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1、CHAPTER 9 RISK MANAGEMENT USING ASSET-BACKED SECURITIES,LOAN SALES,CREDIT STANDBYS,AND CREDIT DERIVATIVES Goal of This Chapter:The purpose of this chapter is to learn about some of the newer financial instruments that financial institutions have used in recent years to help reduce the risk exposure
2、of their institutions and,in some cases,to aid in generating new sources of fee income and in raising new funds to make loans and investments.Key Topics in This Chapter The Securitization Process Securitizations Impact and Risks Sales of Loans:Nature and Risks Standby Credits:Pricing and Risks Credi
3、t Derivatives and CDOs Benefits and Risks of Credit Derivatives Chapter Outline I.Introduction II.Securitizing Bank Loans and Other Assets A.Nature of Securitization B.The Securitization Process C.Advantages of Securitization D.The Beginnings of Securitization The Home Mortgage Market 1.Collateraliz
4、ed Mortgage Obligations CMOs 2.Loan Backed Bonds E.Examples of Other Assets That Have Been Securitized F.The Impact of Securitization Upon Lending Institutions G.Regulators Concerns About Securitization Ill.Sales of Loans to Raise Funds A.Nature of Loan Sales B.Loan Participations and Loan Strips C.
5、Reasons Behind Loan Sales D.The Risks in Loan Sales IV.Standby Credit Letters A.The Nature of Standby Credits(Contingent Obligations)B.Types of Standby Credit Letters C.Advantages of Standbys D.Reasons for Rapid Growth of Standbys E.The Structure of Standby Letters of Credit F.The Value and Pricing
6、of Standby Letters G.Sources of Risk with Standby Credits H.Regulatory Concerns about Standby Credit Arrangements I.Research Studies on Standbys,Loan Sales,and Securitizations V.Credit Derivatives:Contracts for Reducing Credit Risk Exposure on the Balance Sheet A.An Alternative to Securitization B.C
7、redit Swaps C.Credit Options D.Credit Default Swaps E.Credit Linked Notes F.Collateralized Debt Obligations G.Risks Associated With Credit Derivatives VI.Summary of the Chapter Concept Checks 9-1.What does securitization of assets mean Securitization involves the pooling of groups of earning assets,
8、removing those pooled assets from the banks balance sheet,and issuing securities against the pool.As the pooled assets generate interest income and repayments of principal the cash generated by the pooled earning assets flows through to investors who purchased those securities.9-2.What kinds of asse
9、ts are most amenable to the securitization process The best types of assets to pool are high quality,fairly uniform loans,such as home mortgages or credit card receivables.9-3.What advantages does securitization offer lending institutions Securitization gives lending institutions the opportunity to
10、use their assets as sources of funds and,in particular,to remove lower-yielding assets from the balance sheet to be replaced with higher-yielding assets.9-4.What risks of securitization should the managers of lending institutions be aware of Lending institutions often have to use the highest-quality
11、 assets in the securitization process which means the remainder of the portfolio may become more risky,on average,increasing the banks capital requirements.9-5.Suppose that a bank securitizes a package of its loans that bear a gross annual interest yield of 13 percent.The securities issued against t
12、he 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
13、to Arunson Mortgage Servicing Corporation to process the expected payments generated by the packaged loans.If the above items represent all the costs associated with this securitization transaction can you calculate the percentage amount of residual income the bank expects to earn from this particul
14、ar transaction The banks estimated residual income should be about:Gross Loan Security Expected Default On Underwriting Yield-Interest Rate-Packaged Loans-And Advisory Fee 13%8.25%3.5%.35%Servicing Expected-Fee=Residual Income .25%.65%9-6.What advantages do sales of loans have for lending institutio
15、ns trying to raise funds Loan sales permit a lending institution to get rid of less desirable or lower-yielding loans and allow them to raise additional funds.In addition,replacing loans that are sold with marketable securities can increase the liquidity of the lending institution.9-7.Are there any
16、disadvantages to using loan sales as a significant source of funding for banks and other financial institutions The lender may find themselves selling off their highest quality loans,leaving their loan portfolio stocked with poor-quality loans which can trigger the attention of regulators who might
17、require higher capital requirements for the lender.9-8.What is loan servicing Loan servicing involves monitoring borrower compliance with a loans terms,collecting and recording loan payments,and reporting to the current holder of the loan.9-9.How can loan servicing be used to increase income Many ba
