Username: Gary MongioviBook: Bank Management & Financial Services, 9th Edition.

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302 Part Three Tools For Managing and Hedging against Risk

Innovation has crept into the securitization market in recent years. One interesting
example lies in the insurance industry, responding to recent policyholder claims asso-
ciated with such disasters as hurricanes and earthquakes. Catastrophe-linked securities
1216484 2015/09/03 110.52.100.70
("cat bonds") have been developed to shift risk from insurers to the financial markets.
In this case an SPE is created to issue securities designed to cover losses above a given
threshold amount from different kinds of disasters (such as Hurricane Katrina).
The proceeds of the security issue may be invested in high-quality fixed-income instru-
ments (such as Treasury securities) in order to generate sufficient cash to cover excess
losses or serve as a source of repayment for the "cat bonds."
A final trend in the securitization and loan-backed securities market that must be
borne in mind is its international coverage today. This market owes most of its origins to
the United States, but it exploded on the international scene as the 21st century opened.
Nowhere was this more the case than in the European Community, where new groups
of investors and new loan-backed security issuers appeared in droves, freely adopting
innovations from the U.S. market and hiring away securitization specialists from U.S.
companies. Subsequently many Asian lenders entered the securitization marketplace as
well. Unfortunately the international expansion of this market slowed drastically after the
subprime mortgage market virtually collapsed over the 2007-2009 period before mapping
out a possible recovery.

The Impact of Securitization upon Lending Institutions

Securitization may affect the management of lending institutions in several different ways.
Certainly it raises the level of competition for quality loans among lending institutions.
Securitization may also raise the battle among lenders trying to attract deposits because
knowledgeable depositors may find that they can get a better yield by purchasing loan-
backed securities than by buying deposits (although the credit crisis of 2007-2009 dis-
couraged many potential buyers of securitized assets). Securitization has allowed many
corporations to bypass traditional lenders when conditions are right and, instead, seek
credit in the open market through securities sales, thereby reducing lenders' loan revenues.
However, lenders have also been able to benefit indirectly from securitizations con-
ducted by their corporate customers by providing, for a fee, credit letters (discussed later
in this chapter) to enhance the credit rating of corporations selling their securities in the
public market. Moreover, lenders can generate added fee income by providing backup
liquidity in case the securitizing company runs short of cash and by acting as underwriters
for new asset-backed security issues. Lenders also find they can use securitization to assist
a good corporate customer in finding financing without having to make any direct loans
to that customer, which would inflate the lender's risky assets. Overall, securitization
allows a lender to originate a greater volume of loans at lower cost in terms of deposit
insurance fees and reserve requirements and perhaps at lower risk with greater diversity
of funding sources.

Regulators' Concerns about Securitization

Despite its potential advantages for lenders, securitization has increased regulators' con-
cerns about the soundness and safety of individual lenders and the financial system,
especially in the wake of the 2007- 2009 credit crisis, In some instances the growth of
asset securitizations has led to sloppy management practices and a lack of adequate risk
controls. Regulators today are looking closely at (a) the risk of having to come up with
large amounts of liquidity in a hurry to make payments to investors holding asset-backed
securities and cover bad loans; (b) the risk of agreeing to serve as an underwriter for
asset-backed securities that cannot be sold; (c) the risk of acting as a credit enhancer and
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Chapter Nine Risk Management: Asset-Backed Securities, Loan Sales, Credit Standbys, and Credit Derivatives 303

underestimating the need for loan-loss reserves; (d) the risk that unqualified trustees will
fail to protect investors in asset-backed instruments; and (e) the risk of loan servicers
being unable to satisfactorily monitor loan performance and collect monies owed lenders
and investors. Regulators today are also asking questions about the impact of securitiza-
tion on the remaining portfolio of loans that are not securitized, looking for possible dete-
rioration in overall loan portfolio quality.
Indeed, in the wake of the credit crisis of 2007-2009 with so many securitized loans
(especially subprime home mortgages) going bad the Financial Accounting Standards
Board (FASB) began to consider restricting the use of special-purpose vehicles (SPEs),
finding less risky ways to book loans and shift risk, and examining the possible connections
between securitizations and risks to the financial system as a whole (i.e., systemic risk).

