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Chapter 26 Loan Sales.docx

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Ryerson University
FIN 701
Patricia Mc Graw

FIN701 Financial Institutions Management CHAPTER 26 Loan Sales INTRODUCTION  Banks and FI relied on a number of contractual mechanisms to control credit risks of lending 1. Requiring higher interest rate spreads and fees on loans to more risky borrowers 2. Restricting or rationing loans to more risky borrowers 3. Requiring enhanced seniority (collateral) for bank over assets of risky borrowers 4. Diversifying across different types of risky borrowers 5. Placing more restrictive covenant on risky borrowers’ actions, such as restrictions on use of proceeds from asset sales, new debt issued, and dividend payments THE BANK LOAN SALES MARKET Definition of a Loan Sale  Bank loan sale: sale of a loan originated by FI with or without recourse to an outside buyer o Loan agreements contain a clause that allows FI to sell loan to another buyer, sometimes without having to notify the borrower of the sale  Recourse: ability of a loan buyer to sell the loan back to the originator if it goes bad o FI retains contingent credit risk liability Types of Loan Sales  Loan sales market has three segments: two involve sale and trading of domestic loans, while he third involves emerging- market loan sales and trading  Traditional short-term segment of market, FIs sell loans with short maturities, often one to three months o Loan sales are similar to commercial paper but have yields that are 1 to 10 basis points above those of commercial paper of similar rating o Key characteristics of short-term loan sales market  Secured by assets of the borrowing firm  Made to investment-grade borrowers or better  Issued for short term (90 days or less)  Has yields closely tied to commercial paper rate  Sold in units of $1 million and up  Highly leveraged transaction (HLTs) loans – loan made to finance a merger and acquisition; a leveraged buyout results in a high leverage ratio for the borrower o Three U.S. federal bank regulators adopted a definition of HLT loan 1. Involves a buyout, acquisition, or recapitalization 2. Doubles the company’s liabilities and results in a leverage ratio higher than 50%, results in leverage ratio higher than 75%, or is designated as HLT by syndication agent o Loan differs whether they are non-distressed (bid price exceeds 90 cents per $1 of loan) or distressed (bid price is less than 90 cents per $1 of loan or borrower is in default) o Key characteristics of HLT loans  They are term loans (TLs)  Secured by assets of borrowing firm (usually given senior secured status)  Have long maturity (often three- to six-year maturities)  Floating rates tied to LIBOR, the prime rate, or a CD rate (normally 200 to 275 basis points above these rates)  Strong covenant protection  Financial distress – period when borrower is unable to meet a payment obligation to lenders and other creditors Types of Loan Sales Contracts  Two basic types of loan sale contracts or mechanisms by which loans can be transferred between seller and buyer: o Participations in loans – buying a share in a loan syndication with limited contractual control and rights over the borrower  Key features  Holder (buyer) is not a party to the underlying credit agreement so that the initial contract between loan seller and borrower remains in place after the sale FIN701 Financial Institutions Management  Loan buyer can exercise only partial control over changes in the loan contract’s terms; holder can vote only when material changes to loan contract, such as interest rate or collateral backing  Double risk exposure (risk exposure to borrower and risk exposure to loan-selling FI) o Assignments – buying a share in a loan syndication with some contractual control and rights over the borrower  Key features  All rights are transferred on sale, meaning the loan buyer now holds a direct claim on the borrower  Transfer is normally associated with legal proof that a change of ownership has occurred  Loan contract requires either FI agent or borrower to agree to the sale and loan contract may also restrict sale to certain class of institutions  In syndicated loan, two or more banks agree to jointly make a loan to a borrower TRENDS IN LOAN SALES  Correspondent banking – relationship entered into between small bank and big bank in which the big bank provides a number of deposit, lending, and other services  Project finance loan – loan made to a single-purpose entity where principal and interest are paid from the cash flows of the project  JPMorgan Chase, Citigroup, Bank of America, Deutsche Bank, and Wachovia Securities were the top five secondary-market loan syndicators in 2008 The Buyers and the Sellers  The buyers o Investment banks are buyers of HLT loans because (1) analysis of these loans utilizes investment skills similar to those used in junk bond trading and (2) investment banks were too closely associated with HLT distressed borrower in underwriting original junk bond/HLT deals o Vulture funds – specialized hedge fund that invests in distressed loans, often with an agenda that may not include
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