Chapter Twenty-Four

Managing Risk off the

Balance Sheet with Loan
Sales and Securitization
McGraw-Hill/Irwin

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2009, The McGraw-Hill Companies, All Rights

Loan Sales and Securitization

FIs
FIsuse
useloan
loansales
salesand
andsecuritization
securitizationto
tohedge
hedgecredit,
credit,
interest
interestrate,
rate,and
andliquidity
liquidityrisk
riskexposure
exposure
AAloan
loansale
saleoccurs
occurswhen
whenan
anFI
FIoriginates
originatesaaloan
loanand
andthen
then
subsequently
subsequentlysells
sellsitit
Loan
Loansecuritization
securitizationisisthe
thepackaging
packagingand
andselling
sellingof
ofloans
loans
and
andother
otherassets
assetsbacked
backedby
bysecurities
securitiesissued
issuedby
byan
anFI
FI
Loan
Loansecuritization
securitizationgenerally
generallytakes
takesone
oneof
ofthree
threeforms
forms

pass-through
pass-throughsecurities
securities
collateralized
collateralizedmortgage
mortgageobligations
obligations(CMOs)
(CMOs)
mortgage-backed
mortgage-backedbonds
bonds(MBBs)
(MBBs)

McGraw-Hill/Irwin

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2009, The McGraw-Hill Companies, All Rights

Loan Sales and Securitization

AAlarge
largepart
partof
ofcorrespondent
correspondentbanking
bankinginvolves
involvessmall
small
FIs
FIsmaking
makinglarge
largeloans
loansand
andselling
selling(or
(orsyndicating)
syndicating)parts
parts
of
ofthe
theloans
loansto
tolarge
largebanks
banks
correspondent
correspondentbanking
bankingisisaarelationship
relationshipbetween
betweenaasmall
smallbank
bank
and
andaalarge
largebank
bankininwhich
whichthe
thelarge
largebank
bankprovides
providesaanumber
numberof
of
deposit,
deposit,lending,
lending,and
andother
otherservices
services

Large
Largebanks
banksalso
alsosell
sellparts
partsof
oftheir
theirloans,
loans,called
called
participations,
participations,to
tosmaller
smallerFIs
FIs
The
Thesyndicated
syndicatedloan
loanmarket
marketisisthe
thebuying
buyingand
andselling
sellingof
of
loans
loansonce
oncethey
theyhave
havebeen
beenoriginated
originated

McGraw-Hill/Irwin

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2009, The McGraw-Hill Companies, All Rights

Loan Sales and Securitization

Syndicated
Syndicatedloan
loanmarket
marketparticipants
participants
market
marketmakers
makers

generally
generallylarge
largecommercial
commercialbanks
banks(CBs)
(CBs)and
andinvestment
investmentbanks
banks(IBs)
(IBs)

active
activetraders
traders

mainly
mainlyIBs,
IBs,CBs,
CBs,and
andvulture
vulturefunds
funds

occasional
occasionalsellers
sellersand
andinvestors
investors

The
Thesyndicated
syndicatedloan
loanmarket
marketgrew
grewrapidly
rapidlyin
inthe
theearly
early1980
1980
due
dueto
tothe
theexpansion
expansionof
ofHLT
HLTloans
loans
highly
highlyleveraged
leveragedtransaction
transaction(HLT)
(HLT)loans
loansare
areloans
loansthat
thatfinance
finance
aamerger
mergerand
andacquisition;
acquisition;aaleveraged
leveragedbuyout
buyoutresults
resultsininaahigh
high
leverage
leverageratio
ratiofor
forthe
theborrower
borrower

McGraw-Hill/Irwin

24-4

2009, The McGraw-Hill Companies, All Rights

Loan Sales
AAloan
loansale
saleisisthe
thesale
saleof
ofaaloan
loanoriginated
originatedby
byaabank
bankwith
with
or
orwithout
withoutrecourse
recourse
recourse
recourseisisthe
theability
abilityof
ofaaloan
loanbuyer
buyertotosell
sellthe
theloan
loanback
backtotothe
the
originator
originatorshould
shouldititgo
gobad
bad