Concept Checlc

9-1 . What does securitization of assets mean?
9-2. What kinds of assets are most amenable to the
securitization process?
9-3. What advantages does securitization offer lending
institutions?
9-4. What risks of securitization should the managers of
lending institutions be aware of?
9-5. Suppose that a bank securitizes a package of its
loans that bears a gross annual interest yield of
13 percent. The securities issued against the loan
package promise interested investors an annualized
yield of 8.25 percent. The expected default rate on
the packaged loans is 3.5 percent. The bank agrees
to pay an annual fee of 0.35 percent to a security
dealer to cover the cost of underwriting and advisory
services and a fee of 0.25 percent to Arunson Mort-
gage Servicing Corporation to process the expected
payments generated by the packaged loans. If the
above items represent all the costs associated with
this securitization can you calculate the percentage
amount of residual income the bank expects to earn
from this particular transaction?

9-3 Sales of Loans to Raise Funds and Reduce Risk

Filmtoid Not only can loans be used as collateral for issuing securities to raise new funds, but the
What 1993 made- individual loans themselves can be sold to new owners. Loan sales are carried out today
for-HBO movie finds
by financial firms of widely varying sizes. Included among the principal buyers of loans
investment bankers
scurrying for funds to are banks (including foreign banking firms seeking a foothold in the domestic market),
support the leveraged insurance companies, pension funds, nonfinancial corporations, mutual funds (including
buyout of RJR Nabisco? vulture and hedge funds that choose to concentrate on purchasing troubled loans), and
Answer: Barbarians at security dealers (such as Goldman Sachs and Morgan Stanley). Among the leading sellers
the Gate.
of these loans are Deutsche Bank, JP Morgan Chase, the Bank of America, and ING Bank
of the Netherlands. (See Exhibits 9-5 and 9-6.)
As Exhibit 9-6 suggests, only a minority of U.S. depository institutions (about 10
percent today) report regular and significant asset sales. 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. The loan sale
market received a boost during the 1980s when a wave of corporate buyouts led to the
creation of thousands of loans to fund highly leveraged transactions (HLTs). The market
for such loans in the United States expanded more than tenfold during the 1980s, but
then fell and grew only moderately in the new century as corporate buyouts cooled off
and federal regulatory agencies tightened their rules regarding the acceptability of such
loans. Generally, HLT-related loans are secured by the assets of the borrowing company
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304 Part Three Tools For Managing and Hedging against Risk

EXHIBIT9-5 Commercial bank The money and

The Impact of Loan capital markets
Sales*
Proceeds of
*Source: Peter S. Rose, "New
Assets loan sales ($) Individual and institutional
Benefits, New Pitfalls," The investors acquire loans
Canadian Banker, September/ Cash account themselves or receive
October 1988. contracts to the stream of
Total loans on the lender's payments generated by a
books fall as loans are Sales of
selected loans loan (with each investor
sold, or contracts may be relying on the lender's
sold that give investors or of contracts
to sell the expertise in evaluating
access to the cash flow loan applicants to control
expected to be paid out by expected cash
flow from risk exposure)
a loan over time
loans

and, typically, are long-term, covering in some cases out to as long as 10 years or so.
In contrast, most other loans sold carry maturities of only a few weeks or months, are
generally extended to borrowers with high credit ratings, and carry interest rates that
usually are connected to short-term corporate loan rates (such as the prime rate).
Typically, the seller retains servicing rights on the sold loans, enabling the selling insti-
tution to generate fee income (often one-quarter or three-eighths of a percentage point
of the amount of the loans sold) by collecting interest and principal payments from bor-
rowers 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. Over the past two decades
a multibillion-dollar market for floating-rate corporate loans arose as some insurance com-
panies and mutual funds that had purchased ordinary bonds in the past switched some of
their money into corporate loans. These salable loans appear to have several advantages
over bonds for many investors due to their strict loan covenants, floating interest rates,
and array of both short and long maturities.
Two of the most popular forms of loan sales are (1) participation loans and (2) assign-
ments. In a participation loan at least a portion of a lender's interest in a loan is trans-
ferred to another lending institution. Typically the participation purchaser is an outsider
(i.e., not a partner) to the original loan contract between lender and borrower. Only if
the terms of the original loan contract are significantly altered can the buyer of a partici-
pation exercise influence over the terms of the original loan contract. Thus, the buyer
("participant") faces substantial risk: the seller may fail to perform or the borrower may
default on the original loan. This means the buyer of a participation should watch both
borrower and seller closely.
EXHIBIT9-6 Number of FDIC-Insured Depository Institutions
Assets Sold With Reporting Asset Sales 833
Recourse and Not Percent of All FDIC-Insured Depository Institutions
Securitized by FDIC- Reporting Asset Sales 10.6%
Insured Depository
Institutions, 2010* Outstanding Principal Balance by Asset Type Sold($ millions):
1-4 Family Residential Loans $ 62,232
*Source: Federal Deposit
Insurance Corporation, FDIC Other Household-Related Loans (including credit card, home 41
Quarterly, 4, no. 3 (2010), equity, and other household credits)
p. 13. Commercial and Industrial Loans 541
All Other Assets Sold 52,400
Total Assets Sold by FDIC-Insured Depository
Institutions and Not Securitized $115,215
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Chapter Nine Risk Management: Asset-Backed Securities, Loan Sales, Credit Standbys, and Credit Derivatives 305

