Solution manual bank management and financial services 9th edition by rose, peter chap009

Chapter 09 - Risk Management: Asset-Backed Securities, Loan Sales, Credit Standbys, and Credit Derivatives

CHAPTER 9
RISK MANAGEMENT: 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 their risk exposure
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
Securitization’s Impact and Risks
Sales of Loans: Nature and Risks
Standby Credits: Pricing and Risks
Credit Derivatives and CDOs—Benefits and Risks
Chapter Outline

I. Introduction
II. Securitizing Loans and Other Assets
A. Nature of Securitization
B. The Securitization Process
C. Advantages and Disadvantages of Securitization
D. The Beginnings of Securitization—The Home Mortgage Market
1. Collateralized Mortgage Obligations (CMOs)
2. Home Equity Loans

3. 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
III. Sales of Loans to Raise Funds and Reduce Risk
A. Nature of Loan Sales
B. Forms of Loan Sales
1. Participation Loan
2. Assignments
3. Loan Strip
C. Reasons behind Loan Sales
D. The Risks in Loan Sales
IV. Standby Credit Letters to Reduce the Risk of Nonpayment or Nonperformance
A. The Nature of Standby Letter of Credit (Contingent Obligations)
B. Types of Standby Credit Letters
1. Performance Guarantees
2. Default Guarantees
C. Advantages of Standbys

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Chapter 09 - Risk Management: Asset-Backed Securities, Loan Sales, Credit Standbys, and Credit Derivatives

D. Reasons for Rapid Growth of Standbys
E. The Structure of SLCs
F. The Value and Pricing of Standby Letters
G. Sources of Risk with Standbys
H. Regulatory Concerns about SLCs
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. Credit Swaps
C. Credit Options
D. Credit Default Swaps (CDSs)
E. Credit-Linked Notes
F. Collateralized Debt Obligations (CDOs)
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 and removing those pooled assets
from the lender’s balance sheet. After that, the pool is usually designated as a special-purpose
entity (vehicle) and turned into collateral for issuing asset-backed securities. This process refers
to as securitization of assets. As the pooled assets generate interest income and repayments of
principal, the cash generated flows through to investors who purchased these securities.
9-2.

What kinds of assets 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 loans.
9-3.

What advantages does securitization offer to the lending institutions?

Securitization gives lending institutions the opportunity to 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.
The lending institution can create liquid assets out of illiquid, expensive-to-sell assets. Also, this
helps diversify the lender’s credit risk exposure.
It permits lenders to hold a more geographically diversified loan portfolio, perhaps countering
local losses with higher returns available from loans from different geographic areas with more
buoyant economies.
Securitization is also a tool for managing interest rate risk and possibly credit risk, depending on
the quality of the packaged loans.
Securitization opens avenues for lending institutions to earn added fee income from servicing the
packaged loans. Lenders can also benefit from the normal positive interest-rate spread between

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Chapter 09 - Risk Management: Asset-Backed Securities, Loan Sales, Credit Standbys, and Credit Derivatives

the average yield on the packaged loans and the coupon (promised) rate on the securities issued
against those loans, capturing residual income.
9-4.

What risks of securitization should the managers of lending institutions be aware of?

Lending institutions often have to use the highest-quality assets in the securitization process
which means the remainder of the portfolio may become more risky, on average, increasing the
bank’s capital requirements.
There is a risk of having to come up with large amounts of cash in a hurry to make payments to
investors holding asset-backed securities and cover bad loans.
The managers must be aware of the risk of agreeing to serve as an underwriter for asset-backed
securities that cannot be sold. Also, they must ensure that the appointed trustees are capable of

protecting the investors of asset-backed instruments.
9-5. Suppose that a bank securitizes a package of its loans that bears a gross annual interest
yield of 13 percent. The securities issued against the 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 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, can you calculate the
percentage amount of residual income the bank expects to earn from this particular transaction?
The bank’s estimated residual income should be about:
Gross Loan
Yield
13%

-

9-6.