Types
Typesof
ofloan
loansale
salecontracts
contracts

aaparticipation
participationininaaloan
loanisisthe
theact
actof
ofbuying
buyingaashare
shareininaaloan
loan
syndication
syndicationwith
withlimited
limitedcontractual
contractualcontrol
controland
andrights
rightsover
overthe
the
borrower
borrower
an
anassignment
assignmentisisthe
thepurchase
purchaseof
ofaashare
shareininaaloan
loansyndication
syndication
with
withsome
somecontractual
contractualcontrol
controland
andrights
rightsover
overthe
theborrower
borrower

McGraw-Hill/Irwin

24-5

2009, The McGraw-Hill Companies, All Rights

Loan Sales
Traditional
Traditionalshort-term
short-termloan
loansales
sales

secured
securedby
byassets
assetsofofthe
theborrower
borrower
borrowers
are
investment
borrowers are investmentgrade
grade
original
originalmaturities
maturitiesofof90
90days
daysororless
less
sold
soldininunits
unitsof
of$1
$1million
millionand
andup
up
loan
loanrates
ratesare
areclosely
closelytied
tiedtotocommercial
commercialpaper
paperrates
rates

secured
securedby
byassets
assetsofofborrower
borrower
original
originalmaturity
maturityofof33toto66years
years
interest
interestrates
ratesare
arefloating
floating
have
havestrong
strongcovenant
covenantprotection
protection
may
maybe
bedistressed
distressedorornondistressed
nondistressed

HLT
HLTloan
loansales
sales

LDC
LDCloan
loansales
sales

LDC
LDCloans
loansare
areloans
loansmade
madetotoless
lessdeveloped
developedcountries
countries

McGraw-Hill/Irwin

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2009, The McGraw-Hill Companies, All Rights

Loan Buyers
Loan
Loanbuyers
buyers

Investment
Investmentbanks
banksare
arethe
thepredominant
predominantbuyers
buyersof
ofHLT
HLTloans
loans

adept
adeptatatthe
theanalysis
analysisrequired
requiredtotovalue
valuethese
thesetypes
typesofofloans
loans
often
oftenare
areclosely
closelyassociated
associatedwith
withthe
theHLT
HLTborrower
borrower

Vulture
Vulturefunds
fundsare
arespecialized
specializedfunds
fundsthat
thatinvest
investinindistressed
distressedloans
loans
Other
Otherdomestic
domesticbanks
banks
traditional
traditionalcorrespondent
correspondentrelationships
relationshipsare
arebreaking
breakingdown
downasasmarkets
markets
get
getmore
morecompetitive
competitive
counterparty
counterpartyrisk
riskand
andmoral
moralhazard
hazardhave
haveincreased
increased
barriers
barrierstotonationwide
nationwidebanking
bankinghave
haveeroded
erodedand
andfewer
fewersmaller
smallerbanks
banks
exist
existnow
nowthan
thanininthe
thepast
past

McGraw-Hill/Irwin

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2009, The McGraw-Hill Companies, All Rights

Loan Buyers
Loan
Loanbuyers
buyers(cont.)
(cont.)

Foreign
Foreignbanks
banksare
arethe
thedominant
dominantbuyer
buyerof
ofU.S.
U.S.bank
bankloans
loans
Insurance
Insurancecompanies
companiesand
andpension
pensionfunds
fundsbuy
buylong-term
long-termloans
loans
Closed-end
Closed-endbank
bankloan
loanmutual
mutualfunds
fundsbuy
buyU.S.
U.S.bank
bankloans
loans
Nonfinancial
Nonfinancialcorporations:
corporations:predominantly
predominantlyfinancial
financialservice
servicearms
arms
of
ofthe
thevery
verylargest
largestcompanies
companies

Loan
LoanSellers
Sellers

Money
Moneycenter
centerbanks
banksdominate
dominateloan
loansales
sales
Small
Smallregional
regionalor
orcommunity
communitybanks
bankssell
sellloans
loanstotodiversify
diversifycredit
credit
risk
risk
Foreign
Foreignbanks
banks
Investment
Investmentbanks
bankssell
sellloans
loansrelated
relatedtotoHLTs
HLTs

