Risk Management: Asset-Backed

Securities, Loan Sales, Credit Standbys,

and Credit Derivatives

Session 9 and 10

Prof. Jagan Kumar Sur

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 Introduction
• Many issues such as credit risk and the burden of having to raise new
capital to meet the funding needs of your customers and satisfy regulatory
standards keep managers busy
• New tools such as securitizing loans, selling loans off balance sheets,
issuing standby letters of credit, and participating in credit derivative
contracts can help with risk management
▫ Not only have these tools attempted to control risk more effectively, but
they have also opened up new sources of fee income

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 Securitizing Loans and Other Assets
• Securitization of loans and other assets is a simple idea for raising new
funds
▫ Requires a lending institution to set aside a group of income-earning,
relatively illiquid assets, such as home mortgages or credit card loans,
and to sell relatively liquid securities (financial claims) against those
assets in the open market
• In effect, loans are transformed into publicly traded securities

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 Securitizing Loans and Other Assets

• The lender whose loans are securitized is called the originator

• These loans are passed on to an issuer, who is usually designated a special-
purpose entity (SPE)
▫ The SPE is separated from the originator to help ensure that, if the
originating lender goes bankrupt, this event will not affect the credit
status of the pooled loans, supposedly making the pool and its cash flow
“bankruptcy remote”

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 EXHIBIT 9–1 The Heart of the Securitization Process

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 Securitizing Loans and Other Assets
(continued)
Parties involved in Securitization process
• A credit rating agency rates securities to be sold so that investors have a
better idea what the new financial instruments are worth
• The issuer then sells securities in the money and capital markets, often with
the aid of a security underwriter (investment banker)
• A trustee is appointed to ensure the issuer fulfills all the requirements of the
transfer of loans to the pool and provides all the services promised
investors

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 Securitizing Loans and Other Assets
(continued)
• A servicer (who is often the loan originator) collects payments on the
securitized loans and passes those payments along to the trustee, who
ultimately makes sure investors who hold loan-backed securities receive
the proper payments on time
• Investors in the securities normally receive added assurance they will be
repaid in the form of guarantees against default
▫ Credit enhancer
▫ Liquidity enhancer

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 EXHIBIT 9–2 Key Players in the Securitization Process:
Cash Flows and Supporting Services That Make the Process
Work and Generate Fee Income

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 Securitizing Loans and Other Assets
(continued)
The collateralized mortgage obligation (CMO)
• CMOs typically were created through a multistep process in which home
mortgage loans are first pooled together, then securities are issued against
the loan pool and ultimately offered to investors around the globe
• These securities were placed in a trust account off the lender’s balance
sheet and several different classes of CMOs issued as claims against the
security pool and the income they were expected to generate
• Each class of CMO – known as a tranche – promises a different rate of
return (coupon) to investors and carries a different risk exposure

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 Securitizing Loans and Other Assets
(continued)
The different security tranches normally receive the interest payments to which
they are entitled
▫ The loan principal payments flow first to security holders in the top (senior)
tranche until these top-tier instruments are fully retired
▫ Subsequently principal payments then go to investors who purchased
securities belonging to the next tranche until all securities in that tranche are
also paid out, and so on down the “waterfall” until payments are made to
investors in the last and lowest tranche
The “senior” tranches of a CMO generally carry shorter maturities
▫ Reduces their reinvestment risk exposure
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▫ Attractive to risk-averse investors 9-10
 EXHIBIT 9–3 The Structure of Collateralized Mortgage
Obligations (CMOs)

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 Securitizing Loans and Other Assets
(continued)
Home Equity Loans

▫ Home Equity Loans permits homeowners to borrow against the residual

value of their residence – that is the difference between the current

market value of their home and the amount of mortgage loan against

that property

Loan-Backed Bonds

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 Securitizing Loans and Other Assets
(continued)
• Advantages of Securitization
▫ Diversifies a bank’s credit risk exposure
▫ Creates liquid assets out of illiquid assets
▫ Transforms these assets into new sources of fund
▫ Allows the bank to better manage interest rate risk
▫ Allows the bank to generate fee income
▫ Allows the bank to manage the regulatory capital requirement

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 Securitizing Loans and Other Assets
(continued)
• Regulators today are looking closely at
a) The risk of agreeing to serve as an underwriter for asset-backed
securities that cannot be sold
b) The risk of acting as a credit enhancer and underestimating the need
for loan-loss reserves
c) The risk that unqualified trustees will fail to protect investors in asset-
backed instruments
d) The risk of loan servicers being unable to satisfactorily monitor loan
performance and collect monies owed lenders and investors

