Economia degli intermediari finanziari 2/ed - Anthony Saunders, Marcia Millon Cornett, Mario Anolli
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Managing Risk with Loan Sales and Securitization
O U T L I N E
Chapter
Why Financial Institutions Sell and Securitize Loans: Chapter Overview
NAVIGATOR
Loan Sales 1.
What are the purposes of loan sales and securitizations?
2.
What characteristics describe the bank loan sale market?
3.
What factors encourage and deter loan sales growth?
4.
What are the major forms of asset securitization?
5.
Types of Loan Sales Contracts The Loan Sale Market Secondary Market for Less Developed Country Debt Factors Encouraging Future Loan Sales Growth
Can all assets be securitized?
Factors Deterring Future Loan Sales Growth
1
WHY FINANCIAL INSTITUTIONS SELL AND SECURITIZE LOANS: CHAPTER OVERVIEW
Loan sales and securitization—the packaging and selling of loans and other assets backed by loans issued by the FI—are one of the mechanisms that FIs have used to hedge their credit risk, interest rate risk, and liquidity risk exposures. In addition, loan sales and securitization have allowed FI asset portfolios to become more liquid, provided an important source of fee income (with FIs acting as servicing agents for the assets sold), and helped to reduce the adverse effects of regulatory “taxes” such as capital requirements, reserve requirements, and deposit insurance premiums on FI profitability. Loan sales involve splitting up larger loans and loan portfolios, where as loan securitization involves the grouping of smaller loans into larger pools. While loan sales have been in existence for many years, the use of loan sales (by removing existing loans from the balance sheet) is increasingly being recognized as a valuable tool in an FI manager’s portfolio of credit risk management techniques. In Chapter 1, we discussed the role of FIs as both asset transformers and asset brokers. By increasingly relying on loan sales and securitization, FIs such as depository institutions have begun moving away from being strictly asset transformers that originate and hold assets to maturity toward becoming more reliant on servicing and other fees. This makes depository institutions look increasingly similar to securities firms and investment banks in terms of the enhanced importance of asset brokerage over asset transformation functions. In Chapter 7, we discussed the basics of asset sales and securitization and the markets in which these securities trade. This chapter investigates the role of loan sales and
Loan Securitization Pass-Through Security Collateralized Mortgage Obligation Mortgage-Backed Bond Securitization of Other Assets Can All Assets Be Securitized?
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TABLE 24–1 Basic Description of Loan Sales and Other Forms of Mortgage Securitization
Loan Sale—an FI originates a loan and subsequently sells it. Pass-Through Securities—mortgages or other assets originated by an FI are pooled and investors are offered an interest in the pool in the form of pass-through certificates or securities. Examples of pass-through securities are Government National Mortgage Association (GNMA) or Federal National Mortgage Association (FNMA) securities. Collateralized Mortgage Obligations (CMOs)—similar to pass-throughs, CMOs are securities backed by pools of mortgages or other assets originated by an FI. Pass-throughs give investors common rights in terms of risks and returns, but CMOs assign varying combinations of risk and return to different groups of investors in the CMO by repackaging the pool. Mortgage-Backed Bonds (MBBs)—a bond issue backed by a group of mortgages on an FI’s balance sheet. With MBBs, the mortgages remain on the FI’s balance sheet, and funds used to pay the MBB holders’ coupons and principal repayments may or may not come from the collateralized mortgages.
other forms of asset securitization in improving the return–risk trade-off for FIs. It describes the process associated with loan sales and the major forms, or vehicles, of asset securitization and analyzes their unique characteristics. Table 24–1 presents a definition of the loan sale and securitization mechanisms that this chapter discusses.
loan sales and securitization The packaging and selling of loans and other assets backed by securities issued by an FI.
correspondent banking A relationship between a small bank and a large bank in which the large bank provides a number of deposit, lending, and other services.
highly leveraged transaction (HLT) loan A loan that finances a merger and acquisition; a leveraged buyout results in a high leverage ratio for the borrower.
LOAN SALES FIs have sold loans among themselves for more than 100 years. In fact, a large part of correspondent banking involves small FIs making loans that are too big for them to hold on their balance sheets—either for lending concentration risk or capital adequacy reasons— and selling (or syndicating) parts of these loans to large FIs with whom they have had a long-term deposit-lending correspondent relationship. In turn, the large banks often sell (or syndicate) parts of their loans called participations to smaller FIs. The syndicated loan market—that is, the market for buying and selling loans once they have been originated— can be segmented into three categories: market makers, active traders, and occasional sellers/ investors. Market makers are generally the large commercial banks (e.g., J.P. Morgan Chase) and investment banks (e.g., Morgan Stanley), which commit capital to create liquidity and take outright positions in the markets. Institutions that actively engage in primary loan origination have an advantage in trading on the secondary market, mainly because of their acquired skill in accessing and understanding loan documentation. Active traders are mainly investment banks, commercial banks, and vulture funds (see below). Other financial institutions such as insurance companies also trade but to a lesser extent. Occasional participants are either sellers of loans (who seek to remove loans from their balance sheets to meet regulatory constraints or to manage their exposures) or buyers of loans (who seek exposure to sectors or countries, especially when they do not have the critical size to do so in the primary loan markets).1 Even though this market has existed for many years, it grew slowly until the early 1980s when it entered a period of spectacular growth, largely due to expansion in highly leveraged transaction (HLT) loans to finance leveraged buyouts (LBOs) and mergers and
1. See E. I. Altman, A. Gande, and A. Saunders, “International Efficiency of Loans versus Bonds: Evidence from Secondary Market Prices,” New York University Working Paper, 2004.
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Chapter 24 Managing Risk with Loan Sales and Securitization
FIGURE 24–1
Recent Trends in the Loan Sales Market
160 140 Distressed Purchases Volume ($ billions)
120 Par Purchases 100 80 60 40 20 1-3Q04
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
0
Source: Loan Pricing Corporation Web site, April 2005. www.loanpricing.com
loan sale Sale of loan originated by a bank with or without recourse to an outside buyer.
recourse The ability of a loan buyer to sell the loan back to the originator should it go bad.
acquisitions (M&As). Specifically, the volume of loans sold by U.S. banks increased from less than $20 billion in 1980 to $285 billion in 1989. In the early 1990s, the volume of loan sales declined almost as dramatically, along with the decline in LBO and M&A activity. In 1991, the volume of loan sales had fallen to approximately $10 billion. In the late 1990s, the volume of loan sales expanded again, partly due to an expanding economy and a resurgency in M&As.2 For example the loan market research firm Loan Pricing Corporation reported secondary trading volume in 1999 was more than $79 billion. Loan sales continued to grow to almost $120 billion in the early 2000s as FIs sold distressed loans (loans trading below 90 cents on the dollar). Triggered by an economic slowdown, distressed loan sales jumped from 11 percent of total loan sales in 1999 to 36 percent in 2001, and 42 percent in 2002. As the U.S. economy improved in the first decade of the 2000s, the percentage of distressed loan sales fell. In the first three quarters of 2004 distressed loans were just 28 percent of total loan sales. Figure 24–1 shows recent trends in the loan sales market. A loan sale occurs when an FI originates a loan and sells it with or without recourse to an outside buyer. If the loan is sold without recourse, the FI not only removes it from its balance sheet (purchasing new investments with the freed-up funds) but also has no explicit liability if the loan eventually goes bad. The loan buyer (not the FI that originated the loan) bears all the credit risk. If, however, the loan is sold with recourse, under certain conditions the buyer can put the loan back to the selling FI; therefore, the FI retains a contingent (credit risk) liability. As an example, Green Point Financial Corp. issued in excess of $19.4 billion in mortgage loans in the first half of 2004. Over the same period, Green Point had sold over $14.6 billion of these loans to secondary market investors and recorded revenues of $295 million for the period from its mortgage division. In practice, most loan sales are without recourse because a loan sale is technically removed from the balance sheet only when the buyer has no future credit risk claim on the FI. Loan sales usually involve no creation of new types of securities, such as those described later in the chapter when we consider the securitization activities of FIs.
2. Also, the composition of loan sales is changing, with increasing amounts of commercial real estate loans being sold.
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SEARCH THE SITE Go to the Loan Pricing Corporation Web site at www.loanpricing.com and find the most recent information on secondary loan market trading volume and lead secondary loan market arrangers. To get the lead arrangers, under LPC League Tables, click on “XQ0X U.S. Lead Arranger.” Questions
1. How has the dollar volume of secondary market loan market trading changed since 2004 reported in Figure 24–1? 2. What is the percentage of distressed versus par secondary loan market volume? 3. Who are the lead arrangers of secondary loan market trading and what percentage of the total market does each entail?
Types of Loan Sales Contracts The two basic types of loan sales contracts are participations and assignments. Currently, assignments represent the bulk of loan sales.
participation in a loan
Participations. The unique characteristics of participations in loans are:
The act of buying a share in a loan syndication with limited contractual control and rights over the borrower.
• •
The holder (buyer) is not a party to the underlying (primary) credit agreement, so that the initial contract between loan seller (which may be a syndicate of FIs) and borrower remains in place after the sale. The loan buyer can exercise only partial control over changes in the loan contract’s terms. The holder can vote on only material changes to the loan contract, such as the interest rate or collateral backing.
The economic implication of these characteristics is that the buyer of the loan participation has a double risk exposure—to the borrower as well as to the original lender (or lenders). Specifically, if the selling FI fails, the loan participation bought by an outside party may be characterized as an unsecured obligation of the FI rather than a true sale. Alternatively, the borrowers’ claims against a failed selling FI may be netted against its loans, reducing the amount of loans outstanding and adversely impacting the buyer of a participation in those loans. As a result of these exposures, the buyer bears a double monitoring cost as well.
assignment The purchase of a share in a loan syndication with some contractual control and rights over the borrower.
