1.1.1.1.1Chapter Twenty-Four
Managing Risk off the Balance Sheet with
Loan Sales and Securitization
1.1.1.2 I. Chapter Outline
1. Why Financial Institutions Sell and Securitize Loans: Chapter Overview
2. Loan Sales
a. Types of Loan Sales Contracts
b. The Loan Sale Market
c. Secondary Market for Less Developed Country Debt
d. Factors Encouraging Future Loan Sales Growth
e. Factors Deterring Future Loan Sales Growth
3. Loan Securitization
a. Pass-Through Security
b. Collateralized Mortgage Obligation
c. Mortgage-Backed Bond
4. Securitization of Other Assets
5. Can All Assets Be Securitized?
II. Learning Goals
1. Understand the purposes of loan sales and securitizations.
2. Identify characteristics that describe the bank loan sales market.
3. Discuss factors that encourage and deter loan sales growth.
4. Describe the major forms of asset securitization.
5. Determine whether all assets can be securitized.
1.1.1.3 III. Chapter in Perspective
Rather than engaging in hedging activities to limit risk as discussed in the prior chapters, FIs can
also manage their risks via loan sales and asset securitization. Loan sales may involve selling
whole loans or parts of loans, while loan securitization involves transforming portfolios or
pools of loans into marketable securities. In selling or securitizing loans, FIs are passing on the
risk of asset transformation to others and choosing to act as asset brokers instead. Because the
broker function is generally less risky than the asset transformation (or financing) function, sales
and securitization may reduce the rate of return to the selling FI unless a sufficient additional
volume of transactions can be generated. Nevertheless, sales and securitization allow the FI
more alternatives to tailor the risk return combination they choose to bear. Increasing the
emphasis on the loan brokerage function reduces the sensitivity of profits to the net interest
margin (NIM), and may help stabilize profitability because the NIM can fluctuate dramatically as
interest rates change (see Chapter 22). Related benefits may include reduced capital and
reserve requirements and better balance sheet liquidity.1 In theory loan sales and
1 With fewer loans on the balance sheet there may be less need for deposit funding.
securitization may also reduce the government’s deposit insurance liability. Indeed there is no
particular theoretical reason why depository institutions should be the primary providers of loan
financing. With the passage of the FSMA we can expect loan originating institutions to
increasingly act as asset brokers as markets for loan sales and securitization mature. However,
securitization also led to the subprime mortgage crisis. Mortgage companies and other
originators encouraged homebuyers to purchase more home than they could afford and many of
the mortgages financing these purchases were securitized and became collateral for mortgage
backed securities. The causes of the subprime crisis have been discussed elsewhere, but briefly,
a combination of low interest rates for an extended period of time leading to a long run of rising
home prices. The implicit government backing of the two mortgage agencies Fannie and Freddie
and the home price gains led to low risk premiums and excessive amounts of mortgage credit.
Originations made in 2005 and 2006 led to very high default rates. Securitization led to reduced
origination standards as lenders quickly sold and securitized mortgages. Congressional pressure
to increases affordable housing to lower income segments also contributed. Warnings from both
the Bush administration and former Federal Reserve Chairman Alan Greenspan about the
systemic risk in the mortgage agencies, Fannie Mae and Freddie Mac were also ignored. As a
result of the crisis the Dodd-Frank Act of 2010 requires originators to keep 5% of loans
originated when they are securitized, although as of this writing lobbying efforts were attempting
to create broader exclusions to this rule.
1.1.1.4 IV. Key Concepts and Definitions to Communicate to Students
Loan securitization Financial distress
Correspondent banking Vulture fund
Highly leveraged transaction loans (HLT loans) Downsizing
Loan sales Brady bond
Sales with and without recourse Fraudulent conveyance
Loan participation Pass-through security
Assignment Fully amortized
LDC loan Prepayment risk
Collateralized mortgage obligation (CMO) Mortgage backed bonds (MBB)
Interest Only Securities Principal Only Securities
REMICs Sequential pay CMO
Planned Amortization Class CMO Negative Convexity
Financial engineering Distressed loans
Collateralized Debt Obligations (CDOs) Subprime crisis
Collateralized Loan Obligations (CLOS) Syndicated loans
Sovereign bonds Performing sovereign loans
Nonperforming sovereigns
1.1.1.5 V. Teaching Notes
1. Why Financial Institutions Sell and Securitize Loans: Chapter Overview
Loan sales are the sales of individual loans in whole or in part; these sales may be with or
without recourse. A sale without recourse means the loan seller has no contingent obligation to
repay the loan to the loan buyer in the event of borrower default. Loan securitization is the
conversion of loans into marketable securities. This is usually accomplished by placing the loans
in a trust (or selling them to an FI who will do this) and issuing (selling) marketable securities
using the loans as collateral. The basics of securitization are covered in Chapter 7 and readers
should be familiar with that material, although some of the same concepts are repeated in this
chapter for clarity. Loan sales and securitization can improve the FI’s risk return tradeoff by:
reducing the credit risk the FI faces,
improving the liquidity of the balance sheet and by
reducing the regulatory burden imposed on traditional lending and deposit taking
activities.