McGraw-Hill/Irwin

24-8

2009, The McGraw-Hill Companies, All Rights

LDC Debt
LDC
LDCloan-for-bond
loan-for-bondrestructuring
restructuringprograms
programsare
arecalled
called
debt-for-debt
debt-for-debtswaps
swaps

developed
developedunder
underthe
theU.S.
U.S.Treasurys
TreasurysBrady
BradyPlan
Planand
andunder
under
organizations
such
as
the
International
Monetary
Fund
organizations such as the International Monetary Fund(IMF)
(IMF)

aaBrady
Bradybond
bondisisaabond
bondthat
thatisisswapped
swappedfor
forand
andoutstanding
outstandingloan
loantoto
an
anLDC
LDC

once
onceFIs
FIsloans
loansare
areswapped
swappedfor
forbonds,
bonds,the
thebonds
bondscan
canbe
besold
soldinin
the
thesecondary
secondarymarket
market

LDC
LDCbonds
bonds

have
havemuch
muchlonger
longermaturities
maturitiesthan
thanthat
thatpromised
promisedon
onthe
theoriginal
original
loans
loans
have
havelower
lowerpromised
promisedoriginal
originalcoupons
coupons(i.e.,
(i.e.,yields)
yields)than
thanthe
the
interest
rates
on
the
original
loans
interest rates on the original loans

McGraw-Hill/Irwin

24-9

2009, The McGraw-Hill Companies, All Rights

Loan Sales
Factors
Factorsencouraging
encouragingfuture
futureloan
loansales
salesgrowth
growth

fee
feeincome:
income:fee
feeincome
incomefrom
fromoriginating
originatingloans
loansisisreported
reportedasascurrent
current
income,
while
interest
earned
on
the
loans
is
reported
only
when
income, while interest earned on the loans is reported only whenreceived
received
ininfuture
periods
future periods
liquidity
liquidityrisk:
risk:creating
creatingaasecondary
secondarymarket
marketfor
forloans
loansreduces
reducesthe
the
illiquidity
of
loans
held
as
assets
illiquidity of loans held as assets
capital
capitalcosts:
costs:regulatory
regulatorycapital
capitalratios
ratioscan
canbe
beincreased
increasedby
byreducing
reducingthe
the
overall
size
of
the
balance
sheet
overall size of the balance sheet
reserve
reserverequirements:
requirements:reducing
reducingthe
theoverall
overallsize
sizeofofthe
thebalance
balancesheet
sheetcan
can
reduce
the
amount
of
reserves
a
bank
must
hold
against
its
deposits
reduce the amount of reserves a bank must hold against its deposits

Factors
Factorsdiscouraging
discouragingfuture
futureloan
loansales
salesgrowth
growth

access
accesstotothe
thecommercial
commercialpaper
paper(CP)
(CP)market:
market:many
manyfirms
firmsnow
nowrely
relyon
on
CP
CPrather
ratherthan
thanbank
bankloans
loans
legal
legalconcerns
concernssuch
suchasasfraudulent
fraudulentconveyance
conveyance

McGraw-Hill/Irwin

24-10

2009, The McGraw-Hill Companies, All Rights

Loan Securitization
Pass-through
Pass-throughmortgage
mortgagesecurities
securitiespass-through
pass-through
promised
promisedpayments
paymentsby
byhouseholds
householdsof
ofprincipal
principaland
and
interest
intereston
onpools
poolsof
ofmortgages
mortgagescreated
createdby
byFIs
FIsto
tosecondary
secondary
market
marketinvestors
investorsholding
holdingan
aninterest
interestin
inthese
thesepools
pools
Each
Eachpass-through
pass-throughsecurity
securityrepresents
representsaafractional
fractional
ownership
ownershipshare
sharein
inaamortgage
mortgagepool
pool
Pass-through
Pass-throughsecuritization
securitizationwas
wasoriginally
originallydeveloped
developedby
by
government-sponsored
government-sponsoredprograms
programsto
toenhance
enhancethe
theliquidity
liquidity
of
ofresidential
residentialmortgages
mortgages

Ginnie
GinnieMae
Mae(GNMA)
(GNMA)
Fannie
FannieMae
Mae(FNMA)
(FNMA)
Freddie
FreddieMac
Mac(FHLMC)
(FHLMC)