Assignments. Because of the monitoring costs and the risks involved in participations, loans are sold on an assignment basis in more than 90 percent of the cases on the U.S. domestic market. The key features of an assignment are:
• •
All ownership rights are transferred on sale, meaning that the loan buyer holds a direct claim on the borrower. U.S. domestic loans are normally transferred with a Uniform Commercial Code filing, meaning there is documentation of a change of ownership in which the buyer has first claim on the borrower’s assets in the event of bankruptcy.
Although ownership rights are generally much clearer in a loan sale by assignment, contractual terms frequently limit the seller’s (e.g., an FI’s) scope regarding to whom the loan can be sold. A loan sale by assignment means the borrower (e.g., IBM) must negotiate any changes on the loan with an FI it may have had no prior relationship with or knowledge of. To protect the borrower (IBM), the original loan contract may require either the FI agent
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or the borrower (IBM) to agree to the sale.3 The loan contract may also restrict the sale to a certain class of institutions, such as those that meet certain net worth/net asset size conditions (say, Allstate Insurance Company). Currently, the trend appears to be toward originating loan contracts with very limited assignment restrictions. This is true in both the U.S. domestic and less developed country (LDC) loan sales markets. The most tradable loans are those that can be assigned without buyer restrictions. In evaluating ownership rights, the buyer of the loan (Allstate) also needs to verify the original loan contract and to establish the full implications of the purchase regarding the buyer’s (Allstate’s) rights to collateral if the borrower (IBM) defaults. Because of these contractual problems, trading frictions, and costs, some loan sales take as long as three months to complete, although for most loan sales the developing market standard is that loan sales should be completed within 10 days.
The Loan Sale Market LDC loan Loans made to a less developed country (LDC).
The U.S. loan sale market has three segments; two involve sales and trading of domestic loans, and the third involves sales of LDC (less developed country) loans (loans that have been made to certain Asian, African, and Latin American countries).
2
Traditional Short-Term Segment. In the traditional short-term segment of the market, FIs sell loans with short maturities, often one to three months. This market has characteristics similar to that of the market for commercial paper (see Chapter 5) in that loan sales have similar maturities and issue sizes. Loan sales, however, usually have yields that are 1 to 10 basis points above those of commercial paper of a similar rating and, unlike commercial paper, are secured by the assets of the borrowing firm. The key characteristics of the loans bought and sold in the short-term loan sale market are similar to those of commercial paper. That is:
• • • • •
The loans are secured by assets of the borrowing firm or other external guarantors. They have been made to investment-grade borrowers or better. They are issued for a short term (90 days or less). They are sold in units of $1 million and up. Loan rates are closely tied to the commercial paper rate.
Traditional short-term loan sales dominated the market until 1984 and the emergence of the HLT and LDC loan markets. The growth of the commercial paper market (see Chapter 5) has also reduced the importance of this market segment.
www.loanpricing.com
HLT Loan Sales. With the increase in M&As and LBOs financed via HLTs, especially from 1985 to 1989, a new segment in the loan sales market, HLT loan sales or highly leveraged loan market, appeared.4 One measure of the increase in HLTs is that between January 1987 and September 1994, the loan market research firm Loan Pricing Corporation reported 4,122 M&A deals with a combined dollar amount in new-issue HLT loans estimated at $593.5 billion. HLT loans mainly differ according to whether they are nondistressed (bid price exceeds 90 cents per $1 of loans) or distressed (bid price is less than 90 cents per $1 of loans or the borrower is in default). Virtually all HLT loans have the following characteristics:
• • • •
They are secured by assets of the borrowing firm (usually given senior security status). They have long maturity (often three- to six-year maturities). They have floating rates tied to the London Interbank Offered Rate (LIBOR), the prime rate, or a CD rate (HLT rates are normally 200–275 basis points above these rates). They have strong covenant protection.
3. An FI agent is an FI that distributes interest and principal payments to lenders in loan syndications with multiple lenders. 4. What constitutes an HLT loan has often caused dispute. In October 1989, however, the three U.S. federal bank regulators adopted a definition of an HLT as a loan that (1) involves a buyout, acquisition, or recapitalization and (2) either doubles the company’s liabilities and results in a leverage ratio higher than 50 percent, results in a leverage ratio higher than 75 percent, or is designated as an HLT by a syndication agent.
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financial distress The state when a borrower is unable to meet a payment obligation to lenders and other creditors.
vulture fund A specialized fund that invests in distressed loans.
Part 5 Risk Management in Financial Institutions
Nevertheless, HLTs tend to be quite heterogeneous with respect to the size of the issue, the interest payment date, interest indexing, and prepayment features. After origination, some HLT borrowers such as Macy’s and El Paso Electric suffered periods of financial distress5 in that they were unable to make timely payments on many of the bonds they had issued and loans they had outstanding. As a result, a distinction between the market for distressed and nondistressed HLTs is usually made. The Buyers. Of the wide array of potential buyers, some are interested in only a certain segment of the market for regulatory and strategic reasons. In particular, an increasingly specialized group of buyers of distressed HLT loans includes investment banks and vulture funds. For the nondistressed HLT market and the traditional U.S. domestic loan sales market, the five major buyers are other domestic banks, foreign banks, insurance companies and pension funds, closed-end bank loan mutual funds, and nonfinancial corporations. Investment Banks. Investment banks are predominantly buyers of HLT loans because (1) analysis of these loans6 utilizes investment skills similar to those required for junk bond trading and (2) investment banks are often closely associated with the HLT borrower in underwriting the original junk bond/HLT deals. As such, large investment banks—for example, Merrill Lynch and Goldman Sachs—are relatively more informed agents in this market, either by acting as market makers or in taking short-term positions on movements in the market prices of these loans. Vulture Funds. Vulture funds are specialized investment funds established to invest in distressed loans, often with an agenda that does not include helping the distressed firm survive. These investments can be active, especially for those seeking to use the loans purchased for bargaining in a restructuring deal, which generates restructuring returns that strongly favor the loan purchaser. Alternatively, such loans may be held as passive investments or high-yield securities in a well-diversified portfolio of distressed securities. Investment banks, in fact, manage many vulture funds. Most secondary market trading in U.S. loan sales occurs in this segment of the market. The common perception of vulture funds is that after picking up distressed loans at a discount, they force firms to restructure or are quick to realize the break-up value of the firm— for example, turning a 50 cent on the dollar investment into a 70 cent on the dollar investment (i.e., 20 cents on the dollar profit). Thus, a vulture fund’s reputation is often not a congenial one. A possible reason for this adverse reputation is that while banks are looking for a return of loan principal in a restructuring, vulture funds are looking for a return on capital invested. That is, vulture funds are transaction driven, not relationship based. Unlike banks, vulture funds are rarely interested in making decisions based on developing and maintaining longterm relationships with the corporation in question. Nevertheless, they provide an exit strategy for investors and creditors, and they enable assets to be liquidated in an orderly manner. Other Domestic Banks. Interbank loan sales are at the core of the traditional market and historically have revolved around correspondent banking and regional banking/branching restrictions. Restrictions on nationwide banking in the past led banks to originate regionally undiversified and borrower-undiversified loan portfolios. Small banks often sold loan participations to their large correspondents to improve regional/borrower diversification and to avoid regulatory imposed single-borrower loan concentration ceilings. (A loan to a single borrower should not exceed 10 percent of a bank’s capital.) This arrangement also worked in the other direction, with the larger banks selling participations to smaller banks. The traditional interbank market, however, has been shrinking as a result of three factors. First, the traditional correspondent banking relationship is breaking down as markets 5. Thus, an HLT may be distressed or nondistressed. 6. Junk bonds are noninvestment-grade bonds (i.e., those issued with a credit rating of BB or below by Standard & Poor’s or Bal or below by Moody’s)—see Chapter 6.
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become more competitive. Second, concerns about counterparty risk and moral hazard have increased. In particular, moral hazard is the risk that the selling bank will seek to offload its “bad” loans (via loan sales) keeping the “good” loans in its portfolio. An extreme example of this is Penn Square, a small Texas bank, which sold many risky (energy-based) loans to its larger correspondent bank, Continental Illinois, in the early 1980s. Not only did Penn Square fail, but in 1984 Continental Illinois, then the eighth largest bank in the United States, also failed as a result of losses on these loans. Third, the barriers to nationwide banking are being eroded, particularly following the full implementation of interstate banking in 1997 (after the passage of the Riegle-Neal Interstate Banking and Branching Efficiency Act in 1994) and the (continuing) contraction in the number of small banks (see Chapter 13).
downsizing Shrinking an FI’s asset size.
