Loan Sales and Other Credit

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.

Does the FDIC guarantee the performance of loans being offered for sale?

No. The FDIC makes no representations or warranties in connection with any of the loans. The only remedies or recourse provided to the buyer are those set forth in the Loan Sale Agreement. Generally, all risk associated with the loans are passed to the buyer. (Loan Sales FAQs, 2003)

Theil and Ferguson (2003) report that due to various aspects of culture, the following factors impact risk management processes: values and norms, religion, nationality, and political structures. The typical structure of the basic risk management process, as presented by a highly organized business process, includes:

1. Identification and evaluation of exposures to loss, 2. Development of cost efficient and effective alternative tools and techniques to effectively avoid, retain, transfer and/or control those exposures, 3. Selection of desirable alternatives within applicable budgetary constraints (e.g., using objective standard internal rate or return (IRR) and/or net present value (NPV) methodologies), 4. Implementation and administration of the chosen alternative (s), with 5. Dynamic monitoring and feedback systems to better assure long-term effectiveness and efficiency of the ongoing effort (Theil & Ferguson, 2003)

The use of insurance as a risk management tool, accepted by a majority of countries, bears roots based on the religion of the country involved. Risk management and modern insurance evolved from the "Western" economic and society culture. The term, "Western" refers to countries practicing a Judeo-Christian religion. Basic forms of mutual insurance evolved from those created in ancient times, and contributed to the conception and creation of contemporary non-mutual forms. (Theil & Ferguson, 2003)

Holmstrom & Tirole (2000, p. 295) contend that several key decisions contribute to corporation's future ability to access financial funds.

1. The corporation's capital structure sets, including a timetable for reimbursing investors. Equity, albeit, qualifies a firm to qualify for consideration for no exact timetable for dividends' payment.

2. Instead of investing all their resources in long-term profitable projects, corporations additionally invest in less profitable liquid assets, maintained on their balance sheets "as buffers against shocks." (Ibid)

3. Corporations regularly engage in risk management, and can utilize derivatives to counter particular risks (interest rate, currency, raw materials, etc.) (Ibid)

As corporations engage in risk management, they routinely utilize derivatives "to hedge specific risks (interest rate, currency, raw materials, etc.)." A corporation with substantial exports may quickly become short of cash if the exchange rate suddenly turns unfavorable. Foreign exchange swaps allow the firm to insure against this type of liquidity shortage. (Holmstrom & Tirole, 2000, p. 295) Derivatives traditionally utilized to hedge risk, are also regularly used for speculative purposes.

Futures contracts, forward contracts, options and swaps are the most common types of derivatives. Because derivatives are just contracts, just about anything can be used as an underlying asset."

Some derivatives are even "based on weather data, such as the amount of rain or the number of sunny days in a particular region. (Derivative, 2007) Restructuring, AKA, a Debt/Equity Swap in any restructuring, the seller's and buyer's roles prove crucial, as this process frequently reflects distressed debt. Ultimate buyers generally "purchase" distressed debt with the intent to make their profit at the point of purchase, as they become holders of equity in the borrower, resulting from a debt/equity swap. In novation, the buyer directly engages in contractual relations with the borrower, and may participate in its restructuring. The same results occur with assignment, however during this scenario, due to stipulations in law or equity, the buyer maintains control, as well as ownership of the debt.

During the course of an equitable assignment, notice must be given to the borrower, to permit him/her to actively participate in the rescheduling. "With both novation and assignment," the seller may continue to have a role in any rescheduling, if it has not sold off the entire loan." (Cranston, 1997, p. 378) Contrary to novation and assignment, in sub-participation, the buyer does not possess any entitlement as against the borrower; however, in some instances confer certain rights on the buyer. "In the interests of sound banking, Cranston (1997, p. 400) purports, "there is some regulation of the sale by banks of loan assets. Bank regulators are especially concerned about how sales affect risks." A number of bankers routinely attempt to minimize their risk exposure; while others on the other hand, argue that banking risky borrowers presents opportunity for gain. (Powell, 2004) Some banks, touting high credit standards, eke out conservative returns on razor-thin margins, while other banks implement loose credit standards, which consequently produce more profitable shareholder returns from higher-risk activities. The key to profitability, for a multitude of banks, Powell (2004) posits "lies with managing risk exposure in a diverse cadre of loans." Powell (2004P presents the example of the community banker, which simultaneously makes personal loans to customers to purchase a new and used cars, and finances commercial loan for a company that owns the factory that builds automobiles..

Bankers reportedly note that:

The more risk a bank accepts, the more likely it will, at some time, incur a loss of principal.

A bank can only accept a particular amount of credit risk before the losses to necessary, it incurs offset potential gains.

During November 1994, Alan Greenspan, chairman of the Federal Reserve Board. Chairman Greenspan reportedly stated:

The willingness to take risk is essential to the growth of a free market economy.... If all savers and their financial intermediaries invested only in risk-free assets, the potential for business growth would never be realized and money to men.'"

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: