Managing Risk

off the Balance Sheet

with Loan Sales and
Securitization
 Why Financial Institutions
01 Sell and Securitize Loans

Loan Sales
02

CONTENTS Loan Securitization

03

Can All Assets Be Securitized?

04
01
Why Financial Institutions Sell and Securitize
Loans
Loan Sales and Securitization

The packaging and selling of loans and other assets backed

by securities issued by a FI.
One of the mechanisms that FIs have used to hedge their
credit risk, interest rate risk, and liquidity risk exposures.
Loan Sales and Securitization have allowed FI asset
portfolios to become more liquid, provided an important source of
fee income (with FIs acting as servicing agents for the assets
sold), and helped to reduce the adverse effects of regulatory
“taxes” such as capital requirements, reserve requirements, and
deposit insurance premiums on FI profitability.
Basic Description of Loan Sales and
Other Forms of Mortgage
Securitization
Loan sale—an FI originates a loan and subsequently sells it.

Pass-through securities—mortgages or other assets originated

by an FI are pooled and investors are offered an interest in the
pool in the form of pass-through certificates or securities.
Examples of pass-through securities are Government National
Mortgage Association (GNMA) or Federal National Mortgage
Association (FNMA) securities.
Basic Description of Loan Sales and
Other Forms of Mortgage
Securitization

Collateralized mortgage obligations (CMOs)—similar to pass-

throughs, CMOs are securities backed by pools of mortgages or
other assets originated by an FI. Pass-throughs give investors
common rights in terms of risks and returns, but CMOs assign
varying combinations of risk and return to different groups of
investors in the CMO by repackaging the pool.

Mortgage-backed bonds (MBBs)—a bond issue backed by a

group of mortgages on an FI’s balance sheet. With MBBs, the
mortgages remain on the FI’s balance sheet, and funds used to
pay the MBB holders’ coupons and principal repayments may or
may not come from the collateralized mortgages.
 KEY TERMS

L P C M

Loan Sales Pass-through Collateralized Mortgage-backed

and Securities mortgage bonds
Securitization obligations
The packaging and selling Mortgages or other assets Securities backed by pools of A bond issue backed by a
of loans and other assets originated by an FI are pooled mortgages or other assets group of mortgages on an FI’s
backed by securities and investors are offered an originated by an FI. balance sheet.
issued by an FI. interest in the pool in the form
of pass-through certificates or
securities.
02
Loan Sales
Loan Sales

A loan sale occurs when an FI originates a loan and sells it

with or without recourse to an outside buyer. If the loan is sold
without recourse, the FI not only removes it from its balance
sheet (purchasing new investments with the freed-up funds), but it
also has no explicit liability if the loan eventually goes bad. The
loan buyer (not the FI that originated the loan) bears all the credit
risk.
If, however, the loan is sold with recourse, under certain
conditions the buyer can put the loan back to the selling FI.
Therefore, the FI retains a contingent (credit risk) liability.
 FIs have sold loans among themselves for more
than 100 years. In fact, a large part of
correspondent banking involves small FIs making
loans that are too big for them to hold on their
balance sheets—either for lending concentration
risk or capital adequacy reasons—and selling (or
syndicating) parts of these loans to large FIs with
whom they have had a long-term deposit-lending
correspondent relationship.
In turn, the large banks often sell (or syndicate)
parts of their loans (called participations ) to smaller
FIs.
The syndicated loan market—that is, the market for
buying and selling loans once they have been
originated—can be segmented into three
categories:
 1 2 3
Market Makers Active Traders Occasional Sellers/
Inverstors
Generally, the large commercial Mainly investment banks, Either sellers of loans (who seek to remove
banks which commit capital to create commercial banks, and vulture loans from their balance sheets to meet regulatory
liquidity and take outright positions in funds. constraints or to manage their exposures) or
the markets. Other financial institutions such as buyers of loans (who seek exposure to sectors
Institutions that actively engage in insurance companies also trade but or countries, especially when they do not have the
primary loan origination have an to a lesser extent. critical size to do so in the primary loan markets).
advantage in trading on the secondary
market, mainly because of their
acquired skill in accessing and
understanding loan documentation.
 KEY TERMS