Foreign Banks. Foreign banks remain the dominant buyer of domestic U.S. loans. Because of the cost of branching, the loan sales market allows foreign banks to achieve a well-diversified domestic U.S. loan portfolio without developing a nationwide banking network. However, renewed interest in asset downsizing, especially among Japanese banks, has caused this source of demand to contract. Insurance Companies and Pension Funds. Subject to meeting liquidity and credit quality restrictions (such as buying only BBB-rated borrowers or above), insurance companies (such as Aetna) and pension funds are important buyers of long-term loans. Closed-End Bank Loan Mutual Funds. First established in 1988, these leveraged mutual funds, such as Merrill Lynch Prime Fund, invest in domestic U.S. bank loans. Although they could purchase loans in the loan sales market, the largest funds have moved into primary loan syndications as well because of the attractive fee income available. These mutual funds increasingly participate in funding loans originated by commercial banks. Indeed, some money center banks, such as J.P. Morgan Chase, have actively encouraged closedend fund participation in primary loan syndications. Nonfinancial Corporations. Some corporations—primarily the financial services arms of the very largest U.S. and European companies (e.g., GE Capital and ITT Finance)—buy loans. This activity amounts to no more than 5 percent of total U.S. domestic loan sales. The Sellers. The sellers of domestic loans and HLT loans are major money center banks, small regional or community banks, foreign banks, and investment banks. Major Money Center Banks. The largest money center banks have dominated loan selling. In recent years, market concentration in loan selling has been accentuated by the increase in HLTs (and the important role that major money center banks have played in originating loans in HLT deals) as well as growth in real estate loan sales. Small Regional or Community Banks. As mentioned earlier, small banks sell loans and loan participations to larger FIs for diversification and regulatory purposes. Although they are not a major player in the loan sales market, small banks have found loan sales to be essential for diversifying their credit risk. Foreign Banks. To the extent that foreign banks are sellers rather than buyers of loans, these loans come from branch networks such as the Japanese-owned banks in California or through selling loans originated in their home country in U.S. loan sales markets. Investment Banks. Investment banks such as Salomon Smith Barney (a subsidiary of Citigroup) act as loan sellers either as part of their loan origination activities—since the passage of the Financial Services Modernization Act in 1999—or as active traders in the market. Again, these loan sales are generally confined to large HLT transactions.
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Secondary Market for Less Developed Country Debt Since the mid-1980s, a secondary market for trading less developed country (LDC) debt has developed among large commercial and investment banks in New York and London. The volume of trading grew dramatically from around $2 billion per year in 1984 to almost $6 trillion in 1997 (trading in Brazilian debt alone accounted for $1.44 trillion). Trading declined to $4.2 billion in 1998 after the Russian debt defaults and again in 1999 after Ecuador’s failure to pay interest on its Brady bonds (see below). The early 2000s were characterized by increasing trading activity and growing investor confidence in emerging market debt, sparked in large part by Brazil’s rapid economic recovery, Mexico’s upgraded credit rating to investment grade, and Russia’s successful debt restructuring. Like domestic loan sales, the removal of LDC loans from the balance sheet allows an FI to free up assets for other investments. Further, being able to sell these loans—even if at a price below the face value of the original loan—may signify that the FI’s balance sheet is sufficiently strong to bear the loss. In fact, a number of studies have found that announcements of FIs writing down the value of LDC loans—prior to their charge-off and sale—has a positive effect on FI stock prices. The major cost of LDC loan sales is the loss itself (the tax-adjusted difference between the face value of the loan and its market value at the time of the sale). In addition, many FIs engaged in LDC loan sales in 1987 and 1988 after taking big loan-loss reserve additions in May and June 1987. Beginning in 1988, and in particular in the period 1991–1993, the secondary market loan prices of many LDC countries rose in value. However, an economic crisis in southeast Asia, South America, and Russia in the late 1990s sent prices back down. This suggests an additional cost related to loan sales—the optimal timing of such sales (the point when FIs can minimize losses from such sales). Trading in LDC loans often takes place in the high-yield (or junk bond) departments of participating FIs. These reflect programs in the early to mid-1990s under which U.S. and other FIs exchanged their dollar loans for dollar bonds issued by the relevant countries. These bonds have a much longer maturity than that promised on the original loans and a lower promised original coupon (yield) than the interest rate on the original loan. These loans-for-bond restructuring programs, also called debt-for-debt swaps, were developed under the auspices of the U.S. Treasury’s Brady Plan and other international organizations such as the IMF. Once FIs swapped loans for bonds, they could sell them in the secondary market. By converting loans into Brady bonds (a bond that is swapped for an outstanding loan to an LDC—see Chapter 6), an FI’s ownership of an LDC’s assets becomes more liquid7 because these bonds were usually partially collateralized (backed) by U.S. governments securities such as U.S. Treasury bonds. These bond-for-loan swap programs sought to restore LDCs’ creditworthiness and thus the value of FI holdings of such debt by creating longer-term, lower fixed-interest but more liquid securities in place of shorter-term, floating-rate loans. In recent years, many of the more successful emerging market LDCs have repurchased collateralized Brady bonds and replaced them with dollar bonds with no explicit collateral backing—as a result, the price of these bonds reflects the creditworthiness of the issuing country and spreads over U.S. Treasury bonds, for countries like Argentina and Brazil, have often risen to well over 15 and 23 percent, respectively.
Brady bond A bond that is swapped for an outstanding loan to an LDC.
Factors Encouraging Future Loan Sales Growth
3
The introduction to this chapter stated that one reason that FIs sell loans is to manage their credit risk better. Loan sales remove assets (and credit risk) from the balance 7. A Brady bond is usually created on an interest rate rollover date. On that date, floating-rate loans are usually converted into fixed-rate coupon bonds on the books of an agent bank. The agent bank is the bank that keeps the records of loan ownership and distributed interest payments made by the LDC to individual bank creditors. Once converted, the bonds can start trading.
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Chapter 24 Managing Risk with Loan Sales and Securitization
D O Y O U U N D E R S TA N D ? 1. What the reasons are for the rapid growth and subsequent decline in loan sales over the last two decades? 2. Which loans should have the highest yields—loans sold with recourse or loans sold without recourse? 3. What the two basic types of loan sale contracts by which loans can be transferred between seller and buyer are? Describe each. 4. What institutions are the major buyers in the traditional U.S. domestic loan sales market? What institutions are the major sellers in this market? 5. What some of the economic and regulatory reasons are that FIs choose to sell loans? 6. What some of the factors are that will likely encourage loan sales growth in the future?
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sheet8 and allow an FI to achieve better asset diversification. Other than credit risk management, however, FIs are encouraged to sell loans for a number of other economic and regulatory reasons. Fee Income. An FI can often report any fee income earned from originating loans as current income, but interest earned on direct lending can be accrued (as income) only over time (see Chapter 12). As a result, originating and quickly selling loans can boost an FI’s reported income under current accounting rules. Liquidity Risk. In addition to credit risk, holding loans on the balance sheet can increase the overall illiquidity of an FI’s assets. This illiquidity is a problem because FI liabilities tend to be highly liquid. Asset illiquidity can expose the FI to harmful liquidity problems when depositors unexpectedly withdraw their deposits. To mitigate a liquidity problem, an FI’s management can sell some of its loans to outside investors (see Chapter 21). Thus, the FI loan market has created a secondary market that has significantly reduced the illiquidity of loans held as assets on the balance sheet. Capital Costs. The capital adequacy requirements imposed on FIs are a burden as long as required capital exceeds the amount the FI believes to be privately beneficial. Thus, FIs struggling to meet a required capital-to-assets (K/A) ratio can boost this ratio by reducing assets (A) rather than boosting capital (K)—see Chapter 13. One way to downsize or reduce A and boost the K/A ratio is through loan sales.
Reserve Requirements. Regulatory requirements, such as noninterest-bearing reserves that a bank must hold at the central bank, represent a form of tax that adds to the cost of funding the loan portfolio. Regulatory taxes such as reserve requirements create an incentive for banks to remove loans from the balance sheet by selling them without recourse to outside parties.9 Such removal allows banks to shrink both their assets and deposits and, thus, the amount of reserves they have to hold against their deposits.
7. What some of the factors are that will likely deter the growth of the loan sales market in the future?
Factors Deterring Future Loan Sales Growth
3
The loan sales market has experienced a number of up-and-down phases in recent years. Notwithstanding the value of loan sales as a credit risk management tool and other reasons described above, a number of factors may deter the market’s growth and development in the future. We discuss these next. Access to the Commercial Paper Market. Since 1987, large banks have enjoyed much greater powers to underwrite commercial paper directly, without experiencing legal challenges by the securities industry claiming that underwriting by banks is contrary to the Glass-Steagall Act. These underwriting powers were expanded in 1999 with the passage of the Financial Services Modernization Act, which eliminated Glass-Steagall restrictions on underwriting activities such as commercial paper underwriting (see Chapter 13). This means that the need to underwrite or sell short-term bank loans as an imperfect substitute for commercial paper underwriting has now become much less important. In addition, more and more smaller middle markets are gaining direct access to the commercial paper market. As a result, such firms have less need to rely on bank loans to finance their short-term expenditures, with fewer loan originations generally resulting in fewer loans being sold.
8. However, if FIs primarily sell high-quality loans, the average quality of the remaining loans may actually decrease. 9. Under current reserve requirement regulations (Regulation D, amended May 1986), bank loan sales with recourse are regarded as a liability and hence are subject to reserve requirements. The reservability of loan sales extends to a bank issuing a credit guarantee and a recourse provision. Loans sold without recourse (or credit guarantees by the selling bank) are free of reserve requirements. With the elimination of reserve requirements on nontransaction accounts and the lowering of reserve requirements on transaction accounts in 1991, the reserve tax effect is likely to become a less important feature driving bank loan sales (as well as the recourse/nonrecourse mix) in the future.
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Legal Concerns. A number of legal concerns are currently hampering the loan sale market’s growth, especially for distressed loans. In particular, although FIs are normally secured creditors, other creditors may attack this status through fraudulent conveyance proceedings if the borrowing firm enters bankruptcy. Fraudulent conveyance is any transfer of assets (such as a loan sale) at less than fair value made by a firm while it is insolvent. Fraudulent conveyance prevents an insolvent firm from giving away its assets or selling them at unreasonably low prices and thereby depriving its remaining creditors of fair treatment on liquidation or bankruptcy. For example, fraudulent conveyance proceedings have been brought against the secured lenders to firms such as Revco, Circle K, Allied Stores, and RJR Nabisco. In these cases, the sale of loans to a particular party were found to be illegal. As discussed above, contractual terms in loan contracts can limit the loan originator’s scope regarding to whom the loan can be sold. Fraudulent conveyance proceedings are challenges of loan sales as defined in the original loan contract. Such lawsuits represent one of the factors that have slowed the growth of the distressed loan market.
fraudulent conveyance A transaction such as a sale of securities or transference of assets to a particular party that is determined to be illegal.
