CHAPTER 10
OFF-BALANCE-SHEET FINANCING IN BANKING AND CREDIT DERIVATIVES
Goal of This Chapter: To learn about some of the newer financial instruments that banks have ud in recent years to help reduce the risk exposure of their bank, and in some cas, to aid in generating new sources of fee income and in raising new funds to make loans and investments.
Key Terms Prented in This Chapter
Securitization Contingent obligation
Credit Enhancement Issuer
Loan Sales Account party
Servicing Rights Beneficiary
Participation Loans Credit derivatives
Assignments Credit swap
Loan strip Credit option
Financial guarantees Credit default swap
Standby letter of credit (SLC)
Chapter Outline
I. Introduction: Sources of Funds Shortages and Credit Risk for Banks
II. Securitizing Bank Loans and Other Asts
A. Nature of Securitization
B. Advantages of Securitization
C. The Rate Structure of Securitization
D. Beginnings of Securitization – The Home Mortgage Market
1. Collateralized Mortgage Obligations – CMOs
2. Securitization of Home Equity Loans
E. Examples of Other Asts That Have Been Securitized
F. Subordinated Securitizations
G. Trends in Securitizations Today
H. Impact of Securitization on Banks
Ill. Sales of Loans to Rai Funds
A. Nature of Loan Sales
B. Loan Participations and Loan Strips
C. Reasons Behind Loan Sales
D. The Risks in Loan Sales
IV. Standby Credit Letters
A. The Nature of Standby Credits (Contingent Obligations)
B. Types of Standby Credit Letters
C. Advantages of Standbys
D. The Structure of Standby Letters of Credit
E. The Value and Pricing of Standby Letters
F. Sources of Risk with Standby Credits
G. Regulatory Concerns about Standby Credit Arrangements
H. Rearch Studies of Standbys and Other Contingent Obligations
V. Credit Derivatives
A. An Alternative to Securitization
B. Credit Swaps
C. Credit Options
D. Credit Default Swaps
E. Credit Linked Notes
F. Risks Associated With Credit Derivatives
VI. Summary of the Chapter
Concept Checks
10-1. What does curitization of asts mean?
Securitization involves the pooling of groups of earning asts, removing tho pooled asts from the bank’s balance sheet, and issuing curities against the pool. As the pooled asts generate interest income and repayments of principal the cash generated by the pooled earning asts flows through to investors who purchad tho curities.
10-2. What kinds of asts are most amenable to the curitization process?
The best types of asts to pool are high quality, fairly uniform loans, such as home mortgages or credit card receivables.
10-3. What advantages does curitization offer for banks?
Securitization gives banks the opportunity to u their asts as sources of funds and, in particular, to remove lower-yielding asts from the balance sheet to be replaced with higher-yielding asts. 10-4. What risks of curitization should bank managers be aware of?
Banks often have to u the highest-quality asts in the curitization process which means the remainder of the portfolio may become more risky, on average, increasing the bank’s capital requirements.
10-5. Suppo a bank curitizes a package of its loans that bear an expected gross annual interest yield of 13 percent. The curities issued against the loan package promi interested investors an annualized yield of 8.25 percent. The expected default rate on the packaged loans is 3.5 percent. The bank agrees to pay an annual fee of 0.35percent to a curity dealer in order to cover the cost of underwriting and advisory rvices and a fee of 0.25 percent to Arunson Mortgage Servicing Corporation to process the payments generated by the packaged loans. If the above items repren
t all the costs associated with this curitization transaction can you calculate the percentage amount of residual income the bank expects to earn from this particular transaction?
The bank’s estimated residual income should be about:
Gross Loan Security Expected Default On Underwriting Yield - Interest Rate - Packaged Loans - And Advisory Fee
13% 8.25% 3.5% .35%
Servicing Expected
- Fee = Residual Income
.25% .65%
10-6. What advantages do sales of loans have for banks trying to rai funds?
Loan sales permit a bank to get rid of less desirable or lower-yielding loans and allow them to rai additional funds.
10-7. Are there any disadvantages to using loan sales as a significant source of bank funding? Loans may have to be sold at deep discounts and result in a higher average level of risk for the loans the bank still retains on its balance sheet.
10-8. What is loan rvicing?
Loan rvicing involves monitoring borrower compliance with a loan’s terms, collecting and recording loan payments, and reporting to the current holder of the loan.
10-9. How can rvicing be ud to increa bank income?
Many banks have retained rvicing rights on the loans they have sold, earning fees from the current owners of tho loans.
10-10. What are standby credit letters? Why have they grown so rapidly in recent years? Standby credit letters are promis of a bank or other lender to pay off an obligation of one of its customers in ca that customer cannot pay. There are veral reasons that standby credit agreements have grown. There has been a tremendous growth in direct financing by companies (issuance of commercial paper) and with growing concerns about default risk on the direct obligations banks ha
ve been asked to provide a credit guarantee. Another reason for their growth is the ability of the bank to u their skills to add fee income to the bank Another reason is that the have a relatively low cost for the bank. Finally banks and customers perceive that there has been an increa in economic fluctuations and there has been incread demand for risk reducing devices.
10-11. 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.
10-12. What risks accompany a standby credit letter for (a) the issuing bank and (b) the beneficiary?
Standbys prent the issuing bank with the danger that the customer who credit the bank has backstopped with the letter will need a loan. That is, the bank’s contingent obligation will become an actual liability, due and payable. The beneficiary that has to collect on the letter must be sure it meets all the conditions required for prentation of the letter or it will not be able to recover its funds.
10-13 How can a bank mitigate the risks inherent in issuing standby credit letters?
