Week 035 Consequences of Not Holding an Originated Loan

1
Week 03-5 Consequences of Not Holding an
Originated Loan

• Class addresses two issues for four
• substitute activities
• EVA Modeling for Substitute Activities
• Differences in Accounting Treatment of Claims
  Generated

2

• A bank has four substitutes for holding onto a
  business loan
• credit enhancement
• outright sale to an affiliate or third party
• syndication
• pass-through or structured securitization

3
Three Steps in Explaining How Value Creation in
Enhancing a Loan Differs from Value Creation in
Intermediation

• a. Conceptual Differences in service performed
• b. Corresponding EVA formulae
• c. Numerical Illustration of their Consequences

4

• (Review)
• When acting as an intermediary an FSF
• holds loans for own account (both risk-free and
  risky portions)
• funds with own indirect debt (e.g., deposits)
• generates enough value in carrying the loan to
  cover due-diligence investigation, transactions,
  and prospective default costs

5
CREDIT ENHANCER guarantees i.e., bonds the
performance of a borrowers promise to pay the
ultimate holder of a direct debt.

• The credit enhancer acts partly as a broker and
  partly as an intermediary.
• It holds (i.e., intermediates) only the default
  risk of the loan, which it must assess to set up
  and price a reserve for losses.
• But it does not fund the risk-free portion of the
  loan, which it sells to the securitizing entity
  and ultimate investors.

6
A borrowers credit-enhanced security bears a
lower interest rate, much as would the indirect
debt that an intermediary might issue against a
pool of similar direct debt held for its own
account.

• The enhancer must itself have a strong credit
  standing
• It incurs much the same due-diligence and
  transactions costs as a direct lender, which it
  must plan to cover out of its fee.
• An example is a bank standby letter of credit.
  An SLC gives a creditor immediate recourse to the
  guarantor if the borrower fails to make timely
  payment.

7
Accounting Perspective on Same IssuesHow does a
guarantee-issuing banks marginal (i.e.,
incremental) balance sheet and income statement
(T-accounts) differ from those of a traditional
bank lender?
8
Differences in EVA

• ? (holding loan) (RL-RD) L (allocated
  value of all other costs)
• E.g., (6-3) 100 - 2 1
• ? (enhancement) fee-CI(1rE)-CMG(1rE)-2
• N.B. Timing issue The second formula recognizes
  that costs may be incurred both before and after
  revenue is received.
• RE is called COE in the Text.

9
1. Accounting Entries for Lending Bank

• a. Income Statement for a 100 Credit.
• (RL-RD)L minus net imputed (I.e., allocated)
  administrative and capital costs (CA) of loan
• Suppose RL6, RD3, and CA2 (CA is meant to
  represent all costs net of implicit returns
  incurred in the deal).
• Revenue - Costs Income. Accounting profit is
  
• 6 - 3 - 2 ?
• b. Incremental Economic Balance Sheet
• Assets Liabilities
• ? Loan 100 ? Deposits
  100
• PV (? profit) ? NW ?
• (N.B. We need COE to turn EVA in ?NW)

10
2. Entries for Credit-Enhancement Bank

• a. Income Statement
• Economist would reattribute timing of fees from
  guarantees and record them net of imputed
  operating costs CA
• A weakness of GAAP statements is failure to
  segregate and allocate most elements of CA
• b. Balance Sheet
• Until 2003 an enhancement was an
  off-balance-sheet intangible liability.
  Contingent liability for new guarantees must now
  be booked in the body of a GAAP balance sheet.
  Some leeway in how fair value is determined.

11
Calculation of Income from Credit Enhancement

• Suppose CA2 and fee is 1? NI1 - 2 -1.
  What if fees are 3? 3 - 2 1 (Same
  accounting income as the loan imputed, but timing
  of revenues and outlays could make the
  enhancement more profitable to the bank)
• Next slide explains why.

12
Calculation Focusing on the Timing of 3 Cash Flows

• Timing Assumptions the enhancement fee is booked
  upfront, the costs of investigation (CI) are
  incurred a period earlier, and the cost of making
  good on failed credits across the portfolio of
  enhancements (CMG) is incurred two periods later.
  