LOAN SECURITIZATION
4 www.bondmarkets.com
Loan securitization is useful in improving the risk–return trade-off for FIs. This section discusses the three major forms of securitization—the pass-through security, collateralized mortgage obligation (CMO), and mortgage-backed bonds—and analyzes their unique characteristics. Although depository institutions mainly undertake loan securitization, the insurance industry has also entered into this area. In addition, although all three forms of securitization originated in the real estate lending market, these techniques are currently being applied to loans other than mortgages—for example, credit card loans, auto loans, student loans, and commercial and industrial (C&I) loans. The Bond Market Association, a bond industry trade group representing over 260 member and associate securities firms, banks, and government agencies, reported that over $2,131.9 billion of mortgage-backed securities were issued in 2003 and $1,019.1 billion were issued in 2004.
Pass-Through Security FIs frequently pool the mortgages and other loans they originate and offer investors an interest in the pool in the form of pass-through certificates or securities. Pass-through mortgage securities “pass through” promised payments by households of principal and interest on pools of mortgages created by financial institutions to secondary market investors (mortgage-backed security bond holders) holding an interest in these pools. We illustrate this process in Figure 24–2. After a financial institution accepts mortgages (step 1 in Figure 24–2),
FIGURE 24–2
Pass-Through Mortgage Security
Financial Institution
Households
Pass-Through Security Holders
Origination: Receive Funds for Mortgage
1
Pools Mortgages Sells Interest in Pool
2
Buy Pass-Through Securities
Servicing: Pay Principal and Interest
3
Passes Cash Flows (net of servicing fee) through from Mortgage Holder to Pass-through Holder
4 Receives Cash Flow
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Chapter 24 Managing Risk with Loan Sales and Securitization
www.ginniemae.gov www.fanniemae.com www.freddiemac.com
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it pools them and sells interests in these pools to pass-through security holders (step 2 in Figure 24–2). Each pass-through mortgage security represents a fractional ownership share in a mortgage pool. Thus, a 1 percent owner of a pass-through mortgage security issue is entitled to a 1 percent share of the principal and interest payments made over the life of the mortgages underlying the pool of securities. The originating financial institutions (e.g., bank or mortgage company) or a third-party servicer receives principal and interest payments from the mortgage holder (step 3 in Figure 24–2) and passes these payments (minus a servicing fee) through to the pass-through security holders (step 4). Although many different types of loans (and other assets) on FIs’ balance sheets are currently being securitized as pass-throughs, the original use of this type of securitization is a result of government-sponsored programs to enhance the liquidity of the residential mortgage market. These programs indirectly subsidize the growth of home ownership in the United States. We begin by analyzing the government-sponsored securitization of residential mortgage loans. Three government agencies or government-sponsored enterprises (introduced in Chapter 7) are directly involved in the creation of mortgage-backed passthrough securities. Informally, they are known as Ginnie Mae (GNMA), Fannie Mae (FNMA), and Freddie Mac (FHLMC). The Incentives and Mechanics of Pass-Through Security Creation. In beginning to analyze the securitization process, we trace the mechanics of a mortgage pool securitization to provide insights into the return–risk benefits of this process to the mortgageoriginating FI, as well as the attractiveness of these securities to investors. Given that more than $3.6 trillion of mortgage-backed securities are outstanding—a large proportion sponsored by GNMA—we analyze the creation of a GNMA pass-through security next.10 Suppose that an FI has just originated 1,000 new residential mortgages in its local area. The average size of each mortgage is $100,000. Thus, the total size of the new mortgage pool is: 1,000 $100,000 $100 million Each mortgage, because of its small size, receives credit risk insurance protection from the FHA. This insurance costs a small fee to the originating FI. In addition, each of these new mortgages has an initial stated maturity of 30 years and a mortgage rate—often called the mortgage coupon—of 9 percent per year. Suppose that the FI originating these loans relies mostly on liabilities such as demand deposits as well as its own capital or equity to finance its assets. Under current capital adequacy requirements, each $1 of new residential mortgage loans must be backed by some capital. Since residential mortgages fall into the 50 percent risk weight category under the risk-based capital standards and the risk-based capital requirement is 8 percent (see Chapter 13), the FI capital needed to back the $100 million mortgage portfolio is: Capital requirement $100 million .5 .08 $4 million We assume that the remaining $96 million needed to fund the mortgages comes from the issuance of demand deposits. Current regulations require that for every dollar of demand deposits held by the FI, a 10 percent cash reserve has to be held at the Federal Reserve Bank or in the vault (see Chapter 13). Assuming that the FI funds the cash reserves on the asset side of the balance sheet with demand deposits, the bank must issue $106.67 ($96/(1 .1)) in demand deposits (i.e., $96 to fund mortgages and $10.67 to fund the required cash reserves on these demand deposits). The reserve requirement on demand deposits is essentially an additional tax, over and above the capital requirement, on funding the FI’s residential mortgage portfolio. Note that since a 0 percent reserve requirement currently exists on CDs and time deposits, the FI needs to raise fewer funds if it uses CDs to fund its mortgage portfolio. Given these considerations, the FI’s initial postmortgage balance sheet may look like the one in Table 24–2. In addition to the capital and reserve requirement taxes, the FI also 10. At the end of the first quarter 2004, outstanding mortgage pools were $3.547 trillion, with GNMA pools amounting to $442.3 billion; FNMA, $1,895.8 billion; and FHLMC, $1,209.2 billion.
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TABLE 24–2 FI Balance Sheet (in millions of dollars) Assets
Liabilities
Cash reserves Long-term mortgages
$ 10.67 100.00
Demand deposits Capital
$110.67
$106.67 4.00 $110.67
must pay an annual insurance premium to the FDIC based on the size of its deposits (see Chapter 13). Assuming a deposit insurance premium of 27 basis points,11 the fee would be: $106.67 million .0027 $288,000 Although the FI is earning a 9 percent mortgage coupon on its mortgage portfolio, it is facing three levels of regulatory taxes: www.federalreserve.gov www.fdic.gov
1. Capital requirements 2. Reserve requirements 3. FDIC insurance premiums Thus, one incentive to securitize is to reduce the regulatory “tax” burden on the FI to increase its after-tax return. In addition to facing regulatory taxes on its residential mortgage portfolio earnings, the FI in Table 24–2 has two risk exposure problems: 1. Interest Rate Risk Exposure. The FI funds the 30-year mortgage portfolio from (shortterm) demand deposits; thus, it has a maturity mismatch (see Chapters 19 and 22). This is true even if the mortgage assets have been funded with short-term CDs, time deposits, or other purchased funds. 2. Liquidity Risk Exposure. The FI is holding an illiquid asset portfolio of long-term mortgages and no excess reserves; as a result, it is exposed to the type of potential liquidity problems discussed in Chapter 21, including the risk of having to conduct mortgage asset “fire sales” to meet large unexpected demand deposit withdrawals. One possible solution to these interest rate and liquidity risk problems is to lengthen the FI’s on-balance-sheet liabilities by issuing longer-term deposits or other liability claims such as medium-term notes. Another solution is to engage in interest rate swaps to transform the FI’s liabilities into those of a long-term, fixed-rate nature (see Chapter 23). These techniques, however, do not resolve the problem of regulatory taxes and the burden they impose on the FI’s returns. In contrast, creating GNMA pass-through securities can largely resolve the interest rate and liquidity risk problems on the one hand and reduce the burden of regulatory taxes on the other. This requires the FI to securitize the $100 million in residential mortgages by issuing GNMA pass-through securities. In our example, the FI can do this since each of the 1,000 underlying mortgages has FHA/VA mortgage insurance, the same stated mortgage maturity of 30 years, and coupons of 9 percent. Therefore, they are eligible for securitization under the GNMA program if the FI is an approved lender (which we assume it is—see Chapter 7). The steps followed in this securitization process are summarized in Figure 24–3. The FI begins the securitization process by packaging the $100 million in mortgage loans. The packaged mortgage loans are removed from the balance sheet by placing them with a third-party trustee off the balance sheet. This third-party trustee may be another FI of high
11. As of 2005, this was the fee charged to the lowest-quality banks.
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Chapter 24 Managing Risk with Loan Sales and Securitization
FIGURE 24–3
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Summary of a GNMA Pass-Through
FHA/VA/FMHA Mortgage Credit Insurance
1. FI Creates Mortgages on Balance Sheet
GNMA Timing Insurance of Cash Flow to Bond Holders
2. Trustee Places Mortgages in Trust Off Balance Sheet
5. Sale Proceeds (payments) for GNMA Bonds Go to the FI
3. GNMA Creates Bonds
4. Outside Investors (life insurance companies, pension funds) Purchase GNMA Bonds
creditworthiness or a legal trustee. Next, the FI determines that (1) GNMA will guarantee, for a fee, the timing of interest and principal payments on the bonds issued to back the mortgage pool and (2) the FI itself will continue to service the pool of mortgages for a fee, even after they are placed in trust. Then, GMNA issues pass-through securities backed by the underlying $100 million pool of mortgages. These GNMA securities or pass-through bonds are sold to outside investors in the capital market, and the proceeds (net of any underwriting fees) go to the originating FI.
full amortization The equal, periodic repayment on a loan that reflects part interest and part principal over the life of the loan.