"Participating" in loans offers several advantages. Regulated lenders generally face

legal lending limits ( usually based on their capital position) beyond which they cannot
go in extending credit to an individual borrower. When their customer has credit needs
that exceed the lender's legal limit, participations make it possible to continue to meet the
customer's full funding needs. Moreover, participations enable a lender to reduce risk by
diversifying its loans across different geographic regions and industries.
Nevertheless, the limitations of participations result in many loan sales today going the
route of an assignment. Under this arrangement the ownership of a loan is transferred to
the buyer, who thereby acquires a direct claim against the borrower. In some instances,
the borrower may have to formally agree to the sale of his or her loan to another lending
institution before an assignment can be made.
A third type of loan sale is the loan strip. Strips are short-dated pieces of a longer-term
loan and often mature in a few days or weeks. The buyer of a strip is entitled to a fraction
of the expected income from a loan. With strips, the selling institution retains the risk of
borrower default and may have to put up some of its own funds to support the loan until
it reaches maturity.

Reasons behind Loan Sales

Lenders turn to loan sales as an important method for funding their operations for many
reasons. One is the opportunity loan sales provide for getting rid of lower-yielding assets
in order to make room for higher-yielding assets when interest rates rise. Moreover, selling
loans and replacing them with more marketable assets can increase a lender's liquidity,
better preparing the institution for deposit withdrawals or other cash needs. Loan sales
remove both credit risk and interest rate risk from the lender's balance sheet and may gen-
erate fee income up front. Then, too, selling loans off the balance sheet slows the growth
of assets, which helps management maintain a better balance between growth of capital
and the acceptance of risk in the lending function. In this way loan sales help lenders
please regulators, who have put considerable pressure on heavily regulated institutions to
get rid of their riskiest assets and strengthen their capital in recent years. A few studies
(e.g., Hassan [5]), suggest that investors in the capital markets generally view loan sales
as a way to reduce risk for the selling institution, helping to lower its cost of capital and
diversify its asset portfolio. Buyers purchasing these loans receive help in diversifying their
loan portfolio outside their traditional trade areas. Diversification of this sort may lower
borrowing costs for the loan buyer.
The development of the loan sales market may have profound implications for the
future of lending institutions. The growth of this1216484
market means that
2015/09/03 banks, for example,
110.52.100.70
can make some loans without taking in deposits and cover deposit withdrawals merely
by selling loans. Moreover, depository institutions may have less need for deposit insur-
ance or for borrowing from their central bank. Because loan sales are so similar to issuing
securities, this financing device blurs the distinction between financial intermediaries,
like banks and finance companies, that make loans and other financial institutions that
mainly trade in securities.

The Risks in Loan Sales

Loan sales are another form of investment banking, in which the seller trades on his or her
superior ability to evaluate the creditworthiness of a borrower and sells that expertise
(represented by the content of the loan contract) to another investor. Investors may be
willing to purchase loans that a trusted lender originates because they have confidence
in the seller's ability to identify good-quality borrowers and write an advantageous loan
contract. Nevertheless, loan sales as a source of funds for lenders are not without their
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306 Part Three Tools For Managing and Hedging against Risk

problems. For example, the best-quality loans are most likely to find a ready resale market.
But if the seller isn't careful, it will find itself selling off its soundest loans, leaving its port-
folio heavily stocked with poorer-quality loans. This development is likely to trigger the
attention of regulators, and the lending institution may find itself facing demands from
regulatory agencies to strengthen its capital.
Moreover, a sold loan can turn sour just as easily as a direct loan from the originating
lender to its own customer. Indeed, the seller may have done a poor job of evaluating the
borrower's financial condition. Buying an existing loan, therefore, obligates the purchas-
ing institution to review the condition of both the seller and the borrower.
In some instances the seller will agree to give the loan purchaser recourse to the seller
for all or a portion of any sold loans that become delinquent. In effect, the purchaser gets a
put option, allowing him or her to sell a troubled loan back to its originator. This arrange-
ment forces buyer and seller to share the risk of loan default.
A substantial portion of businesses bypass traditional lenders for the loans they need,
leading to a decrease in the availability of quality loans that are the easiest to sell. More-
over, corporate merger and acquisition activity has slowed in the wake of a more slowly
growing economy. However, some authorities expect a future rebound in loan sales due to
tougher capital-adequacy requirements, which may encourage banks, in particular, to con-
tinue to sell off selected loans and strengthen their capital. Also, there has been a swing
among many international banks (such as Deutsche Bank and JP Morgan Chase) toward
more market trading in place of traditional lending, encouraging these institutions to sell
off more loans on their balance sheets.

