Fin 413 Chapter 24

in addition to managing credit risk, what are some other reasons for the sale of loans

(a) Removing loans from the balance sheet by sale without recourse reduces the amount of deposits necessary to fund the FI, which in turn decreases the amount of regulatory reserve requirements that must be kept by the FI. (b) Originating and selling loans is an important source of fee income for the FIs. (c) One method to improve the capital ratio for an FI is to reduce assets. This approach often is less expensive than increasing the amount of capital. (d) The sale of FI loans to improve the liquidity of the FIs has expanded the loan sale market. This has made FI loans even more liquid and reduced FI liquidity risk even farther. Thus, by creating the loan sales market, the process of selling the loans has improved the liquidity of the asset for which the market was initially developed.

Who buys loans

-Investment banks ----predominant buyers ——have economies of scale for analyzing these loans Vulture funds (hedge funds) Foreign banks Pension Funds Closed-end bank loan mutual funds

Syndication Process

1. Issuer (person who wants a loan) solicits bids from arrangers 2. Lenders outline syndication strategy, qualifications, and estimates on loan pricing 3. Issuer awards mandate 4. Arranger prepares an information memo (IM) 5. As arranger assembles IM, gather informal feedback on appetite for investment and price 6. Agent formally markets deal to potential investors 7. Arranger totals commitments and determines price depending on subscription 8. After closing the loan, final terms are documented in detailed credit and security agreements

What is a collateralized mortgage obligation? How is it similar to a pass through security? how does it differ?

A CMO is a mortgage-backed bond issued in multiple classes or tranches. Each tranche typically has a different interest rate (coupon), and any prepayments on the entire CMO typically are allocated to the tranche with the shortest maturity. Thus, prepayment risk does not affect the tranches with longer lives until the earlier tranches have been retired. Many of the tranches in the CMO receive interest rates that are lower than the average pass-through requirement because of the limited prepayment risk protection.

What are highly leveraged transactions? What constitutes the federal regulatory definition of an HLT?

A highly leveraged transaction is a loan to finance an acquisition or merger. Often, the purchase is a leverage buyout with a resulting high leverage ratio for the borrower. U.S. federal bank regulators have adopted a definition that identifies an HLT loan as one that (1) involves a buyout, acquisition, or recapitalization and (2) doubles the company's liabilities and results in a leverage ratio higher than 50 percent, results in a leverage ratio higher than 75 percent, or is designated as an HLT by a syndication agent.

How Syndicated Loans Work

Arrangers serve as middleman source of funds Issuer pays arranger a fee for the service -Fee increases with complexity of issue

Who arranges Syndicated Loans?

Banks (Commercial Banks) Financial Institutions (Mostly smaller deals 25M to 100M ) Institutional Investors

Who sells loans

Banks. Money Center Banks ------predominant sellers Small or community banks Foreign banks U.S. Government and Agencies

What is the difference between loans sold with recourse and without recourse from the perspective of both sellers and buyers?

Loans sold without recourse means that after selling the loan the originator of the loan can take it off the balance sheet. In the event the loan is defaulted, the buyer of the loan has no recourse to the seller for any claims, transferring the credit risk entirely to the buyer. For the originator, it has completely eliminated this loan from its books. In the case of a sale with recourse, credit risk is still present for the originator because the buyer could transfer ownership of the loan back to the originator. Thus, from the perspective of the buyer, loans with recourse bear the least credit risk.

Why Securitization?

Reduces risks Provides liquidity Provides fee income

Why sell loans?

Selling loans generates more liquidity (you sell for cash) Provide fee income (you receive fees from issuing loans) When you sell loans you can lower capital requirement and can lower reserve requirement .. Moving assets from risky loans to safe cash

Loan Sale With Recourse

The buyer can put the loan back to the originator should it go bad

How do loan sales and securitizaton help an FI manage its interest rate and liquidity risk exposure?

The sale or securitization of a loan converts a long term asset on the balance sheet into cash, thus reducing the maturity and increasing the liquidity of the assets.

Types of Syndication

Underwritten -arrangers guarantee the entire commitment and then syndicate the loan -responsible for any shortfalls -more fees because the arranger is taking on risk Best efforts -arrangers commit to underwrite less than the entire amount of the loan -less risk, most widely used method Club deal —smaller loan (25 mil to 100 mil ) —premarketed to group you've already used before

Loan Sale

a financial intermediary or group of intermediaries originates a loan then subsequently sells it

Loan Syndication

a group of financial intermediaries (banks), possibly with different roles in the transaction, jointly make a loan . THEY ORIGINATE IT

Loan Securitization

an intermediary packages loans or other assets into newly created securities and sells them to outside investors

Loan Securitization

is the process of transforming loans (or other debt instruments) into marketable securities through packaging loans or other assets into newly created securities

Loan Sale Without Recourse

the originator sells the loan and then is done with it. If it goes bad then the originator has nothing to do with it. Buyer bears all credit risk * Most loan sales are without recourse*

What is prepayment risk? how does it affect the cash flow stream on a fully amortized mortgage loan?

the process of paying back a loan before its maturity to the FI that originated the loan. In the case of an amortized loan that has fixed periodic payments, prepayment means that the lender will receive fewer of the fixed periodic payments, one or more payments of extra principal, and the final payment will be made before the final payment due date.