McGraw-Hill/Irwin

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2009, The McGraw-Hill Companies, All Rights

GNMA Pass-Through Security Creation

Suppose
Suppose1,000
1,000mortgages
mortgagesfor
for$100,000
$100,000each
eachare
are
originated
originatedby
byan
anFI
FI
As
Asaaresult
resultof
ofthe
themortgages
mortgages(and
(andfrom
fromhaving
havingto
tofund
fundthe
the
mortgages
mortgageswith
withdeposits)
deposits)

the
theFI
FIfaces
facesthe
theregulatory
regulatoryburden
burdenof
ofcapital
capitalrequirements,
requirements,reserve
reserve
requirements,
requirements,and
andFDIC
FDICinsurance
insurancepremiums
premiums
the
theFI
FIisisexposed
exposedtotointerest
interestrate
raterisk
riskand
andliquidity
liquidityrisk
risk

The
TheFI
FIcan
canavoid
avoidthe
theregulatory
regulatoryburden
burdenand
andrisk
riskexposure
exposure
by
bysecuritizing
securitizingthe
theloans
loansand
andthus
thusremoving
removingthem
themfrom
fromthe
the
balance
balancesheet:
sheet:
1.1. the
theloans
loansget
getpackaged
packagedtogether
togetherinto
intoaamortgage
mortgagepool
pool

McGraw-Hill/Irwin

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2009, The McGraw-Hill Companies, All Rights

GNMA Pass-Through Security Creation

2.2. the
themortgage
mortgagepool
poolisisremoved
removedfrom
fromthe
thebalance
balancesheet
sheetby
by
placing
placingititwith
withaathird-party
third-partytrustee
trustee
3.3. GNMA
GNMAguarantees,
guarantees,for
foraafee,
fee,the
thetiming
timingof
ofinterest
interestand
and
principal
principalpayments
paymentsassociated
associatedwith
withthe
thepool
poolof
ofmortgages
mortgages
4.4. the
theFI
FIcontinues
continuesto
toservice
servicethe
thepool
poolof
ofmortgages,
mortgages,for
foraafee,
fee,
even
evenafter
afterthe
themortgages
mortgagesare
areplaced
placedin
intrust
trust
5.5. GNMA
GNMAissues
issuespass-through
pass-throughsecurities
securitiesbacked
backedby
bythe
the
mortgage
mortgagepool
pool
6.6. the
thesecurities
securitiesare
aresold
soldto
tooutside
outsideinvestors
investorsand
andthe
theproceeds
proceeds
go
goto
tothe
theoriginating
originatingFI
FI

McGraw-Hill/Irwin

24-13

2009, The McGraw-Hill Companies, All Rights

Prepayment Risk
Most
Most mortgages
mortgages are
are fully
fully amortized
amortized

full
fullamortization
amortizationisisthe
theequal,
equal,periodic
periodicrepayment
repaymenton
on
aaloan
loanthat
thatreflects
reflectspart
partinterest
interestand
andpart
partprincipal
principalover
over
the
thelife
lifeof
ofthe
theloan
loan

Many
Many mortgages
mortgages are
are paid
paid off
offprior
prior to
to maturity
maturity
because
because borrowers
borrowers move
move or
or refinance
refinance their
their
mortgages
mortgages
to
toprepay
prepayisisto
topay
payback
backaaloan
loanbefore
beforeits
itsmaturity
maturity

Thus,
Thus, realized
realized cash
cash flows
flows can
can deviate
deviate from
from
expected
expected cash
cash flows
flows
McGraw-Hill/Irwin

24-14

2009, The McGraw-Hill Companies, All Rights

Collateralized Mortgage Obligations

Collateralized
Collateralized mortgage
mortgage obligations
obligations (CMOs)
(CMOs)
are
are mortgage-backed
mortgage-backedbonds
bonds issued
issued in
in multiple
multiple
classes
classes or
or tranches
tranches
tranches
tranchesare
aredifferentiated
differentiatedby
bythe
theorder
orderin
inwhich
whicheach
each
class
classisispaid
paidoff
off
each
eachclass
classhas
hasaaguaranteed
guaranteedcoupon
couponpayment
paymentbut
but
prepayment
prepaymentof
ofprincipal
principaloccurs
occurssequentially
sequentiallyto
toonly
only
one
oneclass
classof
ofbondholder
bondholderatataatime
time

thus,
thus,some
someclasses
classesof
ofbondholders
bondholdersare
aremore
moreprotected
protectedagainst
against
prepayment
prepaymentrisk
riskthan
thanothers
others

