Managing Risk off the Balance Sheet with Loan Sales and Securitization

8-1McGraw-Hill/IrwinChapter Twenty-FourManaging Risk off the Balance Sheet with Loan Sales and Securitization24-2McGraw-Hill/IrwinLoan Sales and SecuritizationFIs use loan sales and securitization to hedge credit, interest rate, and liquidity risk exposureA loan sale occurs when an FI originates a loan and then subsequently sells itLoan securitization is the packaging and selling of loans and other assets backed by securities issued by an FILoan securitization generally takes one of three formspass-through securitiescollateralized mortgage obligations (CMOs)mortgage-backed bonds (MBBs)24-3McGraw-Hill/IrwinLoan Sales and SecuritizationA large part of correspondent banking involves small FIs making large loans and selling (or syndicating) parts of the loans to large bankscorrespondent banking is a relationship between a small bank and a large bank in which the large bank provides a number of deposit, lending, and other servicesLarge banks also sell parts of their loans, called participations, to smaller FIsThe syndicated loan market is the buying and selling of loans once they have been originated24-4McGraw-Hill/IrwinLoan Sales and SecuritizationSyndicated loan market participantsmarket makers generally large commercial banks (CBs) and investment banks (IBs)active traders mainly IBs, CBs, and vulture fundsoccasional sellers and investorsThe syndicated loan market grew rapidly in the early 1980 due to the expansion of HLT loanshighly leveraged transaction (HLT) loans are loans that finance a merger and acquisition; a leveraged buyout results in a high leverage ratio for the borrower24-5McGraw-Hill/IrwinLoan SalesA loan sale is the sale of a loan originated by a bank with or without recourserecourse is the ability of a loan buyer to sell the loan back to the originator should it go badTypes of loan sale contractsa participation in a loan is the act of buying a share in a loan syndication with limited contractual control and rights over the borroweran assignment is the purchase of a share in a loan syndication with some contractual control and rights over the borrower24-6McGraw-Hill/IrwinLoan SalesTraditional short-term loan salessecured by assets of the borrowerborrowers are investment gradeoriginal maturities of 90 days or lesssold in units of $1 million and uploan rates are closely tied to commercial paper ratesHLT loan salessecured by assets of borroweroriginal maturity of 3 to 6 yearsinterest rates are floatinghave strong covenant protectionmay be distressed or nondistressedLDC loan salesLDC loans are loans made to less developed countries24-7McGraw-Hill/IrwinLoan BuyersLoan buyersInvestment banks are the predominant buyers of HLT loansadept at the analysis required to value these types of loansoften are closely associated with the HLT borrowerVulture funds are specialized funds that invest in distressed loansOther domestic bankstraditional correspondent relationships are breaking down as markets get more competitivecounterparty risk and moral hazard have increasedbarriers to nationwide banking have eroded and fewer smaller banks exist now than in the past24-8McGraw-Hill/IrwinLoan BuyersLoan buyers (cont.)Foreign banks are the dominant buyer of U.S. bank loansInsurance companies and pension funds buy long-term loansClosed-end bank loan mutual funds buy U.S. bank loansNonfinancial corporations: predominantly financial service arms of the very largest companiesLoan SellersMoney center banks dominate loan salesSmall regional or community banks sell loans to diversify credit riskForeign banksInvestment banks sell loans related to HLTs24-9McGraw-Hill/IrwinLDC DebtLDC loan-for-bond restructuring programs are called debt-for-debt swapsdeveloped under the U.S. Treasury’s Brady Plan and under organizations such as the International Monetary Fund (IMF)a Brady bond is a bond that is swapped for and outstanding loan to an LDConce FIs loans are swapped for bonds, the bonds can be sold in the secondary marketLDC bondshave much longer maturities than that promised on the original loanshave lower promised original coupons (i.e., yields) than the interest rates on the original loans24-10McGraw-Hill/IrwinLoan SalesFactors encouraging future loan sales growthfee income: fee income from originating loans is reported as current income, while interest earned on the loans is reported only when received in future periodsliquidity risk: creating a secondary market for loans reduces the illiquidity of loans held as assetscapital costs: regulatory capital ratios can be increased by reducing the overall size of the balance sheetreserve requirements: reducing the overall size of the balance sheet can reduce the amount of reserves a bank must hold against its depositsFactors discouraging future loan sales growthaccess to the commercial paper (CP) market: many firms now rely on CP rather than bank loanslegal concerns such as fraudulent conveyance24-11McGraw-Hill/IrwinLoan SecuritizationPass-through mortgage securities “pass-through” promised payments by households of principal and interest on pools of mortgages created by FIs to secondary market investors holding an interest in these poolsEach pass-through security represents a fractional ownership share in a mortgage poolPass-through securitization was originally developed by government-sponsored programs to