Objectives:

1. Credit-Related Off-Balance Sheet Activities • Objectives: • Consider how letters of credit, loan commitments, and other credit derivatives can be used to separate the credit risk and funding functions of lending. • Analyze the economic rationale for loan sales. • Examine asset securitizations and how they are structured.

2. Credit Derivatives • Recall that two basic functions of FIs are to efficiently • screen the credit risk of potential borrowers. • monitor borrowers after they have obtained financing. • To have an incentive to perform these functions efficiently, a FI needs to be exposed to losses if the borrower defaults, that is, the FI needs to be exposed to the borrower’s credit risk. • However, this does not imply that the FI needs also to provide the funding (financing) of the borrower. Letters of credit and loan commitments are examples where the party who provides funding for a borrower is different from the party who is exposed to the borrower’s credit risk.

3. Commercial Letters of Credit (CLC): CLCs are a FI’s (bank’s) guarantee against the default of firm on its payment for goods that the firm bought from a seller. CLCs are used to support trade, particularly international trade. • The economic rational for CLC is that shipping goods takes time. A buyer (importer) may wish to pay after it has received the goods, but a seller (exporter) may not know the buyer’s credit-worthiness. The solution is that a reputable FI (in the buyer’s country) will make payment if the goods are shipped. • The arrangement is efficient because • Less costly for the FI to evaluate the buyer’s credit. • Seller avoids the buyer’s credit risk.

4. Suppose at date 0, a buyer and seller agree to a transaction. Shipping the goods takes T periods, which if the goods are received in satisfactory condition, the buyer will pay the bill. • At date 0: • Buyer pays a fee to its (reputable) bank who issues a CLC along with a Bankers Acceptance (BA) to the seller on behalf of the buyer. The BA is a promise by the bank to make a payment at date T for the full amount of the bill. • In most cases, the seller immediately sells the BA back to the bank for its discounted value (PV of date T payment). • The bank then re-issues the BA to a third party investor. Since the BA is a promise by the bank to make a payment at date T, it is similar to a wholesale CD issued by the bank that matures at date T. • The effect is that the bank’s net cash flow at date T is just the “fee” it receives for its CLC guarantee. Effectively, the BA investor funds the buyer’s credit.

5. At date T: • When the buyer receives the goods in satisfactory condition, the buyer’s payment of the bill is due. If the buyer doesn’t default, it pays the bank the full amount which the bank then transfers to the BA investor. The bank’s net cash flow at date T is zero. • If the buyer does default, the bank is still makes its promised payment to the BA investor. In this case, the bank’s net cash flow at date T equals the credit risk loss it suffers due to the buyer’s default. • The net effect of a CLC along with a BA is that the bank receives a fee (default risk premium) at date 0 in return for guaranteeing the buyer’s bill obligation. The BA investor provides financing of the buyer’s credit but is not exposed to the buyer’s credit risk.

6. Standby Letters of Credit (SLC): is a similar to CLC in that the FI (e.g., bank or insurance company) guarantees payment if a party defaults on a debt obligation. • However, for the case of the previous trade example, the seller of the good would provide (trade) credit to the buyer and the FI would make payment to the seller if the buyer defaults. As with a CLC, the buyer pays the FI an initial fee for providing the seller with this default insurance on behalf of the buyer. • SLCs are used in other contexts: • A state or local governments sometimes issues a municipal bond backed by a SLC. The municipality pays a FI an initial fee and the FI guarantees the municipal bondholders that they will received their promised bond payments if the municipality defaults. This insurance lowers the interest rate on the municipal bond required by bondholders.

7. Sometimes a firm issues commercial paper backed by a SLC. In return for paying a fee to the FI, the firm obtains a guarantee on its promised payment to the commercial paper investors, thereby lowering the interest rate (default risk premium) required by the investors. • SLC substitute for construction performance bonds. • SLC are used to guarantee payments on asset-backed securities. • Recall that we showed that the value of a bond guarantee, G, equals the value of a put option on the bond issuer’s assets, A, with an exercise equal to the bond’s promised payment, B: • which implies that a letter of credit’s value (the fair initial fee that a bond issuer would pay a FI) can be estimated using this put option formula.