McGraw-Hill/Irwin

24-15

2009, The McGraw-Hill Companies, All Rights

Creation of a Three-Class CMO

CMOs
CMOsare
areusually
usuallycreated
createdby
byplacing
placingexisting
existingpasspassthrough
throughsecurities
securitiesin
inaatrust
trustoff-the-balance-sheet
off-the-balance-sheet
The
Thetrust
trustissues
issuesthree
threedifferent
differentclasses,
classes,each
eachwith
withaa
different
differentlevel
levelof
ofprepayment
prepaymentrisk
risk

Class
ClassAACMO
CMOholders
holdershave
havethe
theleast
leastprepayment
prepaymentprotection
protectionas
asall
all
principal
principalprepayments
prepaymentsare
arefirst
firstpaid
paidtotothis
thistranche
trancheuntil
untilthey
theyhave
have
been
beenpaid
paidoff
offininfull
full
after
afterall
allClass
ClassAACMOs
CMOshave
havebeen
beenretired,
retired,Class
ClassBBCMO
CMOholders
holders
receive
receiveprincipal
principalprepayment
prepaymentcash
cashflows
flows
finally,
finally,Class
ClassCChas
hasthe
themost
mostprepayment
prepaymentprotection
protectionas
asthey
theyare
are
the
last
trance
to
be
receive
principal
payments
the last trance to be receive principal payments
note:
note:each
eachclass
classalso
alsoreceives
receivesregular
regularcoupon
coupon(interest)
(interest)payments
payments

McGraw-Hill/Irwin

24-16

2009, The McGraw-Hill Companies, All Rights

Collateralized Mortgage Obligations

The
Thesum
sumof
ofthe
theprices
pricesatatwhich
whichCMO
CMOclasses
classescan
canbe
besold
sold
normally
normallyexceeds
exceedsthat
thatof
ofthe
theoriginal
originalpass-through
pass-through
the
theCMOs
CMOsrestructured
restructuredprepayment
prepaymentrisk
riskmakes
makeseach
eachclass
classmore
more
attractive
to
specific
classes
of
investors
attractive to specific classes of investors
CMOs
CMOswith
withup
uptoto17
17different
differentclasses
classeshave
havebeen
beencreated
created

CMOs
CMOsoften
oftencontain
containaaZZclass
classthat
thataccrues,
accrues,but
butdoes
doesnot
not
pay,
pay,interest
interest(or
(orprincipal)
principal)until
untilall
allother
otherclasses
classeshave
havebeen
been
fully
fullyretired
retired
Another
Anotherspecial
specialCMO
CMOclass
classisisaaplanned
plannedamortization
amortization
class
class(PAC)
(PAC)

produces
producesaaconstant
constantcash
cashflow
flowwithin
withinaaband
bandof
ofprepayment
prepaymentrates
rates
offers
offersgreater
greaterpredictability
predictabilityof
ofcash
cashflows
flows
has
haspriority
priorityininreceiving
receivingprincipal
principalpayments
payments

McGraw-Hill/Irwin

24-17

2009, The McGraw-Hill Companies, All Rights

Collateralized Mortgage Obligations

Most
MostCMOs
CMOstoday
todayare
arecreated
createdas
asreal
realestate
estatemortgage
mortgage
investment
investmentconduits
conduits(REMICs)
(REMICs)

REMICs
REMICspass-through
pass-throughall
allinterest
interestand
andprincipal
principalpayments
paymentsbefore
before
taxes
taxesare
arelevied
levied

Mortgage
Mortgagepass-through
pass-throughstrips
stripsare
areaaspecial
specialtype
typeof
ofCMO
CMO
with
withonly
onlytwo
twoclasses
classes
the
theprincipal
principalcomponent
componentof
ofthe
thepass-through
pass-throughisisseparated
separatedfrom
fromthe
the
interest
interestcomponent
component

