Loan sales and other credit risk management techniques

Loan Sales and Other Credit Risk Management Techniques

"a technique of selling loan assets, also known as an assignment in equity. (Cranston, 1997, p. 393)

Derivatives: "A security has priced is dependent upon or deprived from one or more underlying assets. The derivative itself is merely a contract between two or more parties. Its value is determined by fluctuations in the underlying asset. The most common underlying assets include stocks, bonds, commodities, currencies, interest rates and market indexes. Most derivatives are characterized by high leverage." (Derivative, 2007)

Novation: "The extinguishment of a contract between the borrower', B, and the seller, Bank X, and its substitution by a contract of the same nature between B. And the buyer Bank Y. All parties must agree to a novationns." (Cranston, 1997, p. 393)

Risk Management: "The process of identification, analysis and either acceptance or mitigation of uncertainty in investment decision-making. Essentially, risk management occurs anytime an investor or fund manager analyzes and attempts to quantify the potential for losses in an investment and then takes the appropriate action (or inaction) given their investment objectives and risk tolerance." (Risk Management, 2007)

Security: "Any note... bond, debenture, evidence of indebtedness, investment contract,... or, in general, any interest or instrument commonly known as a 'security,' or any certificate of interest or participation in... [or] receipt for... any of the foregoing." (Buckley, 1998, p. 47)

Subparticipation: "A contractual agreement between the 'selling' and 'buying' bank," and does not affect the underlying loan. (Cranston, 1997, p. 393)

Value at Risk www.investopedia.com/terms/v/var.asp" (VAR or sometimes VaR): "the 'new science of risk management', a VAR statistic has three components: a time period, a confidence level and a loss amount (or loss percentage)." (Value at Risk, 2007)

Volatility:

1. "A statistical measure of the dispersion of returns forgive and security of market index.

Volatility can either be measured by using the standard deviation or variance between returns from that same security or market index. Commonly, the higher the volatility, the riskier the security.

2. "A variable in option-pricing formulas showing the extent to which the return of the underlying asset will fluctuate between now and the option's expiration. Volatility, as expressed as a percentage coefficient within option-pricing formulas, arises from daily trading activities. How volatility is measured will affect the value of the coefficient used." (Volatility, 2007)

LOAN SALES and OTHER CREDIT RISK Management TECHNIQUES

There can be no profit, if the outlay exceeds it."

Maccius Plautus (cited by Powell, 2004)

Risk Management Considerations

Risk management, a two-step process the banks and other financial organizations use, includes a number of techniques which serve to help identify existing risks in an investment and determine ways to handle verified risks in the best way to complement investment objectives. Risk management routinely occurs in every aspect of the financial realm, for example, when an investor purchases "low-risk government bonds over more risky corporate debt, when a fund manager hedges their currency exposure with currency derivatives and when a bank performs a credit check on an individual before issuing them a personal line of credit." (Risk Management, 2007) Risk management techniques prove to be a vital contemporary factor, as Maccius Plautus notes in the introductory quote - profit depends on the income not being exceeded by the outlay. Currently, volatility, the traditional and reportedly most popular measure of risk constitutes a problem as it does not consider direction of an investment's movement. For example, a s tock that unexpectedly jumps higher can be considered volatile.

VAR, on the other hand, reportedly the new trend in risk management, reportedly considers common-sense factors, such as the direction of an investment's movement. "VAR answers the question, 'What is... [the] worst-case scenario?' Or "How much could... [an investor] lose in a really bad month?" (Value at Risk, 2007)

Loan Sales, aka, a Credit Risk Management Technique

During recent years, Powell (2004) reports, a dramatic increase in loan sales activities by banks have occurred. "Call report information indicates that loans sold increased from $50 billion in 1984 to $280 billion in 1988, a 460% increase over the five-year period." The following chart (1) reflects these numbers.

Chart 1:

Increase in Loan Sales (created by Researcher, 2007)

Components Affecting Loan Sales

Cranston (1997, p. 393) purports: "The 'sale' of loan assets is effected (six) in practice by novation, assignment, and what in market parlance is termed a sub-participation." A subparticipation, consist of a contractual agreement between the "selling" and "buying" bank and does not affect the underlying loan. Contrary to the term "sale" of a loan, at law, these techniques do not involve and actual sale. Hassan (1993) notes even though the loan's purchaser still maintains rights to the principal and interest payments, the structure of commercial loan sales, involving sales that banks originate, is setup so that the selling bank continues to service the loan.

