Irs Rules Regarding Interest Rate on Stockholder Loans by oqc70458

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									                           Week(s) 07-8/7-9
 Organizational Stripping and Reassembly
is Also Financial Engineering: Stockholder
   Value Can be Created by Overcoming
      Regulatory Burdens and Charter

      Re-Engineering a Firm’s Corporate
       Structure and/or Its Contracting
 Edward J. Kane, BC 07-8
           Week 07-9
 Class interweaves three issues that arise in each of five
     substitute activities:
 1. Value Added in Innovative Substitute Activities
 2. Differences in Accounting Treatments
 3. Complications and Issues Raised by Incentives for
     Inaccurate Allocation of Loss Reserves
Edward J. Kane, BC 07-8
   Unlike Humans, Banks And
  Contracting Structures Evolve
Through Profit-Making Innovations

Edward J. Kane, BC 07-8
   Summary of Modern Lending Process

                        SUPPLY CHAIN - BORROWER
                         DESIGN        MAKE             DEAL               MOVE           SETTLE              SERVICE

                        FINANCIAL SUPPLY CHAIN - BORROWER
                        ANALYZE              AGREE TERMS            SETTLE                        SERVICE

                        Cash requirements    Credit Limits          Documentation                 Information Production
                        Risk concerns        Timing of Access       Dispute Resolution            Payments Delivery
                        Credit requirements  Contract Form          Disclosure Responsibilities   Ancillary Business
                        Authentication       Financing              Funding                       Relationship mgt
                        Reputation assessmentFX Services            Monitoring Capacity           Collections

                        Credit check/ score  Letter of credit       Hedging products              Portfolio Balance
                        Credit support        Escrow                EFT                           Risk Management
                        Lines of credit/      Performance guarantee                               Market Making
                        financing             Credit cards

                        SUPPLY CHAIN - LENDER
                        PLAN      TAILOR             CONTRACT              EXECUTE           SETTLE            SERVICE

                        Convergence of Borrower and Lender Value Chains.

Edward J. Kane, BC 07-8
       Credit risk-mitigation tools
Preloan Considerations
     • Collateralization
     • Third-Party Guarantees
     • Diversification
     • Syndication
Postloan Activities
     •Monitoring and Enforcement
     •Loan Sales or Participations
     •Hedging with Credit Derivatives (swaps and CDOs)   5
Edward J. Kane, BC 07-8
•       Two Products or Activities are substitutes
        when they can take the place of each
•       A bank has five substitutes for holding
        onto a business loan a customer might
      1.     credit enhancement
      2.     outright sale to an affiliate or third party
      3.     Credit Derivatives
      4.     pass-through or structured securitization
      5.     Syndication or participation                   6
    Edward J. Kane, BC 07-8
    Point of this Session: Be
   sure you understand how to
  advise a bank whether to fill a
   customer’s request for credit
        assistance with an
  intermediated loan contract
      or a substitute credit
Edward J. Kane, BC 07-8
Review: Lesson of Previous Weeks
 Active credit enhancement and securitization of
   loan pools has taught markets and academics
   to break down what had traditionally been seen
   as a holistic lending procedure. Contracting
   now “unbundles" pieces of what was once an
   "integrated financing process."
    – Competitors can specialize in bearing only a subset
      of the risks and skills needed at different stages of
      the credit chain.

 Edward J. Kane, BC 07-8
            First Substitute Deal Structure

 Three Steps in Explaining How Value Creation in
   Each Alternative Deal Structure or Some Other
   Type of Deal Structure Differs from Value
   Creation in Intermediation
 a. Conceptual Differences in Service
 b. Formulae For Economic Value Added
 c. Numerical Illustration of their
    Consequences:                                  9
Edward J. Kane, BC 07-8
1. CREDIT ENHANCER guarantees [ i.e., “bonds*”] the
     performance of a borrower’s promise to pay the
            ultimate holder of a direct debt.

    • The credit enhancer acts partly as a broker and
       partly as an intermediary.
    • Partial Intermediation Only: It holds (i.e.,
       intermediates) only the default risk of the loan, for
       which it must assess to set up and price a reserve for
    • Partial Brokerage: But it does not fund the risk-free
       portion of the loan. It sells this portion to the
       securitizing entity and ultimate investors.
    * Reminder: When used as a verb, bond refers to
       binding an obligation with some form of additional
       assurance: tying onself into “bonds” that confine like
       chains or handcuffs.
   Edward J. Kane, BC 07-8
A borrower’s credit-enhanced security bears
   a lower interest rate, much as would the
indirect debt that an intermediary might issue
against a pool of similar direct debt held for its
                 own account.
 • To make the interest rate a great deal lower, the
   enhancer must itself have a strong credit
   standing and low correlation between changes in
   its standing and that of the party it is
 • It incurs much the same due-diligence and
   transactions costs as a direct lender, which it
   must plan to cover out of its fee.
  Edward J. Kane, BC 07-8
Review: Definition of Recourse
1. In ordinary usage: The ability to turn to
   someone else for help when something goes
2. In finance, the right or obligation of a creditor
   to demand the assets of a third party if the
   payment from borrower falls into default. The
   third party’s obligation is an economic liability
   for that party.
3. Recourse is a substitute for
   “overcollateralization” and recourse obligations
   should be reserved for and should be priced.
Edward J. Kane, BC 07-8
  Accounting Perspective on
     How does a “guarantee-
  issuing” bank’s marginal (i.e.,
   incremental) balance sheet
    and income statement (“T-
  accounts”) differ from those of
    a traditional bank lender?
Edward J. Kane, BC 07-8
   A. Accounting Entries for Lending Bank
a. Income Statement for a $100 Credit,
  financed at funding cost RF = marginal
  (RL - RF)L minus net imputed (I.e., “allocated”)
    administrative and capital costs (CA) of loan
  Suppose RL=6%, RF=3%, and CA=$2 (CA is meant to
    represent all costs net of implicit returns incurred in the
  Revenue - Costs = Income. “Accounting profit” is
  [6% - 3% - 2%]100 = $1.
[b. Incremental Economic Balance Sheet
                     Assets       Liabilities
                   Loan 100       Deposits 100
                                   NW = ?
                  PV ( profit)
 Edward J. Kane, BC 07-8
      B. Entries for Credit-Enhancer
 a. Income Statement
      – Economist would reattribute timing of fees from
        guarantees and record them net of “imputed” (i.e.,
        “allocated”) operating and capital costs CA
      – An informational weakness in GAAP statements is
        failure to segregate and allocate most elements
        of CA

 b. Balance Sheet
      – An enhancement is an “intangible” liability. A
        major advance in GAAP in recent years is to
        require a fair value for guarantees to be booked
        in the body of a bank’s GAAP balance sheet.
Edward J. Kane, BC 07-8
   Calculation of Income from
      Credit Enhancement
Suppose CA=2% and fee is 1%? NI=1% -
  2% = -1%. What if fees are 3%? 3% - 2%
  = +1% (Same imputed accounting income
  as the loan, but timing of revenues and
  outlays could make the enhancement
  more profitable to the bank)
• Next slide explains why.

Edward J. Kane, BC 07-8
  Calculation Focusing on the Timing of 3 Cash
• Timing Assumptions: the enhancement fee is
  booked upfront, the costs of investigation (CI)
  are incurred a period earlier, and the cost of
  making good on failed credits across the
  portfolio of enhancements (CMG) is incurred two
  periods later.
• Parameters: the customer pays a fee of 3% and
  r=the bank’s cost of equity capital (COE).
• As of the date guarantee contract is executed,
  the present value of profit = 3%-CI(1+r)-CMG(1+r)-

   – CI is “Carried forward” in time               17
 Edward J. Kane, BC 07-8
        Differences in Economic Value
•  (holding loan) = (RL-RF) L – (allocated
                     value of all other costs)
   – E.g., (6%-3%) $100 - $2 = $1
•  (enhancement) = fee-CI(1+rE)-CMG(1+rE)-

   – N.B. Timing issue: The second formula
     recognizes that costs may be incurred both
     before and after revenue is received.

 Edward J. Kane, BC 07-8
   Applying the EVA Formula
 • Suppose that investigative costs are
    1%, that 2% of loan value is the
    appropriate capital allocation for either
    deal, and that the FSF’s cost of equity
    capital is 20%.
 ANS. Present-value of profit from the
      =3%-1.2% -
Edward J. Kane, BC 07-8
             Numerical Exercise
 Suppose scoring program computes one
    chance in 106 that the borrower will
  default irrevocably and 105/106 that full
 repayment will be received. Assume that
 the bank increases its loan-loss reserves
   by the amount necessary to fund the
     expected losses under the loan or
 guarantee with capital that costs the bank
    20% per annum. Show the bank’s
      incremental balance sheet and
   projected annual income under two
           alternative decisions:           20
Edward J. Kane, BC 07-8
 Case 1) The bank gives a 6% one-
  year “bullet” loan of $100,000 and
  finances the loan with deposits of
  the same maturity, at an “all-in
  interest cost” of 5% per annum.
  • Note: an “all-in interest cost” includes:
             relationship effects
             capital allocation at COE of 20%
             diversification benefits.
Edward J. Kane, BC 07-8
 Case 1): With no contra-asset booked
 on new loans, accountants could project
 default as a “contra-revenue.”

