Loan Sales and Other Credit Term Paper

ETMA accomplishes its primary objective, improving risk management, efficiency and transparency of the secondary market, by surveying and legal requirements and developments. (Buckley, 1998, p. 47)

Loan Sales FAQs

What is a loan sale?

A loan sale is a commonly used term for the sale of loans or loan pools. Loans acquired by the FDIC from failed financial institutions are generally sold in pools through sealed bid sale or English outcry auction.

How are sales structured?

Typically, sales contain loans that have similar characteristics. The loans are refined into pools according to specific criteria. Pooling considerations may include loan size, quality, type, collateral and location.

What documents are available on the site?

The storeroom provides documents for the sale offering and the individual loan pools. The documents that can be found in the storeroom are the: Invitation to Bid, Bid Instructions, Purchaser Eligibility Certification, Loan Sale Agreement, Loan Spreadsheets and other relevant documents.

Are loans an appropriate investment for me?

Every interested party, based on their own circumstances, must determine whether loans are a suitable investment. Prospective purchasers must have the financial sophistication and resources sufficient to evaluate and bear the economic risks of such loan purchases.

Are there any restrictions to purchasing loans from the FDIC?

Yes. The Purchaser Eligibility Certification identifies prospective purchasers who are not eligible to purchase assets from the FDIC under the laws, regulations and policies governing such sales. The FDIC must receive an executed Purchaser Eligibility Certification from the winning bidder upon notification of bid award.

Does the FDIC only sell distressed or troubled loans?

No. The loan portfolios of failed financial institutions usually contain a variety of performing and non-performing loan products including mortgage, commercial, consumer loans, etc.

Does the FDIC guarantee the performance of loans being offered for sale?

No. The FDIC makes no representations or warranties in connection with any of the loans. The only remedies or recourse provided to the buyer are those set forth in the Loan Sale Agreement. Generally, all risk associated with the loans are passed to the buyer. (Loan Sales FAQs, 2003)

Theil and Ferguson (2003) report that due to various aspects of culture, the following factors impact risk management processes: values and norms, religion, nationality, and political structures. The typical structure of the basic risk management process, as presented by a highly organized business process, includes:

1. Identification and evaluation of exposures to loss, 2. Development of cost efficient and effective alternative tools and techniques to effectively avoid, retain, transfer and/or control those exposures, 3. Selection of desirable alternatives within applicable budgetary constraints (e.g., using objective standard internal rate or return (IRR) and/or net present value (NPV) methodologies), 4. Implementation and administration of the chosen alternative (s), with 5. Dynamic monitoring and feedback systems to better assure long-term effectiveness and efficiency of the ongoing effort (Theil & Ferguson, 2003)

The use of insurance as a risk management tool, accepted by a majority of countries, bears roots based on the religion of the country involved. Risk management and modern insurance evolved from the "Western" economic and society culture. The term, "Western" refers to countries practicing a Judeo-Christian religion. Basic forms of mutual insurance evolved from those created in ancient times, and contributed to the conception and creation of contemporary non-mutual forms. (Theil & Ferguson, 2003)

Holmstrom & Tirole (2000, p. 295) contend that several key decisions contribute to corporation's future ability to access financial funds.

1. The corporation's capital structure sets, including a timetable for reimbursing investors. Equity, albeit, qualifies a firm to qualify for consideration for no exact timetable for dividends' payment.

2. Instead of investing all their resources in long-term profitable projects, corporations additionally invest in less profitable liquid assets, maintained on their balance sheets "as buffers against shocks." (Ibid)

3. Corporations regularly engage in risk management, and can utilize derivatives to counter particular risks (interest rate, currency, raw materials, etc.) (Ibid)

As corporations engage in risk management, they routinely utilize derivatives "to hedge specific risks (interest rate, currency, raw materials, etc.)." A corporation with substantial exports may quickly become short of cash if the exchange rate suddenly turns unfavorable. Foreign exchange swaps allow the firm to insure against this type of liquidity shortage. (Holmstrom & Tirole, 2000, p. 295) Derivatives traditionally utilized to hedge risk, are also regularly used for speculative purposes.