2. Loan Sales
Loan sales have been a traditional activity of correspondent banking for over 100 years in the
U.S.2 Small banks often sell all or part of loans they have originated that are too large for them
to finance on their own, and large banks sell loan participations to smaller banks. The market for
buying and selling loans after origination is called the syndicated loan market. This market has
three type participants:
1. Market makers who commit capital to create liquidity and take outright positions in the
markets. These are primarily the large money center banks and investment banks.
2. Institutions that actively participate in the market. These would include some
commercial and investment banks, insurers and specialized investment funds (see below).
3. Occasional participants who either sell or buy loans as opportunities arise. Examples
would include smaller banks involved in correspondent relationships purchasing pieces of
large loans originated by bigger institutions, or the reverse with the small banks selling
shares in a loan to larger institutions.
Loan sales grew rapidly in the 1980s due to the growth of levered buy outs (LBOs). Banks
provided financing for many of these LBOs via lending for so called highly leveraged
transactions or HLTs. HLTs are primarily loans to finance takeovers and mergers where the
2Correspondent banking is the term used to characterize the relationship and the services large
banks offer to smaller banks.
resulting borrower has a high leverage ratio after the takeover. Technically a HLT is a
transaction that meets the following two criteria: 1) the loan is for a buyout, acquisition or
recapitalization and 2) one of the following: either the company’s liabilities are doubled as a
result and the leverage ratio is at least 50%, or the resulting leverage ratio is at least 75%. In
some of the HLTs, large banks divested parts of the loans to smaller banks in order to spread the
high risk of these transactions. The quantity of loan sales tends to rise and fall through time with
M&A and HLT activity.
Loan Sales Through Time
Year Billions $ % Distressed
1980 < $ 20
1989 285
1999 79
2008 510 7.8%
2009 474 29.4%
2010 413 20.5%
2011 409 8.4%
2012 395 5.7%
2013 517 3.9%
Source:
https://www.loanpricing.com/analysis/152-2/
The HLT market grew rapidly in the 1980s, tapered off in the early 1990s, grew again in the
boom years of the latter part of the decade, dropped in the early 2000s and began growing again
with the economy by the mid 2000s. Loan sales continued to grow in 2007 and 2008 before
falling with the crisis. The HLT market suffered larger declines but bounced back along with
total loan sales. Distressed loan sales were very high following the crisis years.
A bank loan sale occurs when the originating institution sells the loan to another party. If the
loan is sold without recourse the loan is removed from the balance sheet and the bank has no
further liability in the event of borrower default. The bank may or may not retain the workout
responsibility (collections and resolution of problem loans). Most loan sales are without
recourse. If the sale is with recourse, the loan seller removes the loan from the balance sheet,
but the seller records a contingent liability that must be disclosed in the footnotes. There may
be reserve and capital requirements for loans sold with resource.
a. Types of Loan Sales Contracts
There are two types of loan sale contracts: participations and assignments. There are technical
differences in the two.
Loan participations: A loan participation is buying a share in a loan, but the buyer has only
limited control and rights over the borrower. In particular, in a participation the original loan
agreement between the originating lender and the borrower remains intact after the sale. The
loan buyer is thus not a direct claimant of the borrower, but of the loan seller. The loan buyer
has only limited control over any changes in the loan contract. The loan buyer(s) can only
vote on changes in the interest rate or collateral backing, but other contractual changes that
the buyer does not approve can occur. Thus, the loan buyers are clearly in a subordinate
position to the original lender. For example if a borrower fails to repay the original loan, the
loan seller, who normally retains a part of the loan, may agree to renegotiated terms that the
loan buyers do not want. Moreover if the loan seller fails, the original borrower’s debt may
be netted against any claims (such as deposits at the failed FI) the borrower has against the
selling FI. This would reduce the amount the loan buyers could collect. The loan buyer must
thus monitor the creditworthiness of the borrower (or trust the loan seller to do so) and
monitor the creditworthiness of the loan seller. Direct loan participations occur in less than
10% of U.S. loan sales.
