Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved.
Chapter 10 Off-Balance Sheet Financing in Banking and Credit Derivatives The purpose of this chapter is to learn about some of the newer Financial instruments that bankers have used in recent years to help Reduce the risk exposure of their banks and, in some cases, to aid in Generating new sources of fee income and in raising new funds to Make loans and investments.
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 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
Copyright © 2002 by 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
Copyright © 2002 by 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
Copyright © 2002 by 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
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Loan Sales Marketing Loan Contracts Held by an Institution in Order to Raise New Cash
Copyright © 2002 by 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.
Copyright © 2002 by 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
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Loan Strip Short-Dated Pieces of a Longer-Term Loan, Entitling the Purchaser to Fraction of the Expected Loan Income
Copyright © 2002 by 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
Copyright © 2002 by 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
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 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
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. 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
Copyright © 2002 by 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
Copyright © 2002 by 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
Copyright © 2002 by 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
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Credit Derivatives Financial Contracts Offering Protection to a Designated Beneficiary in Case of Loan Default
Copyright © 2002 by The McGraw-Hill Companies, Inc. All rights reserved. Types of Credit Derivatives Credit Swaps Credit Options Credit Default Swaps Credit Linked Notes
Copyright © 2002 by 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