CHAPTER EIGHTAsset-Backed Securities, Loan Sales,

Credit Standbys, and Credit Derivatives: Important Risk

Management Tools for Banks and Competing Financial-Service Firms

The purpose of this chapter is to learn about some of the newer financial instruments that bankers and managers of their competitors have used in recent years to help reduce the risk exposure of their institutions and, in some cases, to aid in generating new sources of fee income and in raising new funds to make loans and investments.

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Securitization of Assets

The Pooling of a Group of Similar Loans and Issuing Securities Against the Pool Whose Return Depends on the Stream of Interest and Principal Payments Generated by the Loans

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Advantages of Securitization

Diversifies a Bank’s Credit Risk Exposure

Creates Liquid Assets Out of Illiquid Assets

Transforms These Assets into New Sources of Capital

Allows the Bank to Hold a More Geographically Diverse Loan Portfolio

Allows the Bank to Better Manage Interest Rate Risk

Allows the Bank to Generate Fee Income

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Problems with Securitization

May Not Reduce a Bank’s Capital RequirementsPrepayment RiskNot Available for All BanksMay Increase Competition for the Best Quality LoansMay Increase Competition for Deposits

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Types of Securitized Assets

Residential MortgagesHome Equity LoansAutomobile LoansCommercial MortgagesSmall Business Administration LoansMobile Home LoansCredit Card ReceivablesTruck LeasesComputer Leases

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Loan Sales

Marketing Loan Contracts Held by an Institution in Order to Raise New Cash

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Types of Loan Sales

Participation LoansWhere an Outside Party Purchases a Loan. They Generally Have No Influence Over the Loan Terms

AssignmentsOwnership of the Loan is Transferred to the Buyer of the Loan. The Buyer Has a Direct Claim Against the Borrower.

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Reasons Behind Loan Sales

Way to Rid the Bank of Low Yield Securities

Way to Increase Liquidity of Assets

Way to Eliminate Credit and Interest Rate Risk

Way to Generate Fee Income

Purchasing Bank can Diversify Loan Portfolio and Reduce Risk

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Loan Strip

Short-Dated Pieces of a Longer-Term Loan, Entitling the Purchaser to Fraction of the Expected Loan Income

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Servicing Rights

The Selling Bank Can Generate Fees for Agreeing to Keep Records, Collect Monies Owed and Help Enforce the Terms of a Group of Loan Contracts and Passing the Proceeds on to the Loan Buyers

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Risks In Loan Sales

Best Quality Loans are the Easiest to Sell Which May Increase Volatility of Earnings for the Bank Which Sells the Loans

Loan Purchased From Another Bank Can Turn Bad Just as Easily As One From Their Own Bank

Loan Sales are Cyclical

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Standby Letters of Credit (SLCs)

A Financial Instrument that Guarantees Performance or Insures Against Default in Return for Payment of a Fee. It is a Contingent Obligation

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Reasons for Growth of SLCs

Rapid Growth of Direct Financing Worldwide

Perception Among Banks and Their Customers that the Risk of Economic Fluctuations Has Increased

Opportunity SLCs Offer Banks to Use Their Credit Evaluation Skills to Earn Fee Income

The Relatively Low Cost of Issuing SLCs

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Structure of SLCs

Three Essential Elements:

Commitment From Issuer

An Account Party – For Whom the Letter is Issued

A Beneficiary – Investor Concerned About Funds Committed to Account Party

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Sources of Risk with SLCs

Default Risk of Issuing BankBeneficiary Must Meet All Conditions of Letter to Receive PaymentBankruptcy Laws Can Cause Problems for SLCsIssuer Faces Substantial Interest Rate and Liquidity Risks

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Regulatory Concerns About SLCs

Bank Examiners are Working to Keep Risk Exposure Under Control Leading to New Regulatory Rules:

Banks Must Apply the Same Credit Standards to SLCs as for Loans

Banks Must Count SLCs as Loans When Assessing Risk Exposure to a Single Customer

Banks Must Post Capital Behind Most SLCs

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Credit Derivatives

Financial Contracts Offering Protection to a Designated Beneficiary in Case of Loan Default

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Types of Credit Derivatives

Credit Swaps

Credit Options

Credit Default Swaps

Credit Linked Notes

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Risks of Credit Derivatives

Partners in Swap or Option Contract May Fail to Perform

Smaller Volume – Markets are Thinner and More Volatile

Legal Issues

Regulatory Concerns