Servicing
Fee
0.25%

-

Security
Interest Rate
8.25%

=

-

Expected Default On
Packaged Loans
3.5%

-

Underwriting
and Advisory Fee
0.35%

Expected
Residual Income
0.65%

What advantages do sales of loans have for lending institutions 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. Loan sales remove both credit risk
and interest rate risk from the lender’s balance sheet and may generate fee income up front.

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Chapter 09 - Risk Management: Asset-Backed Securities, Loan Sales, Credit Standbys, and Credit Derivatives

9-7. What are the risks of using loan sales as a significant source of funding for banks and
other financial institutions?

The lenders 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. The
regulators might require higher capital requirements from the lender.
The lender may have done a poor job of evaluating the borrower’s financial condition.Buying
such a loan, obligates the purchasing institution to review the condition of both, the lender and
the borrower.
In some cases, the seller of loan will give the benefit of recourse to the loan purchaser in case the
sold loan becomes delinquent. This arrangement forces both the buyer and seller to share the risk
of loan default.
9-8.

What is loan servicing?

Loan servicing involves monitoring borrower compliance with a loan’s 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 banks have retained servicing rights on the loans they have sold, earning fees from the
current owners of those loans. They generate fee income by collecting interest and principal
payments from borrowers and passing the proceeds along to loan buyers.
9-10. What are standby credit letters? Why have they grown so rapidly in recent years?
Standby credit letters are promises of the issuer to a lender to pay off an obligation of its
customer, in case that customer cannot pay. It can also be in the form of a guarantee that a project
of the customer will be completed on time.
The standby credit agreements have grown substantially in the recent years. There has been a
tremendous growth in direct financing by companies (issuance of commercial paper) and with
growing concerns about default risk on these direct obligations, increasing number of borrowers
have asked banks to provide a credit guarantee.

The opportunity standbys offer lenders to use their credit evaluation skills to earn additional fee
income without the immediate commitment of funds.
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 any other financial
institution known as the “issuer”, the “account party” who requested the letter, and the
“beneficiary” who will receive payment from the issuing institution if the account party cannot
meet its obligation.

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Chapter 09 - Risk Management: Asset-Backed Securities, Loan Sales, Credit Standbys, and Credit Derivatives

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 customer whose credit the issuer has
backstopped with the letter will need a loan. That is, the issuer’s contingent obligation will
become an actual liability, due and payable. This may cause a liquidity squeeze for the issuer.
Also, the beneficiary, that has to collect the letter must be sure that it meets all the conditions
required for presentation of the letter or it will not be able to recover its funds.
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How can a lending institution mitigate the risks inherent in issuing standby credit letters?

They can use various ways to reduce risk exposure from the standby credit letters they have
issued, such as:
1. Frequently renegotiating the terms of any loans extended to customers who have SLCs,
so that loan terms are continually adjusted to the customer’s changing circumstances and
there is less need for beneficiaries to press for collection.
2. Diversifying SLCs issued by region and by industry to avoid concentration of risk
exposure.

3. Selling participations in standbys in order to share risk with other lending institutions.
9-14. Why were credit derivatives developed? What advantages do they have over loan sales
and securitizations, if any?
Credit 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 case 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 customer’s loan repayments. It
was developed so that 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 swap 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.

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Chapter 09 - Risk Management: Asset-Backed Securities, Loan Sales, Credit Standbys, and Credit Derivatives

9-17. How do credit options 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 occurring due to a change in credit ratings. A lending institution, which
purchases a credit option contract, will exercise its option if the asset declines significantly in
value or loses its value completely. If the assets are paid off as expected, then the option will not

be exercised and the lender will lose the premium was paid for the option. The lender can also
purchase a credit option which will be exercised if its borrowing costs rise above a specified
spread between the costs and riskless assets.
9-18. When is a credit default swap useful? Why?
A credit default swap is related to a credit option where a lender may seek of a dealer willing to
write a put option 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
arrangement is designed for banks that can handle relatively small losses but want to protect
themselves from serious losses.
This type of swap is useful because, if the borrower defaults, then the dealer may pay the lender
for the depreciated value of the loan or may pay an amount of money agreed to when the swap
was arranged.
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
factor changes. For example, if more loans, 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 Collateralized Debt Obligations (CDOs)? How do they differ from other credit
derivatives?
A CDO is very similar to loan securitization, where the pool of assets can include high yield
corporate bonds, stock, commercial mortgages, or other financial instruments, which are
generally of higher risk than in the traditional loan securitization. Some CDO pools contain debt
and other financial instruments from dozens of companies in order to boost potential returns and
diversify away much of the risk.
9-21. What risks do credit derivatives pose for financial institutions using them? In your
opinion what should regulators do about the recent rapid growth of this market, if anything?
Answer:
There are several risks associated with the credit derivatives. One risk is that the other party in
the swap or option may fail to meet its obligation. Courts may rule that these instruments are
illegal or improperly drawn.

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Chapter 09 - Risk Management: Asset-Backed Securities, Loan Sales, Credit Standbys, and Credit Derivatives

These types of instruments are relatively new and the markets for these instruments are relatively
less. If a bank needs to resell one of these contracts, it may have difficulty finding a buyer or it
may not be able to sell it at a reasonable price.
Regulators need to understand clearly the benefits and risks of these types of credit instruments
and act to ensure the safety of the banks.
Problems
9-1. GoodLife National Bank placed a group of 10,000 consumer loans bearing an average
expected gross annual yield of 6 percent in a package to be securitized. The investment bank
advising GoodLife estimates that the securities will sell at a slight discount from par that results
in a net interest cost to the issuer of 4.0 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 cover this anticipated loss. Underwriting and
advisory services provided by the investment banking firm will cost 0.5 percent. GoodLife will
also seek a liquidity facility, costing 0.5 percent, and a credit guarantee if actual loan defaults
should exceed the expected loan default rate, costing 0.6 percent. Please calculate the residual
income for GoodLife from this loan securitization.
Answer:
The estimated residual income for GoodLife National Bank is:
Gross Loan
Yield
6%

-

Liquidity
Facility
Fee
0.5%

Security
Interest Rate
4%

-

-

Credit
Enhancement
Fee
0.6%

Expected Default On
Packaged Loans
3%

-

Expected
Residual Income
-2.6%

=

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-

Underwriting
And Advisory Fee
0.5%


Chapter 09 - Risk Management: Asset-Backed Securities, Loan Sales, Credit Standbys, and Credit Derivatives

9-2. Jasper Corporation is requesting a loan for repair of some assembly-line equipment in the
amount of $10.25 million. The nine-month loan is priced by Farmers Financial Corporation at a
6.5 percent rate of interest. However, the finance company tells Jasper that if it obtains a suitable
credit guarantee the loan will be priced at 6 percent. Lifetime Bank agrees to sell Jasper a
standby credit guarantee for $10,000. Is Jasper likely to buy the standby credit guarantee
Lifetime has offered? Please explain.
Answer:
The interest savings from having the credit guarantee would be:
[$10.25 mill. ì 0.065 ì ắ] - [$10.25 mill. ì 0.06 × ¾] =
$499,687.50 - $461,250.00 = $38,437.50
Clearly, the $10,000 guarantee is priced correctly and the standby credit guarantee will be
purchased. Jasper would only have to pay a 6 percent coupon rate and $10,000 towards bank
charges for the loan, instead of 6.5 percent.
9-3. The Pretty Lake 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 Pretty
Lake using the GNMAs as collateral. Each tranche has a face value of $25 million and makes
monthly payments. The annual coupon rates are 4.5 percent for Tranche A, 5 percent for Tranche
B, 5.5 percent for Tranche C, and 6.5 percent for Tranche D.
a. Which tranche has the shortest maturity, and which tranche has the most prepayment