L R C H

Loan Sales Recourse Correspondent Highly Leveraged

Banking Transaction (HLT)
Loan
Sale of a loan originated The ability of a loan buyer A relationship between A loan that finances
by a bank with or without to sell the loan back to a small bank and a large a merger and acquisition; a
recourse to an outside the originator should it bank in which the large leveraged buyout
buyer. go bad. bank provides a number results in a high leverage
of deposit, lending, and ratio for the borrower.
other services.
Types of Loan Sales
Contracts &
Factors Encouraging
and Deterring Future
Loan Sales Growth
 Types of Loan Sales
Contracts
The two basic types of loan sales
contracts are participations and
assignments. Currently,
assignments represent the bulk of
loan sales.

Participation Assignment
 1
Participation

The act of buying a share The unique characteristics of participations in loans are:
in a loan syndication with • The holder (buyer) is not a party to the underlying (primary) credit agreement, so that
limited contractual control and the initial contract between the loan seller (which may be a syndicate of FIs) and the
rights over the borrower remains in place after the sale.
borrower. • The loan buyer can exercise only partial control over changes in the loan contract’s
terms. The holder can vote on onlyy material changes to the loan contract, such as the
interest rate or collateral backing.
 2
Assignment

The purchase of a share Because of the monitoring costs and the risks involved in participations, loans are sold
in a loan syndication with on an assignment basis in more than 90 percent of the cases on the U.S. domestic
some contractual control and market. The key features of an assignment are:
rights over the borrower. • All ownership rights are transferred on sale.
• U.S. domestic loans are normally transferred with a Uniform Commercial Code filing,
meaning there is documentation of a change of ownership.
 Factors Encouraging Future Loan
Sales Growth

Fee Income Liquidity Risk

Capital Costs Reserve Requirements

Factors Dettering Future Loan Sales
Growth

Access to the Legal

Commercial Concerns
Paper Market
 KEY TERMS

F C R C F

Fee Income Cost of Reserve Commercial Paper Fraudulent

Capital Requirements Conveyance

The revenue taken in from The required return necessary The amount of funds that a A commonly used type of A transaction such as
account-related charges to make a capital budgeting bank holds in reserve to ensure unsecured, short-term debt a sale of securities or
project worthwhile. that it is able to meet liabilities instrument issued by transference of assets to
in case of sudden withdrawal. corporations. a particular party that is
determined to be illegal.
03
Loan Securitization
Securitization of Loans

Securitization is the process of transformation of non-

tradable assets into tradable securities. It is a structured finance
process that distributes risk by aggregating debt instruments in a
pool and issues new securities backed by the pool.
When a bank or financial institution is in need of additional
capital to finance a new facility, to raise the fund, instead of selling
the assets, the financial institution decides to sell the portion of the
loan to a Trustee named as Special Purpose Vehicle (SPV) and
collect the fund up front and remove the loan asset from the
balance sheet of the institution. SPV holds the asset as collateral
in balance sheet and issues bonds to the investors. It uses the
proceeds from those bond sales to pay the originator for the
assets.
Securitization Process Flow
 The roles and responsibilities of various
components involved in the securitization structure

Borrower Issuer
An Individual or organization A bankruptcy-remote Special
which obtains loan from Purpose Entity (SPE) formed
financial institution / bank and to facilitate a securitization
pays the monthly payments. and to issue securities to
investors.

Mortgage Broker Lender

Acts as a facilitator between An entity that underwrites and
a borrower and the lender. funds loans that are
The mortgage broker receives eventually sold to the SPE for
fee income upon the loan's inclusion in the securitization.
closing. Lenders can be banks or non-
banks.
 Servicer
An Individual or organization
which obtains loan from
financial institution / bank and
pays the monthly payments.
Underwriter
Trustee
Acts as a facilitator between A bankruptcy-remote Special
a borrower and the lender. Purpose Entity (SPE) formed
The mortgage broker receives to facilitate a securitization
fee income upon the loan's and to issue securities to
closing. investors.

