1. Sales of Loans to Raise Funds and Reduce Risk (continued)
9-1
Sales of Loans to Raise Funds and Reduce Risk (continued)
The 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
Loans purchased from another bank can turn bad just as easily as one from their own bank
Loan sales are cyclical
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2. 9-2
Standby Credit Letters to Reduce the Risk of Nonpayment or Nonperformance
Financial guarantees
Instruments used to enhance the credit standing of a borrower to help insure lenders against default and to reduce the borrower’s financing costs
Designed to ensure the timely repayment of the principal and interest from a loan even if the borrower goes bankrupt or cannot perform a contractual obligation
One of the most popular guarantees is the standby letter of credit (SLC)
SLCs may include
Performance guarantees
A financial firm guarantees that a project will be completed on time
Default guarantees
A financial firm pledges the repayment of defaulted notes when borrowers cannot pay
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3. 9-3
Standby Credit Letters to Reduce the Risk of Nonpayment or Nonperformance (continued)
Key Advantages to Issuing SLCs
Letters of credit earn a fee for providing the service (usually around 0.5 percent to 1 percent of the amount of credit involved)
They aid a customer, who can usually borrow more cheaply when armed with the guarantee, without using up the guaranteeing institution’s scarce reserves.
Such guarantees usually can be issued at relatively low cost because the issuer may already know the financial condition of its standby credit customer
The probability usually is low that the issuer of an SLC will ever be called upon to pay
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4. 9-4
Standby Credit Letters to Reduce the Risk of Nonpayment or Nonperformance (continued)
Standbys have become important financial instruments for several reasons
The spread of direct finance worldwide, with some borrowers selling their securities directly to investors rather than going to traditional lenders
The risk of economic fluctuations has led to demand for risk-reducing devices
The opportunity standbys offer lenders to use their credit evaluation skills to earn additional fee income without the immediate commitment of funds
The relatively low cost of issuing SLCs – they carry zero reserve requirements and no insurance fees
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5. 9-5
Standby Credit Letters to Reduce the Risk of Nonpayment or Nonperformance (continued)
SLCs contain three essential elements
A commitment from the issuer (often a bank or insurance company today)
An account party (for whom the letter is issued)
A beneficiary (usually a lender concerned about the safety of funds committed to the account party)
The key feature of SLCs is they are usually not listed on the issuer’s or the beneficiary’s balance sheet
This is because a standby is only a contingent liability
In most cases it will expire unexercised
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6. EXHIBIT 9–7 The Nature of a Standby Credit Agreement (SLC)
9-6
EXHIBIT 9–7 The Nature of a Standby Credit Agreement (SLC)
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7. 9-7
Standby Credit Letters to Reduce the Risk of Nonpayment or Nonperformance (continued)
In effect, the SLC issuer agrees for a fee to take on a risk that, in the absence of the SLC, would be carried fully by the beneficiary
In general, an account party will seek an SLC if the issuer’s fee for providing the guarantee is less than the value assigned to the guarantee by the beneficiary
If P is the price of the standby, NL is the cost of a nonguaranteed loan, and GL is the cost of a loan backed by a standby guarantee, then a borrower is likely to seek an SLC if
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8. 9-8
Standby Credit Letters to Reduce the Risk of Nonpayment or Nonperformance (continued)
Sources of Risk with SLCs
Default risk of issuing bank
Beneficiary must meet all conditions of letter to receive payment
Bankruptcy laws can cause problems for SLCs
Issuer faces substantial interest rate and liquidity risks
Ways to Reduce Risk Exposure of SLCs
Frequently renegotiating the terms of any loans extended to customers
Diversifying SLCs issued by region and by industry
Selling participations in standbys in order to share risk with other lending institutions
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9. 9-9
Standby Credit Letters to Reduce the Risk of Nonpayment or Nonperformance (continued)
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
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10. 9-10
Credit Derivatives: Contracts for Reducing Credit Risk Exposure on the Balance Sheet
Securitizing assets, selling loans, and issuing standby credits may possibly reduce not only interest rate risk but also exposure to credit risk
However, it may be more efficient to reduce credit risk with a somewhat newer financial instrument – the credit derivative
An over-the-counter agreement possibly offering protection against loss when default occurs on a loan, bond, or other debt instrument