Prepayment Risk on GNMA Pass-Throughs. Mortgage loan securitization reduces (or removes) the regulatory tax burden, interest rate risk exposure, and liquidity risk exposure that FIs face when they issue mortgages. It does, however, introduce a new risk— so-called prepayment risk—to the pass-through security holder. Following the sale, each mortgagee makes a payment every month to the FI. The FI aggregates these payments and passes the funds through to GNMA bond investors via the trustee net of servicing fee and insurance fee deductions. Most fixed-rate mortgages are fully amortized over the mortgage’s life. This means that so long as the mortgagee does not seek to prepay the mortgage early within the 30-year period, either to buy a new house or to refinance the mortgage should interest rates fall, bond holders can expect to receive a constant stream of payments each month analogous to the stream of income on fixed-coupon, fixed-income bonds. In reality, however, mortgagees do not act in such a predictable fashion. For a variety of reasons, they relocate or refinance their mortgages (especially when current mortgage rates are below mortgage coupon rates). This propensity to
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TABLE 24–3 The FI’s Balance Sheet Postsecuritization (in millions of dollars) Assets Cash reserves Cash proceeds from mortgage securitization
Liabilities $ 10.67 100.00 $110.67
prepay To pay back a loan before its maturity to the FI that originated the loan.
Demand deposits Capital
$106.67 4.00 $110.67
prepay means that realized coupons/cash flows on pass-through securities can often deviate substantially from the stated or expected coupon flows in a no-prepayment world (see below). This unique prepayment risk provides the attraction of pass-throughs to some (less risk-averse) GNMA pass-through investors but leads other more risk-averse investors to avoid these instruments. Collateralized mortgage obligations, discussed in the next section, provide a way to reduce this prepayment risk. Assuming that an FI incurs no fees or underwriting costs in the securitization process, its balance sheet might be similar to the one in Table 24–3 immediately after the securitization has taken place. A dramatic change in the FI’s balance sheet exposure has occurred. First, $100 million cash has replaced $100 million illiquid mortgage loans. Second, the maturity mismatch is reduced as long-term mortgages are replaced by cash (a short-term asset). Third, the FI has an enhanced ability to deal with and reduce its regulatory taxes. Specifically, it can reduce its capital, since capital standards require none be held against cash on the balance sheet compared to residential mortgages, which require 8 percent capital be held against 50 percent of the face value of the mortgage (i.e., on a $100,000 mortgage, an FI must hold $4,000 ($100,000 .5 .08) in capital—see Chapter 13). The FI also reduces its reserve requirement and deposit insurance premiums if it uses part of the cash proceeds from the GNMA sale to pay off or retire demand deposits and downsize its balance sheet. Of course, keeping an all- or highly liquid asset portfolio and/or downsizing is a way to reduce regulatory taxes, but these strategies are hardly likely to enhance an FI’s profits. The real logic of securitization is that the FI can use cash proceeds from the mortgage/GNMA sale to create or originate new mortgages, which in turn can be securitized. In so doing, the FI is acting more as an asset (mortgage) broker than a traditional asset transformer, as we discussed in Chapter 1. The advantage of being an asset broker is that the FI profits from mortgage pool servicing fees plus up-front points and fees from mortgage origination. At the same time, the FI no longer must bear the illiquidity and maturity mismatch risks and regulatory taxes that arise when it acts as an asset transformer and holds mortgages to maturity on its balance sheet. Put more simply, the FI’s profitability becomes more fee dependent than interest rate spread dependent. Prepayment Risk on Pass-Through Securities. As we discussed above, the cash flows on the pass-through directly reflect the interest and principal cash flows on the underlying mortgages minus service and insurance fees. However, over time, mortgage rates change. As coupon rates on new mortgages fall, there is an increased incentive for individuals in the pool to pay off old, high-cost mortgages and refinance at lower rates. However, refinancing involves transaction costs and recontracting costs. As a result, mortgage rates may have to fall by some amount below the current coupon rate before there is a significant increase in prepayment in the pool. This was particularly evident from the early 2000s to the middle of the first decade as new residential mortgage rates fell to their lowest levels in 30 years. Figure 24–4 plots the prepayment frequency of a pool of mortgages in relation to the spread between the current mortgage coupon rate (Y ) and the mortgage coupon rate (r)
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Chapter 24 Managing Risk with Loan Sales and Securitization
FIGURE 24–4
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The Prepayment Relationship
Prepayment Function
4% (Yr)
Prepayment Frequency
0
Prepayment and Other Fees
+2%
+4%
+ (Yr )
in the existing pool. Notice when the current mortgage rate (Y ) is above the rate in the pool (Y r), mortgage prepayments are small, reflecting monthly forced turnover as people have to relocate because of jobs, divorces, marriages, and other considerations. Even when the current mortgage rate falls below r, those remaining in the mortgage pool do not rush to prepay because up-front refinancing, contracting, and penalty costs are likely to outweigh any present value savings from lower mortgage rates. However, as current mortgage rates continue to fall, the propensity for mortgage holders to prepay increases significantly. Conceptually, mortgage holders have a very valuable call option on the mortgage when this option is in the money. That is, when current mortgage rates fall sufficiently lower so that the present value savings of refinancing outweigh the exercise price (the cost of prepayment penalties and other fees and costs), the mortgage will be called by the mortgage holder. Since the FI has sold the mortgage cash flows to GNMA investors and must by law pass through all payments received (minus servicing and guaranty fees), investors’ cash flows directly reflect the rate of prepayment. As a result, instead of receiving an equal monthly cash flow, PMT, as is done under a no-prepayment scenario, the actual cash flows (CF) received on these securities by investors fluctuate monthly with the rate of prepayments (see Figure 24–5). In a no-prepayment world, each month’s cash flows are the same: PMT1 PMT2 . . . PMT360. However, in a world with prepayments each month’s realized cash flows from the mortgage pool can differ. In Figure 24–5 we show a rising level of cash flows from month 2 onward peaking in month 60, reflecting the effects of early prepayments by some of the 1,000 mortgagees in the pool. This leaves less outstanding principal and interest to be paid in later years. For example, if 300 mortgagees fully prepay by month 60, only 700 mortgagees will remain in the pool at that date. The effect of prepayments is to lower dramatically the principal and interest cash flows received in the later months
FIGURE 24–5
The Effects of Prepayments on Pass-Through Bondholders’ Cash Flows
No Prepayments
Prepayments
PMT1 PMT2
CF1
CF2
PMT3
CF3
PMT59 PMT60
CF59
CF60
PMT359 PMT360
CF359
CF360
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of the pool’s life. For instance, in Figure 24–5, the cash flow received by GNMA bondholders in month 360 is very small relative to month 60 and even months 1 and 2. This reflects the decline in the pool’s outstanding principal. Thus, the pass-through security places on the investor in the mortgage pool a prepayment risk that reflects the uncertainty, in terms of timing, of the cash flows received from his or her investments in the bonds backed by the mortgage pool.
Collateralized Mortgage Obligation www.freddiemac.com
collateralized mortgage obligation (CMO) A mortgage-backed bond issued in multiple classes or tranches.
Although pass-throughs are still the primary mechanism for securitization, the collateralized mortgage obligation (CMO) is a second vehicle for securitizing FI assets that is used increasingly. Innovated in 1983 by FHLMC and Credit Suisse First Boston, the CMO is a device for making mortgage-backed securities more attractive to investors. The CMO does this by repackaging the cash flows from mortgages and pass-through securities in a different fashion to attract different types of investors with different degrees of aversion to “prepayment risk.” A pass-through security gives each investor a pro rata share of any promised and prepaid cash flows on a mortgage pool; the CMO is a multiclass pass-through with a number of different bond holder classes or tranches differentiated by the order in which each class is paid off. Unlike a pass-through, each bond holder class has a different guaranteed coupon just as a regular T-bond has, but more importantly, the allocation of early cash flows due to mortgage prepayments is such that at any one time, all prepayments go to retire the principal outstanding of only one class of bond holders at a time, leaving the other classes’ prepayment protected for a period of time. Thus, a CMO serves as a way to distribute or reduce prepayment risk. Creation of CMOs. CMOs can be created either by packaging and securitizing whole mortgage loans or, more usually, by placing existing pass-throughs in a trust off the balance sheet. The trust or third-party FI holds the GNMA pass-throughs as collateral against issues of new CMO securities. The trust issues these CMOs in three or more different classes. For example, the first CMO that Freddie Mac issued in 1983, secured by 20,000 conventional home mortgages worth $1 billion, had three classes: A, $215 million; B, $350 million; and C, $435 million. We show a three-class or tranche CMO in Figure 24–6. Class A CMO holders will be the least prepayment protected since after paying any guaranteed coupons to the three classes of bondholders, A, B, and C, all remaining cash flows from the mortgage pool have to be used to repurchase the principal outstanding of class A bond holders. Thus, these bonds have the shortest average life with a minimum of prepayment protection. They are, therefore, of great interest to investors seeking short-duration mortgage-backed assets to reduce the duration of their mortgage-related asset portfolios. In recent years depository institutions have been large buyers of CMO class A securities. After class A bonds have been retired, remaining cash flows (after coupon payments) are used to retire the bonds of class B. As a result, class B holders will have higher prepayment protection than class A and expected durations of five to seven years, depending on the level of interest rates. Pension funds and life insurance companies primarily purchase these bonds, although some depository institutions buy this bond class as well.