• Parameters the customer pays a fee of 3 and
  rthe banks cost of capital.
• As of the date guarantee contract is executed,
  the present value of profit 3-CI(1r)-CMG(1r)-
  2.
• CI is Carried forward in time
• CMG is carried back
• On term loans, time to default could be more than
  two periods

13
Applying the EVA Formula

• Suppose that investigative costs are 1, that 2
  of loan value is the appropriate capital
  allocation for either deal, and that the FSFs
  cost of equity capital is 20.
• ANS. Present-value of profit from the
  enhancement
• 3-1(1.20)-2(1.20)-2
• 3-1.2 -
• 3-1.2-1.375.425

14
ExerciseSuppose scoring program computes one
chance in 106 that the borrower will default
irrevocably and 105/106 that full repayment will
be received. Assume that the bank increases its
loan-loss reserves by the amount necessary to
fund the expected losses under the loan or
guarantee with capital that costs the bank 20
per annum. Show the banks incremental balance
sheet and projected annual income under two
alternative decisions
15
Case 1) The bank gives a 6 one-year bullet
loan of 100,000 and finances the loan with
deposits of the same maturity, at an all-in
interest cost of 5 per annum.

• Note an all-in interest cost includes
• relationship effects
• capital allocation
• diversification benefits.

16
Case 1) With no contra-asset for LLR,
accountants should project a contra-revenue.
17

• -- A loan-loss reserve (LLR) of 1/1.06 or 1/1.2
  with an appropriate offset could be recorded
  either within the net-worth account or as a
  contra-asset on the asset side. In the
  contra-asset approach, an offsetting entry for
  the PV of deposit-taking opportunity could be
  recognized in principle. The actual write-off of
  the LLR would be projected as part of earnings at
  Date 1.
• -- What implicit elements might be included in
  the all-in cost of funds? Unspecified net
  implicit interest on loans and deposits CA
  burden of capital requirements.
• -- What implicit benefit might be relevant?
  Strengthening customers relationship
  diversification of risk concentrations that need
  to be managed.

18
Case 2) The bank decides to sell the customer a
credit enhancement. The bank collects a 1,000
upfront fee from the customer for guaranteeing
purchasers of 100,000 worth of 5.0 one-year
bullet bonds the customer issues in the public
market. The bank promises that each bondholder
will be paid in full and on time in the event the
banks customer does not meet its obligations.
19
Case 2) Prompt and Full LLR Provisioning
20

• --Why is the credit-enhancement activity more
  profitable? ANS Time value of money and slightly
  lesser exposure to loss at yearend 105K rather
  than 106K.
• --How might the enhancement be less profitable if
  implicit costs and benefits are introduced?
  Enhancement exposes the customers relationship
  value to observation by a wider number of
  competing FSFs.

21
Point of this Session To be sure that you could
figure out whether to advise the bank to fill the
customers request for credit assistance with the
loan or via the guarantee
22

• --Why is the credit-enhancement activity more
  profitable? ANS Time value of money and slightly
  lesser exposure to loss at yearend 105K rather
  than 106K.
• --How might the enhancement be less profitable if
  implicit costs and benefits are introduced?
  Enhancement exposes the customers relationship
  value to observation and capture by a wider
  number of competing FSFs.

23
Second Substitute for Holding an Originated Loan
SECURITIZATION

• Combining loans previously originated into pools
  whose risks can be made interpretable to
  outsiders.
• Creating liquidity by issuing marketable claims
  against the collateral of particular pools.
• Effect is to transfer Risk Reduce Geographic
  Segmentation of Localized Markets

24
Three Ways to Mitigate Informationand Monitoring
Risks Posed to Bondholders fromBank-Dependent
Borrowers

• Make Borrower improve various of the 5Cs
• 1. Lowering loan-to-value (LTV) ratio
• 2. Collateralization
• 3. Covenanting verifiable proxies for changing
  conditions firm performance and value of
  net-worth position
• Support via Risk Retention by Originator
• 1. Reputation misperformance would cause losses
  on other deals
• 2. Full recourse or other credit enhancement
• 3. Retaining a first-loss position
• -- market for first-loss exposures is virtually
  zero
• Contract for Third-Party Ratings or Credit
  Enhancements

25
Extent of Lender Risk Retention Substitutes the
Banks Credit for that of the Borrower. Funding
Cost for Bank is Lower when Banks Standards,
Performance, and Condition are

• Strong
• Transparent easy to monitor
• Supervised and guaranteed by government or
  credible private regulator.

26
Plain-Vanilla Passthrough Securitization
Cash
Cash
FSF Originator of Loans
Conduit Institution
End Investors
Loan Instrument info.
Securities info.

• Other flavors are covered in middle weeks of
  the course stripping timing mismatches
  enhancements reliance on multiple originators or
  multiple conduits.

27
More on Securitization

• Creating a readily tradeable title to returns
  derived from an illiquid asset securitizes
  that asset. It must be emphasized that
  piggy-backing on a trading system or making a
  market in the titles is an essential part of
  securitization.
• First step is to set up --or contract with-- a
  legally separate entity (usually a trust) to
  serve as a conduit for cash flows
• This special-use vehicle (SUV) is designed to
  align the incentives of SUV management with
  investors.

28

• SUV must be made free from originator control.
• SUV is insulated from bankruptcy risk by limiting
  its business to acquiring and holding the assets
  and issuing the asset-backed securities.
• For Asset Pools to be readily securitized, the
  underlying assets must have identifiable default
  risk.
• Risk need not be low, but it must be predictable
  from historical data (e.g., credit-card debt).
• Predictability can be enhanced by pooling that
  eliminates overconcentrations in individual
  borrowers, in industries, or in geographic areas.

29
Links in Chain of Securitization

• 1. Originate a loan
• 2. Contact a Packaging Agent (such as FNMA) or
  set up a legally separate trust to be conduit for
  cash flows
• 3. Sell designated pool of loans to the
  packaging agent
• 4. Strip and reassemble the cash flows from the
  pool e.g., creating differences in timing or
  seniority (optional)
• 5. Have the trust issue tradeable claims to
  (possibly repackaged) cash flows from the pool
  and sell the securities to the public
• 6. Contract with an efficient servicing
  organization to collect loan payments and
  forward them to securities owners (optional)
• 7. Arrange for a credit rating, perhaps after
  enhancement by the bank or a reputable third
  party
• 8. Create Tradability Make sure a liquid
  secondary market exists for the securities or
  convey reasonable putback rights. Need for
  tradability to qualify as securitization.

30
Deals Within--and on Top of--Deals Support
Mortgage Derivative Contracts
31

• In traditional intermediation, the original
  lender holds not just the risk, but the entire
  loan the position fully and immediately.
• In securitization, the original lender may hold
  onto some of or all of the risk (if it sells with
  recourse)
• - may contract out all or some of risk to a
  credit enhancer.
• - Must fund only an in-process inventory of
  new loans.

32
Lesson of Weeks 3 to 5

• Active securitization of mortgage pools has
  taught markets and academics to break down what
  had traditionally been seen as a holistic lending
  procedure. Contracting now unbundles" what was
  once an "integrated financing process."
  Competitors can specialize in bearing only a
  subset of the risks and skills needed at each of
  eight stages.

33
Credit-Enhanced Securitization
Cash
Cash
FSF Originator of Loans
End Investors
Conduit Institution
Loan Instrument info.
Securities info.
Fee info.
Credit Enhancer
(Info. contractual obligation)
34
Besides securitizing or internally funding loans,
banks might sell or trade them postloan in
increasing liquid secondary markets. 65 bil. in
outstanding loans traded in 1999.Preselling of
large loans to bank and nonbank partners is
called SYNDICATION.
Third Substitute for Holding a Loan
35

• Loan sales and syndication are helpful
  foils with give insights into securitization
  activity. Syndicated Loan structures establish ad
  hoc partnerships among lenders, but the partners
  shares cannot be anonymously traded away.
• What is a foil in literature and drama?

36
In modern loan sales, the buyer steps into the
shoes of the originators.

• To make an independent credit analysis,
  purchasers must
• receive proper information from borrower and
  originator credit scores ratings
• must obtain copies of all relevant documents
• must establish plans to remedy bank or borrower
  defaults
• Separate trading specialists/websites exist for
  par loans and distressed loans .