8. Loan commitments: Loan commitments are sometimes used to provide “partial” credit insurance. This occurs most commonly when a firm issues commercial paper with a back-up line of credit (BULC) from a FI. • When a firm issues commercial paper, in most cases it pays a fee to its bank in return for obtaining a BULC that covers the period when the paper is outstanding. • If, at the commercial paper’s maturity date, the firm has difficulty coming up with funds to make its promised payment, it may borrow from its bank using its BULC. Knowing the firm has a BULC, investors have more confidence in being paid. • However, a BULC contain a “Materially Adverse Change” clause that banks will sometimes invoke to pull their BULC and the commerical paper will default. Hence, a BULC is not as solid default insurance as is a SLC.

9. Credit default swap (CDS): an agreement between two parties whereby the “protection buyer” (short the credit) party makes periodic fixed payments to the “protection seller” (long the credit) party in return for the protection seller buying a loan or bond at its par value should the loan or bond default. • Example: Citicorp makes a 5-year, $100 m. floating rate loan to Mirant Corp. where Mirant promises to make semi-annual coupon payments equal to 6-month LIBOR plus a spread of 1.25 % and to pay the $100 m. principal at maturity. • Shortly after the loan is originated, Citicorp agrees to a CDS with the insurance company Aegon. At each of Mirant’s semi-annual coupon payment dates, Citicorp pays Aegon a fixed fee equal to ½x1 % x $100m. = $0.5m as long as Mirant does not default. If Mirant does default, Aegon purchases the Mirant loan for $100 m. and the swap ends.

10. In one scenario, Mirant would not default during the 5-year period and, effectively, Aegon would collect a 1 % semi-annually paid fee from Citicorp over the entire period. • In another scenario, Mirant would default three years into the contract at the sixth coupon payment date. Aegon would collect the 1 % fee for only the first five coupon dates and then purchase the defaulted loan from Citicorp at the sixth date. If the market price of Mirant’s loan at the time of default is $40m (reflecting the present value of the loan’s recovery value in bankruptcy proceedings), Aegon’s loss at the time of the default is $100m - $40 m. = $60 m. Pays fixed fee if no default Citicorp Protection Buyer Aegon Protection Seller Buys loan at par if default

11. The CDS is like a SLC but with the fee paid over the life of the debt instrument rather than all at the beginning. • A concern that arises when a bank originates a loan and then purchases credit protection via a CDS is that the bank may no longer have an incentive to efficiently monitor the borrower. • In addition, since the bank usually has better (private) information about the borrower than the public, it may have an incentive to buy credit protection after it learns that the borrower’s financial condition is deteriorating. • These moral hazard problems could mean that sellers of credit protection may demand high fees. Indeed, after Enron and Worldcom bankruptcies, FIs selling credit protection have become more hesistant and the CDS market slowed.

12. Loan Sales • As we have seen, credit derivatives are ways that FI can increase or reduce their exposure to credit risks. They allow for the separation of funding and risk exposure. • Loan sales are another way that FIs can transfer funding and credit risks. Loan sales occur when a bank originates a loan but then sells its cashflows to another FI. • To qualify as a true loan sale, so that the loan can be transferred from the selling FI’s balance sheet to the buying FI’s balance sheet, the loan must be sold without recourse. This means that the loan buyer cannot seek compensation from the seller if the loan defaults.

13. While loan sales have some similarities to bond underwriting, the originating bank may still collect the loan payments paid by the borrower and transfer them to the loan buyer. • Also, loans made to lesser-known firms are more difficult to sell because buyers are wary of the moral hazard incentives of the seller: the originating (selling) bank may not efficiently screen and monitor the borrower if the loan is sold because the seller is no longer is exposed to the borrower’s credit risk. • In these cases, the selling bank may need to retain a share of the loan to convince buyers that it will act efficiently. • Hence, there are limits on loan sales. Loans of well-known (lesser-known) firms that require little (much) screening and monitoring are easy (difficult) to sell. But improvements in information technology have increased information on firms, thereby increasing loan sales.