Futures contracts, forward contracts, options and swaps are the most common types of derivatives. Because derivatives are just contracts, just about anything can be used as an underlying asset."

Some derivatives are even "based on weather data, such as the amount of rain or the number of sunny days in a particular region. (Derivative, 2007) Restructuring, AKA, a Debt/Equity Swap in any restructuring, the seller's and buyer's roles prove crucial, as this process frequently reflects distressed debt. Ultimate buyers generally "purchase" distressed debt with the intent to make their profit at the point of purchase, as they become holders of equity in the borrower, resulting from a debt/equity swap. In novation, the buyer directly engages in contractual relations with the borrower, and may participate in its restructuring. The same results occur with assignment, however during this scenario, due to stipulations in law or equity, the buyer maintains control, as well as ownership of the debt.

During the course of an equitable assignment, notice must be given to the borrower, to permit him/her to actively participate in the rescheduling. "With both novation and assignment," the seller may continue to have a role in any rescheduling, if it has not sold off the entire loan." (Cranston, 1997, p. 378) Contrary to novation and assignment, in sub-participation, the buyer does not possess any entitlement as against the borrower; however, in some instances confer certain rights on the buyer. "In the interests of sound banking, Cranston (1997, p. 400) purports, "there is some regulation of the sale by banks of loan assets. Bank regulators are especially concerned about how sales affect risks." A number of bankers routinely attempt to minimize their risk exposure; while others on the other hand, argue that banking risky borrowers presents opportunity for gain. (Powell, 2004) Some banks, touting high credit standards, eke out conservative returns on razor-thin margins, while other banks implement loose credit standards, which consequently produce more profitable shareholder returns from higher-risk activities. The key to profitability, for a multitude of banks, Powell (2004) posits "lies with managing risk exposure in a diverse cadre of loans." Powell (2004P presents the example of the community banker, which simultaneously makes personal loans to customers to purchase a new and used cars, and finances commercial loan for a company that owns the factory that builds automobiles..

Bankers reportedly note that:

The more risk a bank accepts, the more likely it will, at some time, incur a loss of principal.

A bank can only accept a particular amount of credit risk before the losses to necessary, it incurs offset potential gains.

During November 1994, Alan Greenspan, chairman of the Federal Reserve Board. Chairman Greenspan reportedly stated:

The willingness to take risk is essential to the growth of a free market economy.... If all savers and their financial intermediaries invested only in risk-free assets, the potential for business growth would never be realized and money to men.'"

Today's Trends

Contemporary legal contracting, along with new data processing technology advances facilitate securitization, the pooling of a large group of loans, a treatable security. Regulators expressed concerns; however that if the problems develop with a loan, and banks retain risks, as they provide loan purchasers partial recourse or implicit guarantee. Current capital regulation, however "discourages recourse for credit risk by including such loans' full value in banks' capital requirements." (Haubrich, 1989)

Numerous studies in the past explored loan sales' riskiness by theoretical models "or empirically regressing implied asset risk from equity and CD rates against on-balance sheet and off-balance sheet loan sales activities." (Ibid) Theoretical literature proposes a number of various motivations and reasons banks originate and sell loans. The banks' ability to originate loans and afterwards sell them, Haubrich (1989) proposes, seems to counter the theoretical assertion that bank loans are "nonmarketable securities."

Over the last decade, scores of financial institutions have utilized the small business credit scoring (SBCS), to evaluate applicants for "micro credits" under $250,000 ($250K). The SBCS's lending technology involves analyzing consumer data regarding a firm's owner and, combining this data with somewhat limited data about the firm. After the combination of data it is completed, financial institutions then utilize statistical methods to predict a firm's future credit performance. This, consequently, results in low-cost, commoditized credits, frequently sold into secondary markets, while at the same time, yielding significant growth in consumer credit availability. Not until the mid-1990s, albeit, did financial institutions begin to on a widespread basis, combine consumer and business information and create scores for small business credits. Currently, no significant secondary market exists for small business credits. (Berber & Frame, 2007) SBCS,.....