Swaps

1
Chapter 26

• Swaps

2
Overview

• The market for swaps has grown enormously and
  this has raised serious regulatory concerns
  regarding credit risk exposures. Such concerns
  motivated the BIS risk-based capital reforms. At
  the same time, the growth in exotic swaps such as
  inverse floater have also generated controversy
  (e.g., Orange County, CA). Generic swaps in order
  of quantitative importance interest rate,
  currency, credit, commodity and equity swaps.

3
Interest Rate Swaps

• Interest rate swap as succession of forwards.
• Swap buyer agrees to pay fixed-rate
• Swap seller agrees to pay floating-rate.
• Purpose of interest rate swap
• Allows FIs to economically convert variable-rate
  instruments into fixed-rate (or vice versa) in
  order to better match the duration of assets and
  liabilities.
• Off-balance-sheet transaction.

4
Plain Vanilla Interest Rate Swap Example

• Consider money center bank that has raised 100
  million by issuing 4-year notes with 10 fixed
  coupons. On asset side CI loans linked to
  LIBOR. Duration gap is negative.
• DA - kDL
• Second party is savings bank with 100 million in
  fixed-rate mortgages of long duration funded with
  CDs having duration of 1 year.
• DA - kDL 0

5
Example (continued)

• Savings bank can reduce duration gap by buying a
  swap (taking fixed-payment side).
• Notional value of the swap is 100 million.
• Maturity is 4 years with 10 fixed-payments.
• Suppose that LIBOR currently equals 8 and bank
  agrees to pay LIBOR 2.

6
Realized Cash Flows on Swap

• Suppose realized rates are as follows
• End of Year LIBOR
• 1 9
• 2 9
• 3 7
• 4 6

7
Swap Payments

• End of LIBOR MCB Savings MCB
• Year 2 Payment Bank Net
• 1 11 11 10 1
• 2 11 11 10 1
• 3 9 9 10 - 1
• 4 8 8 10 - 2
• Total 39 40 - 1

8
Off-market Swaps

• Swaps can be molded to suit needs
• Special interest terms
• Varying notional value
• Increasing or decreasing over life of swap.
• Structured-note inverse floater
• Example Government agency issues note with
  coupon equal to 7 percent minus LIBOR and
  converts it into a LIBOR liability through a swap.

9
Macrohedging with Swaps

• Assume a thrift has positive gap such that
• DE -(DA - kDL)A DR/(1R) 0 if rates rise.
• Suppose choose to hedge with 10-year swaps.
  Fixed-rate payments are equivalent to payments on
  a 10-year T-bond. Floating-rate payments repriced
  to LIBOR every year. Changes in swap value DS,
  depend on duration difference (D10 - D1).
• DS -(DFixed - DFloat) NS DR/(1R)

10
Macrohedging (continued)

• Optimal notional value requires
• DS DE
• -(DFixed - DFloat) NS DR/(1R)
• -(DA - kDL) A DR/(1R)
• NS (DA - kDL) A/(DFixed - DFloat)

11
Pricing an Interest Rate Swap

• Example
• Assume 4-year swap with fixed payments at end of
  year.
• We derive expected one-year rates from the
  on-the-run Treasury yield curve treating the
  individual payments as separate zero-coupon bonds
  and iterating forward.

12
Solving the Discount Yield Curve

• P1 108/(1R1) 100 R1 8 d1 8
• P2 9/(1R2) 109/(1R2)2 100 R2 9
• 9/(1d1) 109/(1d2)2 100 d2 9.045
• Similarly, d3 9.58 and d4 10.147

13
Solving Implied Forward Rates

• d1 8 E(r1) 8
• 1 E(r2) (1d2)2/(1d1) E(r2) 10.1
• 1 E(r3) (1d3)3/(1d2)2 E(r3) 10.658
• 1 E(r4) (1d4)4/(1d3)3 E(r4) 11.866

14
Currency Swaps

• Fixed-Fixed
• Example U.S. bank with fixed-rate assets
  denominated in dollars, partly financed with 50
  million in 4-year 10 percent (fixed) notes. By
  comparison, U.K. bank has assets partly funded by
  100 million 4-year 10 percent notes.
• Solution Enter into currency swap.

15
Cash Flows from Swap
16
Fixed-Floating Currency

• Fixed-Floating currency swaps.
• Allows hedging of interest rate and currency
  exposures simultaneously

17
Credit Swaps

• Credit swaps designed to hedge credit risk.
• Total return swap
• Pure credit swap
• Interest-rate sensitive element stripped out
  leaving only the credit risk.