 Date-0 Bank’s Incremental Balance Sheet (in $ thousands)

   Loans 100              Deposits 100

  PV(profit) = 0          NW = 0

 Projected Explicit Income for the Bank realized at Date 1 (in $ thousands)

     Projected Revenue: 6  1 (106)  5
     Projected Costs: 5
     Projected Net Earnings (= Contribution to Net Worth): 0

Edward J. Kane, BC 07-8
 Case 2) The bank decides to sell the
   customer a credit enhancement.
   The bank collects a $1,000 upfront
   fee from the customer for
   guaranteeing purchasers of
   $100,000 worth of 5.0% one-year
   “bullet” bonds the customer issues in
   the public market. The bank
   promises that each bondholder will
   be paid in full and on time in the
   event the bank’s customer does not
   meet its obligations.                   23
Edward J. Kane, BC 07-8
Case 2) Prompt and Full LLR Provisioning
Date-0 Bank’s Incremental Balance Sheet (in $ thousands)

          Cash 1        Reserve for Default .825*

                      NW .175
      * This item could be recorded alternatively as a “contra-asset” on the asset

    Projected Explicit Income for the Bank at Date 0
         Immediate Explicit Revenue: 1,000
         Present value of Reserve Fund to Cover “Make-Good Cost” of
                  1  $105 
                      1.2   $. 82547 thous.  $825 .47
                 106      
         Present value of Projected Net Earnings: .17453 = $174.53 = $175.
  Edward J. Kane, BC 07-8
--Why is the credit-enhancement activity
  more profitable? ANS Time value of
  money and slightly lesser exposure to loss
  at yearend = 105K rather than 106K.
--How might the enhancement be less
  profitable if implicit costs and benefits are
  introduced? A bank might fear that the
  enhancement exposes the customer’s
  relationship value to observation and
  capture by a wider number of competing
  FSFs (including investment banks).
Edward J. Kane, BC 07-8
2. Second Substitute: Loan
• Besides securitizing or internally funding loans,
  banks might sell or trade them postloan in
  increasing liquid secondary markets. $65 bil. in
  outstanding loans traded as early as 1999.
• If sold without explicit or implicit recourse,
  accounting treatment and EVA should be
  obvious for such “true sales.”
• Most loans sold this way are “problem loans.”

Edward J. Kane, BC 07-8
 Ways of Dealing Promptly with Problem
1. Watch List to Trigger Exit Strategies
   • Loan covenants should enable early identification of:
        – Leadership, profitability, and capitalization issues.
        – Sentinel events: court filings, etc.
2. Internal Workout Specialist(s)
   • restructure loan: rate, schedule, collateral package
   • force strategic changes on borrower
   • take possession of collateral
3. Secondary Market: sell to bad-loan specialists
  ( auction site) or partner lender
4. Pool and Securitize                            27
 Edward J. Kane, BC 07-8
An Expanding Industry of Outsourcers are Willing
           “to Ride to the Rescue”

  Edward J. Kane, BC 07-8
  In modern loan sales, the buyer “steps
    into the shoes” of the originators.

 • To make an independent credit analysis,
   purchasers must:
      – receive proper information from borrower and
        originator: credit scores & ratings
      – must obtain copies of all relevant documents
      – must establish plans to remedy bank or borrower
 • Separate trading specialists/websites exist for
   par loans and distressed loans. (Accounting
   for sales may differ, too.)
Edward J. Kane, BC 07-8
   Opportunities to Sell Distressed
   Loans Have Surged Since 1999
 • Regulators require banks to account for
   impaired loans they plan to sell
 • Such loans are supposed to be
   transferred into a “held-for-sale”
   account in the trading book and written
   down regularly to cost or fair value,
   whichever is lower.
 • Loans held for sale in the “banking
   book” need not be marked down
   aggressively and usually aren’t.        30
Edward J. Kane, BC 07-8
      3rd Substitute is to Use Credit
Often no secondary market exists in which the underlying
  “whole assets” can be sold.
Simplest case is to use a “Credit Default Swap” (CDS) to
  transfer default risk exposure from a particular borrower to
  a third party that is willing and able to bear this exposure.
  These swaps “commoditize” the market for enhancements.
• Credit risk becomes “insurable by a third party” when it can
  be defined as the exposure to verifiable changes in the
  market value of a traded instrument brought about by the
  occurrence of stipulated credit events
• Definition: “Credit events” are developments in the
  borrower’s corporate affairs that counterparties agree
  might change its ability to service its debts.
  Edward J. Kane, BC 07-8
Review: A CDS Resembles a Casualty
       Insurance Policy (CIP)
• Potential Payouts are triggered by a series
   of well-defined loss-causing events
• One party is designated as providing (i.e.,
   selling) “protection against covered events”
• The Party “buying protection” pays a fee to
   the Protection Seller on a periodic basis as
   long as the coverage exists.
• The contract stipulates how the loss
   associated with any insured event will be
   measured and how soon claims for damage
   will be
  Edward J. Kane,paid.
                 BC 07-8
Review: Two Important Differences
   Between a CDS and a CIP
1. In a CIP, the protection buyer must have an
   “insurable interest.” In a CDS, the Protection
   Buyer need not have a long position in the
   covered asset. (Hence, the protection buyer in
   a CDS may be speculating rather than
2. In a CIP, the insured party has an obligation to
   prove its loss using third-party appraisers. In a
   CDS, the amount of the “protection payment”
   due is given by the price movement observed in
   a “reference security” during x days or weeks
   after a covered event occurs.                   33
 Edward J. Kane, BC 07-8
   4. Fourth Substitute for Holding an
   Originated Loan: SECURITIZATION
 • Combining loans previously originated
   into pools whose risks can be made
   interpretable to outsiders.
 • Creating liquidity by issuing marketable
   claims against the collateral of particular
 • Effect is to transfer Risk & Reduce Any
   Geographic Segmentation From Limited
   Office Coverage
Edward J. Kane, BC 07-8
   Three Ways to Mitigate Information
and Monitoring Risks Posed to Bondholders
      Bank-Dependent Borrowers
 • Make Borrower improve various of the 5Cs
      1. Lowering loan-to-value (LTV) ratio
      2. Collateralization
      3. Covenanting verifiable proxies for changes in the 5Cs and
          for firm performance and value of net-worth position
 • Support Risk Retained by Originator
      1. Reputation: misperformance would cause losses on other
      2. Full recourse or other credit enhancement
      3. Retaining the tranche that has the first-loss position
            -- market for first-loss exposures is virtually zero
 •Edward J. Kane, BC 07-8
     Contract for Third-Party Ratings or Credit Enhancements 35
  To the Extent That Lender Retains Risk, it Lets
  Bondholders Substitute the Bank’s Credit for
  that of the Borrower. Funding Cost for Bank is
  Lower when Bank’s Standards, Performance,
  and Condition are:
• Strong
• Transparent: (i.e., easy to monitor)
• Supervised and guaranteed by
  government or credible private regulator.

Edward J. Kane, BC 07-8
             “Plain-Vanilla” Passthrough

                          Cash                       Cash
   FSF                               Conduit                       End
Originator                          Institution                  Investors
of Loans          Loan Instrument
                                                  Securities +
                      + info.

• Other “flavors” include: stripping; timing mismatches;
  enhancements; reliance on multiple originators or multiple
  conduits; creating tranches of differently rated or differently
  enhanced loans.

Edward J. Kane, BC 07-8
                   Review: More on
 • Creating a readily “tradeable” title to returns
   “derived” from an illiquid asset “securitizes” that
   asset. It must be emphasized that piggy-backing on a
   trading system or “making a market in the titles is an
   essential part of “securitization.”
 • First step is to set up --or contract with-- a legally
   separate entity (usually a trust) to serve as a conduit
   for cash flows
 • This special-purpose entity (SPE) is designed to align
   the incentives of SPE management with investors.
   (To make it harder to use off-balance sheet vehicles to
   hide losses, FASB tightened rules on OBS entities
   effective 7-1-03).
Edward J. Kane, BC 07-8
  To minimize conflicts of interest, conduit SPE
   must be kept demonstrably free from originator
  SPE is insulated from bankruptcy risk by limiting
   its business to acquiring and holding the assets and
   issuing the asset-backed securities.
  For Asset Pools to be readily securitized, the
   underlying assets must have identifiable default
       Risk need not be low, but it must be predictable from
        historical data (e.g., credit-card debt).

