McGraw-Hill/Irwin ©2008 The McGraw-Hill Companies, All Rights Reserved Chapter Nine Risk Management Using Asset-Backed Securities, Loan Sales, Credit Standbys, and Credit Derivatives

9-2 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Securitization of Loans 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

9-3 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Securitization Process Originator – Bank or Lender Who Makes the Loan Issuer – Special Purpose Entity That Issues the Securities Credit Rating Agency – Rates the Securities Security Underwriter or Investment Banker Helps Issue Securities Trustee – Makes Sure Issuer Fulfills All Their Obligations Servicer- Collects Payments on the Securitized Loans

9-4 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 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

9-5 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Problems with Securitization May Not Reduce a Bank’s Capital Requirements Prepayment Risk Not Available for All Banks May Increase Competition for the Best Quality Loans May Increase Competition for Deposits

9-6 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Promised Fees and Payments on Securitized Loans Coupon Rate Promised to Investors Who Buy Securities Default Rate on the Pooled Loans Fees to Compensate for Servicing Loans Fees Paid to Advise on Setting Up Securitization Process Fees Paid for Providing Liquidity Enhancement Residual Income For Security Seller, Trust or Credit Enhancer

9-7 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Types of Securitized Assets Residential Mortgages Home Equity Loans Automobile Loans Commercial Mortgages Small Business Administration Loans Mobile Home Loans Credit Card Receivables Truck Leases Computer Leases

9-8 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Regulator Concerns About Securitization Risk of Having to Come Up with Large Amounts of Liquidity Quickly to Make Payments To Investors Holding Securities Risk of Agreeing to Serve as Underwriter for Securities that Cannot be Sold Risk of Acting as Credit Enhancer and Underestimating Need for Loan Reserves Risk that Unqualified Trustees Will Fail to Protect Investors Risk of Loan Servicers Being Unable to Satisfactorily Monitor Loan Performance and Collect Monies Owed

9-9 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Loan Sales Selling Loan Contracts Held by an Institution in Order to Raise New Cash

9-10 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Types of Loan Sales Participation Loans –Where an Outside Party Purchases a Loan. They Generally Have No Influence Over the Loan Terms Assignments –Ownership of the Loan is Transferred to the Buyer of the Loan. The Buyer Has a Direct Claim Against the Borrower. Loan Strip –Short-Dated Pieces of Longer Term Loans

9-11 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 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

9-12 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 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

9-13 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 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

9-14 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Standby Letters of Credit (SLCs) Financial Instrument that Guarantees Performance or Insures Against Default in Return for Payment of a Fee. It is a Contingent Obligation –Performance Guarantees – Guarantees a Project Will be Completed On Time –Default Guarantees – Financial Institution Pledges Repayment of Defaulted Notes When Borrowers Cannot Pay

9-15 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Advantages of SLCs Letters of Credit Earn a Fee for Providing the Service They Aid a Customer Who Can Borrow More Cheaply When There is a Guarantee Such Guarantees Can be Issued at Relatively Low Cost Probability is Usually Low that an Issuer of SLC Will Ever Be Called On to Pay

9-16 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Reasons for Growth of SLCs Rapid Growth of Direct Financing Worldwide Risk of Economic Fluctuations has led to Demand for Risk-Reducing Devices Opportunity SLCs Offer Lenders to Use Their Credit Evaluation Skills to Earn Fee Income Without the Immediate Commitment of Funds The Relatively Low Cost of Issuing SLCs

9-17 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 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

9-18 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Sources of Risk with SLCs Default Risk of Issuing Bank Beneficiary Must Meet All Conditions of Letter to Receive Payment Bankruptcy Laws Can Cause Problems for SLCs Issuer Faces Substantial Interest Rate and Liquidity Risks

9-19 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Ways to Reduce Risk Exposure of SLCs Frequently Renegotiating the Terms of Any Loans Extended to Customers Diversifying SLCs Issued by Region and Industry Selling Participations in Standbys in Order to Share Risk

9-20 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 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

9-21 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Credit Derivatives Financial Contracts Offering Protection to a Designated Beneficiary in Case of Loan Default

9-22 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Types of Credit Derivatives Credit Swaps Credit Options Credit Default Swaps Credit Linked Notes Collateralized Debt Obligations

9-23 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Credit Swaps Two Lenders Agree to Swap a Portion of Their Customer’s Loan Payments Can Help Each Lender Further Spread Out Their Risk Variation is a Total Return Swap Where the Dealer Guarantees Parties a Specific Rate of Return

9-24 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Credit Options Guards Against Losses in Value of a Credit Asset or Helps Offset Higher Borrowing Costs Due to Changes in Credit Ratings of the Borrower

9-25 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Credit Default Swaps Aimed at Lenders Able to Handle Comparatively Limited Declines in Value But Who Want Insurance Against Serious Losses

9-26 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Credit Linked Notes Fuses Together a Normal Debt Instrument with a Credit Option Contract to Give Borrower Greater Payment Flexibility

9-27 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. Collateralized Debt Obligations Contain Pools of High-Yield Corporate Bonds, Stocks or Other Financial Instruments Contributed by Businesses Interested In Strengthening Their Balance Sheets and Raising New Funds. Notes of Varying Grades are Sold to Investors Seeing Income From Pooled Assets

9-28 McGraw-Hill/Irwin Bank Management and Financial Services, 7/e © 2008 The McGraw-Hill Companies, Inc., All Rights Reserved. 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