protection?
Answer: Tranche A 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 Pretty Lake, and the
trustee uses the funds to pay coupons to CMO bondholders. What are the coupon
payments owed for each tranche for the first month?
Answer:
Tranche A: 25 million × (.045/12) = $93,750
Tranche B: 25 million × (.050/12) = $104,167
Tranche C: 25 million × (.055/12) = $114,583
Tranche D: 25 million × (.065/12) = $135,417
c. If scheduled mortgage payments and early prepayments bring in $5 million, how much
will be used to retire the principal of CMO bondholders and which tranche will be
affected?
Answer:
Total interest to be paid: $93,750 + $104,167 + $114,583 + $135,417 = $447,917
Amount applied to principal: $5,000,000 - $447,917 = $4,552,083

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Chapter 09 - Risk Management: Asset-Backed Securities, Loan Sales, Credit Standbys, and Credit Derivatives

Tranche A will be affected by the reduction in principal.
d. Why does Tranche D have a higher expected return?
Answer:
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 Security National Bank has been approached by a long-standing customer, United
Safeco Industries, for a $30 million term loan for five years to purchase new stamping machines
that would further automate the company’s assembly line in the manufacture of metal toys and
containers. The company also plans to use at least half the loan proceeds to facilitate its buyout
of Calem Corp., which imports and partially assembles video recorders and cameras. Additional
funds for the buyout will come from a corporate bond issue that will be underwritten by an
investment banking firm not affiliated with First Security.
The problem the bank’s commercial credit division faces in assessing this customer’s
loan request is a management decision reached several weeks ago that the bank should gradually
work down its leveraged buyout loan portfolio due to a significant rise in nonperforming credits.
Moreover, the prospect of sharply higher interest rates has caused the bank to revamp its loan
policy toward more short-term loans (under one year) and fewer term (over one year) loans.
Senior management has indicated it will no longer approve loans that require a commitment of
the bank’s resources beyond a term of three years, except in special cases.
Does First Security have any service option in the form of off-balance-sheet instruments
that could help this customer while avoiding committing $30 million in reserves for a five-year
loan? What would you recommend that management do to keep United Safeco happy with its
current banking relationship? Could First Security earn any fee income if it pursued your idea?
Suppose the current interest rate on Eurodollar deposits (three-month maturities) in
London is 3.40 percent, while Federal funds and six-month CDs are trading in the United States
at 3.57 percent and 3.19 percent, respectively. Term loans to comparable quality corporate
borrowers are trading at one-eighth to one-quarter percentage point above the three-month
Eurodollar rate or one-quarter to one-half point over the secondary-market CD rate. Is there a
way First Security could earn at least as much fee income by providing United Safeco with
support services as it could from making the loan the company has asked for (after all loan costs
are taken into account)? Please explain how the customer could benefit even if the bank does not
make the loan requested.
Answer:
In view of these reasonable objectives on the part of First Security National Bank’s management,
the bank should consider recommending that the leveraged buy-out portion of the request be

handled by an offering of bonds or, perhaps, 5-year notes, with the bank issuing a standby letter
of credit for a portion (though probably not all) of the bond or note issue. Armed with First
Security’s standby credit agreement, United Safeco should be able to borrow through a security
issue at a substantially lower interest rate. First Security could sell participations in the standby
credit to share its risk exposure.