Edward J. Kane, BC 07-8
      Review: Dealmaking Links in Chain of
 1.    Originate a loan
 2.    Contact a Packaging Agent (such as FNMA) or set up a legally
       separate trust to be conduit for cash flows
 3.    Sell designated pool of loans to the packaging agent (possibly with
       recourse or excess collateralization)
 4.    Strip and reassemble the cash flows from the pool: e.g., creating
       differences in timing or seniority*
 5.     Have the trust issue tradeable claims to (possibly repackaged) cash
       flows from the pool and sell the securities to the public
 6.    Contract with an efficient “servicing organization” to collect loan
       payments and forward them to securities owners (optional)
 7.    Arrange for a credit rating, perhaps after enhancement by the bank
       or a reputable third party
 8.    Create Tradability: Make sure a liquid secondary market exists
       for the securities or convey reasonable putback rights. Need for
       “tradability” to qualify as securitization.
 * Tranching cash flows from a repackaged reference portfolio of corporate
       debt by seniority produces a first-generation collateralized debt
       obligation (CDO).
Edward J. Kane, BC 07-8
Review: Deals Within and on Top of Deals
Support Asset-Backed Derivative Contracts

 Edward J. Kane, BC 07-8
 [1. In traditional intermediation, the original
   lender holds not just the risk, but the entire
   loan: funds the position fully and
 2. In securitization, the original lender may
   hold onto some of or all of the risk (if it
   sells with recourse)
      – may "contract out" all or some of risk to a
        credit enhancer.
      – Must fund only an in-process inventory of
        new loans.
Edward J. Kane, BC 07-8
   Credit-Enhanced Securitization

                            Cash                       Cash
      FSF                              Conduit                       End
   Originator                         Institution                  Investors
    of Debt         Loan Instrument                  Securities
  Instruments               + info.                   + info.
                                       Fee + info.

                                       Credit        (Info. + contractual obligation)
N.B. Bottom corresponds to the new “flavoring”
  Edward J. Kane, BC 07-8
             Structure of a Syndicated Synthetic CDO
2003 24 October (Risk News): JP Morgan Chase has taken a leaf out of the bond and loan markets by putting
the first syndicated synthetic collateralised debt (CDO).

The deal, called Overture, will be managed by France’s AXA Investment Managers and will be distributed by at
        least seven
regional bookrunners, in an attempt to maximise client penetration and transparency of CDO transactions,
        according sources
familiar with the deal.

“The idea is really to get a number of top banks with regional focus to distribute a standardised product, which
improve liquidity and transparency in the CDO market and offer a benchmark for future deals,” says one source.

The confirmed bookrunners to date are ABN Amro for the Benelux region, Bayerische Landesbank in
Ixis in France, DBS Bank for Asia ex-Japan, Mizuho in Japan, Standard Chartered in the Middle East and
in the U.S. J.P. Morgan Chase will act as lead manager and global bookrunner. All bookrunners will take on a
perion of the underwriting commitments.

The deal, which is expected to price within the next month, will create a reference portfolio of $3-4 billion,
will comprise four tranches of rated notes. The AAA tranche will make up around 6% of the deal, the AA
tranche will comprise around 3.25%, the A tranche 1.25% and the BBB 1.75%. The equity portion makes
around 3.75%, while the unfunded super senior tranche accounts for 84% of the transaction. The
will comprise of investment-grade corporate credits-bonds, loans and credit default swaps-with around
originating from the US, 50% from Europe, and 5% from other regions.                                       44
    Edward J. Kane, BC 07-8
AXA Investment Managers will follow the same active trading blueprint they used for their JAZZ CDOs launched in
     5. Fifth Substitute for Holding
           a Loan: Syndication

Preselling of shares in large loans to bank
and nonbank partners is called
SYNDICATION. Postselling of pro rata
claims to cash flows is often called

Edward J. Kane, BC 07-8
 • Loan sales and 4th substitute of
   “syndication” are helpful “foils”* with give
   insights into securitization activity. Syndicated
   Loan structures establish ad hoc partnerships
   among lenders, but the partners’ shares
   cannot be anonymously traded away.

 [ Reminder: What is a foil in literature and

 Examples: Cinderella & her stepsisters; Satan &
   Job; Bart & Lisa Simpson; Batman & Joker or
   Alfred; Sherlock Holmes & Dr. Watson.]        46
Edward J. Kane, BC 07-8
      Syndications: Even with financial
    engineering, most bank loans are held to
       maturity by the originating bank.

Selling whole loans faces three potential
 Borrowers must be notified of sale, which
  may jeopardize their customer relationship
 “Lemons” Pricing: Pricing of risk may turn
  on expensive-to-verify information
 Asset sales trigger tax and accounting
  consequences that are often adverse.
Edward J. Kane, BC 07-8
a. At moment loan is originated
             Bank Balance Sheet
    Loan +$500 mil.       Borrower Deposit
                            +$500 mil.

b. When loan is securitized without recourse, but with a formal residual
                  Bank                        Securitizing Trust
   Cash                 +$498 m.       Loan +$498 m.       Securities
   Loan                 -$500 m.       Cash  $498 m.        +$498 m.
   Securitization Residual +$2 m

   Query: In what ways do loan syndications and whole-loan sales
     resemble loan securitization? In what ways do they differ?

    Edward J. Kane, BC 07-8
• Accounting treatment turns on ability to prove the
  “sale of an interest” in the loan. 7-29-04 FASB
  proposal treats most participations as “loan sales”
  only if contract specifies that the transaction is not
  disguising a financing. The originator’s sale must
  also be certified as “true” by a legal opinion that
  specified that requirements are met on custody and
  noncomingling with other originator assets. Concern
  is to avoid participants becoming claimants against
  FDIC receivership in event the originator fails.

Edward J. Kane, BC 07-8
   Effects of Loan Sales Differ from
Syndications, Participations, and Credit
 Whole or Partial Loan Sales “unbook” the
  amount sold: transfer ownership and the post-loan
  monitoring and loss-control function to the
  buyer to the extent that recourse is not
 In Loan Syndications and Participations, primary
  responsibility for monitoring and loss-control
  typically stays with the lead bank. But
  sublenders have duty of “prudence.”

Edward J. Kane, BC 07-8

                                             Who has monitoring and
                      Who has title to loan?     loss control?
  Loan sales          Purchaser            Primarily purchaser;
                                           complicated by recourse

  Syndication         Joint                Primarily lead lender

  Participation       Originator           Lead lender

  Securitization Conduit SUV               Often third-party credit
                                           enhancer or originator
                                           that holds a residual

Edward J. Kane, BC 07-8
What Kinds of Loans May be Sold, Syndicated,
 or Securitized Most Easily? Loans with low
  preloan information risk and low postloan
               monitoring risk.

   Those with low preloan and postloan “agency
   • Reliable and readily available information
     makes borrower’s creditworthiness easy to
     assess directly or by sampling (low potential
     for “hidden information”).
   • Minimal need for direct postloan monitoring
     (low potential for “hidden actions”).
  Edward J. Kane, BC 07-8
Each Syndicate has a Managing Institution
  (Commercial or Investment Bank)
      –   Choice: Agent-only vs. shareholding capacity
      –   Preloan information production & distribution
      –   Pricing and structuring (maturities, covenants) duties
      –   Postloan coordination of postloan covenant
          enforcement: relief and repricing
 Junior Partners include:
      –   Domestic banks
      –   Foreign Banks
      –   Finance companies
      –   Insurance companies
      –   Mutual funds
      –   Assorted hard-to-classify funds                      53
Edward J. Kane, BC 07-8
   Third Issue: Public-Policy Concerns about
        Inaccurate Reserve Provisioning in
     Credit Enhancements and Securitizations.
Problem: GAAP encourages banks to be deficient in
breaking down and managing the risk of performing

 • Itemization Rules: Choose too few risk
   categories (out of sight, out of mind)
 • Valuation Rules: Seldom use internal or
   external risk ratings to guide:
      – profitability analysis (vs. contract rate)
      – capital allocation
      – allocation of workout effort
Edward J. Kane, BC 07-8
How do banks track hundreds of
counterparties with limited resources?
                             • Most credit managers only
                             review credit limits ‘as needed’
                             • Tend to focus on
                             counterparties with lower credit
                             quality or larger exposures
                             • Many counterparties are
                             virtually ignored.

   Edward J. Kane, BC 07-8
• The consequence is that, when
  nonperforming assets are cyclically low,
  LLR become greatly understated. The
  release of accounting reserves that is
  authorized by this neglect of performing
  loans overstates profits and capital.

• Such a release of reserves inflated bank
  profits throughout 2005.

Edward J. Kane, BC 07-8
 As Illustrated in the Hamilton Bank Case, Bankers and Field
Examiners Often Differ on Whether to Reserve for a Loan Loss

                          Performing Borrower
Edward J. Kane, BC 07-8
• This forces banks to restate past and/or current
  profits when large borrowers show or approach
• Example: Columbia Banking System Inc. in Wash.
  State revised its previous quarter’s earnings
  downward by 14.3% on 3-22-01 to reflect a
  “deterioration in a single substantial credit
  relationship.” Went from earning 32¢ per share to
  losing 1¢.
• Minicase covered in 06-10: Hamilton National Bank
  of Miami, FLA Disputed OCC efforts to write down
  Ecuadorian Loans before its closure in 2002.
  Edward J. Kane, BC 07-8
Edward J. Kane, BC 07-8
Edward J. Kane, BC 07-8
Rule is Especially Dangerous for New Instruments: How to Reserve for Losses on
Option ARMs?