37
Syndications Even with financial engineering,
most bank loans are held to maturity by the
originating bank.

• Selling whole loans faces three potential
  disincentives
• Borrowers must be notified of sale, which may
  jeopardize their customer relationship
• Pricing of risk may turn on expensive-to-verify
  information
• Asset sales trigger tax and accounting
  consequences that are often adverse.

38
Query In what ways do loan syndications and
whole-loan sales resemble loan securitization?
In what ways do they differ?
39

• Transferable participation certificates may be
  sold against any pool of returns from any
  intelligible class of risky receivables car
  loans manufactured housing loans credit-card
  receivables commercial real-estate debt leases
  student loans franchisee debt.
• Often no secondary market exists in which the
  underlying whole assets can be sold.
• Usually sold with recourse or a recourse
  substitute. Recourse is a substitute for
  overcollateralization and recourse obligation
  should be reserved for and should be priced.

40

• Only if the participation certificates can be
  sold without explicit and implicit recourse is
  the asset moved completely off the originators
  economic balance sheet.

41
How would the incremental GAAP balance sheets of
a Loan-Originating Bank and its conduit
Securitizing Trust look with fees

• When loan is securitized without recourse?

42
What if Investors have partial recourse whose
value is x?
Of course, the fee will be higher with recourse
than without.
43
Effects of Loan Sales Differ from Syndications
and Participations

• Whole or Partial Loan Sales unbook the amount
  sold transfer the title and the post-loan
  monitoring and loss-control function to the buyer
  to the extent that recourse is not established.
• In Loan Syndications and Participations, primary
  responsibility for monitoring and loss-control
  typically stays with the lead bank. But
  sublenders have duty of prudence.

44
COMPARING DEAL STRUCTURES
45
(Shared National Credit database shows
syndications falling off in 2001 and 2002)
46
To be marketable or suitable for syndication a
loan must have low preloan information risk and
low postloan monitoring risk.

• This means those with low agency costs
• Reliable and readily available information makes
  borrowers creditworthiness easy to assess
  directly or by sampling (low potential for
  hidden information).
• Minimal need for direct post-loan monitoring (low
  potential for hidden actions).

47
Each Syndicate has a Managing Institution
(Commercial or Investment Bank)

• Choice Agent-only vs. shareholding capacity
• Preloan information production distribution
• Pricing and structuring (maturities, covenants)
• Postloan coordination of postloan covenant
  enforcement relief and repricing
• Junior Partners include
• Domestic banks
• Foreign Banks
• Finance companies
• Insurance companies
• Mutual funds
• Assorted hard-to-classify funds

duties
48
Top managers are losing market share.
49
Market PowerTop syndicated lenders and their
market share in 2003
194B
207B
137B
26B
105B
44B
Source Thomas Financial
50
Summary of Lending Process
51
Credit risk-mitigation tools

• Preloan Considerations
• Collateralization
• Third-Party Guarantees
• Diversification
• Postloan Activities
• Monitoring and Enforcement
• Loan Sales
• Syndication
• Securitization
• Credit Derivatives (Next Week)