18、nks have retained servicing rights on the loans they have sold,earning fees from the current owners of those loans.9-10.What are standby credit letters Why have they grown so rapidly in recent years Standby credit letters are promises of a lender to pay off an obligation of one of its customers in c
19、ase that customer cannot pay.It can also be a guarantee that a project of customer is completed on time.There are several reasons that standby credit agreements have grown.There has been a tremendous growth in direct financing by companies(issuance of commercial paper)and with growing concerns about
20、 default risk on these direct obligations banks have been asked to provide a credit guarantee.Another reason for their growth is the ability of the bank to use their skills to add fee income to the bank Another reason is that these have a relatively low cost for the bank.Finally banks and customers
21、perceive that there has been an increase in economic fluctuations and there has been increased demand for risk reducing devices.9-11.Who are the principal parties to a standby credit agreement The principal parties to a standby credit agreement are the issuing bank or other institution,the account p
22、arty who requested the letter,and the beneficiary who will receive payment from the issuing institution if the account party cannot meet its obligation.9-12.What risks accompany a standby credit letter for(a)the issuer and(b)the beneficiary Standbys present the issuer with the danger that the custom
23、er whose credit the issuer has backstopped with the letter will need a loan.That is,the issuers contingent obligation will become an actual liability,due and payable.This may cause a liquidity squeeze for the issuer.The beneficiary that has to collect on the letter must be sure it meets all the cond
24、itions required for presentation of the letter or it will not be able to recover its funds.9-13 How can a lending institutions mitigate the risks inherent in issuing standby credit letters They can use various devices to reduce risk exposure from the standby credit letters they have issued,such as:1
25、.Frequently renegotiating the terms of any loans extended to customers who have standby credit guarantees so that loan terms are continually adjusted to the customers changing circumstances and there is less need for the beneficiaries of those guarantees to press for collection.2.Diversifying standb
26、y letters issued by region and by industry to avoid concentration of risk exposure.3.Selling participations in standbys in order to share risk with a variety of lending institutions.9-14.Why were credit derivatives developed What advantages do they have over loan sales and securitizations,if any Cre
27、dit derivatives were developed because not all loans can be pooled.In order to be pooled,the group of loans has to have common features such as maturities and cash flow patterns and many business loans do not have those common features.Credit derivatives can offer the beneficiary protection in the c
28、ase of loan default and may help the bank reduce its credit risk and possibly its interest rate risk as well.9-15.What is a credit swap For what kinds of situations was it developed A credit swap is where two lenders agree to swap portions of their customers loan repayments.It was developed so that
29、banks do not have to rely on one narrow market area.They can spread out the risk in the portfolio over a larger market area.9-16.What is a total return swap What advantages does it offer the swap beneficiary institution A total return swap is a type of credit swap where the dealer guarantees the swa
30、p parties a specific rate of return on their credit assets.A total return swap can allow a bank to earn a more stable rate of return than it could earn on its loans.This type of arrangement can also shift the credit risk and the interest rate risk from one bank to another.9-17.How do credit options
31、work What circumstances result in the option contract paying off A credit option helps guard against losses in the value of a credit asset or helps offset higher borrowing costs.A bank which purchases a credit option contract will exercise their option if the asset declines significantly in value or
32、 loses its value completely.If the assets are paid off as expected then the option will not be exercised and the bank will lose the premium they paid for the option.A bank can also purchase a credit option which will be exercised if their borrowing costs rise above a specified spread between their c
33、ost and a riskless asset.9-18.When is a credit default swap useful Why A credit default swap is a credit option written on a portfolio of assets or a credit swap on a particular loan where the other bank in the swap agrees to pay the first bank a certain fee if the loan defaults.This type of arrange
34、ment is designed for banks that can handle relatively small losses but want to protect themselves from serious losses.9-19.Of what use are credit-linked notes A credit-linked note allows the issuer of a note to lower the coupon payments if some significant fact changes.For example,if more loans on w