 Edward J. Kane, BC 07-8
     First Minicase: A Twist on the Arm, Risk magazine, Oct. 1, 2006, by Jayne
US banks have been reaping rewards from option adjustable-rate mortgages over the past two years. But
with the US housing market slowing sharply, some analysts believe default rates in these products are set to
With US housing prices on a seemingly unstoppable upward trajectory for the best part of a decade, it has
been increasingly difficult for first-time buyers to get on to the property ladder. Many have turned to a
growing range of exotic mortgages, offering low teaser rates and a low minimum payment for an initial
period - effectively enabling homebuyers to borrow more.
However, 17 consecutive interest rate increases by the US Federal Reserve between June 2004 and June
2006 means some of these mortgages are now resetting at sharply higher rates. At the same time, there are
signs that the US housing market is slowing - for instance, in September, the Washington, DC-based Office
of Federal Housing Enterprise Oversight announced that the decline in house price rates for the second
quarter of this year was the sharpest since it began recording house prices in 1975 - raising the prospect of
negative equity for some borrowers. This has prompted analysts to predict a sharp rise in defaults among
borrowers - in turn, potentially leading to losses among those lenders that haven't properly managed their
credit risk exposure.

The products causing concern are option adjustable-rate mortgages (option Arms). In essence, these
products offer more flexibility in the way borrowers repay the loan. Homeowners can choose to pay a
minimum rate, an interest-only payment, a 15-year fully amortising amount or a 30-year fully amortising
amount. The minimum rate is usually so low that it doesn't cover the accrued interest, with the interest
shortage automatically added to the debt - a situation known as negative amortisation.

Borrowers can usually choose to pay the minimum amount for a predetermined period - for instance, the
first five years. However, most loans contain a negative amortisation limit.
   Edward J. Kane, BC 07-8
Once this limit - between 110% and 125% of the principal balance - is reached, the
minimum payment no longer applies, potentially leading to higher rates earlier than
had been anticipated by borrowers.

Option Arms were first created to target those with high, but variable, incomes: the
product would allow a broker, for example, to make low payments when sales were
slow, and then later make large lump sum payments after commissions or bonuses
are paid out.

However, critics of the product claim the initial teaser rates and low minimum
payments have enticed homebuyers to borrow beyond their means. Kevin Stein, an
associate director at the California Reinvestment Coalition, a San Francisco-based
advocacy coalition, believes many residents will be caught off-guard over the next few
years. "Borrowers don't understand the dynamics behind an option Arm, in particular
when it's overlaid with loose underwriting standards like stated income loans," says
Stein. In stated income loans, borrowers do not need to provide proof of their income.

Also, the rise in interest rates could mean some borrowers are faced with significantly
higher rates once the mortgage is reset or the negative amortisation limit is reached.
"It has become an affordability product, and there may be borrowers who do not
understand the risks and may not be as prepared when they hit the balance cap (that
forces higher monthly payments) much sooner than expected, because teaser rates
have been kept low and interest rates have risen significantly over the past few years,"
says Suzanne Mistretta, a New York-based senior director at Fitch Ratings.           63
    Edward J. Kane, BC 07-8
Option Arm sales have been big business for mortgage houses. The growth in affordability products
can be gauged by the proportion of option Arm loans within residential mortgage-backed
securitisation (RMBS) portfolios. Option Arm loans made up 0.8% of the total principal balances in
prime deals rated by Standard & Poor's in May 2003 - that figure had rocketed to over 33.2% by
June 2006.

Stated income loans are also growing as a percentage of securitised deals, jumping from 20-30% last
year to 30-40% this year, says Mistretta. And with signs that option Arms are increasingly being
marketed to sub-prime borrowers, there are fears that default rates could start to climb as repayment
rates are reset at higher levels. For example, two of the metropolitan areas in the US with the highest
percentage of option Arm loans to total loans - Modesto and Salinas - have large farming
populations (see figures 1 and 2). "We think defaults will go up because we don't think this
environment is sustainable. We know home prices are slowing and if option Arm borrowers are
faced with higher payments and can't refinance, they'll have a higher probability of default," says

Growing default rates could cause problems for those banks that haven't properly managed their
credit risk exposure. One New York-based senior risk officer at a leading Wall Street securities firm
says the fact that option Arm mortgages are still relatively new means there is little historical data
with which to calibrate risk models. "The truth is we don't know how that's going to play through the
market," he says. "And with these new products, we're slightly sailing into uncharted territory."
    Edward J. Kane, BC 07-8
So, how are banks risk-managing these loans? At the core are quantitative models that measure
the two major risks banks face - prepayment risk and credit default risk.[ In a standard
prepayment model, common inputs include current and future interest rates, the size of the loan,
the credit grade, geographic location, a burnout rate (the rate at which prepayment falls over time
given a constant interest rate environment), and an assumption on housing price appreciation
(which factors in the loan to the value of the house)]. In an option Arm model, additional inputs
comprise the T+0 Arm rate (or the amount the Arm would be settled at today), the type of
payments the borrower made last year, the likely payment that the borrower will make this year,
and whether he or she is approaching the negative amortisation balance limit.

In addition to classic prepayment risk, it is the greater potential for default risk that has some
worried. For credit risk, several types of models are being used, says Mark Adelson, head of
structured finance research at Nomura Securities in New York. Some banks use a flat constant
default rate based on historical data, while others use a constant default rate adapted to a loss curve,
which distributes the cumulative losses over time. "But arguably the more meaningful way is to look
at these products and try to connect the loans, delinquencies and losses to macroeconomic variables.
The theory is that if you go into a down economy, you have a certain amount of people losing their
jobs. Then how much worse than traditional mortgage loans will these loans perform?" says Adelson.

Given the difficulty in determining the impact of these macroeconomic variables, most lenders use
constant default rates or default rates adapted to a loss curve. To get a better idea of the impact of an
economic shock on these products, banks stress test their models. So, if they use a constant default
rate, they might increase the default rates by a rating-based factor of 1.5 or 2, which approximates A
or BBB rated loans defaulting, says Adelson.
    Edward J. Kane, BC 07-8

However, understanding macroeconomic trends and how they affect the behaviour of option
Arm borrowers is the most important factor in risk managing the product, say analysts.
"These loans are more sensitive to changes in the value of housing than standard fixed-rate
loans. Research shows home price appreciation is the key driver in realised defaults and
prepays," says Jeremy Shor, head of structured products at Brown Brothers Harriman, a
private bank based in New York. That's because borrowers have prepaid option Arms or
avoided default in the past by refinancing and extracting the rising value of their homes.

One analyst at a leading California-based mortgage bank explains that rising house prices
have created a cushion that has offset increases in negative amortisation. However, with
house prices levelling off, borrowers can no longer rely on rising property values to bail them
out. Consequently, the magnitude of housing price moves will have a significant impact on
the performance of option Arm portfolios, the analyst says. "If home prices decline by 1-2%,
it doesn't hurt us. If it goes down more than 5-10%, it starts becoming an issue."

To understand how changes in house prices affect default and prepayment rates, Brown
Brothers Harriman creates prepay and default vectors, which describe the loss distribution for
each month in the future. The firm then stresses the losses using Monte Carlo simulations to
run through different home price appreciation scenarios. "From a macro perspective, I would
want to measure the net sensitivity of all the home equity bonds (or loans) we own to
potential changes in home price appreciation," says Shor.
 Edward J. Kane, BC 07-8
But how susceptible are banks to increases in default rates? Many of the more sophisticated
institutions securitise their option Arm portfolios to lay-off risk. "We describe ourselves as being
in the moving business, not the storage business. In terms of how much risk we hold on our desks,
we have really adjusted our limits, but then we try not to hold very much risk anywhere," says the
New York-based senior risk officer.

The volumes of option Arms backing prime jumbo loan securitisations rated by S&P grew $602 million
to $3.4 billion in the second quarter of 2006 - a rise of 21% over the first quarter. The major investors in
equity tranches of RMBS are hedge funds, while hedge funds and managers of collateralised debt
obligations are buying the mezzanine pieces of subprime RMBS, says Jeff Verschleiser, a New York-
based senior managing director in mortgage-backed securities trading at Bear Stearns.

To protect investors, rating agencies require loan enhancements for option Arm portfolios. For instance,
S&P increases the foreclosure frequency (the probability of the borrower defaulting on the loan) by 20%
for option Arm products, and loss severity is calculated based on an assumed default of the loan at the
fully negatively amortised amount.