52
Minicase on Consequences of Certifying Earnings
At Sign-Off Deadline, Household Restates From
1994 to 2002, overstated pretax earnings by
600MFrom American BankerThursday, August 15,
2002 By Erick Bergquist Household
International Inc. on Wednesday became the first
financial services company forced to restate
earnings so that its top executives could vouch
for its financials, as required by the Securities
and Exchange Commission. The restatement -
which lowered pretax earnings by 600 million
over the past eight years - came as the deadline
expired for big public companies to comply with
the SEC's edict. By midday Wednesday all but six
of the nation's largest banking companies had
certified that their statements were accurate, a
move the SEC required to boost investor
confidence amid a string of corporate governance
scandals. Most had filed before the deadline,
but PNC Financial Services Group Inc.,
FleetBoston Financial Corp., Bank of New York
Co., Fifth Third Bancorp, Huntington Bancshares
of Columbus, Ohio, and National City Corp. of
Cleveland waited until Wednesday. The initial
wave of certifications applies only to the
largest publicly traded firms. Under the
Sarbanes-Oxley Act, the leaders of all public
companies will be required to make similar
attestations over the coming months. In a
conference call with analysts and reporters
Wednesday, Household's chairman and chief
executive officer, William F. Aldinger, tried to
downplay the restatement, which he said stemmed
from a "good-faith difference of opinion." On an
after-tax basis, from 1994 to 2002 the company
overstated earnings by 386 million - a
relatively small amount, considering that its
total earnings for the period were roughly 10
billion. "Frankly, we were surprised," Mr.
Aldinger said. "I don't think there is any
culture that says we are cutting corners. We
wouldn't try 'to cook the books' to improve our
rate by two-tenths of one percent."
53
Minicase (cont.)
Some outsiders agreed with his assessment, but
others blasted the Prospect Heights, Ill.,
lender. Moshe Orenbuch, an analyst with Credit
Suisse First Boston Corp., reiterated his "strong
buy" rating on Household, despite shaving 10
cents off his 2002 earnings target, to 4.60.
While the restatement caused Household's capital
ratios to fall about 30 basis points, "this does
not affect the way the company does business," he
said. But Daniel S. Loeb, a managing member with
Third Point Partners LP, a money management firm
in New York, saw it differently. "This is really
a half-billion-dollar pickup," he said on the
call. "When you talked about this thing being a
small matter of a difference of opinion, you seem
to minimize a major error here that involves
something of huge magnitude." Another critic,
William Ryan, an analyst with Portales Partners,
wrote in a report issued Wednesday "When the
going gets tough the accounting department gets
going. Household has a history of using subtle
accounting changes to hit estimates." But
investors seemed to take the news in stride.
Household's stock sank in early trading, but
recovered to gain less than 1, to close at
38.09 a share. However, that is well below the
stock's 52-week high of 68.45 a share last
August. Mr. Aldinger insisted that the
restatement reflected nothing more than a
difference in opinion on how to account for
certain credit card assets. The restatements,
surfaced after a review by Household's new
auditor, KPMG LLP, he said. (Household fired its
longtime auditor, Arthur Andersen, in the wake of
the Enron Corp. scandal). KPMG recommended that
Household revise its accounting policies
regarding three credit card deals it entered
between 1992 and 1999. Two of the deals were part
of its MasterCard/Visa co-branding affinity
credit card business the third dealt with an
unrelated card marketer.
54
Minicase (cont.)
Relying on the advice of Andersen, Household had
treated its payments to these partners as prepaid
assets and had amortized them over longer periods
of time. However, KPMG officials said that
Household should have either charged the payments
against earnings at the time they were made or
amortized them over shorter periods of
time. David Schoenholz, Household's president and
chief operating officer, said that investors
should not expect any more surprises. After
reviewing Household's financials for 1999-2001,
KPMG had signed off on all of the firm's basic
operations, including "merchant partnership
agreements, the provision for credit losses and
loan loss reserves, securitization accounting,
income tax reserves, and litigation matters," Mr.
Schoenholz said. Mr. Ryan and other analysts did
mention litigation as a potential problem for
Household. For instance, the company has been
besieged recently by several high-profile
consumer groups seeking to eradicate predatory
lending. Spreads between the Treasury bond yield
curve and Household's debt have widened to over
350 basis points in recent months. One source
attributed that to concerns in the marketplace
over a spate of lawsuits consumer groups have
filed against Household over the last
year. William Lerach, a partner in the securities
class-action law firm of Milberg, Weiss, Bershad,
Hynes Lerach, said Wednesday that Household
will likely be sued over its restatement.
"Because a restatement is an admission that
financial statements were false before, it is
virtually inevitable that any company that
restates in a material amount will find itself in
sued in a securities case." Asked if his firm,
which is representing Enron shareholders and is
also involved in suits against Andersen and
WorldCom Inc., has been retained to take action
against Household, Mr. Lerach said "A number of
large investors have contacted us, and we are
