Boston College, MF 820 Professor Strahan Midterm Exam, Fall 2010 1. State and explain two reasons why short-maturity loans are safer (meaning lower credit risk) to the lender than long-maturity loans (10 points). First, there is more uncertainty for longer term loan, so the value of the firm or the value of the collateral backing the loan may fall, leading to default. Second, short-term loans create more powerful incentives for borrowers to maximize value since they need to come back to the lender more frequently for capital. 2. Why are loans to small businesses rarely securitized (10 points)? Such loans are hard for outsiders other than the originating bank to value (e.g. ratings agencies). Thus, there would be high risk of adverse selection in the pool of loans if a bank were to try to securitize small business loans. Hence, securitization rarely happens. 3. Citigroup s stock price is currently trading for about $4 per share, even though the market value of Citi s assets is likely less than the market value of its liabilities. Provide two reasons why this might be possible (10 points). First, the market value of equity prices in PV of future growth opportunities, which may be positive for Citi. Second, Citi has support of government, which lowers its financing costs and acts as a subsidy that will raise the value of the equity. 4. Basel I sets the same level of required (equity) capital for all business loans, regardless of the credit rating. Why does this rule make the banking system riskier over time (10 points)? Under Basel I, banks have an incentive to sell off low-risk loans (since capital requirement is too high for them), and hold high-risk loans (since required capital is too low for them). This makes bank holdings grow increasingly risky over time. 1 of 6
5. Basel II ties required (equity) capital to the credit rating of the borrower. Explain why this rule may worsen business downturns relative to Basel I (10 points). Basel II leads to a mechanical increase in required capital when downgrades occur. Since downgrades occur en masse in recessions, bank required capital goes up in recessions, leading to a decline in credit supply and a worse downturn. Vice versa for booms (too much credit, bubbles, etc). 6. What are two ways that banks provide funding liquidity to customers (10 points)? Transactions deposits providing funding liquidity because they allow the deposit holder to get cash on demand; lines of credit also provide funding liquidity because they allow the borrower to draw funds up to a limit on demand. 7. State two reasons why Venture Capitalists do not finance their projects with standard debt (10 points). First, because projects have very high risk the moral hazard problem of asset substitution is unusually bad hence convertible preferred is a better contract than straight debt since it lessens the incentive for the insider to gamble. Second, projects tend to have low cash flow and can t meet interest burden of debt. Convertible preferred pays the VC with potential upside, thus eliminating the high cash flow burden of straight debt. Longer Questions 8. Your bank has the following balances sheet: Loans 1500 Cash 500 Deposits 1800 Equity 200 You have decided to securitize all of your loans ($1500). After working with your investment bank and the credit rating agencies, you have decided to sell the loans to an SPV, which will pay for the loans by issuing four classes of securities. The first two classes are AAA-rated; the SPV will sell $300 million of these bonds to outside investors, and the other class of AAA-rated bonds 2 of 6
($1,000) will be sold to your bank; the third class are BBB-rated and will fund $150 million of the SPV; the bottom class is unrated and will fund the remaining $50 million. Your bank plans to retain the bottom (unrated) tranche. The unrated tranche will suffer all of the losses on the pool of loans until that tranche is exhausted; if losses exceed $50 million, then the BBB rated tranche will begin to experience losses. The AAA rated tranches will only experience losses if both of the other two are completely exhausted. The average annual yield on the loans in the pool is 12%. AAA-rated bonds yield 5% and BBB rated bonds yield 7%. The servicing and administrative costs for the loan pool are 2% per year. Expected losses are 1%. A) Write down the balance sheet of your bank after the securitization. Assume that your bank holds the proceeds of the securitization in cash. (10 points) Cash 950 Deposits 1800 Residual 50 Equity 200 AAA bonds 1000 B) Write down the balance sheet of the SPV. (10 points) Loans 1500 AAA rated bonds sold to Bank 1000 AAA rated bonds sold to investors 300 BBB rated bonds sold to investors 150 Residual sold to bank 50 C) What is the excess spread on the unrated tranche of the pool of loans? (10 points) 1500*12% - 1300*5% - 150*7% - 1500*3% = $59.5 3 of 6
D) Describe how you could achieve a similar outcome using a credit default swap as in BISTRO. Be sure to explain the balance sheets of both your bank and the SPV that you need to set up, and describe how much the bank needs to pay for the credit default swap (20 points). The securitization above insures 450 of losses out of the total pool of 1500. The first 50 in losses hit the bank because it holds the residual tranche, and the next 450 would be covered by investors, but the bank is exposed to catastrophic losses because it holds 1000 of the AAA rated bonds. A parallel CDS structure would work as follows. First, leave the bank s original balance sheet as is. The loans are never sold. Second, set of an SPV as follows: Treasury 500 AAA rated bonds sold to investors 300 BBB rated bonds sold to investors 150 Residual sold to bank 50 To buy the Treasuries, we use $450 proceeds from the SPV s sale of bonds to investors, plus the bank puts in the remaining $50 (the case calls this a reserve account). This could be achieved by annuitizing the $50 over 5 years (or whatever the term is). Third, the SPV writes a CDS on the whole $1500 loan portfolio with its holdings of Treasuries as collateral. The SPV collects a fee from the bank in return for the default protection equal to the additional yield over the Treasury rate needed to pay interest on the AAA and BBB bonds, plus the periodic payment needed to amass the additional $50 in Treasuries. Fee = 300*(5% - T-rate) + 150*(7% - T-rate) + $50 / Annuity Factor (5-years at the T-rate). If losses on the whole portfolio are less than $50, then the bank would effectively be uninsured since they put that money into the SPV (and would lose it in their investment in the residual). Losses between $50 and $500 would be taken on by the holders of the AAA and BBB bonds. Losses above $500 would be born by the bank. 4 of 6
9. Consider the following two syndication strategies for a $3.3 billion loan: Underwritten Sub-Underwritten Amount N Amount Amount Held Strategy #1 Lead Bank 1 $3,300 N/A $300 Sub Underwriter 0 Participant 20 $150 Strategy #2 Lead Bank 1 $3,300 $660 $300 Sub Underwriter 4 $660 $300 Participant 9 $200 A) Briefly compare the risks and rewards from the lead bank=s perspective of these two structures. (10 points) Strategy 1 has greater underwriter risk, but the lead gets 100% of the underwriter fees, so there is both more risk and more reward. Strategy 2 is safer for the lead bank because the possibility of holding more than the desired $300 is reduced. The downside is obviously lower fees. B) What is a market flex provision? How does it affect the risks and rewards to the lead bank (10 points)? Market flex allows the lead bank to change the terms of the loan prior to syndication if market conditions change. This reduces underwriter risk. Market flex may be resisted by borrower, but it could also be beneficial to them if conditions improve and the lead improves the terms of the deal. 5 of 6
C) Provide three reasons why the borrower might prefer the second strategy. Explain each briefly. (20 points) Sub-underwriter approach may help strengthen relationships between borrower and regional players by allowing those players to get a bigger piece of the action (fees). Sub-underwriter approach has fewer banks, which would make ex post renegotiation easier if the borrower got into trouble (e.g. violated a financial covenant or was late on a payment). Sub-underwriter approach has fewer banks, which reduces the risk of proprietary information leaking out to the market. 6 of 6