Loan assignments: An assignment of a loan is the purchase of a share in a loan where the
loan buyer is assigned or granted contractual control and rights over the borrower.
Assignments are used in over 90% of U.S. loan sales instead of participations. In an
assignment the loan buyer holds a direct claim on the borrower, that is, the loan buyer obtains
all rights upon purchase of the loan. In some cases the original loan agreement will prevent
assignment to certain parties or in certain conditions. Loan buyers must be sure that the loan
agreement does not contain specific exclusions that limit their rights. Because of the
complexity involved a loan sale is not a quick, easy process. It may take several months to
complete the sale of a loan although most are completed within about two weeks.
b. The Loan Sale Market
There are three segments of the market, two are discussed in this section and the third is
discussed in part c):
The short term segment is comprised of sales of one to three month loans. The loans are
normally secured by tangible collateral of the borrower and are of investment grade.
These loans are typically sold in units of $1 million and up and are the traditional segment of
the loan sale market. The rates on these loan sales are closely tied to the commercial paper
market, a competing source of short term funds for well secured borrowers.
Teaching Tip: These characteristics keep the risk down. Many bankers, particularly at smaller
conservative institutions, are reluctant to invest in loans when they did not conduct the credit
evaluation. As a result, sales of well secured loans by creditworthy corporations have been the
traditional mainstay of the loan sale market.
HLT loan sales: Loan sales grow with the volume of HLTs. This segment of the market was
insignificant before 1985 but grew with the increased interest in LBOs and takeovers in the
latter part of the 1980s. HLTs and other loans can be either ‘distressed’ (the borrower is
having difficulty making the scheduled loan payments) or ‘nondistressed.’ A distressed HLT
loan is valued at less than 80¢ on the dollar (the text mentions 90¢ rather than 80¢). HLT
loans are usually long term, secured with collateral, floating rate and have strong covenant
protections. Distressed loan sales peaked at about 20% of loan sales in 2009 and 2010 before
declining over the next three years to a 2013 low of under 4%.
Teaching Tip: The junk bond market grew rapidly in the 1980s as takeovers of increasingly
larger firms occurred. Banks were unable or unwilling to provide the necessary financing to
fund the large takeovers. Michael Milken and his firm Drexel Burnham saw an opportunity and
successfully created a secondary market for junk bonds (below investment grade bonds). Junk
bond financing allowed the takeovers of firms previously considered too large to acquire.
Loan buyers:
Vulture funds: These are specialized funds that invest in distressed loans and bonds. These
funds are often operated by investment banks. They can be actively managed; loan purchasers of
distressed funds are often able to dictate favorable terms that can result in high rates of return.
Other funds passively diversify their holdings instead, being content with the higher promised
yield on distressed loans. The active funds sometimes pressure borrowers to restructure debts
and/or sell off assets. These investors are looking for a quick return on their capital, and unlike a
bank lender, are usually not interested in building long term relationships with the borrowers.
Investment banks: Investment banks invest in HLT loans because of their expertise in analyzing
M&A activity and their role in junk bond financing (a related product, see the Teaching Tip
above).
Commercial banks: Banks have historically been interested in buying loans to circumvent
interstate banking prohibitions (perhaps due to the desire to remain fully invested in loans in
periods of weak local loan demand), generate better geographic diversification of their loan
portfolio and develop correspondent banking relationships. Small banks have often had to sell
large loans to avoid loan concentration limits. This market has been shrinking with the demise
of interstate banking prohibitions and the large number of bank mergers. Correspondent banking
relationships are also less important today. Finally there are increasing concerns about the moral
hazard involved in loan sales. Originating institutions may sell problem loans and keep the
good ones.3 The moral hazard problem was evident in the securitization of subprime mortgages.
Foreign banks: Foreign banks are the dominant buyer of U.S. domestic loans. Loan sales allow
them to participate in U.S. loans without incurring the cost of branching.
Closed End Bank Loan Mutual Funds: Some mutual funds both purchase and originate loans.