Novation Novation, as depicted in the figure below, occurs when a contract is extinguished between the borrower, B, and the seller, Bank. The former contract is replaced by a contract of identical nature between B. And the buyer Bank Y. For a novation to transpire, all parties must concur. The following figure (1) depicts a process of novation. (Cranston, 1997, p. 393)

Figure 1: Novation (Recreated by Researcher from Cranston, 1997, p. 393)

Assignment Assignment, also known as an assignment in equity, according to Cranston (1997, p. 393) represents a technique of selling loan assets. As loan sales traditionally relate to only a portion of loan, for commercial reasons, banks do not always notify a borrower when assignment takes place. This could, some contend, denote a sign of a bank's weakness, and perhaps contribute to decreased confidence in the bank. Practical advantages to an assignment may include preserving priorities, along with the ending off additional cross-claims and/or defenses, as well as the selling of bank reducing the potential of pressures to provide new money on a rescheduling. When an agent bank is appointed, as in the case with syndicated loans, albeit, the borrower does not experience any risk, if he/she is not notified, as payments automatically go to the agent bank. The following figure (2) depicts Assignment.

Figure 2: Assignment (Recreated by Researcher from Cranston, 1997, p. 395)

http://images.questia.com/?fif=b714223/b714223p0396.fpx&obj=iip,1.0&wid=300&hei=85&rgn=0.0,0.0,1.00000000,1.00000000&lng=en_US&vtrx=1&cvt=jpeg

Sub-participation

In a sub-participation, as reflected in the following figure (3), the buyer pays a particular amount to the selling bank. The selling bank, in turn, agrees to pay the buyer a specific amount, generally geared to the borrowers' payments on the underlying loan. As the buyer bank provides funds to the selling bank, at times, this is deemed a funded sub-participation. In risk participation, on the other hand, the third-party bank receives a fee for providing a guarantee to the lending bank, related to potential failure of the borrower to pay on the underlying loan. The following figure depicts (3) the process in Sub-participation.

Figure 3: Sub-participation (Recreated by Researcher from Cranston, 1997, p. 395)

Regulated Regulators

Secondary market started as a result of the debt crisis of 1983 with country debtors, referred to as LDC's (less developed countries), owing a record turnover of $1.3 trillion face value of debt in 1993 and $5.3 trillion in 1996. (Buckley, 1998, p. 47) Under the headline, "Fed Likes Secondary Market for LDC Debt," the American Banker reported that "[t]he Federal Reserve is becoming one of the stronger advocates of nurturing the secondary market for buying, selling and trading the extensive foreign loans of U.S. commercial banks." (Ibid)

On January 10, 1984 in Washington D.C., Preston Martin, Vice-Chairman of the Federal Reserve Bank, International Management and Development Institute, reportedly promoted the development of a secondary market in the equities of the LDC's over debt, as this new route opened to channel foreign capital into the economy. In turn, during the same year, the Federal Reserve began to implement and develop new routes such as the secondary market in debt. (Buckley, 1998, p. 47)

Along with the positive components of this new development, unscrupulous individuals began to implement and develop unethical and immoral business practices within the secondary market. During the 1990s, the regulation of the secondary markets began, leading to current principal regulatory agencies, which consist of the Federal Reserve System, the Security Exchange Commission (SEC), and the Office of the Comptroller of the Currency (OCC). To date, the Federal Reserve System oversees the commercial banks, while the SEC oversees the investment banks and security dealers. The OCC, an agency within the U.S. Treasury, constitutes a second bank regulator and oversees federally licensed foreign banks and affiliates of U.S. banks abroad. (Buckley, 1998, p. 47) the EMTA, a not-for-profit service organization, headquartered in New York City, purports a mission statement that recites its dedication to: "promoting the orderly development of a fair, efficient and transparent trading market for Emerging Markets instruments and to supporting the globalization and integration of the emerging capital markets." (Buckley, 1998, p. 47)

During 1993, the EMTA consisted of 118 members. Four years later, it had grown to 165 members with 65 full members engaged in trading emerging markets instruments. ETMA accomplishes its primary objective, improving risk management, efficiency and transparency of the secondary market, by surveying and legal requirements and developments. (Buckley, 1998, p. 47)

Loan Sales FAQs

What is a loan sale?