ConceP.t Checl<

9-6. What advantages do sales of loans have for lend- 9-8. What is loan servicing?
ing institutions trying to raise funds? 9-9. How can loan servicing be used to increase
9-7. Are there any disadvantages to using loan sales as income?
a significant source of funding for banks and other
financial institutions?

9-4 Standby Credit Letters to Reduce the Risk

of Nonpayment or Nonperformance
One of the more interesting of all risk-focused markets in recent years has been the market
for 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. Financial
guarantees are 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 in the banking and insurance communities is the standby
letter of credit (SLC). The growth of standby letters has been substantial from time to time,
although this remains a large-bank market. It is estimated that more than 90 percent of
SLCs issued by U.S.-insured commercial banks come from those banking firms above a bil-
lion dollars in assets each- lenders whose guarantees are widely accepted.
SLCs may include ( 1) performance guarantees, in which a financial firm guarantees that
a project (such as the construction of a building) will be completed on time, or (2) default
guarantees, under which a financial institution pledges the repayment of defaulted notes
when borrowers cannot pay. These standbys help borrowing customers get the credit they
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Chapter Nine Risk Management: Asset-Backed Securities , Loan Sales, Credit Standbys, and Credit Derivatives 307

require at lower cost and on more flexible terms. In order to sell SLCs successfully, how-
ever, the service provider must have a higher credit rating than its customer.
A standby credit letter is a contingent obligation of the letter's issuer. The issuing firm,
in return for a fee, agrees to guarantee the credit of its customer or guarantee the fulfill-
ment of a contract made by its customer with a third party. The key advantages to a finan-
cial institution issuing SLCs are the following:
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 guar-
antee, 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 (e.g., when that
customer applied for his or her last loan).
4. The probability usually is low that the issuer of an SLC will ever be called upon to pay.
Standbys have become important financial instruments for several reasons:
Key URLs 1. The spread of direct finance worldwide, with some borrowers selling their securities
It's fun to explore the directly to investors rather than going to traditional lenders. Direct financing increases
use of standby credit investor concerns about borrower defaults and may result in increased demand for
letters at such sites as
SLCs.
www.huntington.com/
tm/IM24.htm and 2. The risk of economic fluctuations (recessions, inflation, etc.) has led to demand for
www.crfonline.org/orc/ risk-reducing devices.
cro/cro-9-1.html. 3. The opportunity standbys offer lenders to use their credit evaluation skills to earn addi-
tional fee income without the immediate commitment of funds.
4. The relatively low cost of issuing SLCs-unlike selling deposits, they carry zero reserve
requirements and no insurance fees.

The Structure of SLCs

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), and
(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. Delivery of funds to the beneficiary can occur only
if something unexpected happens to the account party (such as bankruptcy or nonperfor-
mance). Moreover, the beneficiary can claim funds from the issuer only if the beneficiary
meets all the conditions laid down in the SLC. If any of those conditions are not met, the
issuer is not obligated to pay. (See Exhibit 9-7.)

EXHIBIT9-7 Issues credit letter securing a loan made

to the account party or guaranteeing that Beneficiary
The Nature of a Bank or
bank or
nonbank party's performance
Standby Credit nonbank
issuer of a
Agreement (SLC) institution or
credit letter
individual

I Requests
credit
letter
Seeks a loan or agrees to
perform under a contract
IAccount party 1-----------------------------~
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308 Part Three Tools For Managing and Hedging against Risk

The Value and Pricing of Standby Letters

Under the terms of an SLC, the issuer of the letter will pay any interest
1216484 2015/09/03or110.52.100.70
principal to
the beneficiary left unpaid by its customer, the account party. In effect, the issuer agrees
for a fee to take on a risk that, in the absence of the SLC, would be carried fully by the
beneficiary. Therefore, the beneficiary may be willing to lend the account party more
money or provide the same amount of funds at a lower interest rate than if there were no
standby.
In general, an account party will seek an SLC if the issuer's fee for providing the guar-
antee is less than the value assigned to the guarantee by the beneficiary. Thus, 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

