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726 Fourteenth Class

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					Chapter 26


      Swaps




               2/2/2010 10:10 AM   1
     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.

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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.
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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: C&I loans linked to
     LIBOR. Duration gap is negative.
              DA - kDL < 0
   ◦ 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



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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%.




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Realized Cash Flows on Swap
   Suppose realized rates are as follows
       End of Year      LIBOR
            1                   9%
            2                   9%
            3                   7%
            4                   6%



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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       -
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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.




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       Macrohedging with Swaps
   Assume a thrift has positive gap such that
    DE = -(DA - kDL)A [DR/(1+R)] >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/(1+R)]




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Macrohedging (continued)
   Optimal notional value requires
                       DS = DE
    -(DFixed - DFloat) × NS × [DR/(1+R)]
    = -(DA - kDL) × A × [DR/(1+R)]
    NS = [(DA - kDL) × A]/(DFixed - DFloat)




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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.




                     2/2/2010 10:10 AM               11
     Solving the Discount Yield Curve*
P1= 108/(1+R1) = 100 ==> R1 = 8%
  ==> d1 = 8%
P2 = 9/(1+R2) + 109/(1+R2)2 = 100
  ==> R2 = 9%
   9/(1+d1) + 109/(1+d2)2 = 100 ==>
  d2 = 9.045%
Similarly, d3 = 9.58% and       d4 =
  10.147%



                        2/2/2010 10:10 AM   12
Solving Implied Forward Rates*
                d1 = 8% ==> E(r1) = 8%
1+ E(r2) = (1+d2)2/(1+d1) ==> E(r2) =
 10.1%
1+ E(r3) = (1+d3)3/(1+d2)2 ==> E(r3) =
 10.658%
1+ E(r4) = (1+d4)4/(1+d3)3 ==> E(r4) =
 11.866%



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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.



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Cash Flows from Swap
                   U.S. FI      U.K. FI
Outflows (B/S) -10% × £50    -10% × $100
Inflows (Swap) 10% × £50     10% × $100
Outflows         -10% × $100 -10% × £50
(Swap)
Net              10% × $100 -10% × £50
Rates on notes      10.5%       10.5%
Fixed-Floating + Currency
   Fixed-Floating currency swaps.
    ◦ Allows hedging of interest rate and currency
      exposures simultaneously




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        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.




                            2/2/2010 10:10 AM                17
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
                   2/2/2010 10:10 AM          18
Pertinent Websites
BIS www.bis.org
Moody’s Investor Services
  www.moodys.com




                2/2/2010 10:10 AM   19
Chapter 27

   Loan Sales and other risk management
    techniques




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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.

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  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 M&A’s.




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Bank Loan Sale Market
    ◦ May be sold with or without recourse.
   Types of loan sales
    ◦ Emerging market
    ◦ Domestic
      Traditional short term
      HLT Loan sales




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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 +.




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          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.




                              2/2/2010 10:10 AM                25
Web Resources
Visit:
Loan Pricing Corporation
 www.loanpricing.com




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        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



                            2/2/2010 10:10 AM       27
    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



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        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.



                             2/2/2010 10:10 AM            29
     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.


                          2/2/2010 10:10 AM             30
Web Resources
FDIC www.fdic.gov
Housing and Urban Development
 www.hud.gov




              2/2/2010 10:10 AM   31
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.




                           2/2/2010 10:10 AM              32
Why FIs Sell Loans (continued)
   Capital costs
    ◦ Meet capital requirements by reducing assets.
   Liquidity risk reduced by loan sales.




                             2/2/2010 10:10 AM        33
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.




                                2/2/2010 10:10 AM         34
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
       Japan’s second largest bank, SMFG.



                           2/2/2010 10:10 AM           35
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


               2/2/2010 10:10 AM         36

				
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