A loan sale is a commonly used term for the sale of loans or loan pools. Loans acquired by the FDIC from failed financial institutions are generally sold in pools through sealed bid sale or English outcry auction.

How are sales structured?

Typically, sales contain loans that have similar characteristics. The loans are refined into pools according to specific criteria. Pooling considerations may include loan size, quality, type, collateral and location.

What documents are available on the site?

The storeroom provides documents for the sale offering and the individual loan pools. The documents that can be found in the storeroom are the: Invitation to Bid, Bid Instructions, Purchaser Eligibility Certification, Loan Sale Agreement, Loan Spreadsheets and other relevant documents.

Are loans an appropriate investment for me?

Every interested party, based on their own circumstances, must determine whether loans are a suitable investment. Prospective purchasers must have the financial sophistication and resources sufficient to evaluate and bear the economic risks of such loan purchases.

Are there any restrictions to purchasing loans from the FDIC?

Yes. The Purchaser Eligibility Certification identifies prospective purchasers who are not eligible to purchase assets from the FDIC under the laws, regulations and policies governing such sales. The FDIC must receive an executed Purchaser Eligibility Certification from the winning bidder upon notification of bid award.

Does the FDIC only sell distressed or troubled loans?

No. The loan portfolios of failed financial institutions usually contain a variety of performing and non-performing loan products including mortgage, commercial, consumer loans, etc.

Today's Trends

Contemporary legal contracting, along with new data processing technology advances facilitate securitization, the pooling of a large group of loans, a treatable security. Regulators expressed concerns; however that if the problems develop with a loan, and banks retain risks, as they provide loan purchasers partial recourse or implicit guarantee. Current capital regulation, however "discourages recourse for credit risk by including such loans' full value in banks' capital requirements." (Haubrich, 1989)

Numerous studies in the past explored loan sales' riskiness by theoretical models "or empirically regressing implied asset risk from equity and CD rates against on-balance sheet and off-balance sheet loan sales activities." (Ibid) Theoretical literature proposes a number of various motivations and reasons banks originate and sell loans. The banks' ability to originate loans and afterwards sell them, Haubrich (1989) proposes, seems to counter the theoretical assertion that bank loans are "nonmarketable securities."

Over the last decade, scores of financial institutions have utilized the small business credit scoring (SBCS), to evaluate applicants for "micro credits" under $250,000 ($250K). The SBCS's lending technology involves analyzing consumer data regarding a firm's owner and, combining this data with somewhat limited data about the firm. After the combination of data it is completed, financial institutions then utilize statistical methods to predict a firm's future credit performance. This, consequently, results in low-cost, commoditized credits, frequently sold into secondary markets, while at the same time, yielding significant growth in consumer credit availability. Not until the mid-1990s, albeit, did financial institutions begin to on a widespread basis, combine consumer and business information and create scores for small business credits. Currently, no significant secondary market exists for small business credits. (Berber & Frame, 2007) SBCS, " a relatively new transactions lending technology for making 'micro credits' under $250K... was adopted by most large U.S. banking organizations in the latter half of 1990s and has since become more widely used in the United States and abroad." (Stiroh, 2004) Research purports SBCS complements increased small business credit availability in the following, but not limited to, arenas:

1) increasing the quantity of credit extended;

2) increasing lending to relatively opaque, risky borrowers;

3) increasing lending within low-income areas;

4) lending over greater distances; and 5) increasing loan maturity. (Stiroh, 2004)

Stiroh (2004) also points out that the current trend in the U.S. banking industry, transition away from traditional revenue sources, such as making loans, continues to grow.

Banks reportedly regularly increase their participation in activities that guarantee income, such as "service charges, trading revenue, and other types of noninterest income."

Although in the past, noninterest income constituted a vital contributor to a bank's revenue, today's figures support the contentions that this trend continues to grow.

In a sense, this practice compliments the contention that increasing noninterest income sources can lower bank profit volatility, while simultaneously reducing revenue risks. Noninterest income, unlike loan sales and other common risk management techniques may be less dependent on overall business conditions. In turn, less reliance on interest income reduces the bank profits' and revenues' the cyclical variances.