Meanwhile, issuers of mortgage loan securitisations are often required to hold the first loss tranche -
partly because of the difficulty of selling these tranches, but also to show that the interests of the bank
and the investor are aligned. And while many originators look to securitise or sell loan portfolios, large
chunks of the risk are often still retained by the banks. Washington Mutual, for example, sold $14.3
billion of option Arm loans during the first quarter of 2006, but retained more than $5 billion within its
home loan portfolio. Countrywide retained about $25 billion, or about 72%, of the option Arms
originated in the first quarter of 2006, according to its quarterly report.                                 67
       Edward J. Kane, BC 07-8

While the larger originators have sophisticated underwriting standards, some participants raise
doubts over whether the smaller players have rigorous enough credit processes. With the increase
of stated income loans and the extension by some firms into the sub-prime market, there could be
potential problems for those banks holding option Arm risk on their balance sheet

"The small issuers are so profit-motivated that you run the risk that their credit standards are low
and they don't properly check a borrower's history. For the bigger ones, you know it's a longer-term
business," says Brown Brothers Harriman's Shor. "Unfortunately, a lot is going to be qualitative,
but that is the nature of the beast.“

Not everyone, however, believes option Arms necessarily expose the mortgage banks to
significantly higher defaults than more traditional mortgages. Bruce Fuller, a financial planner at
World Savings, a division of California-based Golden West, claims default rates on affordability
products have been relatively low. Since 1981, when the firm first started offering the product, the
bank's delinquency rates (on loans with an average size of $175,000) have been "well below
industry averages, including those for institutions that offer only fixed rate loans", said Fuller,
speaking at a public hearing arranged by the Federal Reserve Bank of San Francisco in June.

However, because the probability of default is very low in the first few years of a loan when the
teaser rates are available, meaningful industry-wide default rates for option Arm loans originated
between 2003 and 2005 are unavailable.

      Edward J. Kane, BC 07-8
Nonetheless, some option Arm originators say there can be benefits in keeping the risk
on their balance sheets. For instance, Brian Cote, chief financial officer at Downey
Savings, a Newport Beach-based mortgage lender, explains that the product is used as
a tool in its asset-liability management. Downey Savings offers two types of option
Arms - one indexed to the 12-month moving Treasury average (MTA) index, and the
other to the cost of funds index (Cofi), which reflects interest paid on savings and
checking accounts by savings institutions comprising the eleventh Federal Home Loan
Bank district.

The MTA is the most common underlying index for option Arms. Cote says the firm
sells almost all the MTA index products and keeps those referenced to the Cofi index
on its books. "This is because the secondary market has more of an appetite for the
MTA product, and also the Cofi product sits on our balance sheet nicely. Our internal
cost of funds tracks relatively closely with Cofi, and it helps in terms of managing our
net interest rate margin and interest rate risk," he says.
However, starting in February this year, negative amortisation among borrowers
started to pick up pace. In fact, for the first quarter of 2006, the accumulated negative
amortisation of the total principal balance of Countrywide's borrowers increased from
$75 million to $301 million - a 301% increase. And with higher interest rates and a
cooling housing market, the institutions managing option Arm mortgage risk are about
to have their mettle tested.                                                              69
 Edward J. Kane, BC 07-8
Minicase on Sarbanes-Oxley: Credibility Lost From Falsely “Certifying” Earnings
 At Sign-Off Deadline, Household Restates
 From 1994 to 2002, overstated pretax earnings by $600M

 From: American Banker
 Thursday, August 15, 2002
 By Erick Bergquist

 Household International Inc. on Wednesday became the first financial services company forced to restate earnings so
 that its top executives could vouch for its financials, as required by the Securities and Exchange Commission. < /P>
 The restatement - which lowered pretax earnings by $600 million over the past eight years - came as the deadline
 expired for big public companies to comply with the SEC's edict. By midday Wednesday all but six of the nation's
 largest banking companies had certified that their statements were accurate, a move the SEC required to boost investor
 confidence amid a string of corporate governance scandals.
 Most had filed before the deadline, but PNC Financial Services Group Inc., FleetBoston Financial Corp., Bank of New
 York Co., Fifth Third Bancorp, Huntington Bancshares of Columbus, Ohio, and National City Corp. of Cleveland
 waited until Wednesday.
 The initial wave of certifications applies only to the largest publicly traded firms. Under the Sarbanes-Oxley Act, the
 leaders of all public companies will be required to make similar attestations over the coming months.
 In a conference call with analysts and reporters Wednesday, Household's chairman and chief executive officer, William
 F. Aldinger, tried to downplay the restatement, which he said stemmed from a "good-faith difference of opinion." On
 an after-tax basis, from 1994 to 2002 the company overstated earnings by $386 million - a relatively small amount,
 considering that its total earnings for the period were roughly $10 billion.
 "Frankly, we were surprised," Mr. Aldinger said. "I don't think there is any culture that says we are cutting
 corners. We wouldn't try 'to cook the books' to improve our rate by two-tenths of one percent."                    70
     Edward J. Kane, BC 07-8
                           Minicase (cont.)
Some outsiders agreed with his assessment, but others blasted the Prospect Heights, Ill., lender.
Moshe Orenbuch, an analyst with Credit Suisse First Boston Corp., reiterated his "strong buy" rating on
Household, despite shaving 10 cents off his 2002 earnings target, to $4.60. While the restatement caused
Household's capital ratios to fall about 30 basis points, "this does not affect the way the company does business,"
he said.
But Daniel S. Loeb, a managing member with Third Point Partners LP, a money management firm in New York,
saw it differently.
"This is really a half-billion-dollar pickup," he said on the call. "When you talked about this thing being a small
matter of a difference of opinion, you seem to minimize a major error here that involves something of huge
Another critic, William Ryan, an analyst with Portales Partners, wrote in a report issued Wednesday: "When the
going gets tough … the accounting department gets going. Household has a history of using subtle accounting
changes to hit estimates."
But investors seemed to take the news in stride. Household's stock sank in early trading, but recovered to gain
less than 1%, to close at $38.09 a share. However, that is well below the stock's 52-week high of $68.45 a share
last August.
Mr. Aldinger insisted that the restatement reflected nothing more than a difference in opinion on how to account
for certain credit card assets.
The restatements, surfaced after a review by Household's new auditor, KPMG LLP, he said. (Household fired its
longtime auditor, Arthur Andersen, in the wake of the Enron Corp. scandal).
KPMG recommended that Household revise its accounting policies regarding three credit card deals it entered
between 1992 and 1999. Two of the deals were part of its MasterCard/Visa co-branding affinity credit card
business; the third dealt with an unrelated card marketer.                                                  71
   Edward J. Kane, BC 07-8
                               Minicase (cont.)
Relying on the advice of Andersen, Household had treated its payments to these partners as prepaid assets and had
amortized them over longer periods of time. However, KPMG officials said that Household should have either charged the
payments against earnings at the time they were made or amortized them over shorter periods of time.
David Schoenholz, Household's president and chief operating officer, said that investors should not expect any more surprises.
After reviewing Household's financials for 1999-2001, KPMG had signed off on all of the firm's basic operations, including
"merchant partnership agreements, the provision for credit losses and loan loss reserves, securitization accounting, income tax
reserves, and litigation matters," Mr. Schoenholz said.
Mr. Ryan and other analysts did mention litigation as a potential problem for Household. For instance, the company has been
besieged recently by several high-profile consumer groups seeking to eradicate predatory lending.
Spreads between the Treasury bond yield curve and Household's debt have widened to over 350 basis points in recent
months. One source attributed that to concerns in the marketplace over a spate of lawsuits consumer groups have filed against
Household over the last year.
William Lerach, a partner in the securities class-action law firm of Milberg, Weiss, Bershad, Hynes & Lerach, said Wednesday that
Household will likely be sued over its restatement. "Because a restatement is an admission that financial statements were false
before, it is virtually inevitable that any company that restates in a material amount will find itself in sued in a securities
Asked if his firm, which is representing Enron shareholders and is also involved in suits against Andersen and WorldCom Inc., has
been retained to take action against Household, Mr. Lerach said: "A number of large investors have contacted us, and we are
looking into that."
However, Mr. Orenbuch said that he still expects Hosuehold to maintain or increase its market share while complying with various
state and local lending restrictions.
What's more, none of the three major Wall Street debt rating agencies changed their ratings on Household after the restatement.
Fitch Inc. maintained its "A with negative outlook" rating on the company.
"While the avoidance of restatements through use of more conservative accounting would have clearly been preferable, similar
restatements are not expected for Household in the future," Fitch said in a press statement.14                         72
     Edward J. Kane, BC 07-8
1. Differences in Ownership Structures alter owners’ responsibility for
    losses: corporations, partnerships, sole proprietorships, holding
2. Importance of Choosing the Right Charter: Charter is a legal
    document authorizing specific rights and functions.
          a. Stock vs. Mutual vs. Partnership Form
          b. Alternative Charter Issuers: State (which state?) vs.
    Federal vs. Foreign (which country?)
          c. Charter type: Com. Bank vs. thrift vs. industrial
            loan co. vs. credit union vs. securities firm vs.
            Insurance Co., etc.
3. Regulators Compete for Jurisdiction: This explains why U.S. fin.
    system is so messy. Leads to Loopholes and Regulatory Migration
    in response to differences in net regulatory benefits.
4. Managerial searches for Value-Creating Teamups and
    Consolidations Are Always in the Background.