P < (NL - GL) (9-1)

For example, suppose a borrower can get a nonguaranteed loan at an interest cost of
7.50 percent, but is told that a quality SLC would reduce the loan's interest cost to 6. 75
percent. If a bank offers the borrower a standby for 0.50 percent of the loan's face value, it
will pay the borrower to purchase the guarantee because the savings on the loan of (7.50
percent - 6.75 percent) or 0.75 percent exceeds the 0.50 percent guarantee fee.
In tum, the value to the beneficiary of an SLC is a function of the credit ratings
of issuer and account party and the information cost of assessing their credit standing.
Beneficiaries will value highly the guarantee of an issuer with a superior credit rating.
Account parties will be less likely to seek out a weak institution to issue a credit letter,
because such a guarantee gives them little bargaining power. If the cost of obtaining
relevant information about the condition of the guaranteeing institution or about the
account party is high, the beneficiary also may find little or no value in an SLC.

Sources of Risk with Standbys

Standby credits carry several forms of risk exposure for the institution (beneficiary) rely-
ing upon them. For example, the issuing institution may not be able to cover its commit-
ment, resulting in default. Also, some jurisdictions have held that an issuing institution
cannot be forced to pay off on an SLC if doing so would force it to violate regulations
(e.g., if the amount to be paid exceeds a lender's legal lending limit).
Beneficiaries relying on standbys received from other institutions must take care that
such agreements are fully documented so they know how to file a valid claim for payment.
A beneficiary cannot legally obtain reimbursement from the issuer unless all of the condi-
tions required for successful presentation of a credit letter are met. In some bankruptcy
court jurisdictions it has been held that any payments made upon presentation of a valid
SLC are "preference items" under the federal bankruptcy code and, therefore, must be
returned to the account party if bankruptcy is declared.
There also may be substantial interest rate and liquidity risks. If the issuer is compelled
to pay under a credit letter without prior notice, it may be forced to raise substantial
amounts of funds at unfavorable interest rates. Managers can use various devices to reduce
risk exposure from standbys they have issued, such as
1. Frequently renegotiating the terms of any loans extended to customers who have SLCs
so that loan terms are continually adjusted to the customer's changing circumstances
and there is less need for beneficiaries to press for collection.
2. Diversifying SLCs issued by region and by industry to avoid concentration of risk
exposure.
3. Selling participations in standbys in order to share risk with other lending institutions.
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Chapter Nine Risk Management: Asset-Backed Securities, Loan Sal.es, Credit Standbys, and Credit Derivatives 309

Key URL Regulatory Concerns about SLCs

For an in-depth
discussion of the rules Recent growth of contingent obligations like SLCs has raised the specter of more insti-
for banks handling tutional failures if more standbys than expected are presented for collection. For exam-
standby letters of credit ple, many regulators fear that investors in bank securities, including holders of uninsured
(SLCs) see especially
deposits, may be lulled to sleep (i.e., will tend to underprice risk) if a bank books fewer
www.fdic.gov/
regulations/safety/
loans but at the same time takes on a large volume of SLCs. Unfortunately, there is ample
manuaVsection3-8 incentive for lenders to take on more standbys due to their relatively low production costs
.html which deals with and the added leverage they generate because no cash reserves are required, at least at the
schedule RC-L (Off- beginning of the agreement.
Balance Sheet Items). Examiners and regulatory agencies are working to keep risk exposure from standbys
under control. Several new regulatory rules are in use today. For example, in the banking
community,
1. Lenders must apply the same credit standards for approving SLCs as they do for approv-
ing direct loans.
2. Lenders must count standbys as loans when assessing how risk-exposed the institution
is to a single credit customer.
3. Since the adoption of international capital agreements between the United States and
other leading nations (discussed in Chapter 15), banks have been required to post capi-
tal behind most standbys as though these contingent agreements were loans.

