Loan Sales and Other Credit Risk Management Techniques Chapter 27 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. K. R. Stanton

McGraw-Hill/Irwin 27-2 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Overview This chapter discusses the growing role of loan sales and other techniques that can be used to address the control of credit risk in FIs. The use of loan sales is not new and may even involve foreign loans. With development of secondary markets for many types of loans, and securitized variants, loan sales are employed even by relatively small FIs.

McGraw-Hill/Irwin 27-3 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Loan Sales Loan sales have taken place for over 100 years. Correspondent banking  Small banks selling parts of loans to larger banks.  Participations. Expansion of loan sales during 1980s.  Due to expansion of HLT loans. Early 1990s decline in loan sales followed by recent expansion.  Expanding economy and resurgence in M&A’s.

McGraw-Hill/Irwin 27-4 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Bank Loan Sale Market May be sold with or without recourse.  Types of loan sales Emerging market Domestic  Traditional short term  HLT Loan sales

McGraw-Hill/Irwin 27-5 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Traditional Short Term  Key characteristics Secured by assets of borrowing firm. Loans to investment grade borrowers or higher. Short term. Yield closely tied to commercial paper. Denominations of $1 million +.

McGraw-Hill/Irwin 27-6 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. HLT Loan Sales  Key characteristics Term loans. Usually senior secured. Long maturity (often 3- to 6-year maturities). Floating at rates tied to LIBOR, prime or a CD rate. Strong covenant protection. Usually distinguished as distressed / nondistressed.

McGraw-Hill/Irwin 27-7 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Web Resources Visit: Loan Pricing Corporation

McGraw-Hill/Irwin 27-8 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Types of Loan Sales Contracts  Participations Limited contractual control.  Assignments Currently form bulk of the market (90% +). All rights transferred on sale of loan. Normally associated with Uniform Commercial Code filing. Complexity associated with accrued interest

McGraw-Hill/Irwin 27-9 © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Buyers Often segmented. Example: distressed HLT loan buyers generally investment banks, hedge funds, vulture funds. Inter-bank loan sales in traditional market historically due to branching restrictions. Foreign banks important buyer of domestic loans Insurance companies and pension funds in long-term loans. Mutual funds and nonfinancials

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. The Sellers  Major money center banks, U.S. government and its agencies.  Good Bank - Bad Bank: Establishment of subsidiary banks specializing in handling nonperforming loans (NPLs). Increases value of Good Bank. Allows structuring of Bad Bank to improve management incentives and operating efficiency.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Other Sellers  Foreign banks ING is a major market maker (HLTs).  Investment Banks Bear Stearns. Generally large HLTs.  Government and agencies (HUD for example) Increased due to Federal Debt Improvements Act, Largest sales to date, RTC.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Web Resources FDIC Housing and Urban Development

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Why Banks and Other FIs Sell Loans  Credit risk management  Reserve requirements If sold without recourse, removed from balance sheet.  Fee income boosts reported earnings under current accounting rules.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Why FIs Sell Loans (continued)  Capital costs Meet capital requirements by reducing assets.  Liquidity risk reduced by loan sales.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Factors Deterring Future Loan Sales Growth  Access to commercial paper market  Customer relationship effects Customers may take negative view of having their loan sold to another party.  Legal concerns Fraudulent conveyance.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Factors Encouraging Loan Sales Growth  BIS Capital Requirements  Market Value Accounting  Asset Brokerage and Loan Trading  Government loan sales  Credit rating of loans offered for sale  Purchase and sale of foreign bank loans Goldman Sachs fund to buy troubled loans from Japan’s second largest bank, SMFG.

McGraw-Hill/Irwin © 2006 The McGraw-Hill Companies, Inc., All Rights Reserved. Pertinent Websites BIS HUD FDIC FASB Loan Pricing Corp. SEC Wall Street Journal