14. What are the reasons for loan sales? First, similar to loan syndications, loan sales allow a FI to diversify risks. It can originate a large loan but share its risk by selling part of it. • Second, by selling a loan, a FI can originate a loan but have other investors (FIs) fund the loan. This can reduce the loan’s cost of funding because costs of capital (and possibly reserve) requirements are avoided. • To see this, recall that when a bank funds loans using deposits and required equity capital, its return on equity is given by • where rN is a bank’s rate of return on loans, rD is its interest rate on deposits, t is its corporate tax rate,  is the require reserve / deposit ratio and k is the required capital / asset ratio.

15. Recall also that (large) money center banks finance their assets by issuing “purchased funds” (such as wholesale CDs) which are free from reserve requirements ( =0) but require the bank to pay a competitive money market interest rate, say rD = rM. Thus, this bank’s return on equity would be • If this bank made a loan to a well-known, creditworthy corporation, the competitive loan rate would be rN = rM + s where s is a small spread. If this loan was funded by purchased funds and required capital the bank’s ROE would be

16. Thus, if s is sufficiently small, it would not be profitable to make the loan and fund it with deposits and required equity capital. • However, if the money center bank made the loan and sold it to a loan buyer, the loan would be taken off the bank’s balance sheet so that no deposits or equity capital would be needed to fund the loan. Funds to finance the loan would come from a loan buyer at the competitive rate of rM. • Importantly, because no additional equity capital needs to be raised (which would increase the bank’s corporate taxes), the bank’s all in cost of funding the loan is simply rM. This means that the bank would receive rM + s on the loan and payout rM to the loan buyer, pocketing the spread, s, as fee income for originating the loan.

17. Traditional On-Balance Sheet Funding rM Depositors rM + s < rM Borrower Bank Shareholders taxes from higher capital IRS Off-Balance Sheet Loan Sale rM + s rM Borrower Bank Loan Buyer • Loan buyers can include “deposit rich” small banks that can issue retail deposits at interest rates rD < rM. Their ROE would be

18. Asset Securitization • Asset securitization is like a loan sale but involves selling the cashflows of a portfolio of loans, rather than a single loan. • The most common form of asset securitization involves selling mortgage-backed securities (MBS): securities that are claims on the cashflows from a portfolio of mortgages. • All non-mortgage securitizations involve so-called asset-backed securities (ABS): securities that are claims on the cashflows of non-mortgage loans, often consumer loans like automobile loans (CARS) and credit card receivables (CARDS). • The motivations for ABS are the same as single loan sales: diversification and lower funding costs. In addition, MBS can reduce a mortgage lender’s (thrift’s) reduce interest rate risk.

19. Asset securitizations start by a FI that originates a portfolio of loans, say auto loans, and then sells them to a specially created trust. The assets of the trust are the auto loans, while its liabilities are ABS (e.g., CARS). • Because the trust’s assets involve consumer loans whose credit quality might be suspect by ABS buyers, the securitization must include “credit enhancements.” The most common are a senior – subordinated ABS tranches and obtaining standby letters of credit (SLC) on the amount of loan defaults. ABS Trust Assets Liabilities Auto Loans Subordinated Tranche (Equity) SLC on loans Senior Tranche (Debt)

20. The originating FI arranges for a SLC from another FI to cover a portion of auto loan defaults. This reduces the risk of the trust’s assets. • The ABS representing the senior tranche are first in line to obtain their promised payments from the auto loan payments, while the subordinated tranche are second and bear the bulk of the risk of auto loan defaults. • The originating FI may retain a portion of the subordinated tranche (equity), which gives it an incentive to efficiently screen and monitor the auto loans because it retains a disproportionate share of the loans’ risk. • The safer senior tranche is sold to outside investors (e.g., pension funds, mutual funds). It usually receives a AAA credit rating.