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1. Loan Sales and Securitization
Chapters 27 & 28

2. Credit Risk Management
 contractual mechanisms to control credit risks of
lending:
– requiring higher interest rate spreads and fees on loans
to more risky borrowers
– restricting or rationing loans to more risky borrowers
– requiring enhanced security (collateral) for banks over
assets of risky borrowers
– diversifying across different types of risky borrowers
– placing more restrictive covenants on risky borrower’s
actions

3. Loan Sales
 correspondent banking
– small banks often make loans that are too large
for them to hold in full and then sell part to large
bank
 HLT (highly leveraged transaction) loan
– loan made to finance LBOs and M&As
 Loan sales
– with recourse
– without recourse

4. Loan Sales
 types of loan sales
– traditional short term
– HLT loan sales
 types of loan sale contracts
– participations
 buyer is not party to underlying credit agreement so initial loan
contract remains in place after sale
 buyer can only exercise partial control over changes in contract
terms and can only vote on material changes to contract
– assignments
 all rights are transferred on sale (buyer had direct claim on
borrower)
 transfer of loan has proof of change of ownership

5. Loan Sales
 buyers
– vulture funds
 specialized fund that invests in distressed loans
– investment banks
– other domestic banks
– foreign banks
– insurance companies and pension funds
– closed-end and open-end bank loan funds
– nonfinancial corporations
 sellers
– money center banks
– good bank-bad bank
– investment banks
– US government and agencies

6. Loan Sales
 reasons loans are sold
– manage credit risk
– reserve requirements
– fee income
– capital costs
– liquidity risk

7. Why do banks issue?
 Origins of CC ABS (cont’d):
– CEBA growth cap in 1987;
 Restricted nonbank banks.
– Bank capital crunch of late 1980s;
 Capital scarcity.
…all led to development of the ABS market.

8. Why do banks issue?
 Three main reasons:
– Asset-liability matching;
– Liquidity;
– Capital deepening (arbitrage).

9. Securitization
 packaging and selling of loans and other
assets backed by securities
– used to hedge interest rate gap exposures
– increase liquidity of asset portfolios
– provide source of fee income
 forms of securitization originated in real
estate market but being applied to many
other types of loans (credit card, auto,
student, C&I)

10. What do banks issue?
 Banks issue fixed income securities backed
by various types of assets.
 When assets are sold by issuer, they
become “super-collateral” owned by
securities holders.

11. What do banks issue?
 Interest and principal payments on
securities come from cash flows on assets
owned by securities holders.
– Pass-through security: all securities holders
equal have equal claim to cash flows;
– Asset-backed security: different seniority
classes of securities have sequential claims to
cash flows.

12. Pass-Through Security
 FIs pool mortgages – offer investors an
interest in pool (pass-through security
represents this interest)
– originally done to enhance liquidity of mortgage
market and thus subsidize growth of home
ownership
 GNMA
 FNMA
 FHLMC

13. Pass-Through Security
 bank originated 1,000 mortgages with average
size of $100,000
– maturity of 30 years and coupon of 12%
 bank uses capital and demand deposits to finance
loans
– also must fund reserve requirement
– need to pay deposit insurance premium
 all these “extra” costs give banks incentive to
securitize – profitability is “fee dependent” not
“interest rate spread dependent”

14. Pass-Through Securities
Assets Liabilities
Cash Reserves 10.67
Long-Term Mortgages 100
TOTAL 110.67
Demand deposits 106.67
Capital 4.00
TOTAL 110.67
Assets Liabilities
Cash Reserves 10.67
Cash Proceeds from Securiti 100
TOTAL 110.67
Demand deposits 106.67
Capital 4.00
TOTAL 110.67

15. CMOs
 collateralized mortgage obligations – 1983
 CFs from pool of mortgages are allocated to
multiple classes with different priority claims
 sequential-pay classes
 planned amortization classes (PACs)

16. What do banks issue?
 Sequential claims form the “waterfall.”
Senior
Sub 2
Sub 1

17. What do banks issue?
 Banks issue fixed income securities backed
by various types of assets.
– Since coupons on AAA are lowest, makes
sense for banks to issue as much AAA as will
be confirmed by ratings agencies.
– Lower quality loans will require lower AAA
issuance.
– Different market conditions may require lower
AAA issuance.

18. How do banks issue?
 Basic Method: Borrower
Loan
Originator
Special
Purpose
Trust
Rating
Agency
Credit
Enhancer
Underwriter
Investors

19. Credit Enhancement
 What is credit enhancement?
 Why is it needed?
 Is it important where the credit enhancement
comes from?
– outside credit enhancement
– inside credit enhancement

20. How do banks issue?
 How is credit enhancement achieved?
AAA
BBB
A
Recall, sequential claims form
the “waterfall.”
Since probability of receiving
principal and interest
payments is higher for the
senior securities, these may be
rated more highly by
Moodys/S&P/Fitch.
The most subordinated class
is very risky and may require
special placement in order for
the deal to sell.
CE

21. Example 1
 Suppose the mortgages in the pool have a
9% interest rate and further suppose the
CMO makes monthly payments. It could
make quarterly or semiannual payments as
well. The mortgage holders make their
scheduled monthly payments, if there are
defaults the pool organizer will make the
scheduled payment:

22. Example 1
Month 1 Amount paid into pool in Month 1: $2 million
Class
Beginning
Balance
Interest Due
& Paid Actual Principle reduction End Balance
A $50,000,000 $375,000 $2 mill - $1,125,000 =$875,000 $49,125,000
B $50,000,000 $375,000 $50,000,000
C $50,000,000 $375,000 $50,000,000
Total $1,125,000
Month 2 Amount paid into pool in Month 2: $3 million
Class
Beginning
Balance
Interest Due
& Paid Actual Principle reduction End Balance
A $49,125,000 $368,437 $3 mill - $1,118,437 =$1,881,563 $47,243,437
B $50,000,000 $375,000 $50,000,000
C $50,000,000 $375,000 $50,000,000
Total $1,118,437

23. Example 2
 IB buys a $150 million issue of GNMAs and
places them in a trust as collateral. It then
issues a CMO with the following 3 classes:
– Class A – annual fixed coupon 7%, class size
$50m
– Class B – annual fixed coupon 8%, class size
$50m
– Class C – annual fixed coupon 9%, class size
$50m

24. Mortgage-Backed Bond
 bonds collateralized by pools of assets
 different from pass-throughs and CMOs
– MBBs remain on balance sheet
– no direct link between CF on mortgages
backing the bond and the interest and principal
payments on the MBB
 FI takes pool of mortgages and pledges as
collateral on bonds they then issue

25. Example 3
 Consider FI with $20m in long-term mortgages
as assets. It is financing these with $10m in
short-term uninsured deposits and $10m in
insured deposits. (Ignore capital and reserve
requirements.)
Assets Liabilities
Long-term mortgages $20
Total $20
Insured Deposits $10
Uninsured Deposits $10
Total $20

26. Example 3
 consider balance sheet after MBB issue
Assets Liabilities
Collateral = (MV of segregated $12
Mortgages)
Other mortgages 8
Total $20
Insured Deposits $10
MBB Issue $10
Total $20

27. Mortgage Pass-Through Strips
 special type of CMO with two classes
 characteristic of mortgages is that they are fully
amortizing
– part of monthly payment is principal and part is interest
 strips – FI issuers strip out interest component
from principal component and sell each payment
stream to different class
– IO class – attractive to DIs for on balance sheet hedging
– PO class – attractive to FIs to increase interest rate
sensitivity of portfolio – also traders who want to take
speculative position on future course of interest rates
 interest rate changes affects each class differently