FIN 683 Financial Institutions Management Selling Loans

Transcription

1 FIN 683 Financial Institutions Management Selling Loans Professor Robert B.H. Hauswald Kogod School of Business, AU Originate to Distribute New business model financial innovation or financial excess Premise: rende liquid what is illiquid loan sales securitization Changing incentives market failures 2

2 Loan Sale Market May be sold with or without recourse what is the difference? does it matter? Types of loan sales: depends on collateral Domestic Traditional short term HLT loan sales: highly leveraged loans? Syndication as another way of spreading risk 3 Traditional Short Term Key characteristics Secured by assets of borrowing firm Loans to investment grade borrowers or higher Short term Yield closely tied to commercial paper Denominations of $1 million + Importance has declined with emergence of HLT and emerging market loan sales Growth of commercial paper markets ABCP and securitization 4

3 HLT Loan Sales Term loans Usually senior secured Long maturity (often 3- to 6-year maturities) Floating at rates tied to LIBOR, etc. Strong covenant protection Usually distinguished as distressed vs. nondistressed Covenant lite [sic] loans: crazy! 5 Types of Loan Sales Contracts Participations (less than 10%) Limited contractual control Dual risk exposure and monitoring cost Assignments Currently form bulk of the market (90% +) All rights transferred on sale of loan Normally associated with Uniform Commercial Code filing Complexity: legal, accrued interest, rights 6

4 Trends in Loan Sales Loan sales have taken place for over 100 years Correspondent banking: early form of syndication Small banks selling parts of loans to larger banks Participations Expansion of loan sales during 1980s Early 1990s decline followed by expansion Expanding economy and resurgence in M&As Early 2000s, economic slowdown triggered growth in distressed loan sales Effects of the crisis on loan sales and the proportion of distressed loan sales 7 The Buyers Often segmented: there is a buyer for every asset Distressed HLT loan buyers generally investment banks, hedge funds, vulture funds Inter-bank loan sales in traditional market historically due to branching restrictions Foreign banks important buyer of domestic loans Downsizing of assets: Japanese banks Insurance companies, pension funds: long-term loans Mutual funds and nonfinancials: hedge funds vulture investors 8

5 The Sellers Major money center banks, U.S. government, and government agencies Good Bank - Bad Bank: Establishment of subsidiary banks specializing in handling nonperforming loans (NPLs) Increases value of Good Bank Allows structuring of Bad Bank to improve management incentives and operating efficiency Proposed to remove toxic assets in the crisis 9 Other Sellers Foreign banks: spread risk and exposure Japanese banks Investment Banks Merrill Lynch, generally large HLTs Government and agencies (HUD for example) Increased due to Federal Debt Collection Improvements Act, 1996 Largest sales to date, RTC: resolving the S&L crisis in the early 1990s 10

6 Fee income Why? boosts reported earnings under current accounting rules: why? good reason? Credit risk management Reserve requirements without recourse: removed from balance sheet Capital costs meet capital requirements by reducing assets Liquidity risk reduced by loan sales 11 Factors Deterring Future Loan Sales Growth Access to commercial paper market Customer relationship effects customers may take negative view of having their loan sold to another party Legal concerns Fraudulent conveyance Perverse incentives: deteriorating asset quality kills the market 12

7 Factors Encouraging Future Loan Sales Growth BIS capital requirements Market value accounting Asset brokerage and loan trading Government loan sales Credit rating of loans offered for sale Purchase and sale of foreign bank loans Goldman Sachs fund to buy troubled loans from Japan s second largest bank, SMFG 13 Securitization Packaging and selling of loans and other assets backed by securities Many types of loans and assets are being repackaged in this fashion Original use was to enhance the liquidity of the residential mortgage market Separates the risk of assets from lending Perverse incentive effects instrumental in creating the financial crisis 14

8 From Assets to Securities 1. Creation of special purpose vehicle, or SPV, to facilitate the removal of assets from balance sheet 2. Originator earns fees from creation and servicing 3. All cash flows pass through the SPV according to terms of the ABS contract 4. SPV exists until cash flows from the assets are fully distributed: issues various ABS to investors 5. Or: structured investment vehicle, or SIV/SPV, issues commercial paper to purchase bank loans essentially an affiliated asset-backed securities itself 15 Traditional Process Using SPV 16

9 Structured Investment Vehicles SIV responsible for payments on its ABCP even if underlying assets do not generate sufficient cash flows When the cash flows exceed costs, the SIV keeps the spread Usually has lines of credit or loan commitments from sponsoring bank Liquidity risk implications & exposure to runs 17 Traditional Process using SIV 26-18