enhance the liquidity of residential mortgagesGinnie Mae (GNMA)Fannie Mae (FNMA)Freddie Mac (FHLMC)24-12McGraw-Hill/IrwinGNMA Pass-Through Security CreationSuppose 1,000 mortgages for $100,000 each are originated by an FIAs a result of the mortgages (and from having to fund the mortgages with deposits)the FI faces the regulatory burden of capital requirements, reserve requirements, and FDIC insurance premiumsthe FI is exposed to interest rate risk and liquidity riskThe FI can avoid the regulatory burden and risk exposure by securitizing the loans and thus removing them from the balance sheet:the loans get packaged together into a mortgage pool24-13McGraw-Hill/IrwinGNMA Pass-Through Security Creationthe mortgage pool is removed from the balance sheet by placing it with a third-party trusteeGNMA guarantees, for a fee, the timing of interest and principal payments associated with the pool of mortgagesthe FI continues to service the pool of mortgages, for a fee, even after the mortgages are placed in trustGNMA issues pass-through securities backed by the mortgage poolthe securities are sold to outside investors and the proceeds go to the originating FI24-14McGraw-Hill/IrwinPrepayment RiskMost mortgages are fully amortizedfull amortization is the equal, periodic repayment on a loan that reflects part interest and part principal over the life of the loanMany mortgages are paid off prior to maturity because borrowers move or refinance their mortgagesto prepay is to pay back a loan before its maturityThus, realized cash flows can deviate from expected cash flows24-15McGraw-Hill/IrwinCollateralized Mortgage ObligationsCollateralized mortgage obligations (CMOs) are mortgage-backed bonds issued in multiple classes or tranchestranches are differentiated by the order in which each class is paid offeach class has a guaranteed coupon payment but prepayment of principal occurs sequentially to only one class of bondholder at a timethus, some classes of bondholders are more protected against prepayment risk than others24-16McGraw-Hill/IrwinCreation of a Three-Class CMOCMOs are usually created by placing existing pass-through securities in a trust off-the-balance-sheetThe trust issues three different classes, each with a different level of prepayment riskClass A CMO holders have the least prepayment protection as all principal prepayments are first paid to this tranche until they have been paid off in fullafter all Class A CMOs have been retired, Class B CMO holders receive principal prepayment cash flowsfinally, Class C has the most prepayment protection as they are the last trance to be receive principal paymentsnote: each class also receives regular coupon (interest) payments24-17McGraw-Hill/IrwinCollateralized Mortgage ObligationsThe sum of the prices at which CMO classes can be sold normally exceeds that of the original pass-throughthe CMO’s restructured prepayment risk makes each class more attractive to specific classes of investorsCMOs with up to 17 different classes have been createdCMOs often contain a Z class that accrues, but does not pay, interest (or principal) until all other classes have been fully retiredAnother special CMO class is a planned amortization class (PAC)produces a constant cash flow within a band of prepayment ratesoffers greater predictability of cash flowshas priority in receiving principal payments24-18McGraw-Hill/IrwinCollateralized Mortgage ObligationsMost CMOs today are created as real estate mortgage investment conduits (REMICs)REMICs pass-through all interest and principal payments before taxes are leviedMortgage pass-through strips are a special type of CMO with only two classesthe principal component of the pass-through is separated from the interest componentan interest only (IO) strip is a CMO with claim to the interesta principal only (PO) strip is a CMO with claim to the principal24-19McGraw-Hill/IrwinCollateralized Mortgage ObligationsSpecial features of IO stripswhen prepayment occursthe amount of interest payments the IO investor receives falls as the outstanding principal in the mortgage pool fallsthe number of interest payments the IO investor receives may also shrinkbecause the values of IO strips can fall when interest rates decline, IO strips are a rare security with negative durationthis unique feature makes IO strips useful as a portfolio- hedging device24-20McGraw-Hill/IrwinMortgage Backed BondsMortgage backed bonds (MBBs) are bonds collateralized by a pool of mortgagesMBBs differ from pass-throughs and CMOsmortgages remain on the balance sheetmortgages collateralize MBBs, but are not directly related to the associated cash flowsFIs usually back MBBs with excess collateral, which results in a higher investment rating for the MBB than for the issuing FIMBB costsMBBs tie up mortgages on the balance sheet for long periods of timethe FI is subject to prepayment risk on the underlying mortgagesthe FI continues to face capital adequacy and reserve requirement taxes as the mortgages remain on the balance sheet24-21McGraw-Hill/IrwinSecuritization of Other AssetsThe same securitization techniques applied to mortgages have been used to securitize other assets:automobile loanscredit card receivables (CARDs)Small Business Administration guaranteed small business loanscommercial and industrial loansstudent loansmobile home loansjunk bondstime share loansadjustable-rate mortgages