 Edward J. Kane, BC 07-8
         Why Do FSFs Let Themselves Be
1. Regulatory services can produce benefits for society and private benefits
    for regulatees.
2. But who watches the watchdogs? Layers of conflict of interest exist for
    regulators: These result in either partial or total “regulatory capture.”
3. Etymology: REGULA (latin for “rules”): Distinction between rulemaking and
    enforcement. Example of Montana “enforcement” of 55 mph limit.
          a. Different rewards accrue to rule-breakers and to those who
          b. Enforcement uses both carrots and sticks.
4. Metaphor: FSF safety regulations share entailments with traffic safety.
          a. stop signs (e.g., C&D orders)
          b. speed limits (caps on activities)
          c. one-way street restrictions (exclusionary rules)
          d. radar guns vs. radar detectors (resistance to transparency)
          e. traffic courts (due-process guarantees)
          f. Risk-rated insurance premiums
5. Different Incentives for Private vs. Government Regulators: Self-Regulatory
6. Role of Regulatory Culture.
 Edward J. Kane, BC 07-8
 Definition of “Financial Regulation”
• Purposeful efforts to monitor, discipline, and
  coordinate the behavior of individual firms in the
  financial-services industry to generate social and
  private value by promoting specific macroeconomic and
  microeconomic goals.
• Microeconomically, the socially approved purposes
  are to increase FSF-customer confidence and
  convenience. A socially unpopular purpose is to
  insulate banks from competition to some degree.
• Overtly, regulators seek financial-stability missions, but
  covertly also seek jurisdiction and prestige.
• Internationally, regulators help their regulatees compete
  more effectively against differently regulated foreign
  and domestic firms.
Edward J. Kane, BC 07-8
             Regulatory Competition
• Regulators compete whenever their jurisdictions overlap
  or when they proffer “chartering relationships” that
  differently chartered FSFs may choose among. In
  “negotiating” a contract with a government regulation
  supplier, exchanges of value take place as repeat
  business in markets for political and bureaucratic
  services that are imperfectly competitive and
  dysfunctional in the discipline they generate.
• Why and how dysfunctional? -- Regulatory agencies
  resist their exit even when exit might be efficient. – Top
  regulators are made to pay a price if they weaken their
  clientele: often they become “cheerleaders” and seek
  post-government careers in the regulated industry.
• Promontory is a shining example of loophole-exploiting
  postgovernment career opportunities. Top managers are
  an ex-Comptroller of the Currency and an ex-Fed
  Governor.                                                  76
  Edward J. Kane, BC 07-8
 Six Elements Define a Regulatory
Culture and Vary Across Jurisdictions
-- Legal Authority and Reporting Obligations
- Formulation and Promulgation of Specific Rules
-- Technology Used to Monitor for Violations and
-- Penalties for Proven and Material Violations
-- Duties of Client Consultation and Administrative
   Due Process, with Assigned Burdens of Proof
   (to Guarantee Fairness)
- Right to Invoke Outside Judicial Review: Appeals
   Procedures (to bond the fairness guarantee)
Edward J. Kane, BC 07-8
     Avoiding vs. Evading Rules
• Legalistic elements imbedded in a country’s regulatory
  culture both empower and limit avoidance.
• We may illustrate this by drawing an analogy to filling out
  one’s tax return optimally. Avoidance activities and their
  control are restrained by: TAX LAW (which specifies
  rules and penalties) TAX AUDITS (monitoring),
  the IRS), TAX COURT (which exists to handle first
  stages of outside appeals).
• Evasion is illegal avoidance of burdens of rules.
  Distinction between avoidance and evasion is jesuitical.
  It turns on whether the letter of the law is obeyed while
  its spirit is broken and on the size and likelihood of
  penalties imposed on violators.
Edward J. Kane, BC 07-8
Definition of an HC: A corporation that owns enough of at least
  one other corporation to control it. May even be a “shell
  corporation” that does no other business. [A “shell” is a hard
  outer case or “covering.” A “shell corporation” serves only to
  layer or mask a corporation’s ownership.]
  1. Every HC must have at least one subsidiary corporation
  (“sub”), but it may have many.
  2. Queries: What is a holding-company subsidiary? an
  affiliate? a consolidated income statement or balance sheet?
  (Be sure that you can show the difference on an Organization
  3. Metaphoric use is made of language of the human family:
  parents, progeny, siblings. CARTOON scolding of a sub’s
  board members by CEO.
  4. What is meant by upstreaming and downstreaming funds
  within a HC? What would “sidestreaming” describe?
 Edward J. Kane, BC 07-8
  What is a bank holding company
- A corporation that “owns” a “bank” as the quoted terms
   are defined in the BHC Act of 1956, as subsequently
   amended. BHCs are usually named after their leading
   bank sub. [e.g., Banc One differed from Bank One].
- Subject to Evolving Affiliation and Ownership Restrictions.
   BHC and S&L HC (SLHC) regulations differently restrict
   the affiliations that are allowed within the HC. Statutes
   also constrain what type of corporations may own or
   sponsor various types of chartered FSFs.
- Provided a circumventive platform through which banking
   industry could test the limits of geographic, capital,
   product-line, and ownership restrictions piecemeal on
   many fronts.
Edward J. Kane, BC 07-8
    Financial-Engineering Origin of
              BHC Form
• Initially used mainly to disguise
  ownership or to save taxes.
• Became even more important as a way for
  bank owners to transform an FSF’s
  “offices” and “divisions” into separate
  corporations with separate charters.
• This kind of transformation can favorably
  affect FSF profit generators and profit
Edward J. Kane, BC 07-8
 It is Instructive to Compare a BHC
      With Each of the Following:
1. A bank with nonbank subsidiaries. BHC is usually not itself a bank.
   (A national bank may not itself even be a BHC, but some states do
   permit the banks that they charter to become a BHC.
2. A financial-services mall in which a commercial bank, brokerage
   firm, insurance company, S&L, leasing-company, and sales-finance
   company have offices located around a central parking lot. Sources
   of difference:
         - common vs. diverse ownership? Idea of “minority interests.”
         - presumption of back-office links?
         - extent of common marketing and employee
         - Do components have to be located in a single geographic
3. A Japanese or European “financial conglomerate” in which individual
   firms own each other (cross-shareholding with no parent
4. A European universal bank.
 Edward J. Kane, BC 07-8
           What is a One-Bank BHC
1. How might an OBHC not be a single-
  subsidiary BHC?
2. How many different kinds of affiliates can an
  OBHC have? Many kinds. BHC Act largely
  allows the Federal Reserve Board to determine
  this. A secular expansion of “laundry list” driven
  by Regulatory Competition led to Gramm-Leach-
  Blilely Act of 1999.
3. Why were OBHCs more common before 1970
  than afterwards?

Edward J. Kane, BC 07-8
What is a Nonbank BHC Subsidiary?
• Any sub that is not a bank by the definitions of the BHC
  Act: e.g., a monoline credit-card bank.
       1. How does it differ from a subsidiary of a bank?
       2. Illustration of where subs metaphorically “hang”
          on the following chart:

                               BHC Parent Corp.
                                                                         Domestic & Foreign
                                                                       NonBank & Nonsecurities
                  Bank Sub 1

                                                  Bank Sub 2
   Sub’s operating subs
   - service corporation
   - mortgage banking sub                         Foreign Banks or                     84
Edward J. Kane, BC 07-8                           Foreign Securities
Multibank Holding Company (MHBHC) With
  a Lead Bank vs. Multi-Office Banking
•   A “branch office” is a direct and integral extension of the corporation of which it is a
    part: organization would have one charter and a consolidated balance sheet.
•   A multibank holding company differs in several dimensions from a bank that puts
    branch offices in exactly the same locations and premises as the MBHC puts its
•   Which of the following items in the sub might be separated from or consolidated
    into the HC?
         a. in management structure: separate officers & boards
         b. in balance sheet: sub net worth passes through via stock
         c. in income statements: key role played by dividends from bank(s)
         d. in deposit-insurance coverage (per account name; branches & foreign subs)
         e. in regulatory relationships
           1) parent regulated by Fed
           2) bank sub regulated by chartering authority
           3) special treatment of state-chartered member banks
           4) source-of-strength doctrine (slide 19).
         f. in transferability of ownership: branches cannot offer stock, but can be
            sold as units.
         g. in managerial authority or independence: FRB rules limit when an official
             may work for two different banks
         h. in taxation (especially for foreign subs)
    Edward J. Kane, BC 07-8
       Legislative Chronology of Changes in
      Federal Reserve Responsibilities in BHC
           Regulation and Reregulation
1. BHC Act of 1956: OBHC exemption (Douglas Amendment)
2. BHC Amendments of 1970: Closed OBHC loophole and
   established BHC bank definition
3. CEBA of 1987: Amended 1970 amendments. Importantly
   Revised BHC “bank” definition
4. FIRREA of 1989: Instituted cross-guarantees among affiliated
5. FDICIA of 1991: Strengthened regulators’ rights to demand
   that capital be injected from parent BHC.
6. GLBA of 1999: Authorized reciprocal entry of banks, securities
   firms, and inscos into one another’s signature businesses.
7. Law-Making Role of the Courts: Key rules are always
   challenged and litigated. Courts sometimes resist and
   sometimes legitimize cross-jurisdictional forays by regulatees.
    Edward J. Kane, BC 07-8
In the Past, BHC Subsidiaries Served to
       Circumvent Limitations On:
1. Where a bank might locate a branch office (say, across
   Massachusetts counties or across state lines)?
   Leapfrog Loophole: 30-mile moves of headquarters after
   a merger represented a loophole for national banks and
   later for state banks in a few states.
2. What activities a bank may undertake? ANS. Parent
   can deliver bank-restricted financial services from a
   nonbank sub that it operates as an affiliate of the bank.
3. Restrictions on bank mergers? (How does an HC
   acquisition differ legally from a merger? ANS. Purchase
   of controlling position in stock vs. complete consolidation
   of both firms’ accounts).