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Chapter 09 - Risk Management: Asset-Backed Securities, Loan Sales, Credit Standbys, and Credit Derivatives

For the portion of the loan that calls for the purchase of new assembly-line equipment,
management might seriously consider proposing a shorter-term loan for about one-third to onehalf the total amount requested by Safeco. This loan would be secured by a pledge of the new
equipment plus sufficient covenants to insure the maintenance of adequate liquidity and require
bank approval before significant amounts of other forms of debt are undertaken.
First Security could generate fee income from this relationship by assessing a fee for issuing the
standby letter of credit. The fee for a standby letter of credit typically ranges from 1/2 percent to
1 percent of the amount of the standby guarantee, depending upon the bank’s assessment of the
degree of risk exposure in the guarantee.
If First Security issues a standby letter of credit on behalf of United Safeco as described above,
both parties should benefit. First Security, by issuing the standby credit agreement, does not have
to tie up $30 million in reserves for an extended period of time as it would if it made the
requested loan, particularly in a projected rising interest rate environment. The 1/2 percent to 1
percent fee would compare favorably in amount to the 1/8 to 1/4 percent spread over the
Eurodollar rate or the 1/4 to 1/2 percent spread over the federal funds or CD rate that currently
prevails in the market. Under the risk-based capital standards now in effect, the standby letter of
credit will require the bank to hold capital in an amount equal to the capital requirement for the
loan. Therefore, United Security National will have the same capital requirement for either
transaction, the loan or the standby letter of credit.
Also, as stated above, United Safeco should be able to issue bonds or notes at a more favorable

rate with United Security National’s standby letter of credit behind them.
9-5. What type of credit derivatives contract would you recommend for each of the following
situations:
a. A bank plans to issue a group of bonds backed by a pool of credit card loans but fears
that the default rate on these credit card loans will rise well above 6 percent of the
portfolio – the default rate it has projected. The bank wants to lower the interest cost on
the bonds in case the loan default rate rises too high.
Answer:
The best solution to this problem is to use credit-linked notes. The interest payments on
these notes will change if significant factors change.
b. A commercial finance company is about to make a $50 million project loan to develop
a new gas field and is concerned about the risks involved if petroleum geologists’
estimates of the field’s potential yield turn out to be much too high and the field
developer cannot repay.
One possibility for solving this problem is to use a credit option. If the developer cannot
repay the loan then the option would pay off. They would lose their premium if the
developer can repay the loan but they are protected against significant loss.

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Chapter 09 - Risk Management: Asset-Backed Securities, Loan Sales, Credit Standbys, and Credit Derivatives

c. A bank holding company plans to offer new bonds in the open market next month, but
knows that the company’s credit rating is being reevaluated by credit-rating agencies. The
holding company wants to avoid paying sharply higher credit costs if its rating is lowered
by the investigating agencies.
A credit risk option would be a good solution to this problem because it protects the
bank from higher borrowing costs in the future. If the borrowing costs rise above the
spread specified in the option contract, the contract would pay off.

d. A mortgage company is concerned about possible excess volatility in its cash flow off a
group of commercial real estate loans supporting the building of several apartment
complexes. Moreover, many of these loans were made at fixed interest rates, and the
company’s economics department has forecast a substantial rise in capital market interest
rates. The company’s management would prefer a more stable cash flow emerging from
this group of loans if it could find a way to achieve it.
One possibility to solve this problem would be to enter into a total return swap with
another bank. The other bank would receive total payments of interest and principal on
this loan as well as the price appreciation on this loan. The original bank would receive
LIBOR plus some spread in return as well as compensation for any depreciation in value
of the loan.
e. First National Bank of Ashton serves a relatively limited geographic area centered
upon a moderate-sized metropolitan area. It would like to diversify its loan income but
does not wish to make loans in other market areas due to its lack of familiarity with loan
markets outside the region it has served for many years. Is there a derivative contract that
could help the bank achieve the loan portfolio diversification it seeks?
This bank could enter into a credit swap with another bank. This swap agreement means
that the two banks simply exchange a portion of their customers’ loan repayments. The
purpose of this type of swap agreement is to help the two banks diversify their market
area with having to make loans in an unfamiliar area and further spread out the risk.

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