35、hich the notes are based default than expected,the coupon payments on the notes can be lowered.The lender has taken on credit-related insurance from the investors who have purchased the note.9-20.What are CDOs How do they differ from other credit derivatives A CDO is very similar to loan securitizat
36、ion,where the pool of assets can include high yield bonds,equities and other financial instruments,which are generally of higher risk than in the traditional loan securitization.9-21.What risks do credit derivatives pose financial institutions using them In your opinion what should regulators do abo
37、ut the recent rapid growth of this market,if anything There are several risks associated with these instruments.One risk is that the other party in the swap or option may fail to meet their obligation.Courts may rule that these instruments are illegal or improperly drawn.These types of instruments a
38、re relatively new and the markets for these instruments are relatively thin.If a bank needs to resell one of these contracts they may have difficulty finding a buyer or they may not be able to sell it at a reasonable price.Regulators need to understand clearly the benefits and risks of these types o
39、f credit instruments and act to ensure the safety of the banks.Problems 9-1.Giant National Bank has placed a group of 10,000 consumer loans bearing an average expected gross annual yield of 8 percent in a package to be securitized.The investment bank advising Giant estimates that the securities will
40、 sell at a slight discount from par that results in a net interest cost to the issuer of 9 percent.Based on recent experience with similar types of loans,the bank expects 3 percent of the packaged loans to default without any recovery for the lender and has agreed to set aside a cash reserve to cove
41、r this anticipated loss.Underwriting and advisory services provided by the investment banking firm will cost.5 percent.Giant will also seek a liquidity facility,costing.5 percent and a credit guarantee if actual loans should exceed the expected loan default rate,costing.6 percent.Please calculate th
42、e residual income for Giant from this loan securitization.The estimated residual income for Giant National Bank is:Gross Loan Security Expected Default On Underwriting Yield-Interest Rate-Packaged Loans-And Advisory Fee 8%9%3%.5%Liquidity Facility Credit Enhancement Expected-Fee-Fee=Residual Income
43、.5%.6%-5.6%9-2.Colburn Corporation is requesting a loan for repair of some assembly-line equipment in the amount of$7 million.The nine-month loan is priced by Farmers Financial Corporation at a 7.25 percent rate of interest.However,the finance company tells Colburn that if it obtains a suitable cred
44、it guarantee the loan will be priced at percent.Quinmark Bank agrees to sell Colburn a standby credit guarantee for$10,000.Is Colburn likely to buy the standby credit agreement Please explain.The interest savings from having the credit guarantee would be:$7 mill.*0.0725*?-$7 mill.x 0.0700*?=$380,625
45、-$367,500=$13,125 Clearly,the$10,000 guarantee is priced correctly and will be purchased.9-3.The Monarch Bank Corp.has placed$100 million of GNMA-guaranteed securities in a trust account off the balance sheet.A CMO with four tranches has just been issued by Monarch using the GNMAs as collateral.Each
46、 tranche has a face value of$25 million and makes monthly payments.The annual coupon rates are 4 percent for Tranche A,5 percent for Tranche B,6 percent for Tranche C,and 7 percent for Tranche D.a.Which tranche has the shortest maturity and which tranche has the most prepayment protection Tranche A
47、has the shortest maturity and tranche D has the most prepayment protection.b.Every month principal and interest are paid on the outstanding mortgages and some mortgages are paid in full.These payments are passed through to Monarch and the trustee uses the funds to pay the coupons to CMO bondholders.
48、What are the coupon payments owed for each tranche for the first month Tranche A:25 million x(.04/12)=$83,333 Tranche B:25 million x(.05/12)=$104,177 Tranche C:25 million x(.06/12)=$125,000 Tranche D:25 million x(.07/12)=$145,833 c.If scheduled mortgage payments and early prepayments bring in$1 mill
49、ion,how much will be used to retire the principal of CMO bondholders and which tranche will be affected Total interest to be paid:$83,333+$104,177+$125,000+$145,833=$458,343 Amount applied to principal:$1,000,000-$458,343=$541,657 Tranche A will be affected by the reduction in principal.d.Why does T
50、ranche D have a higher expected return Tranche D has the longest maturity and the highest reinvestment risk and thus,should have the highest expected return.In addition,since prepayments are first applied to the other tranches,tranche D also carries the highest amount of default risk.9-4.First Secur