 Edward J. Kane, BC 07-8
1. Capital requirements initially focused only on how much capital a bank had to hold to
    support its risk-taking.
2. The following balance sheets illustrate the concept of consolidated leverage:
            Assets 100                     Deposits 80
                                           Owner’s Equity 20

                           OBHC (parent)
         Assets (Bank Stock) 20      BHC Debt 19
                                     BHC Stock 1

    - The bank’s leverage [A/E] is only 5 to 1, but the consolidated leverage of the bank
    and          its parent is 100 to 1. Try to construct the consolidated balance sheet.
            What terms cancel out?
3. What market and regulatory reactions serve to limit such “double-leveraging?”
            1) Market requirement for sizeable interest-rate premiums on BHC debt when
               BHC leverage is high. Most BHCs have lower credit ratings than their lead
            2) FR regulation of consolidated entity: Since 1987, Fed has sought to enforce
              its twofold “source-of-strength doctrine:” (1) that a BHC parent should infuse
              additional capital into any failing bank sub and (2) that a BHC could not
    selectively          liquidate its weakest bank subs: FRB’s assertion insisted that
    affiliated banks cross-guarantee one another was eventually passed into law.

    Edward J. Kane, BC 07-8
   Instructive History Lesson: How BHC Loopholes
 Destroyed Longstanding Restrictions on Bank Activities
               and Geographic Locations
• IBBEA of 1994 and GLBA of 1999 reduced need for circumvention
• Passage of this legislation resembled a pair of storms taking down a
  forest of hollowed-out trees: Expansion of de jure powers followed
  prior de facto hollowing out of limits:
        1. Charter shifting: state vs national charters; thrift vs.
  bank charters; mutual vs. stockholder form.
        2. Insurance powers: small-town exemption + credit life +
           annuities + South Dakota loophole
        3. Securities Powers: Starting in 1987, “not principally
           engaged” loophole for Section 20 securities affiliates, was
           widened by an expanding definition of “principally”
        4. Leapfrog loophole for national-bank branches
        5. OBHC and Unitary S&L loopholes
        6. Non-bank bank: debanking
        7. Nonbranch-office geographic extension: e.g., Loan-
           Production Offices
        8. Shuffling bad loans across subs ahead of scheduled
                   examiner visits (Butcher Banks)
 Edward J. Kane, BC 07-8
 • Medieval City Walls: “Fences” with “Gates” and
   “Leapfrog Opportunities”
 • Laundry List
 • Fig-Leaf Outsourcing
 • Upstreaming and Downstreaming “funds”
 • Spinning activities out of the bank
 • Salami-slicing
 • Speed limits: De Jure vs. De Facto
 • “Grandfathering” of privileges: Underlying metaphor
   recalls exemption from literacy tests for voters that were
   introduced to exempt illiterate white people in the South.
   These rules allowed people to vote if their Grandfather
 Edward J. Kane, BC 07-8
Why Change Control of a Bank or BHC?
  Benefits that might be pursued   Substitute Forms of Dealmaking
   Correct Inefficiencies           Joint Ventures; Outsourcing
   Enhance Market Power             Cartel Agreements
   Pursue Loophole Benefits         Lobbying; Building Clout;
                                    Offering Bribes

 Edward J. Kane, BC 07-8
• Mergers (e.g., fold target into an existing
  bank sub) vs. Direct Acquisitions of Stock
     -- voluntary vs. supervisory
     -- hostile vs. friendly
 Terms
     -- pay by cash vs. swap of stock vs.

Edward J. Kane, BC 07-8
               Stanford Weill’s Assembly of Citigroup

Edward J. Kane, BC 07-8
 Why is Consolidation Happening Now
  and Why at Such a Rapid Pace?
1. Twofold push from: (1) Too-big-to-fail and
  too-big-to-discipline adequately policy
  frameworks and (2) release of pressure
  against consolidations that past regulatory
  policies had damned up;
2. Twofold pull from industry’s prospects for
  a different and richer (1) national and
  global competitive environment and (2)
  technological future.

Edward J. Kane, BC 07-8
              Industry Conditions: 1940s through 1970s
    • Regulation protected commercial banks from competition
       – Geographic entry barriers (McFadden Act, state laws).
       – Product-line entry barriers (Glass-Steagall Act, limited
         thrift powers).
       – De novo entry slowed by FRB’s application of
         “convenience and needs” tests.
       – Deposit-rate ceilings (Regulation Q, but money-market
         mutual funds).
    • Relatively stable population of between 13,000 and 14,000
       – Most banks operating well below efficient scale.
       – Bank mergers tightly regulated.
        Edward J. Kane, BC 07-8
(with thanks to Robert DeYoung of FDIC)
              Industry Conditions: 1940s through 1970s
    • Very stable demand for banking services, primarily due
      to the lack of substitute products and services.
          – Physical bank offices were the main portal to a paper-
            based payments system.
          – Banks were the primary source of investment
            products for households (savings accounts, time
            deposits, CDs).
          – Banks were the primary source of business finance.
            Only the largest firms could access capital markets.
          – Banks and thrifts were the main sources of consumer
            finance (auto loans, mortgages).

        Edward J. Kane, BC 07-8
(with thanks to Robert DeYoung of FDIC)
        Industry Conditions: 1940s through 1970s

     • Through the 1960s, little technological change or
           –   Pre-computer, pre-internet, pre-cell phone.
           –   Pre-mutual fund, pre-money-market fund, pre-NOW account.
           –   Pre-junk bond, pre-NASDAQ.
           –   Banks held information advantages about most firms.
     • Relatively stable market interest rates
     • Bank financial performance was profitable and
           – “3-6-3 banking”
           – Failure unlikely: Most large losses traced to fraud rather than to
             exposures to credit or interest-rate risk.

        Edward J. Kane, BC 07-8
(with thanks to Robert DeYoung of FDIC)
     • Deregulation was an endogenous response to economic
       conditions (volatile rates) and technological progress.
     • Riegle-Neal Act (IBBEA of 1994) and prior state laws
       allowed geographic entry.
           –   Over 9,000 commercial bank mergers between 1980 and 2001.
           –   1980: 14,078 community banks, with 33.4% of industry assets.
           –   2001: 7,631 community banks, with 16.0% of industry assets.
           –   1986: 28% of industry assets in ten largest BHCs.
           –   2001: 76% of industry assets in ten largest BHCs.
     • Gramm-Leach-Bliley Act of 1994 and prior regulatory
       rulings directly exposed banking markets to nonbank
           – Thrifts, credit unions, brokerages, insurance companies,
             investment banks.
     • Repeal of Reg. Q authorized explicit price competition for
        Edward J. Kane, BC 07-8
(with thanks to Robert DeYoung of FDIC)
               Information and Financial Technology
     • Payments:
           – Credit cards reduced consumer bank deposit balances.
           – ATMs, Internet, debit cards reduced consumer reliance on
             paper-based payments and physical bank location.
     • “Hard information” (credit scoring) transforms consumer
       credit into a commodity product.
           – Mortgages in bank share of household debt in 1983: 11.6%
           – Mortgages in bank share of household debt in 2001: 38.0%
     • Mutual funds, online brokerage, and 401K plans reduce
       banks’ share of household investments.
           – Household assets held in depositories in 1983: 22.7%
           – Household assets held in depositories in 2001: 10.3%
     • Businesses forgo bank loans for direct finance (high-
       yield bonds, commercial paper, IPOs).                            99
        Edward J. Kane, BC 07-8
(with thanks to Robert DeYoung of FDIC)
                      Increased FSF Competition

     • Nonbank competition for investment products.
     • Nonbank competition for business finance.
     • Nonbank competition for consumer finance.
     • Intensified competition required banks to
       become more efficient:
           – 27 FTEs per office in 1970............... 23 FTEs per
             office in 2001.
           – 586,000 payments per office in 1987.............
             1,001,000 in 2001.