Until the credit crisis the credit derivatives market was one of the fastest growing in the world
Bankers generally lead the credit derivatives market, followed by security dealers, insurers, and managers of hedge funds
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11. 9-11
Credit Derivatives: Contracts for Reducing Credit Risk Exposure on the Balance Sheet (continued)
Credit Swaps
Two lenders agree to swap a portion of their customer’s loan payments
Can help each lender further spread out their risk
Variation is a total return swap, where the dealer guarantees parties a specific rate of return
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12. EXHIBIT 9–8 Example of a Credit Swap
9-12
EXHIBIT 9–8 Example of a Credit Swap
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13. EXHIBIT 9–9 Example of a Total Return Swap
9-13
EXHIBIT 9–9 Example of a Total Return Swap
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14. 9-14
Credit Derivatives: Contracts for Reducing Credit Risk Exposure on the Balance Sheet (continued)
Credit Options
Guards against losses in the value of a credit asset or helps to offset higher borrowing costs that may occur due to changes in credit ratings
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15. EXHIBIT 9–10 Example of a Credit Option
9-15
EXHIBIT 9–10 Example of a Credit Option
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16. 9-16
Credit Derivatives: Contracts for Reducing Credit Risk Exposure on the Balance Sheet (continued)
Credit Default Swaps (CDSs)
Aimed at lenders able to handle comparatively limited declines in value, but wanting insurance against serious losses
In this case a lender may seek out a dealer willing to write a put option on a portfolio of bonds, loans, or other assets
There may be a materiality threshold
A minimum amount of loss required before any payment occurs
Credit default swaps were first developed at JP Morgan (now JP Morgan Chase) in 1995
Today more than 90 percent of all credit derivatives are credit default swaps
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17. EXHIBIT 9–11 Example of a Credit Default Swap
9-17
EXHIBIT 9–11 Example of a Credit Default Swap
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18. 9-18
Credit Derivatives: Contracts for Reducing Credit Risk Exposure on the Balance Sheet (continued)
Credit-Linked Notes
Fuses together a normal debt instrument, such as a bond, plus a credit option contract, to give a borrower greater payment flexibility
Grants its issuer the privilege of lowering the amount of loan repayments it must make if some significant factor changes
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19. 9-19
Credit Derivatives: Contracts for Reducing Credit Risk Exposure on the Balance Sheet (continued)
Collateralized Debt Obligations (CDOs)
CDOs may contain pools of high-yield corporate bonds, stock, commercial mortgages, or other financial instruments
Notes (claims) of varying grade are sold to investors seeking income from the pooled assets
The claims sold are divided into tranches similar to those created for the securitization of home mortgages, from the most risky tranche offering the highest potential return to the least risky (“senior”) tranche with lowest expected returns
Regular CDOs have been surpassed by an explosion in synthetic CDOs
These instruments rest on pools of credit derivatives (especially credit default swaps) that mainly ensure against defaults on corporate bonds
Thus, creators of synthetic CDOs do not have to buy and pool actual bonds, but can create synthetic instruments and generate revenues from selling and trading them
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20. 9-20
Credit Derivatives: Contracts for Reducing Credit Risk Exposure on the Balance Sheet (continued)
Risks Associated with Credit Derivatives
Partners in swap or option contract may fail to perform
Smaller volume – Markets are thinner and volatile
Legal issues
Regulatory concerns
Lessons of recent Credit Crisis:
Securitized assets and credit swaps are complex financial instruments that are difficult to correctly value and measure in terms of risk exposures
These derivatives operate in cyclically sensitive markets
Contagion effect cannot be stopped without active government intervention
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21. Quick Quiz What does securitization of assets mean?
9-21
Quick Quiz
What does securitization of assets mean?
What kinds of assets are most amenable to the securitization process?
What advantages does securitization offer lending institutions? Disadvantages?
What advantages do sales of loans have for lending institutions trying to raise funds?
What is loan servicing?
What are standby credit letters? Why have they grown so rapidly in recent years? Who are the principal parties to a standby credit agreement?
Why were credit derivatives developed? What advantages do they have over loan sales and securitizations, if any?
What risks do credit derivatives pose for financial institutions using them? In your opinion what should regulators do about the recent rapid growth of this market, if anything?
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