Bankers can u various devices to reduce risk exposure from the standby credit letters they have issued, such as:
1. Frequently renegotiating the terms of any loans extended to customers who have
standby credit guarantees so that loan terms are continually adjusted to the
customers’ changing circumstances and there is less need for the beneficiaries of
tho guarantees to press for collection.
2. Diversifying standby letters issued by region and by industry to avoid
concentration of risk exposure.
3. Selling participations in standbys in order to share risk with a variety of lending
institutions.
10-14. Why were credit derivatives developed? What advantages do they have over other loan sales and curitizations, if any?
Credit derivatives were developed becau not all loans can be pooled. In order to be pooled, the group of loans has to have common features such as maturities and cash flow patterns and many business loans do not have tho common features. Credit derivatives can offer the beneficiary protection in the ca of loan default and may help the bank reduce its credit risk and possibly its interest rate risk as well.
10-15. What is a credit swap? For what kinds of situations was it developed?
A credit swap is where two lenders agree to swap portions of their customer’s loan repayments. It was developed so that banks do not have to rely on one narrow market area. They can spread out the risk in the portfolio over a larger market area.
10-16. What is a total return swap? What advantages does it offer the swap’s beneficiary’s institution?
A total return swap is a type of credit swap where the dealer guarantees the swap parties a specific rate of return on their credit asts. A total return swap can allow a bank to earn a more stable rate of return than it could earn on its loans. This type of arrangement can also shift the credit risk and the interest rate risk from one bank to another.
10-17. How do credit options work? What circumstances result in the option contract paying off?
A credit option helps guard against loss in the value of a credit ast or helps offt higher borrowing costs. A bank which purchas a credit option contract will exerci their option if the ast declines significantly in value or los its value completely. If the asts are paid off as expected then the option will not be exercid and the bank will lo the premium they paid for the option. A bank can also purcha a credit option which will be exercid if their borrowing costs ri above a specified spread between their cost and a riskless ast.
10-18. When is a credit default swap uful? Why?
A credit default swap is a credit option written on a portfolio of asts or a credit swap on a particular loan where the other bank in the swap agrees to pay the first bank a certain fee if the loan defaults. This type of arrangement is designed for banks that can handle relatively small loss but want to protect themlves from rious loss.
10-19. Of what u are credit-linked notes?
A credit-linked note allows the issuer of a note to lower the coupon payments if some significant fact
changes. For example, if more loans on which the notes are bad default than expected, the coupon payments on the notes can be lowered. The lender has taken on credit-related insurance from the investors who have purchad the note.
10-20. What risks do credit derivatives po for banks using them? What is the attitude of the regulatory community, thus far, toward banks using the credit-related instruments? In your opinion what should regulators do about the recent rapid growth of this market, if anything? There are veral risks associated with the instruments. One risk is that the other party in the swap or option may fail to meet their obligation. Courts may rule that the instruments are illegal or improperly drawn. The types of instruments are relatively new and the markets for the instruments are relatively thin. If a bank needs to rell one of the contracts they may have difficulty finding a buyer or they may not be able to ll it at a reasonable price. So far regulators have left this market virtually unregulated, although this could change any time. Regulators need to understand clearly the benefits and risks of the types of credit instruments and act to ensure the safety of the banks.
Problems
10-1. Deltone National Bank has placed a group of 10,000 consumer loans bearing an average expected gross annual yield of 14.5 percent in the curitization process. The expected costs are:
Interest on Securities Issued 10.08%
Expected Default Rate 2.67
Investment Banking Fees 0.65
Liquidity Facility 0.45
Credit Guarantee 0.55
Sum of Expected Costs 14.40%
The estimated residual income for Deltone National Bank is:
Gross Annual Sum of Estimated Residual
Yield on Loans - Expected Costs of = Income of
of 14.50% 14.40% .10%
10-2. Ryfield Corporation is requesting a loan for repair of some asmbly-line equipment in the amount of $5 million. The 9-month loan is priced by First National Bank at a 9 ¼ percent rate of interest. However, the bank tells Ryfield that if it obtains a suitable credit guarantee the loan will be priced at 9 percent. Quinmark Bank agrees to ll Ryfield a standby credit guarantee for $10,000. Is Ryfield likely to buy the standby credit agreement. Plea explain.
The interest savings from having the credit guarantee would be:
[$5 mill. * 0.0925 * ¾] - [$5 mill. x 0.0900 * ¾] = $9,375
Clearly, the $10,000 guarantee is overpriced and will not be accepted.
10-3. First Security National Bank has a $30 million, 5-year term loan request from United Safeco Industries, about half of which will be ud to buy new stamping machines ud in the manufacture of metal toys and containers. The remainder of the funds are to be ud to help fund a leveraged buyout of Calem Corporation which imports video equipment. However, the bank wishes to reduce its aggregate risk exposure from funding leveraged buy-outs. A forecast of higher interest rates argues against locking the bank in to longer-term, less flexible loan agreements currently.
Does the bank have any rvice option in the form of off-balance-sheet instruments that could help this customer meet its credit needs while avoiding committing $30 million in rerves for a
five-year loan? What would you recommend that management do to keep United Safeco happy with its current banking relationship? Could the bank earn any fee income if it pursued your idea? In view of the reasonable objectives on the part of First Security National Bank’s management, the bank should consider recommending that the leveraged buy-out portion of the request be handled by an offering of bonds or, perhaps, 5-year notes, with the bank issuing a standby letter of credit for a portion (though probably not all) of the bond or note issue. Armed with First Security’s standby credit agreement, United Safeco should be able to borrow through a curity issue at a substantially lower interest rate. First Security could ll participations in the standby credit to share its risk exposure.
For the portion of the loan that calls for the purcha of new asmbly-line equipment, management might riously consider proposing a shorter-term loan for about one-third to