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 Sales of Loans to Raise Funds and Reduce
Risk
• Loan sales are carried out today by financial firms of widely varying sizes
▫ Among the leading sellers of these loans are Deutsche Bank, JP Morgan
Chase, the Bank of America, and ING Bank of the Netherlands
• These are concentrated among residential mortgage credits and other
miscellaneous loans extended primarily to the household sector
• Most loans sold in the open market usually mature within 90 days and may
be either new loans or loans that have been on the seller’s books for some
time

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 Sales of Loans to Raise Funds and Reduce
Risk (continued)
• Usually the seller retains servicing rights on the sold loans, enabling the
selling institution to generate fee income by collecting interest and
principal payments from borrowers and passing the proceeds along to loan
buyers
• Servicing institutions also monitor the performance of borrowers and act
on behalf of loan buyers to make sure borrowers are adhering to the terms
of their loans
• Most loans are purchased in million-dollar units by investors that already
operate in the loan marketplace and have special knowledge of the debtor

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 Sales of Loans to Raise Funds and Reduce
Risk (continued)
• Types of Loan Sales
▫ Participation Loans
▫ When an outside party purchases a part of 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

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 EXHIBIT 9–5 The Impact of Loan Sales

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 Sales of Loans to Raise Funds and Reduce
Risk (continued)
• Reasons behind Loan Sales
▫ Way to rid the bank of lower-yielding assets to make room for higher-
yielding assets when interest rates rise
▫ Way to increase the marketability and liquidity of assets
▫ Way to minimise credit and interest rate risk
▫ Way to generate fee income
▫ Purchasing bank can diversify loan portfolio and reduce risk

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 Sales of Loans to Raise Funds and Reduce
Risk (continued)
• The 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

▫ Loans purchased from another bank can turn bad just as easily as one

from their own bank

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 Standby Credit Letters to Reduce the Risk
of Nonpayment or Nonperformance
• Financial guarantees
▫ Instruments used to enhance the credit standing of a borrower to help
insure lenders against default and to reduce the borrower’s financing
costs
▫ Designed to ensure the timely repayment of the principal and interest
from a loan even if the borrower goes bankrupt or cannot perform a
contractual obligation
▫ One of the most popular guarantees is the standby letter of credit (SLC)

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 Standby Credit Letters to Reduce the Risk
of Nonpayment or Nonperformance
• SLCs may include
1. Performance guarantees
▫ A financial firm guarantees that a project will be completed on time
2. Default guarantees
▫ A financial firm pledges the repayment of defaulted notes when
borrowers cannot pay

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 Standby Credit Letters to Reduce the Risk
of Nonpayment or Nonperformance (continued)
• Key Advantages to Issuing SLCs
1. Letters of credit earn a fee for providing the service (usually around 0.5
percent to 1 percent of the amount of credit involved)
2. They aid a customer, who can usually borrow more cheaply when armed
with the guarantee, without using up the guaranteeing institution’s scarce
reserves.
3. Such guarantees usually can be issued at relatively low cost because the
issuer may already know the financial condition of its standby credit
customer
4. The probability usually is low that the issuer of an SLC will ever be called
upon to pay
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 Standby Credit Letters to Reduce the Risk
of Nonpayment or Nonperformance (continued)
• Standbys have become important financial instruments for several reasons
1. The spread of direct finance worldwide, with some borrowers selling
their securities directly to investors rather than going to traditional lenders
2. The risk of economic fluctuations has led to demand for risk-reducing
devices
3. The opportunity standbys offer lenders to use their credit evaluation skills
to earn additional fee income without the immediate commitment of funds
4. The relatively low cost of issuing SLCs – they carry zero reserve
requirements and no insurance fees

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 Standby Credit Letters to Reduce the Risk
of Nonpayment or Nonperformance (continued)
• SLCs contain three essential elements
1. A commitment from the issuer (often a bank or insurance company
today)
2. An account party (for whom the letter is issued)
3. A beneficiary (usually a lender concerned about the safety of funds
committed to the account party)
• The key feature of SLCs is they are usually not listed on the issuer’s or the
beneficiary’s balance sheet
▫ This is because a standby is only a contingent liability
▫ In most cases it will expire unexercised
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 EXHIBIT 9–7 The Nature of a Standby Credit Agreement
(SLC)