Securitization Credit Enhancement

Documents Provider
A bankruptcy-remote Special Securitization transactions may
Purpose Entity (SPE) formed include credit enhancement provided
to facilitate a securitization by an independent third party in the
and to issue securities to form of letters of credit or guarantees.
investors.
 Securitization takes the role of the lender and breaks it into
separate components. Unlike the more traditional relationship
between a borrower and a lender, securitization involves the sale
of the loan by the lender to a new owner--the issuer--who then
sells securities to investors. The investors are buying ‘bonds’ that
entitle them to a share of the cash paid by the borrowers on their
mortgages. Once the lender has sold the mortgage to the issuer,
the lender no longer has the power to restructure the loan or make
other accommodations for its borrower. That becomes the
responsibility of a servicer, who collects the mortgage payments,
distributes them to the issuer for payment to investors, and if the
borrower cannot pay, action is taken to recover cash for the
investors. The servicer can only do what the securitization
documents allow it to do. These contracts may constrain the
servicer's flexibility to restructure the loans
 EXAMPLE

Suppose that a financial institution has processed 10 housing loans under

the total worth of 5,000,000 USD (each loan for 500,000USD). The Maximum
Tenor for the loan is 20 Years and aggregated Monthly Installment for the
housing loan is 50,000USD.
In order to overcome the financial crisis, the financial institution decided to
sell the loan assents and raise capital. It sold the loan assets to an SPV for
7,000,000 USD and got the profit of 2,000,000 USD.
Once the contract has been signed after the legal verification, the financial
institution becomes the service provider for borrowers and SPV. It transfers
the monthly payments / interest / charges / Fees / Prepayment / penalty
charges directly to SPV as per the agreement.
 KEY TERMS

Securitization

The process of transformation

of non-tradable assets into
tradable securities.
04
Can All Assets Be Securitized?
 Securitization
The process of conversion of
receivables and cash flow
generated from a collection or pool
of financial assets like mortgage
loans, auto loans, credit card
receivables, etc. into the marketable
securities.
auto loans mortgage loans credit card receivables

marketable securities.
Asset Securitization

The process whereby interest in loans and receivables are packaged and sold
in the form of ABS (Asset Backed Securities).
 Parties involved in
Securitization

Credit Risk
Originator Borrowers SPV Investors
Agencies
 1
Asset Backed
2
Collateralized
3
Mortgage-
4
Collaterized
Securities (ABS) Debt Obligation backed Mortgage
Securities (MBS) Obligations
The bonds or notes An investment grade The bonds that are A multiclass bond backed
backed by some financial security backed by a pool backed by pools of by a pool of mortgage
assets. These assets of various other mortgage loans. pass-through or
consist of receivables securities. Examples of this are mortgage loans.
such as mortagage Mortgage papers, House
loans, credit card papers, Land and
receivable, auto loans, Property papers.
manufactured-housing
contracts and home-
equity loans.
Difference between
MBS and ABS
 All assets that generates funds can be securitized

In theory, any financial asset can be securitized—that is, turned into

a tradeable, fungible item of monetary value. In essence, this is
what all securities are. However, securitization most often occurs
with loans and other assets that generate receivables such as
different types of consumer or commercial debt.
Why do we Securitize Assests?

In securitization, an originator pools or groups debt into portfolios

which they sell to issuers.
Issuers create marketable financial instruments by merging
various financial assets into tranches.
Investors buy securitized products to earn a profit.
Securitized instruments furnish investors with good income
streams.
Products with riskier underlying assets will pay a higher rate of
return.
 Effects of Asset
Securitization

Pros Cons
1. Turns illiquid assets into liquid 1. Investor assumes creditor
ones role
2. Frees up capital for the 2. Risk of default on underlying
originator loans
3. Provides income for investors 3. Lack of transparency
4. Lets small investor play regarding assets
4. Early repayment damages
investor's returns
 KEY TERMS

A S

Asset Securitization
Securitization

The process whereby interest The process of conversion of

in loans and receivables are receivables and cash flow

generated from a collection or
packaged and sold in the form
pool of financial assets like
of ABS (Asset Backed
mortgage loans, auto loans,
Securities). credit card receivables, etc. into
the marketable securities.