Loan Sales and Securitization

1
Loan Sales and Securitization

• Chapters 27 28

2
Credit Risk Management

• contractual mechanisms to control credit risks of
  lending
• requiring higher interest rate spreads and fees
  on loans to more risky borrowers
• restricting or rationing loans to more risky
  borrowers
• requiring enhanced security (collateral) for
  banks over assets of risky borrowers
• diversifying across different types of risky
  borrowers
• placing more restrictive covenants on risky
  borrowers actions

3
Loan Sales

• correspondent banking
• small banks often make loans that are too large
  for them to hold in full and then sell part to
  large bank
• HLT (highly leveraged transaction) loan
• loan made to finance LBOs and MAs
• Loan sales
• with recourse
• without recourse

4
Loan Sales

• types of loan sales
• traditional short term
• HLT loan sales
• types of loan sale contracts
• participations
• buyer is not party to underlying credit agreement
  so initial loan contract remains in place after
  sale
• buyer can only exercise partial control over
  changes in contract terms and can only vote on
  material changes to contract
• assignments
• all rights are transferred on sale (buyer had
  direct claim on borrower)
• transfer of loan has proof of change of ownership

5
Loan Sales

• buyers
• vulture funds
• specialized fund that invests in distressed loans
• investment banks
• other domestic banks
• foreign banks
• insurance companies and pension funds
• closed-end and open-end bank loan funds
• nonfinancial corporations
• sellers
• money center banks
• good bank-bad bank
• investment banks
• US government and agencies

6
Loan Sales

• reasons loans are sold
• manage credit risk
• reserve requirements
• fee income
• capital costs
• liquidity risk

7
Why do banks issue?

• Origins of CC ABS (contd)
• CEBA growth cap in 1987
• Restricted nonbank banks.
• Bank capital crunch of late 1980s
• Capital scarcity.
• all led to development of the ABS market.

8
Why do banks issue?

• Three main reasons
• Asset-liability matching
• Liquidity
• Capital deepening (arbitrage).

9
Securitization

• packaging and selling of loans and other assets
  backed by securities
• used to hedge interest rate gap exposures
• increase liquidity of asset portfolios
• provide source of fee income
• forms of securitization originated in real estate
  market but being applied to many other types of
  loans (credit card, auto, student, CI)

10
What do banks issue?

• Banks issue fixed income securities backed by
  various types of assets.
• When assets are sold by issuer, they become
  super-collateral owned by securities holders.

11
What do banks issue?

• Interest and principal payments on securities
  come from cash flows on assets owned by
  securities holders.
• Pass-through security all securities holders
  equal have equal claim to cash flows
• Asset-backed security different seniority
  classes of securities have sequential claims to
  cash flows.

12
Pass-Through Security

• FIs pool mortgages offer investors an interest
  in pool (pass-through security represents this
  interest)
• originally done to enhance liquidity of mortgage
  market and thus subsidize growth of home
  ownership
• GNMA
• FNMA
• FHLMC

13
Pass-Through Security

• bank originated 1,000 mortgages with average size
  of 100,000
• maturity of 30 years and coupon of 12
• bank uses capital and demand deposits to finance
  loans
• also must fund reserve requirement
• need to pay deposit insurance premium
• all these extra costs give banks incentive to
  securitize profitability is fee dependent not
  interest rate spread dependent

14
Pass-Through Securities
15
CMOs

• collateralized mortgage obligations 1983
• CFs from pool of mortgages are allocated to
  multiple classes with different priority claims
• sequential-pay classes
• planned amortization classes (PACs)

16
What do banks issue?

• Sequential claims form the waterfall.

Senior
Sub 1
Sub 2
17
What do banks issue?

• Banks issue fixed income securities backed by
  various types of assets.
• Since coupons on AAA are lowest, makes sense for
  banks to issue as much AAA as will be confirmed
  by ratings agencies.
• Lower quality loans will require lower AAA
  issuance.
• Different market conditions may require lower AAA
  issuance.

18
How do banks issue?

• Basic Method

Borrower
Loan Originator
Special Purpose Trust
Rating Agency
Credit Enhancer
Underwriter
Investors
19
Credit Enhancement

• What is credit enhancement?
• Why is it needed?
• Is it important where the credit enhancement
  comes from?
• outside credit enhancement
• inside credit enhancement

20
How do banks issue?

• How is credit enhancement achieved?

Recall, sequential claims form the waterfall.
Since probability of receiving principal and
interest payments is higher for the senior
securities, these may be rated more highly by
Moodys/SP/Fitch. The most subordinated class is
very risky and may require special placement in
order for the deal to sell.
AAA
A
BBB
CE
21
Example 1

• Suppose the mortgages in the pool have a 9
  interest rate and further suppose the CMO makes
  monthly payments. It could make quarterly or
  semiannual payments as well. The mortgage
  holders make their scheduled monthly payments, if
  there are defaults the pool organizer will make
  the scheduled payment

22
Example 1
23
Example 2

• IB buys a 150 million issue of GNMAs and places
  them in a trust as collateral. It then issues a
  CMO with the following 3 classes
• Class A annual fixed coupon 7, class size 50m
• Class B annual fixed coupon 8, class size 50m
• Class C annual fixed coupon 9, class size 50m

24
Mortgage-Backed Bond

• bonds collateralized by pools of assets
• different from pass-throughs and CMOs
• MBBs remain on balance sheet
• no direct link between CF on mortgages backing
  the bond and the interest and principal payments
  on the MBB
• FI takes pool of mortgages and pledges as
  collateral on bonds they then issue

25
Example 3

• Consider FI with 20m in long-term mortgages as
  assets. It is financing these with 10m in
  short-term uninsured deposits and 10m in insured
  deposits. (Ignore capital and reserve
  requirements.)

26
Example 3

• consider balance sheet after MBB issue

27
Mortgage Pass-Through Strips

• special type of CMO with two classes
• characteristic of mortgages is that they are
  fully amortizing
• part of monthly payment is principal and part is
  interest
• strips FI issuers strip out interest component
  from principal component and sell each payment
  stream to different class
• IO class attractive to DIs for on balance sheet
  hedging
• PO class attractive to FIs to increase interest
  rate sensitivity of portfolio also traders who
  want to take speculative position on future
  course of interest rates
• interest rate changes affects each class
  differently