Term Paper on "Loan Sales and Other Credit Risk Management Techniques"

Term Paper 13 pages (3727 words) Sources: 7

[EXCERPT] . . . .

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… READ MORE

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