FIGURE 24–6
The Creation of a CMO
Mortgages Originated and Packaged by FI
GNMA Guarantees
GNMA Passthrough Bonds Issued by FI
GNMA Bonds Purchased by Investment Bank or Other FI
GNMA Bonds Placed in Trust as Collateral
A B C
CMO Created with Three Classes
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Class C holders will have the greatest prepayment protection. Because of their long expected duration, class C bonds are highly attractive to insurance companies and pension funds seeking long-term duration assets to match their long-term duration of liabilities. Indeed, because of their failures to offer prepayment protection, regular GNMA passthroughs may not be very attractive to these institutions. Class C CMOs, with their high but imperfect degree of prepayment protection, may be of greater interest to the managers of these institutions. EXAMPLE 24–1
Calculation of Payments to Three Classes of CMO Bond Holders
Suppose that an investment bank buys a $150 million issue of GNMAs and places them in trust as collateral. It then issues a CMO with the following three classes: Class A: Annual fixed coupon 7 percent, class size $50 million. Class B: Annual fixed coupon 8 percent, class size $50 million. Class C: Annual fixed coupon 9 percent, class size $50 million. Suppose that in month 1 the promised amortized cash flows (R) on the mortgages underlying the GNMA pass-through collateral are $1 million, but an additional $1.5 million cash flow results from early mortgage prepayments. Thus, in the first month, the cash flows available to pay promised coupons to the three classes of bond holders is: R Prepayments $1 million $1.5 million $2.5 million This cash flow is available to the trustee, who uses it in the following fashion: 1. Coupon Payments. Each month (or more commonly, each quarter or half-year), the trustee pays the guaranteed coupons to the three classes of bond holders at annualized coupon rates of 7 percent, 8 percent, and 9 percent, respectively. Given the stated principal of $50 million for each class, the class A (7 percent annual coupon) bond holders receive approximately $291,667 in coupon payments in month 1; the class B (8 percent annual coupon) receive approximately $333,333 in month 1; and the class C (9 percent annual coupon) receive approximately $375,000 in month 1. Thus, the total promised coupon payments to the three classes amounts to $1,000,000 (equal to R, the no-prepayment principal and interest cash flows in the GNMA pool). 2. Principal Payments. The trustee has $2.5 million available to pay as a result of promised mortgage payments plus early prepayments, but the total payment of coupon interest amounts to only $1 million. For legal and tax reasons, the remaining $1.5 million must be paid to the CMO bond holders. The unique feature of the CMO is that the trustee pays this remaining $1.5 million to class A bond holders only. This retires early some of these bond holders’ principal outstanding. At the end of month 1, only $48.5 million ($50 million $1.5 million) of class A bonds remains outstanding, compared to $50 million of class B and $50 million of class C. These payment flows are shown graphically in Figure 24–7. Suppose that in month 2 the promised amortized cash flows (R) on the mortgages underlying the GNMA pass-through collateral are $991,250, but again an additional $1.5 million cash flow results from early mortgage prepayments. Thus, in month 2, the cash flows available to pay promised coupons to the three classes of bondholders is: R Prepayments $991,250 $1.5 million $2,491,250 This cash flow is available to the trustee, who uses it in the following fashion: 1. Coupon Payments. The trustee pays the guaranteed coupons to the three classes of bond holders at annualized coupon rates of 7 percent, 8 percent, and 9 percent, respectively. Given the remaining principal of $48.5 million for class A (7 percent annual coupon) bonds, these bondholders receive approximately $282,917 in coupon payments
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FIGURE 24–7
Allocation of Cash Flows to Owners of CMO Classes
P = $1,500,000 C = $ 291,667 Households
$2.5 Million
FI
CMO Trustee
Class A
C = $333,333
C = $375,000 C = Coupon payment P = Principal payment
Class B
Class C
in month 2. The $50 million for class B bonds (8 percent annual coupon) again receive approximately $333,333 in month 2; and the $50 million for class C bonds (9 percent annual coupon) again receive approximately $375,000 in month 2. Thus, the total promised coupon payments to the three classes amounts to $991,250 (equal to R, the no-prepayment principal and interest cash flows in the GNMA pool). 2. Principal Payments. The trustee has $2,491,250 million available to pay as a result of promised mortgage payments plus early prepayments. Again, the remaining $1.5 million must be paid to the CMO bond holders. The unique feature of the CMO is that the trustee pays this remaining $1.5 million to class A bond holders only. This retires early some of these bond holders’ principal outstanding. At the end of month 2, only $47 million ($48.5 million $1.5 million) of class A bonds remains outstanding, compared to $50 million of class B and $50 million of class C. This continues until the full amount of the principal of class A bonds is paid off. Once this happens, any subsequent prepayments go to retire the principal outstanding to class B bond holders and, after they are paid off, to class C bond holders. Clearly, issuing CMOs is often equivalent to engaging in double securitization. An FI packages mortgages and issues a GNMA pass-through. An investment bank such as Goldman Sachs or another CMO issuer such as FHLMC, a commercial bank, or a savings bank may buy this entire issue or a large part of it. Goldman Sachs, for example, then places these GNMA securities as collateral with a trust and issues three new classes of bonds backed by the GNMA securities as collateral. (These trusts are sometimes called real estate mortgage investment conduits (REMICs)). As a result, the investors in each CMO class have a claim to the GNMA collateral should the issuer fail. The investment bank or other issuer creates the CMO to make a profit by repackaging the cash flows from the singleclass GNMA pass-through into cash flows more attractive to different groups of investors. The sum of the prices at which the three CMO bond classes can be sold normally exceeds that of the original pass-through: 3
a PiCMO PGNMA i1
Gains from repackaging come from the way CMOs restructure prepayment risk to make it more attractive to different classes of investors. Specifically, under a CMO, each class has a guaranteed or fixed coupon.12 By restructuring the GNMA as a CMO, an FI can offer investors who buy bond class C a high degree of mortgage prepayment protection compared to a pass-through; those who buy class B receive an average degree of 12. Coupons may be paid monthly, quarterly, or semiannually.
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Chapter 24 Managing Risk with Loan Sales and Securitization
FIGURE 24–8
673
Principal Balance Outstanding to Classes of Three-Class CMO
Principal Outstanding
M
Class A
X
Class B Y Class C Z 1.5 to 3 Years
5 to 7 Years
20 Years
N 30 Time Years
prepayment protection; those who buy class A have virtually no prepayment protection. Thus, CMOs redistribute prepayment risk among investors. Figure 24–8 illustrates the typical pattern of outstanding principal balances for a threetranche (class) CMO over time. With no prepayment, the outstanding principal balance is represented in Figure 24–8 by the curved line MN. Given any positive flow of prepayments, within a few years, the class A bonds clearly would be fully retired, point X in Figure 24–8. In practice, this often occurs between 1.5 and 3 years after issue. After the trustee retires class A, only classes B and C remain. As the months pass, the trustee uses any excess cash flows over and above the promised coupon payments to class B and C bond holders to retire bond class B’s principal. Eventually, all of the principal on class B bonds is retired (point Y in Figure 24–8)—in practice, five to seven years after CMO issue. After class B bonds are retired, all remaining cash flows are dedicated to paying the promised coupon of class C bond holders and retiring the full amount of principal on class C bonds (point Z in Figure 24–8). In practice, class C bonds can have an average life of as long as 20 years. CMOs can always have more than three classes described above. Indeed, issues of up to 17 different classes have been made. Clearly, the 17th-class bond holders would have an enormous degree of prepayment protection, since the first 16 classes would have had their bonds retired before the principal outstanding on this bond class would be affected by early prepayments. In addition, trustees have created other special types of classes as products to attract investor interest. Frequently, CMO issues contain a Z class as the last regular class. The Z implicitly stands for zero, but these are not really zero-coupon bonds. This class has a stated coupon such as 10 percent and accrues interest for the bond holder on a monthly basis at this rate. The trustee does not pay this interest, however, until all other classes of bonds are fully retired. When the other classes have been retired, the Z class bond holder receives the promised coupon and principal payments plus accrued interest payments. Thus, the Z class has characteristics of both a zero-coupon bond (no coupon payments for a long period) and a regular bond. Another type of CMO class that is partially protected from prepayment risk is a planned amortization class, or PAC class. A PAC is designed to produce constant cash flows within a range (or band) of prepayment rates. The greater predictability of the cash flows on these classes of bonds occurs because they must satisfy a principal repayment schedule, compared to other CMO classes in which principal repayment might or might not occur. PAC bondholders have priority over all other classes in the CMO issue in receiving principal payments from the underlying mortgages. Thus, the greater certainty of the cash flows for the PAC bonds comes at the expense of the non-PAC classes, called support
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FIGURE 24–9
IO/PO Strips
IO Class GNMA Pass-through
Trust PO Class
bonds, which absorb the prepayment risk. Just as sequential bonds were created to allow investors to specify maturity ranges for their investments, PACs can be divided sequentially to provide more narrow paydown structures. Although PAC bonds are somewhat protected from prepayment risk, they are not completely risk free. If prepayments are fast enough or slow enough, the cash flows of the PAC bonds will change.13 One drawback of CMOs is that originators may not be able to pass through all interest payments on a tax-free basis when they issue multiple debt securities. This creates a tax problem for various originators. A provision of the 1986 Tax Reform Act authorized the creation of a new type of mortgage-backed security called a REMIC (real estate mortgage investment conduit). A REMIC allows for the pass-through of all interest and principal payments before taxes are levied. Today, most CMOs are created as REMICs because of this tax advantage. As noted above, CMOs are attractive to secondary mortgage market investors because they can choose a particular CMO class that fits their maturity needs. While there is no guarantee that the CMO securities will actually mature in exact accordance with the horizon desired by the investor, the CMO significantly increases the probability of receiving cash flows over a specified horizon. For example, a third-class CMO holder knows that he or she will not be paid off until all first- and second-class holders are paid in full.
IO strips A CMO whose owner has a claim to the present value of interest payments by the mortgagees in the GNMA pool.