10 Special Purpose Entities Profitability of SPVs and SIVs hinges on maintaining high credit rating who pays for ratings? who obliges? Prominent role in the financial crisis Misperceptions of the credit risk: subprime market Complexity encouraged regulator reliance on the banks complex models Abdication of responsibility: no skin in the game Perverse incentives: deteriorating asset quality 19 The Pass-Through Security Government National Mortgage Association (GNMA) Sponsors MBS programs and acts as a guarantor Timing insurance FNMA actually creates MBSs by purchasing packages of mortgage loans Fully guarantees the securities 20

11 Federal Home Loan Mortgage Corporation Similar function to FNMA except major role has involved savings institutions Stockholder owned with line of credit from the Treasury In conservatorship with the FHFA Sponsors conventional loan pools as well as FHA/VA mortgage pools 21 Pass-Through SecuritIes Example: Create a mortgage pool from onethousand $100,000 mortgages results in $100 million face value Each mortgage receives credit risk protection from FHA Keeping loans on the book Capital requirement: $4 million Must issue more than $96 million in liabilities due to reserve requirements + FDIC premia Reduces regulatory tax burden 22

12 Gap exposure Further Incentives Illiquidity exposure Default risk by mortgagees FHA/VA bears the default risk Default risk by bank/trustee GNMA responsible for payments to bondholders 23 Present Value of a Mortgage For monthly payments (PMT), the monthly interest rate equals r/m, where r is the APR and m = 12 months For a mortgage with a remaining time to maturity of n years, the present value is calculated as: PMT 1 ( ( )) PV = 1 mn r / m 1+ r / m Recognizable as the product of PMT and PVAF Present value of pass-through: due to servicing fees the present value of the payments to the holder of the pass-through will be less than the present value of the underlying mortgage payments, assuming zero prepayments 24

13 Prepayments result of: Prepayment Refinancing vs. prepayment penalties and points Housing turnover Most GNMA pools allow assumable mortgages Not the case for FNMA or FHLMC pass-throughs Good news effects Lower market yields increase present value of cash flows Principal received sooner Bad news effects Fewer interest payments in total Reinvestment at lower rates 25 Prepayment Models Prepayment affects the cash flows to MBS: pricing models require estimates of the prepayment rates Weighted-average life WAL = [Σ Time Expected Principal received] Total principal outstanding Methods: Public Securities Association (PSA) approach Other empirical approaches Option pricing approach 26

14 PSA Model Assumes 0.2 percent per annum in first month, increasing by 0.2% per month for first 30 months, until annualized prepayment rate equals 6 percent Actual outcomes affected by relative coupon level age of mortgage pool amortization and assumability size of pool conventional/non-conventional location and demographics 27 Other Empirical Models Generally proprietary variants of PSA model Incorporate: Economic variables Burn-out factor variables Idiosyncratic factors 28

15 Option Model Approach Use option pricing theory to figure fair yield spread of pass-throughs over Treasuries Fair price on pass-through, decomposable into two parts: P GNMA = P TBOND - P PREPAYMENT OPTION Option-Adjusted Spread (OAS): lattice (tree) model OAS = spread over UST yield curve needed to equate the PV(cash flows) with the observed price of the security Value of the prepayment option: OAS between GNMAs and T-bonds reflects value of a call option 29 FNMA and FHLMC Concerns Gained too much market share and pose a serious risk to financial system Credit losses and high debt to equity FNMA: excessive interest rate risk exposure overcharging lenders: how would one know? Perception of complete federal backing Freddie Mac misstatement of earnings FNMA $1.1 billion restatement of equity Threat to the financial system during the crisis Would you agree? conflicts of interest: private funding of public policy objectives 30

16 Collateralized Mortgage Obligations CMO structure Prepayment effects differ across tranches (classes) Z-Class CMO R Class Improves marketability of the bonds Slicing and dicing of risks: prepayment credit 31 Innovations in Securitization Pass-through strips IO strips: Negative duration PO strips: prepayments, highly sensitive to interest rate changes Europe: no public mortgage insurance covered bonds: underlying assets remain on the balance sheet better incentives, less risk transfer 32

17 Securitization of Other Assets Securitization of other assets CARDs Various receivables, loans, junk bonds, ARMs Bounds on securitization: Degree of homogeneity of underlying assets Credit quality of underlying assets If difficult to value, costs of securitizing are higher 33 Bounds on Securitization Serious damage to SIVs, the FIs that owned them, and to financial markets from CDOs backed by subprime alt-a CMO tranches Most investors did no analysis Homogeneous assets are better assets for the purpose of securitization Lack of diversification: how could they 34