        Edward J. Kane, BC 07-8
(with thanks to Robert DeYoung of FDIC)
             A Strategic Map of the Banking Industry

             hard                         INFORMATION                    soft
    high                    Relationship banking                                small
                        Low-volume, high value-added
                              Personal service
                               Interest income

COSTS                                                                           SCALE

                                              Transactions banking
                                          High-volume, low value-added
                                              Commodity products
                                                   Fee income
      low                                                                       large
             standardized                  PRODUCTS           personalized       101
        Edward J. Kane, BC 07-8
(with thanks to Robert DeYoung of FDIC)
    Growing less alike: Loans as % of assets.

                      1991 = 100             small community
                                             community banks

                                             large community
      1.00                                   banks

                                             very large banks
             1991 1993 1995 1997 1999 2001
        Edward J. Kane, BC 07-8
(with thanks to Robert DeYoung of FDIC)
         Different production technologies for
                 large and small banks

  • Patterns of survival are consistent with cost studies of
    traditional banks, performed during the 1970s and 1980s.
        • Substantial scale efficiencies up to about $500 million.
  • Studies using more recent data that sample larger sizes
    than existed before suggest that the largest banks have not
    yet reached efficient scale!
        • Hughes, Lang, Mester, and Moon (2001).
        • Rossi (1998) for mortgage banks (transactions banks).
        • DeYoung (2005) for Internet banks (transactions banks).

        Edward J. Kane, BC 07-8
(with thanks to Robert DeYoung of FDIC)
                      Market extension mergers
   • Quickest way to exploit the scale economies available to
     “transactions banks.”
   • Concentration in local markets is unaffected, but…
         • the business plan of acquired bank changes.
         • competitive rivalry in the local market changes.
   • External entry improves local bank efficiency (DeYoung, Hasan,
     and Kirchhoff 1998; Evanoff and Ors 2005).
   • Outside entrants with “brand images” gain local market share
     more quickly (Berger and Dick 2004).
   • De novo re-entry response of small banks when managerial jobs
     are extinguished by outside entry via acquisitions by large banks
     (Berger, et al 1999, Keeton 2001)

        Edward J. Kane, BC 07-8
(with thanks to Robert DeYoung of FDIC)
 Sources of increased non-interest income

  1. Production or delivery of non-traditional banking services
     (insurance, brokerage, mutual funds, etc.).
  2. Production of traditional banking services:
         • New methods (e.g., electronic payments and banking).
         • Expand existing products (e.g., back-up credit lines).
  3. New pricing schemes for traditional banking services:
         • Vertical unbundling of loan production (e.g., origination,
           securitization, servicing) generates fees.
         • Unbundled deposit pricing (concept?) generates fees.
     Edward J. Kane, BC 07-8
(with thanks to Robert DeYoung of FDIC)
                  Advertising and Image Creation
    • Large banks spend twice as much per dollar of output on
      advertising, relative to small banks.
    • Little research on advertising at banks, but what exists
      suggests that depositories use advertising strategically.
    • DeYoung and Ors (2005) examined advertising by thrifts:
        • For differentiable deposit products (e.g., checking
          accounts), data suggests that thrifts use advertising of
          elements of implicit interest to reduce elasticity of
        • For commodity deposit products (e.g., CDs), data
          suggests that thrifts use advertising to communicate
        Edward J. Kane, BC 07-8
(with thanks to Robert DeYoung of FDIC)
         Creating Customer Switching Costs
• Transactions banks encourage customers to use “direct
  deposit” and “direct payment” services.
    • (Have you tried to change banks recently?)
• Transactions banks differentiate themselves by “packing the
  map” with multiple, convenient delivery channels.
    • Bank branches doubled, and ATMs tripled, since 1990.
    • Internet banking obviates geographic location.
    • Convenience masquerades as personal service.
• Depositors appear willing to pay higher fees at “convenient”
    • FRB annual surveys support this.                       107
     Edward J. Kane, BC 07-8
(with thanks to Robert DeYoung of FDIC)
                                Precluding Entry
  • The explosion in bank branches has been largely a
    strategic phenomenon:
      • “Packing the map” (product differentiation)
      • “Waving the flag” (image differentiation)
      • “Toeholds” and “packing the map” (preclude entry)
  • Chicago provides an excellent example.

     Edward J. Kane, BC 07-8
(with thanks to Robert DeYoung of FDIC)
    Transactions banking and risk mitigation

  • Pure size creates diversification opportunities
      • Geographic
      • Product lines
  • Loan securitization separates and redistributes risks
  • So does hedging in financial markets
      • Interest rate derivatives
      • Credit derivatives

     Edward J. Kane, BC 07-8
(with thanks to Robert DeYoung of FDIC)
     U.S. banking system is flush with capital





     Edward J. Kane, BC 07-8
(with thanks to Robert DeYoung of FDIC)
            Multiple drivers of increased capital
   • Record earnings
      • Fortunate macroeconomic conditions
      • Freeing up of longtime regulatory constraints
      • Innovation and Strategic Focus
      • Globalization of large institutions
   • Pressures to operate efficiently:
      • More banks publicly traded
      • Market for corporate control
      • Strong competition from nonbanks
   • Improved regulation and supervision:
      • Basel I standards
      • FDICIA and the specter of Prompt Corrective Action

        Edward J. Kane, BC 07-8
(with thanks to Robert DeYoung of FDIC)
        Minicases for Classroom Discussion
1. Wachovia-Golden West Deal
       a. how big?
       b. what kind of “fit?”
       -- geographically?
       -- product-line revenues and costs?
       -- charter issues?
       -- corporate culture?
2. Bank divestures of proprietary mutual funds and their
   purchase by large asset-management firms [e.g.,
   Amsouth Bancorp sold to Pioneer Investment Mgt. (July
       - comparative advantages in gathering assets vs.
          managing them
       - small size of most bank fund families.
 Edward J. Kane, BC 07-8
More Minicases

3.   Citigroup’s Decision (July 2006) to fold $164B in assets
     at its San Francisco and Virginia Federal Saving Banks
     into its main National Bank charter.

4. Demutualizations: Two-Step Conversions:
      (a) of credit unions to mutual thrifts and thence to
          stockholder form
      (b) of mutual thrifts into federal mutual holding
          companies wholly owning a subsidiary
          stockholder bank followed by “partial” or full
          conversion of the mutual HC to stockholder

 Edward J. Kane, BC 07-8
Example: People's of Conn. Takes Second Step
  From: American Banker
  Thursday, September 21, 2006
  By Laurie Kulikowski
  Ending months of market speculation, People's
  Bank of Bridgeport, Conn., said it plans to
  become a fully public company -- a move analysts
  said could raise as much as $3.4 billion. People's
  said Wednesday that it plans to convert to a
  public-stock savings and loan company. It took its
  first step toward doing so 18 years ago when it
  created People's Mutual Holdings, the mutual
  holding company that now owns 58% of the $11
  billion-asset bank’s shares… People’s stock rose
  by 6.9% Wednesday.

     Edward J. Kane, BC 07-8
   Under the second step of its conversion, People's said, it would retire the majority of
   its shares held by the mutual holding company and sell them as common stock
   under the company's new name, People's Holdings. The bank also said it would
   exchange the 42% of its shares that are already publicly traded with shares of the
   new company… The bank, which converted to a mutual holding structure in 1988,
   said it plans to conduct an appraisal of the new holding company and determine the
   exchange ratio at a later date. It did not provide an estimate on the value of the
   offering, though analysts said the proceeds could range from $2 billion to $3.4 billion.
   In June 2005, Hudson City Bancorp Inc. of Paramus, N.J., completed the largest
   second-step offering by a banking company. It sold 53% of its ownership stake to
   raise $3.93 billion.
   For months analysts had questioned People's executives on whether a second-step
   offering was in the works…In March it said it was interested in acquiring companies
   outside Connecticut that would make it look more like a commercial bank. In May it
   announced that it was switching from a state charter to a federal one, and that over
   the next three years it would open 15 Westchester County, N.Y., branches -- its first
   outside the state. The charter conversion was completed in August.
   On Sept. 6, People's disclosed that it had recently sold the remaining $835 million of
   securities on its balance sheet as part of a restructuring plan. It said it would use the
   proceeds to pay down short-term borrowings and reinvest the rest in federal funds
   and other short-term securities.
   Jared Shaw, an analyst at Keefe, Bruyette & Woods Inc., who estimated that the
   offering could raise up to $3.4 billion, said People's "needed to get their ducks in a
   row internally" before going public.
   "For the last three years they've been keeping busy with improving fundamentals at
   the bank," he said. "The first priority was improving earnings. The second was
   improving its balance sheet. ... Now that they've hit all those they feel they have
   cleaned up enough in-house" to do the offering. He rates People's stock
   Edward J. Kane, BC 07-8

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