Chapter Nine: Risk Management: Asset-Backed Securities, Loan Sales, Credit Standbys, and Credit Derivatives

Securitization

Pooling income-earning, relatively illiquid assets (mortgages, credit loans) to selling liquid securities against them in the open market.

Originator

The lender whose loans are being securitized.

Special-Purpose Entity (SPE)

These loans are passed on to an issuer, which is usually designed a special-purpose entity (SPE).

The SPE is separated from the originator to help ensure that, if the originating lender goes bankrupt, this even will not affect the credit status of the pooled loans, supposedly making the pool and its cash flow “bankruptcy remote”.

The Heart of the Securitization Process

• Lending Institution (original source of loans)

• Pooled Loans with Similar Features

• Special Purpose Entity (SPE) or Vehicle (SPV)

• Asset-Backed Securities

• Investors in the Global Capital Markets

Bankruptcy Remote

A feature of CMOs where the mortgage assets are separated from the issuer’s assets, reducing the risk that investors will lose cash flows if the issuer goes bankrupt. Investors continue to receive cash flows from the underlying mortgages even if the originating company experiences financial trouble.

Trustee

Ensure the issuer fulfills all the requirements of the transfer of loans to the pool and provides all the services promised to investors.

Servicer

A servicer (who is often the loan originator) collects payments on the securitized loans as passed those payments along to the trustee, who ultimately makes sure investors who hold-loans backed securities receive the proper payments on time.

Government-sponsored enterprises (GSEs) worked to improve the salability of residential mortgage loans:

• The Government National Mortgage Association (GNMA - Ginnie Mae)

• The Federal National Mortgage Association (FNMA - Fannie Mae)

• The Federal Home Loan Mortgage Corporation (FHLMC - Freddie Mac)

Collateralized Mortgage Obligation (CMOs)

CMOs typically were created through a multistep process in which home mortgage loans are first pooled together, then GNMA-guaranteed securities are issued against the loan pool and ultimately offered to investors around the globe.

Tranche

One class of a CMO, which promises a different rate of return (coupon) to investors and carried a different risk exposure.

Waterfall

The principal goes first to the senior tranche, then the next, and so on down to the last tranche.

• The “senior” tranches of a CMO generally carry shorter maturities. Reduced their reinvestment risk exposure. Attractive to risk-averse investors.

Advantages of Securitization

• Diversifies a bank’s credit risk exposure

• Created liquid assets out of illiquid assets

• Transforms these assets into new sources of capital

• Allows the bank to hold a more geographically diversified loan portfolio

• Allows the bank to better manage interest rate risk

• Allows the bank to generate fee income

Regulators today are looking closely at:

• The risk of having to come up with large amounts of liquidity in a hurry to make payments to investors holding asset-backed securities and cover bad loans

• The risk of agreeing to serve as an underwriter for asset-backed securities that cannot be sold

• The risk of acting as a credit enhancer and underestimating the need for loan-loss reserves

• The risk that unqualified trustees will fail to protect investors in asset-backed instruments

• The risk of loan servicers being unable to satisfactorily monitor loan performance and collect monies owed lenders and investors

Participation Loans

• When an outside party purchases a (portion of a ) loans

• They generally have no influence over the loan terms

Assignment

• Ownership of the loan is transferred to the buyer of the loan

• The buyer has a direct claim against the borrower

Loan Strip

Short-dated pieces of longer term loans, maturing in a few days or weeks

Reasons behind Loan Sales

• Way to rid the bank of lower-yielding assets to make room for higher-yielding assets when interest rates rise

• Way to increase the marketability and liquidity of assets

• Way to eliminate credit and interest rate risk

• Way to generate fee income

• Purchasing bank can diversify loan portfolio and reduce risk

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

Standby Letters of Credit (SLCs) 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

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

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

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

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

Credit Derivative

An over-the-counter agreements protection against loss when default occurs on a loan, bond, or other debt instrument.

Credit Swaps

• Two lenders agree to swap a portion of their customers’ 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

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.

Credit Default Swaps (CDSs)

Aimed at lenders able to handle comparatively limited declines in value, but wanting insurance against serious losses

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

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

Risks Associated with Credit Derivatives

• Partners in swap or options 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