Mortgage Pass-Through Strips. The mortgage pass-through strip is a special type of CMO with only two classes of securities. The fully amortized nature of mortgages means that any given monthly payment contains an interest component and a principal component. Beginning in 1987, investment banks and other financial institution issuers stripped out the interest component from the principal component and sold each payment stream separately to different bond class investors. They sold an interest only (IO) class and a principal only (PO) class. We show this stripping of the cash flows in Figure 24–9. The owner of an IO strip has a claim to the interest payments made by the mortgage holder in the GNMA pool—that is, to the IO segments of each month’s cash flows received from the underlying mortgage pool. An IO strip has no par value. If interest rates decrease slightly, the value of an IO strip increases (e.g., its present value increases as interest rates decrease). However, an IO investor receives interest only on the amount of the principal outstanding. Thus, he or she hopes prepayments on the mortgage will not occur. If interest rates fall significantly, mortgage borrowers will prepay their mortgages (and refinance them at the lower rate). When prepayments occur, the amount of interest payments the IO investor receives falls as the outstanding principal in the mortgage pool falls. In absolute terms, the number of IO payments the investor receives is likely to shrink. For example, the investor might receive only 100 monthly IO payments instead of the expected 360 in a
13. The PAC band is the range of constant prepayment speeds defined by a minimum and maximum under which the scheduled payments will remain unchanged. The minimum and maximum prepayment speeds are stated in the contract governing the CMO. As long as the prepayment speed remains within this stated range, the PAC payments are known and guaranteed. If prepayment falls outside of the stated range, cash flows on the PAC can vary.
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FIGURE 24–10
Price-Yield Curves of IO/PO Strips
IO Strip
Pr
ate nt R ates in cou Dis t Dom ec Eff
ep ay Do men t mi na Effe tes ct
Prices/ Values
10% Coupon Rate
Yields
PO Strip Prices/ Values
PO Strip Value
10% Coupon Rate
Yields
no-prepayment world of a 30-year mortgage. The decrease in total payments reduces the value of the IO, counteracting the positive effect a decrease in interest rates has on the present value of the remaining payments on the IO. If prepayments are large, the IO investor may not recover his or her initial investment in the IO strip. Note the price-yield curve in Figure 24–10 for an IO strip on a pass-through bond with 10 percent mortgage coupon rates. If interest rates rise above 10 percent, mortgage prepayments will be relatively low. Thus, the discount effect of interest rates dominates the determination of price of the IO. However, one can expect that as interest rates fall below the mortgage coupon rate of the bonds in the pool, 10 percent, prepayments increase. Thus, the prepayment effect gradually dominates the discount effect, so that over some range the price or value of the IO bond falls as interest rates fall. This means that as current interest rates fall (rise), IO values or prices fall (rise). As a result the IO is a rare example of a negative duration asset that is very valuable as a portfolio-hedging device when included with regular bonds whose price-yield curves show the normal inverse relationship. That is, while as interest rates rise the value of the regular bond portfolio falls, the value of an IO
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FIGURE 24–11
Hedging with IOs
Prices/ Values IO Strip Value
Regular Bond/Mortgage Value
Yields
PO strip The mortgage principal components in each monthly payment by the mortgagee.
portfolio may rise. Note in Figure 24–10 that at rates above the pool’s mortgage coupon of 10 percent, the price-yield curve changes shape and tends to perform like any regular bond. In recent years, thrifts have been major purchasers of IOs to hedge the interest rate risk on the mortgages and other bonds held as assets in their portfolios. We depict the hedging power of IOs in Figure 24–11. The PO strip represents the mortgage principal components in each monthly payment by the mortgage holder. This includes both the scheduled monthly amortized principal component and any prepayments of principal by the mortgage holder. As with any security, as interest rates fall, the (present) value of the PO strip increases. In addition, if interest rates fall significantly, mortgage borrowers will prepay their mortgages. Consequently, the PO investor receives the fixed principal balance outstanding on the pool of mortgages earlier than expected. As illustrated in Figure 24–10, the faster prepayments occur (i.e., the lower interest rates fall), the faster the PO investor receives a return on his or her investment and the greater the value of the PO. Thus, the prepayment effect also works to increase the value of the PO strip. As a result, in contrast to the IO investor, the PO investor hopes for large and speedy prepayments. That is, as interest rates fall, both the discount rate and prepayment effects point to a rise in the value of the PO strip. The price–yield curve reflects an inverse relationship, but with a steeper slope than for normal bonds; that is, PO strip bond values are very interest rate sensitive, especially for yields below the stated mortgage coupon rate. We show this in Figure 24–10 for a 10 percent PO strip. (Note that a regular coupon bond is affected only by the interest rate effect.) As you can see, when yields fall below 10 percent, the market value or price of the PO strip can increase very fast. At rates above 10 percent, it tends to behave like a regular bond (as the incentive to prepay disappears). The IO/PO strip is a classic example of financial engineering. From a given GNMA pass-through bond, two new bonds have been created. Each class is attractive to different investors and investor segments. The IO is attractive to banks and thrifts as an on-balancesheet hedging vehicle—as interest rates increase, the gain in value on an IO can offset the loss in value from mortgages and other bonds in the bank or thrift’s asset portfolio (see Figure 24–11). The PO is attractive to those financial institutions that wish to increase the interest rate sensitivity in their portfolios in expectation of falling interest rates and to investors or traders who wish to take a speculative position regarding the future course of interest rates. Their high and complex interest sensitivity has resulted in major traders such as J.P. Morgan Chase and Merrill Lynch, as well as many investors such as hedge funds, suffering considerable losses on their investments in these instruments when interest rates move unexpectedly against them.
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Mortgage-Backed Bond mortgage- (asset-) backed bonds Bonds collateralized by a pool of assets.
As discussed in Chapter 7, mortgage- (asset-) backed bonds (MBBs) differ from passthroughs and CMOs in two key dimensions. First, while pass-throughs and CMOs help FIs remove mortgages from their balance sheets, MBBs normally remain on the balance sheet. Second, pass-throughs and CMOs have a direct link between the cash flows on the underlying mortgages and the cash flows on the bond instrument issued. By contrast, the relationship for MBBs is one of collateralization—the cash flows on the mortgages backing the bond are not necessarily directly connected to interest and principal payments on the MBB. An FI issues an MBB to reduce risk to the MBB holders, who have a first claim to a segment of the FI’s mortgage assets. The FI segregates a group of mortgage assets on its balance sheet and pledges this group of assets as collateral against the MBB issue. A trustee normally monitors the segregation of assets and ensures that the market value of the collateral exceeds the principal owed to MBB holders. That is, FIs back most MBB issues by excess collateral. This excess collateral backing of the bond, in addition to the priority rights of the bond holders, generally ensures the sale of these bonds with a high investment grade credit rating. In contrast, the FI, when evaluated as a whole, could be rated as BB or even lower. A high credit rating results in lower coupon payments than would be required if significant default risk had lowered the credit rating. To explain the potential benefits and the sources of any gains to an FI from issuing MBBs, we examine the following simple example.
EXAMPLE 24–2
Gains to an FI from Issuing MBBs
Consider an FI with $20 million in long-term mortgages as assets. It is financing these mortgages with $10 million in short-term uninsured deposits (e.g., wholesale deposits over $100,000) and $10 million in insured deposits (e.g., retail deposits of $100,000 or less). In this example, we ignore the issues of capital and reserve requirements. Look at the balance sheet structure shown in Table 24–4. This balance sheet poses problems for the FI manager. First, the FI has significant interest rate risk exposure due to the mismatch of the maturities of its assets and liabilities. Second, because of this interest rate risk and the potential default and prepayment risk on the FI’s mortgage assets, uninsured depositors are likely to require a positive and potentially significant risk premium to be paid on their deposits. By contrast, the insured depositors may require approximately the risk-free rate on their deposits because they are fully insured by the FDIC (see Chapter 21). To reduce its interest rate risk exposure and to lower its funding costs, the FI can segregate $12 million of the mortgages on the asset side of its balance sheet and pledge them as collateral backing a $10 million long-term MBB issue. Because the $10 million in MBBs is backed by mortgages worth $12 million, the mortgage-backed bond issued by the FI may cost less to issue, in terms of required yield, than uninsured deposit rates currently being paid—it may well be rated AA while uninsured deposits might be rated BB. The FI can then use the proceeds of the $10 million bond issue to replace the $10 million of uninsured deposits. Consider the FI’s balance sheet after the issue of the MBBs (Table 24–5). It might seem that the FI has miraculously engineered a restructuring of its balance sheet that has resulted in a better match of the maturities of its assets and liabilities and a decrease in funding costs. The bond issue has lengthened the average maturity of liabilities by replacing short-term wholesale deposits with long-term MBBs and has lowered funding costs because AA-rated bond coupon rates are below BB-rated uninsured deposit rates. This outcome, however, occurs only because the insured depositors do not worry about risk exposure since they are 100 percent insured by the FDIC. The result of the MBB issue and the segregation of $12 million of assets as collateral backing the $10 million bond issue is that the insured deposits of $10 million are now backed by only $8 million in free or unpledged assets. If smaller depositors were not insured by the FDIC, they would surely demand very high risk premiums for holding these risky deposits. The implication of this is that the FI
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TABLE 24–4 Balance Sheet of Potential MBB Issuer (in millions of dollars) Assets Long-term mortgages
Liabilities $20
Insured deposits Uninsured deposits
$20
$10 10 $20
TABLE 24–5 FI’s Balance Sheet after MBB Issue (in millions of dollars) Assets Collateral (maket value of segregated mortgages) Other mortgages
Liabilities $12 8
MBB issue Insured deposits
$20
$10 10 $20
gains only because the FDIC is willing to bear enhanced credit risk through its insurance guarantees to depositors.14 As a result, the FI is actually gaining at the expense of the FDIC. Consequently, it is not surprising that the FDIC is concerned about the growing use of this form of securitization by risky banks and thrifts.
D O Y O U U N D E R S TA N D ? 1. What the three forms of asset securitization are? What are the major differences in the three forms? 2. How a simple bank balance sheet would change when a pass-through mortgage is securitized? Assume the mortgage is funded with demand deposits and capital and reserve regulations are in force. 3. Why an investor in a securitized asset who is concerned about prepayment risk would prefer a CMO over a pass-through security? 4. Why an AAA-rated FI would ever issue mortgage-backed bonds? Explain your answer.