In and out of cyclical variance, some bankers and financial organizations' managers determine to minimize their risk exposure. Others, on the other hand, argue that much can be gained by banking risky borrowers. Whatever the decision, the ability to reduce risk proves valuable for individual banks, bank regulators and supervisors. In addition, bank supervision costs, tied to the institution's perceived riskiness, contribute additional incentives for banks to reduce risk. (Stiroh, 2004)

In banking, nevertheless, losses evolving from risk in lending activities must be exceeded by the gain from such undertaking, if profits the arch and utilize. After all, long before risk management became popular, Maccius Plautus (cited by Powell, 2004) made a point to pronounce that to secure profit, risk management techniques must be implemented to ensure the outlay does not exceed it.

References www.questia.com/PM.qst?a=o&d=5019679285

Berger, a.N., & Frame, W.S. (2007). Small Business Credit Scoring and Credit Availability. Journal of Small Business Management, 45(1), 5+. Retrieved September 22, 2007, from Questia database: http://www.questia.com/PM.qst?a=o&d=5019679285 www.questia.com/PM.qst?a=o&d=5001398208

Buckley, R.P. (1998). The Regulation of the Emerging Markets Loan Market. Law and Policy in International Business, 30(1), 47. Retrieved September 22, 2007, from Questia database: http://www.questia.com/PM.qst?a=o&d=5001398208 www.questia.com/PM.qst?a=o&d=34689598

Cranston, R. (1997). Principles of Banking Law. Oxford: Clarendon Press. Retrieved September 22, 2007, from Questia database: http://www.questia.com/PM.qst?a=o&d=34690467

Derivative. (2007). Investopedia. A Forbes media company. Retrieved September 23, 2007, at http://www.investopedia.com/terms/d/derivative.asp www.questia.com/PM.qst?a=o&d=5000176748

Hassan, M.K. (1993). Capital Market Tests of Risk Exposure of Loan Sales Activities of Large U.S. Commercial Banks. Quarterly Journal of Business and Economics, 32(1), 27+. Retrieved September 22, 2007, from Questia database: http://www.questia.com/PM.qst?a=o&d=5000176748 www.questia.com/PM.qst?a=o&d=5001073902

Holmstrom, B., & Tirole, J. (2000). Liquidity and Risk Management. Journal of Money, Credit & Banking, 32(3), 295. Retrieved September 22, 2007, from Questia database: http://www.questia.com/PM.qst?a=o&d=5001073902

Loan Sales FAQs. (2003). Retrieved September 23, 2007, at http://www.fdic.gov/buying/loan/loan/index.html. The Basic Risk Management Process www.questia.com/PM.qst?a=o&d=5002441930

Powell, S.H. (2004). Credit Risk: How Much Is Too Much? A Bank Can't Profit without Taking Risks, but How Do You Determine the Optimum Level? Data from 100 Community Banks Offer Insights. ABA Banking Journal, 96(3), 43+. Retrieved September 22, 2007, from Questia database: http://www.questia.com/PM.qst?a=o&d=5002441930

Risk Management. (2007). Investopedia. A Forbes media company. Retrieved September 23, 2007, at http://www.investopedia.com/terms/r/riskmanagement.asp www.questia.com/PM.qst?a=o&d=5007705395

Stiroh, K.J. (2004). Diversification in Banking: Is Noninterest Income the Answer?. Journal of Money, Credit & Banking, 36(5), 853+. Retrieved September 22, 2007, from Questia database: http://www.questia.com/PM.qst?a=o&d=5007705395 www.questia.com/PM.qst?a=o&d=5006142365

Theil, M., & Ferguson, W.L. (2003). Risk Management as a Process: An International Perspective. Review of Business, 24(3), 30+. Retrieved September 22, 2007, from Questia database: http://www.questia.com/PM.qst?a=o&d=5006142365

Value at Risk. (2007). Investopedia. A Forbes media company. Retrieved September 23, 2007, at http://www.investopedia.com/articles/04/092904.asp

Volatility. (2007). Investopedia. A Forbes media company. Retrieved September 23, 2007, at http://www.investopedia.com/terms/v/volatility.asp