junk bond) departments of participating banks Brady bond

©2007, The McGraw-Hill Companies, All Rights Reserved 24-8 McGraw-Hill/Irwin 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 –Legal concerns 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 –Legal concerns

©2007, The McGraw-Hill Companies, All Rights Reserved 24-9 McGraw-Hill/Irwin 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”) –FNMA (“Fannie Mae”) –FHLMC (“Freddie Mac”) The original use of securitization is a result of government-sponsored programs to enhance the liquidity of the residential mortgage market –GNMA (“Ginnie Mae”) –FNMA (“Fannie Mae”) –FHLMC (“Freddie Mac”)

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin 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 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

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin 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

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin 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

©2007, The McGraw-Hill Companies, All Rights Reserved McGraw-Hill/Irwin 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