• • •
MBB issuance also has a number of costs. First, MBBs tie up mortgages on the FI’s balance sheet for a long time, thus decreasing the asset portfolio’s liquidity. Further, the balance sheet becomes more illiquid due to the need to collateralize MBBs to ensure a high-quality credit risk rating for the issue; in our example, the overcollateralization was $2 million. Second, the MBB issuer (the FI) is subject to any prepayment risk on the mortgages underlying the MBB. Third, the FI continues to be liable for capital adequacy and reserve requirement taxes by keeping the mortgages on the balance sheet. Because of these costs, MBBs are the least used of the three basic vehicles of securitization.
SECURITIZATION OF OTHER ASSETS The major use of the three securitization vehicles—pass-throughs, CMOs, and mortgage-backed bonds—has been to package fixed-rate residential mortgage assets. The standard features on mortgages have made the packaging and securitization of these securities relatively easy. But these techniques can and have been used for other assets, including the following:
• • •
Automobile loans. Credit card receivables (CARDs) Small-business loans guaranteed by the Small Business Administration Commercial and industrial loans Student loans Mobile home loans
14. The FDIC does not make the risk-based deposit insurance premium to banks and thrifts sufficiently large to reflect this risk.
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TABLE 24–6 Benefits versus Costs of Securitization Benefits
Costs
1. New funding source (bonds versus deposits). 2. Increased liquidity of bank loans. 3. Enhanced ability to manage the maturity gap and thus interest rate risk. 4. A savings to the issuer, if off balance sheet, on reserve requirements, deposit insurance premiums, and capital adequacy requirements.
1. Public/private credit risk insurance and guarantees. 2. Overcollateralization. 3. Valuation and packaging (the cost of asset heterogeneity).
• • •
Junk bonds Time share loans Adjustable rate mortgages15
CAN ALL ASSETS BE SECURITIZED? The extension of securitization technology to assets other than fixed-rate residential mortgages raises questions about the limits of securitization and whether all assets and loans can eventually be securitized. Conceptually, the answer is that they can, so long as doing so is profitable or the benefits to the FI from securitization outweigh its costs. With heterogeneous loans, it is important to standardize the D O Y O U U N D E R S TA N D ? salient features of loans. Default risks, if significant, have to be reduced by diversification. Expected maturities have to be reasonably similar. As mechanisms are 1. Whether or not all assets and developed to overcome these difficulties, it is perfectly reasonable to expect seculoans can be securitized? Explain your answer. ritization to grow. Table 24–6 summarizes the overall benefits versus the costs of securitization. From Table 24–6, given any set of benefits, the more costly and difficult it is to find asset packages of sufficient size and homogeneity, the more difficult and expensive it is to securitize. For example, C&I loans have maturities running from a few months to eight years; in addition, they have varying interest rate terms (fixed, LIBOR floating, federal funds-rate floating) and fees. In addition, C&I loans contain different contractual covenants (covering items such as dividend payments by firms) and are made to firms in a wide variety of industries. Given this, it is often difficult for investors, insurers, and bond rating agencies to value C&I loan pools.16 The more difficult it is to value such asset pools, the higher are the costs of securitization. The potential boundary to securitization may well be defined by the relative degree of homogeneity of an asset type or group—the more homogeneous or similar are the assets in any pool, the easier they are to securitize. Thus, it is not surprising that 30-year fixed-rate residential mortgages were the first assets to be securitized, since they are the most homogeneous of all assets on FI balance sheets (i.e., have similar maturities and interest rates). Moreover, the existence of secondary markets for houses provides price information that allows for reasonably accurate market valuations of the underlying asset to be made by originators, insurers, and investors in the event of mortgage defaults.
5
15. At the end of 2004, securitized automobile loans totaled $232.1 billion, credit card receivables totaled $390.7 billion, student loans totaled $115.2 billion, and mobile homes totaled $42.2 billion. 16. Despite this, there has been some securitization of C&I loans. These are called collateralized loan obligations (CLOs). A CLO is modeled on the CMO. An FI collects a diversified pool of loans, places them in a trust, and usually issues three tranches of securities against the pool: usually a senior tranche, a subordinated tranche, and a tranche that has features similar to the residual tranche of CMOs. Most issues so far have involved securitizing highly leveraged loans to finance mergers and acquisitions.
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SUMMARY Loan sales provide a simple alternative to the full securitization of loans through bond packages. In particular, they provide a valuable tool to an FI that wishes to manage its credit risk exposure better. Recently, by increasingly relying on securitization, banks and thrifts have begun to move away from being asset transformers to become asset brokers. Thus, over time, we can expect the traditional differences between commercial banking and investment banking to diminish as more and more loans and assets are securitized. This chapter discussed the increasing role of loan sales in addition to the legal and regulatory factors that are likely to affect the future growth of this market. The chapter also discussed three major forms of securitization—pass-through securities, collateralized mortgage obligations (CMOs), and mortgage-backed bonds—and described recent innovations in the securitization of other FI assets.
SEARCH THE SITE Go to the Bond Markets Association Web site at www.bondmarkets.com and find the most recent level of mortgage-backed securities using the following steps. Click on “MBS/ABS/CDO.” Click on “Statistical Data.” Under MBS/ABS, click on “Issuance of Agency Mortgage-Backed Securities” and “Asset Backed Securities Outstanding by Major Types of Credit.” The information on the most current levels of mortgage-backed securities is on these two pages.
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Questions
1. What is the total amount of agency mortgage-backed securities outstanding? Calculate the percentage of this amount issued by GNMA, FNMA, and FHLMC. 2. What is the total amount of asset-backed securities outstanding? Calculate the percentage of this amount backed by automobile loans, credit card loans, home equity loans, manufactured home loans, and student loans.
QUESTIONS 1. What is the difference between loans sold with recourse and without recourse from the perspective of both sellers and buyers? 2. What are some of the key features of short-term loan sales? How have banks used this sector of the loan market to circumvent Glass-Steagall limitations? 3. Why are yields higher on loan sales than they are for similar maturity and issue size commercial paper issues?
4. What is the difference between loan participations and loan assignments? 5. Why have FIs been very active in loan securitization issuance of pass-through securities while they have reduced their volume of loan sales? Under what circumstances would you expect loan sales to dominate loan securitization? 6. Who are the buyers and sellers of U.S. loans? Why do they participate in this activity?
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Chapter 24 Managing Risk with Loan Sales and Securitization
7. A bank has made a three-year $10 million dollar loan that pays annual interest of 8 percent. The principal is due at the end of the third year. a. The bank is willing to sell this loan with recourse at an 8.5 percent discount rate. What should it receive for this loan? b. The bank also has the option to sell this loan without recourse at a discount rate of 8.75 percent. What should it expect for selling this loan? c. If the bank expects a 1⁄2 percent probability of default on this loan over its three-year life, is it better off selling this loan with or without recourse? It expects to receive no interest payments or principal if the loan is defaulted. 8. City Bank has made a 10-year, $2 million HLT loan that pays annual interest of 10 percent per year. The principal is expected at maturity. a. What should it expect to receive from the sale of this loan if the current market rate on loans is 12 percent? b. The prices of loans of this risk are currently being quoted in the secondary market at bid-offer prices 88–89 cents (on each dollar). Translate these quotes into actual prices for the above loan. c. Do these prices reflect a distressed or nondistressed loan? Explain. 9. What role do reserve requirements play in the decision to sell a loan with or without recourse? 10. What are the three levels of regulatory taxes faced by FIs when making loans? How does securitization reduce the levels of taxation? 11. How will a move toward market value accounting affect the market for loan sales? 12. An FI is planning to issue $100 million in commercial loans. It will finance all of it by issuing demand deposits. a. What is the minimum capital required if there are no reserve requirements? b. What is the minimum demand deposits it needs to attract in order to fund this loan if you assume there is a 10 percent average reserve requirement on demand deposits, all reserves are held in the form of cash, and $8 million of funding is through equity? c. Show a simple balance sheet with total assets and total liabilities and equity if this is the only project funded by the bank.
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13. How do loan sales and securitization help an FI manage its interest rate and liquidity risk exposures? 14. What are the differences between CMOs and MBBs? 15. Consider $200 million of 30-year mortgages with a coupon of 10 percent paid quarterly. a. What is the quarterly mortgage payment? b. What are the interest repayments over the first year of life of the mortgages? What are the principal repayments? Construct a 30-year CMO using this mortgage pool as collateral. There are three tranches (where A offers the least protection against prepayment and C offers the most). A $50 million tranche A makes quarterly payments of 9 percent; a $100 million tranche B makes quarterly payments of 10 percent; and a $50 million tranche C makes quarterly payments of 11 percent. c. Assuming no amortization of principal and no prepayments, what are the total promised coupon payments to the three classes? What are the principal payments to each of the three classes for the first year? d. If, over the first year, the trustee receives quarterly prepayments of $10 million on the mortgage pool, how are the funds distributed? e. How can the CMO issuer earn a positive spread on the CMO? 16. Assume an FI originates a pool of short-term real estate loans worth $20 million with maturities of five years and paying interest rates of 9 percent (paid annually). a. What is the average payment received by the FI (both principal and interest) if no prepayment is expected over the life of the loans? b. If the loans are converted into real estate certificates and the FI charges a 50 basis points servicing fee (including insurance), what are the payments expected by the holders of the securities, if no prepayment is expected? 17. How do FIs use securitization to manage their interest rate, credit, and liquidity risks? 18. Why do buyers of class C tranches of collateralized mortgage obligations (CMOs) demand a lower return than do purchasers of class A tranches?
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