McGraw-Hill/Irwin

an
aninterest
interestonly
only(IO)
(IO)strip
stripisisaaCMO
CMOwith
withclaim
claimtotothe
theinterest
interest
aaprincipal
principalonly
only(PO)
(PO)strip
stripisisaaCMO
CMOwith
withclaim
claimtotothe
theprincipal
principal

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2009, The McGraw-Hill Companies, All Rights

Collateralized Mortgage Obligations

Special
Special features
features of
of IO
IO strips
strips
when
whenprepayment
prepaymentoccurs
occurs

the
theamount
amountof
ofinterest
interestpayments
paymentsthe
theIO
IOinvestor
investorreceives
receivesfalls
falls
as
asthe
theoutstanding
outstandingprincipal
principalininthe
themortgage
mortgagepool
poolfalls
falls
the
thenumber
numberof
ofinterest
interestpayments
paymentsthe
theIO
IOinvestor
investorreceives
receivesmay
may
also
alsoshrink
shrink

because
becausethe
thevalues
valuesof
ofIO
IOstrips
stripscan
canfall
fallwhen
wheninterest
interest
rates
ratesdecline,
decline,IO
IOstrips
stripsare
areaarare
raresecurity
securitywith
with
negative
negativeduration
duration
this
thisunique
uniquefeature
featuremakes
makesIO
IOstrips
stripsuseful
usefulas
asaaportfolioportfoliohedging
hedgingdevice
device

McGraw-Hill/Irwin

24-19

2009, The McGraw-Hill Companies, All Rights

Mortgage Backed Bonds

Mortgage
Mortgagebacked
backedbonds
bonds(MBBs)
(MBBs)are
arebonds
bondscollateralized
collateralizedby
byaapool
pool
of
ofmortgages
mortgages
MBBs
MBBsdiffer
differfrom
frompass-throughs
pass-throughsand
andCMOs
CMOs

mortgages
mortgagesremain
remainon
onthe
thebalance
balancesheet
sheet
mortgages
mortgagescollateralize
collateralizeMBBs,
MBBs,but
butare
arenot
notdirectly
directlyrelated
relatedtotothe
the
associated
associatedcash
cashflows
flows

FIs
FIsusually
usuallyback
backMBBs
MBBswith
withexcess
excesscollateral,
collateral,which
whichresults
resultsininaa
higher
higherinvestment
investmentrating
ratingfor
forthe
theMBB
MBBthan
thanfor
forthe
theissuing
issuingFI
FI
MBB
MBBcosts
costs

MBBs
MBBstie
tieup
upmortgages
mortgageson
onthe
thebalance
balancesheet
sheetfor
forlong
longperiods
periodsof
oftime
time
the
theFI
FIisissubject
subjecttotoprepayment
prepaymentrisk
riskon
onthe
theunderlying
underlyingmortgages
mortgages
the
theFI
FIcontinues
continuestotoface
facecapital
capitaladequacy
adequacyand
andreserve
reserverequirement
requirementtaxes
taxes
asasthe
mortgages
remain
on
the
balance
sheet
the mortgages remain on the balance sheet

McGraw-Hill/Irwin

24-20

2009, The McGraw-Hill Companies, All Rights

Securitization of Other Assets

The
Thesame
samesecuritization
securitizationtechniques
techniquesapplied
appliedto
tomortgages
mortgages
have
havebeen
beenused
usedto
tosecuritize
securitizeother
otherassets:
assets:

automobile
automobileloans
loans
credit
creditcard
cardreceivables
receivables(CARDs)
(CARDs)
Small
SmallBusiness
BusinessAdministration
Administrationguaranteed
guaranteedsmall
smallbusiness
businessloans
loans
commercial
commercialand
andindustrial
industrialloans
loans
student
studentloans
loans
mobile
mobilehome
homeloans
loans
junk
junkbonds
bonds
time
timeshare
shareloans
loans
adjustable-rate
adjustable-ratemortgages
mortgages

McGraw-Hill/Irwin

24-21

2009, The McGraw-Hill Companies, All Rights