looking into that." However, Mr. Orenbuch said
that he still expects Hosuehold to maintain or
increase its market share while complying with
various state and local lending
restrictions. What's more, none of the three
major Wall Street debt rating agencies changed
their ratings on Household after the restatement.
Fitch Inc. maintained its "A with negative
outlook" rating on the company. "While the
avoidance of restatements through use of more
conservative accounting would have clearly been
preferable, similar restatements are not expected
for Household in the future," Fitch said in a
press statement.14
55
Minicase on Competition facing Fair Isaac
TrueLink Says It Has Better Credit Profiler
From American BankerThursday, August 22, 2002
By W.A. Lee Six months before Fair, Isaac Co.
made its credit scores available to consumers for
the first time in March 2001, a company formed by
a group of former Citigroup Inc. executives was
already peddling credit products over the
Internet. TrueLink Inc., a 7-year-old company
mostly owned by Lehman Brothers, says it has sold
more than one million credit products, including
scores, reports, and comprehensive profiles of
credit standing. Fair, Isaac says that it and
its credit bureau partner Equifax Inc. have sold
more than 1.5 million. TrueLink is a
well-connected company whose management team
includes the former president and the former
chief financial officer of Citibank's consumer
finance group. It counts Citibank (which owns a
small share of the company - under 1), Conseco
Inc., Cendant Corp., and Providian Financial
Corp. as clients and says its truecredit.com Web
site and its pages on clients' Web sites receive
700,000 visits a month. To boost sales, last week
True -Link, which has offices in New York and San
Luis Obispo, Calif., began to offer free credit
profiles. Consumers who take advantage of the
offer are enrolled in a credit monitoring
service, which costs 79.95 a year. Those who
cancel the monitoring service within 30 days are
not charged for it. Like Fair, Isaac, TrueLink
offers "simulators," which let consumers see how
their payment behavior would affect their scores.
However, Russell Schaub, TrueLink's president and
chief executive officer, said simulators are a
minor part of its package.
56
Minicase, cont
"We don't look at ourselves as selling a gimmick
to consumers to help them raise their scores for
a day or two," he said. TrueLink's credit
profile includes a score generated from a model
developed by Neuristics LLC that consumer Web
sites commonly use. The profile also includes a
credit report with data from all three bureaus, a
"borrowing power analysis" with debt management
advice, and a "debt consolidation tool" with
specific financing or refinancing
guidelines. Despite many consumers' perceptions,
the credit score is not the only or even
necessarily the most important part of their
profiles, Mr. Schaub said. TrueLink shows people
how lenders evaluate their debt, for example,
along with their score, he said. A consumer's
debt level is "a compensating factor," Mr. Schaub
said. "As a consumer's credit score goes down,
lenders will look at their debt burden." If it is
relatively low, "odds are they will still get the
better interest rate," even though the score
alone would not merit a lower rate, he said.
Scores alone do not give consumers a clear
picture of how creditors evaluate them, according
to Mr. Schaub. TrueLink competitors such as Fair,
Isaac have essentially repackaged risk management
products to consumers without making them readily
understandable, he said. TrueLink plans to launch
a site, knowyourloanrate.com, within the next two
months that will feature a product consumers can
use to determine the interest rates lenders would
offer them. Fair, Isaac and its partners offer a
similar product, but Mr. Schaub said that,
instead of plugging in a consumer's credit score,
TrueLink's interest rate evaluator conducts a
"miniunderwriting," by assessing other pertinent
information, such as the collateral value of a
person's home and car, he said. Fair, Isaac
called those criteria "interesting" but said that
the problem with providing that type of analysis
to consumers is that they may be misled into
thinking that all lenders evaluate the data in
the same way - if at all.
57
Minicase, cont
The company built its offering around the FICO
score because "it is the one thing that lenders
tend to use very consistently," according to Sue
Simon, a vice president of consumer-direct
products at Fair, Isaac. "How lenders look at
debt-to-income ratios, collateral, or reserves on
a consumer's asset sheet is very different from
one to the other," she said. "It's very
subjective. The bedrock is really the FICO
score." The credit score TrueLink uses is not an
industry standard, Ms. Simon said. "Neuristics is
interesting. You see it on a lot of consumer
information sites, but in reality it's not as
widely used by lenders. "If consumers undertake
an improvement plan based on a score that's not
really used," they could be misled about their
credit standing. Providian says that it has used
TrueLink's products for several years in its
GetSmart card program and has offered TrueLink's
credit report and monitoring services to its
online customers. "TrueLink has developed a very
user-friendly product," said Ellen Rosenfels,
Providian's executive vice president in charge of
customer development. It offers "the flexibility
to tailor a solution to meet our business and
consumer needs, the ability to provide consumers
a three-bureau credit report online and offline,
substantial technological and development
expertise, and a strong site infrastructure to
ensure security," she said.