Insurance Companies, Pension Funds & Nonfinancial Corporations: Large insurers and
pensions buy a significant amount of loans and a few corporations purchase loans.
The loan sellers include:
Money center banks: These are the primary loan sellers
Small banks
Foreign banks
Investment banks (generally limited to HLTs)
Hedge funds (generally in HLTs)
U.S. government and agencies, including Housing and Urban Development (HUD)
c. The Secondary Market For Lesser Developed Country (LDC) Debt
A third segment of the loan sale market is the sale of LDC loans (see Chapter 19). The major
players in this market are large U.S. and foreign commercial and investment banks. LDC loans
are the highest risk component of the loan portfolio and only the largest banks have LDC loans.
3This problem can be partially resolved by requiring the selling institution to keep a significant
portion of the loan, as is usually the case and as is now required under the 2010 Dodd-Frank law.
Many of the problem LDC loans made throughout the 1980s and 1990s were restructured as
Brady bonds. A Brady bond is a bond that was created via a swap for a distressed LDC loan
(see Chapter 6). The bonds were fixed rate, whereas most LDC loans are variable rate. The
bonds were more liquid than the loans, but they were of lower value than the original loan
amount. The swap allowed the lender to eliminate any further losses by selling the bonds. Many
bonds of emerging countries had good performance in the early 2000s. Brazil’s economic
growth, Mexico’s credit rating upgrade, and Russia’s debt restructuring encouraged investors and
resulted in growing interest in these markets. Low U.S. yields undoubtedly helped as well. The
experience of Argentina’s creditors has not been as promising and growing unrest in other South
and Central American countries will continue to contribute to the riskiness of this region.
In recent years three market segments of sovereign debt have emerged:
Sovereign bonds (government issued debt)
Performing loans which are sovereign loans that are collecting interest and principal
Deep discount nonperforming loans which are sovereign loans that are not currently
collecting interest and principal
d. Factors Encouraging Future Loan Sales Growth
Sales without recourse eliminate the credit risk faced by the originating institution.
Sales may still generate fee income for the loan seller. The bank can retain the servicing
contract (processing term payments) for which it receives a fee, and the lender normally
charges a loan origination fee. By creating and selling more loans, the FI can report higher
current earnings than by financing the loans and reporting interest income through time.
The ability to sell the loans improves the liquidity of the bank’s loan portfolio. This may
allow the bank to hold fewer liquid assets and invest more in higher earning assets.
Most loans carry a substantial risk weight in calculating the required amount of capital. If
the loans are sold without recourse the amount of capital a FI must hold can be reduced and
additional growth in total assets may be possible for a given level of capital.
Loans sold without recourse do not have any reserve requirements. If loans are routinely
sold, the FI does not need as large a deposit base to fund its activities. With the smaller
deposit base, its required reserves will be reduced.
e. Factors Deterring Future Loan Sales Growth
Corporations are increasingly using the commercial paper market to fund short term
financing needs. This reduces the quantity of high grade loans available for sale.
Loan customers may not like having their loan sold, taking it as a sign the bank does want its
business.
Some high profile fraudulent conveyance proceedings may limit the popularity of loan
sales. Fraudulent conveyance means that a loan sale was conducted improperly or illegally
according to the terms of the original loan agreement. In particular, fraudulent conveyance is
the transfer of assets at less than fair value made while a firm is insolvent. This activity is
prohibited to protect the interests of creditors. In 2011 the Federal Housing Finance Agency
(FHFA) sued Bank of America, J.P. Morgan Chase, Goldman Sachs and Citigroup alleging
the banks had misstated the value of the mortgages sold to the housing agencies, Fannie Mae
and Freddie Mac. The Justice Department also filed a complaint against Bank of America for
problems with loans sold to the same agencies. Most of these loans were originated by
Countrywide which was taken over by Bank of America.
Teaching Tip: Suppose a bank is technically insolvent but is still operating. Bank managers
have an incentive to sell loans at fire sale prices in order to raise cash to keep the institution
afloat as long as possible. Alternatively, suppose a corporation is insolvent. Its banker may
attempt to sell any loans the bank has with the corporation at discounted prices to limit its
losses. The loan buyer may be unaware of the corporation’s insolvency and would be
purchasing a claim that is different than represented by the selling bank. Notice that both
these problems stem from information asymmetry between the parties.