Research Studies on Standbys, Loan Sales, and Securitizations

Several studies have addressed the issue of the relative riskiness of direct loans versus stand-
bys, loan sales, and securitizations for lenders. For example, Bennett [11] observed that
direct loans carry substantially higher market risk premiums than do SLCs. This supports
the idea that investors as a whole believe standbys carry significantly less risk than loans
themselves. One reason may be that SLCs are usually requested by prime-quality borrowers.
Another factor may be the market's expectation that most standbys will never be presented
for collection. Apparently issuing SLCs has little impact on lenders' borrowing costs.
More recently, Hassan [1] finds evidence from option-pricing models that stockholders
and creditors view off-balance-sheet SLCs as reducing risk by increasing the diversification
of assets. Hassan argues that imposing capital requirements on standbys, therefore, may not
be appropriate because, if properly used, they can reduce risk for the issuers of these letters.
Moreover, various researchers have argued that standbys, loan sales, and securitizations are
principally defensive reactions by financial firm managers to regulation. These off-balance-
sheet activities can be viewed as attempts to increase financial leverage, thereby augment-
ing stockholder returns. Contingent obligations are being substituted for regular assets and
deposits whenever regulation increases the cost of more traditional intermediation activities.
But according to James [2], for example, regulation is not the only motivation for loan
sales, standbys, and other nontraditional fund-raising devices. These transactions are bet-
ter viewed as substitutes for collateralized debt because depository institutions are pro-
hibited from selling collateralized deposits (with the exception of government deposits
where specific assets are pledged to protect these deposits). Both regulations and the cost
of deposit insurance can be incentives for banks, for example, to pursue off-balance-sheet
activities. However, if these instruments increase the value of financial firms (i.e., raise
their stock prices), it might be a mistake to severely restrict them by government regula-
tion unless they give rise to excessive and destructive risk exposure.
Finally a most recent study by Federal Reserve economists Noeth and Sengupta [20]
reviews the literature on securitizations and finds several benefits. They suggest that origi-
nating and then distributing loans (as opposed to simply holding loans) tends to diversify
away some lender risk, lowers credit costs, and promotes greater disclosure and openness
in the lending process.
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310 Part Three Tools For Managing and Hedging against Risk

ConceP.t Checl<

9-10. What are standby credit letters? Why have they 9-12. What risks accompany a standby credit letter for
grown so rapidly in recent years? (a) the issuer and (b) the beneficiary?
9-11. Who are the principal parties to a standby credit 9-13. How can a lending institution mitigate the risks
agreement? inherent in issuing standby credit letters?

9-5 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-
an over-the-counter agreement possibly offering protection against loss when default
occurs on a loan, bond, or other debt instrument.
Until the 2007-2009 credit crisis the credit derivatives market was one of the fastest
growing in the world. For example, according to the International Swaps and Deriva-
tives Association the notional (face) value of credit derivatives reached more than
$45 trillion in June 2007-a jump of more than a trillion dollars in just six months! So rapid
Key Video Link was the growth of these instruments that recordkeeping, especially trying to keep up with
@ http://accordent
.powerstream.net/008/ assignments and settlements, often lagged well behind actual events in the marketplace,
00102/080229ala/ possibly increasing market volatility and risk exposure. Derivatives' volume fell sharply.
msh.html see Brain Bankers generally lead the credit derivatives market, followed by security dealers, insur-
Gordon of the Federal ers, and managers of hedge funds. Banks and security firms have used credit derivatives to
Reserve Bank of Chicago protect their own portfolios of corporate IOUs and, acting as dealers, also sell this form of
speak about credit
derivatives for
risk protection to their largest customers in return for fee income. Credit derivatives help
hedging and speculation. financial managers "unbundle" credit risk from other forms of risk and may provide a more
efficient method for dealing with default-risk exposure.

Credit Swaps
Key URL
One of the most One prominent example of a credit derivative is the credit swap, where two lenders
controversial agree to exchange a portion of their customers' loan repayments. For example, Banks
institutions in the credit A and B may find a dealer, such as a large insurance company, that agrees to draw up a
derivatives market is
credit swap contract between the two banks. Bank A then transmits an amount (perhaps
hedge funds that value
these credit agreements $100 million) in interest and principal payments that it collects from its credit customers
and may buy and sell to the dealer. Bank B also sends all or a portion of the loan payments its customers make
them in large volume. to the same dealer. The dealer will ultimately pass these payments along to the other
For an overview of this party that signed the swap contract. (See Exhibit 9-8.) Usually the dealer levies a fee
aspect of the credit
for the service of bringing these two swap partners together and may also guarantee each
derivatives market, see
www.credit-deriv.com/. swap partner's performance for an additional charge.

EXHIBIT9-8 Loan principal and Loan principal and

Example of a Credit interest payments Credit interest payments
Swap swap
intermediary
Loan principal and (dealer) Loan principal and
interest payments interest payments