18
Swaps and Credit Risk Concerns

• Credit risk concerns partly mitigated by netting
  of swap payments.
• Netting by novation
• When there are many contracts between parties.
• Payment flows are interest and not principal.
• Standby letters of credit may be required.
• Greenspan claims that credit swap market has
  helped strengthen the banking systems ability to
  deal with recession

19
Pertinent Websites

• BIS www.bis.org
• Moodys Investor Services www.moodys.com

20
Chapter 27

• Loan Sales and other risk management techniques

21
Overview

• This chapter discusses the growing role of loan
  sales and other techniques that can be used to
  address the control of credit risk in FIs. The
  use of loan sales is not new and may even involve
  foreign loans. With development of secondary
  markets for many types of loans, and securitized
  variants, loan sales are employed even by
  relatively small FIs.

22
Loan Sales

• Loan sales have taken place for over 100 years.
• Correspondent banking
• Small banks selling parts of loans to larger
  banks.
• Participations.
• Expansion of loan sales during 1980s.
• Due to expansion of HLT loans.
• Early 1990s decline in loan sales followed by
  recent expansion.
• Expanding economy and resurgence in MAs.

23
Bank Loan Sale Market

• May be sold with or without recourse.
• Types of loan sales
• Emerging market
• Domestic
• Traditional short term
• HLT Loan sales

24
Traditional Short Term

• Key characteristics
• Secured by assets of borrowing firm.
• Loans to investment grade borrowers or higher.
• Short term.
• Yield closely tied to commercial paper.
• Denominations of 1 million .

25
HLT Loan Sales

• Key characteristics
• Term loans.
• Usually senior secured.
• Long maturity (often 3- to 6-year maturities).
• Floating at rates tied to LIBOR, prime or a CD
  rate.
• Strong covenant protection.
• Usually distinguished as distressed /
  nondistressed.

26
Web Resources

• Visit
• Loan Pricing Corporation www.loanpricing.com

27
Types of Loan Sales Contracts

• Participations
• Limited contractual control.
• Assignments
• Currently form bulk of the market (90 ).
• All rights transferred on sale of loan.
• Normally associated with Uniform Commercial Code
  filing.
• Complexity associated with accrued interest

28
The Buyers

• Often segmented.
• Example distressed HLT loan buyers generally
  investment banks, hedge funds, vulture funds.
• Inter-bank loan sales in traditional market
  historically due to branching restrictions.
• Foreign banks important buyer of domestic loans
• Insurance companies and pension funds in
  long-term loans.
• Mutual funds and nonfinancials

29
The Sellers

• Major money center banks, U.S. government and its
  agencies.
• Good Bank - Bad Bank
• Establishment of subsidiary banks specializing in
  handling nonperforming loans (NPLs).
• Increases value of Good Bank.
• Allows structuring of Bad Bank to improve
  management incentives and operating efficiency.

30
Other Sellers

• Foreign banks
• ING is a major market maker (HLTs).
• Investment Banks
• Bear Stearns. Generally large HLTs.
• Government and agencies (HUD for example)
• Increased due to Federal Debt Improvements Act,
  1996.
• Largest sales to date, RTC.

31
Web Resources

• FDIC www.fdic.gov
• Housing and Urban Development www.hud.gov

32
Why Banks and Other FIs Sell Loans

• Credit risk management
• Reserve requirements
• If sold without recourse, removed from balance
  sheet.
• Fee income
• boosts reported earnings under current accounting
  rules.

33
Why FIs Sell Loans (continued)

• Capital costs
• Meet capital requirements by reducing assets.
• Liquidity risk reduced by loan sales.

34
Factors Deterring Future Loan Sales Growth

• Access to commercial paper market
• Customer relationship effects
• Customers may take negative view of having their
  loan sold to another party.
• Legal concerns
• Fraudulent conveyance.

35
Factors Encouraging Loan Sales Growth

• BIS Capital Requirements
• Market Value Accounting
• Asset Brokerage and Loan Trading
• Government loan sales
• Credit rating of loans offered for sale
• Purchase and sale of foreign bank loans
• Goldman Sachs fund to buy troubled loans from
  Japans second largest bank, SMFG.

36
Pertinent Websites

• BIS www.bis.org
• HUD www.hud.gov
• FDIC www.fdic.gov
• FASB www.fasb.org
• Loan Pricing Corp. www.loanpricing.com
• SEC www.sec.gov
• Wall Street Journal www.wsj.com