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 Pricing of Standby Credit Letters

• In effect, the SLC issuer agrees for a fee to take on a risk that, in the
absence of the SLC, would be carried fully by the beneficiary
• In general, an account party will seek an SLC if the issuer’s fee for
providing the guarantee is less than the value assigned to the guarantee by
the beneficiary
• If P is the price of the standby, NL is the cost of a nonguaranteed loan, and
GL is the cost of a loan backed by a standby guarantee, then a borrower is
likely to seek an SLC if

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 Standby Credit Letters to Reduce the Risk
of Nonpayment or Nonperformance (continued)
• Sources of Risk with SLCs

▫ Default risk of issuing bank

▫ Beneficiary must meet all conditions of letter to receive payment

▫ Issuer faces substantial interest rate and liquidity risks

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 • Ways to Reduce Risk Exposure of SLCs

▫ Frequently renegotiating the terms of any loans extended to customers

▫ Diversifying SLCs issued by region and by industry

▫ Selling participations in standbys in order to share risk with other

lending institutions

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 Standby Credit Letters to Reduce the Risk
of Nonpayment or Nonperformance (continued)
• 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: Contracts for Reducing Credit
Risk Exposure on the Balance Sheet
• Securitizing assets, selling loans, and issuing standby credits may possibly
reduce not only interest rate risk but also exposure to credit risk
• However, it may be more efficient to reduce credit risk with a somewhat
newer financial instrument – the credit derivative
• Until the 2007-2009 credit crisis the credit derivatives market was one of
the fastest growing in the world
• Bankers generally lead the credit derivatives market, followed by security
dealers, insurers, and managers of hedge funds

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 Credit Derivatives: Contracts for Reducing Credit
Risk Exposure on the Balance Sheet (continued)
• 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

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 EXHIBIT 9–8 Example of a Credit Swap

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 EXHIBIT 9–9 Example of a Total Return Swap

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 Credit Derivatives: Contracts for Reducing Credit
Risk Exposure on the Balance Sheet (continued)
• Credit Options
▫ Guards against losses in the value of a credit asset or helps to offset
higher borrowing costs that may occur due to changes in credit ratings

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 EXHIBIT 9–10 Example of a Credit Option

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 Credit Derivatives: Contracts for Reducing Credit
Risk Exposure on the Balance Sheet (continued)
• Credit Default Swaps (CDSs)
▫ Aimed at lenders able to handle comparatively limited declines in value, but
wanting insurance against serious losses
▫ In this case a lender may seek out a dealer willing to write a put option on
a portfolio of bonds, loans, or other assets
▫ There may be a materiality threshold
▫ A minimum amount of loss required before any payment occurs
▫ Credit default swaps were first developed at JP Morgan (now JP Morgan
Chase) in 1995
▫ Today more than 90 percent of all credit derivatives are credit default swaps
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 EXHIBIT 9–11 Example of a Credit Default Swap

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 Credit Derivatives: Contracts for Reducing Credit
Risk Exposure on the Balance Sheet (continued)
• Credit-Linked Notes
▫ Fuses together a normal debt instrument, such as a bond, plus a credit
option contract, to give a borrower greater payment flexibility
▫ Grants its issuer the privilege of lowering the amount of loan
repayments it must make if some significant factor changes

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 Credit Derivatives: Contracts for Reducing Credit
Risk Exposure on the Balance Sheet (continued)
• Collateralized Debt Obligations (CDOs)
▫ CDOs may contain pools of high-yield corporate bonds, stock,
commercial mortgages, or other financial instruments
▫ Notes (claims) of varying grade are sold to investors seeking income
from the pooled assets
▫ The claims sold are divided into tranches similar to those created for the
securitization of home mortgages, from the most risky tranche offering
the highest potential return to the least risky (“senior”) tranche with
lowest expected returns

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 Credit Derivatives: Contracts for Reducing Credit
Risk Exposure on the Balance Sheet (continued)
• Risks Associated with Credit Derivatives
▫ Partners in swap or option contract may fail to perform
▫ Smaller volume – Markets are thinner and volatile
▫ Regulatory concerns
▫ Lessons of recent Credit Crisis:
▫ Securitized assets and credit swaps are complex financial instruments
that are difficult to correctly value and measure in terms of risk
exposures
▫ These derivatives operate in cyclically sensitive markets
▫ Contagion effect cannot be stopped without active government
intervention

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 Thank you

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