What are some of the reasons why banks sell loans? Distinguish between loan sale
ID: 1170365 • Letter: W
Question
What are some of the reasons why banks sell loans?
Distinguish between loan sales with recourse and without recourse.
Why are loan participations particularly risky?
What is a distressed loan?
What are “vulture funds?”
How does moral hazard arise in the interbank loan market?
Why do foreign banks buy large quantities of loans from American banks?
What is “fraudulent conveyance?”
What is a pass-through security?
Why does the government sponsor agencies like Ginnie Mae, Fannie Mae, and Freddie Mac?
Contrast what happens to holders of pass-through securities with what happens to holders of “normal” bonds when interest rates change.
Consider both increases and decreases in interest rates.
Explanation / Answer
(b) In both types of loans, the lender is allowed to take possession of any assets that were used as collateral to secure the loan. In most cases, the collateral is the asset that was purchased by the loan. For example, in both recourse and non-recourse mortgages, the lender would be able to seize and sell the house to pay off the loan if the borrower defaults.e distinction comes into play if money is still owed on the debt after the collateral is sold. In a recourse mortgage, the lender can go after the borrower's other assets or sue to have his or her wages garnished – anything to
be made whole, basically. In a non-recourse mortgage, however, the lender is out of luck. If the asset does not sell for at least what the borrower owes, the lender must absorb the difference and walk away; he has no claim on the lender's other funds or funding sources.
Not surprisingly, as a matter of principle, borrowers almost always favor non-recourse loans, while lenders almost always favor recourse loans. While potential borrowers might find it attractive to hold out for non-recourse loans, it is important to remember that they come with higher interest rates and are reserved for individuals and businesses with the best credit. Additionally, failure to pay off a non-recourse debt may leave a borrower's other assets untouched, but the default is still on record, with all that implies for the borrower's credit score (hint: The impact is not a positive one).
(c) loan participation
The Lead Bank and Participants define their relationship in a participation agreement or, in some instances, a participation certificate.
At a minimum, the agreement should reflect the amount of the loan being purchased by the Participant, the interest rate; critical dates and deadlines; and all fees associated with the participation. Most also include limited representations from the Lead Bank to the Participants such as a statement that the loan is current or in good standing.
Lead Banks are usually reticent to make any additional representations or warranties. This reflects the limited standard of care that Lead Banks owe to Participants.
Participants should ensure that the participation agreement specifically outlines the duties of the Lead Bank. Such duties generally include a requirement to give the Participants copies of the executed loan documents; provide notice of material changes in the borrower’s status; and a general duty to maintain ongoing administration and enforcement of the loan.
Participants should also ensure that the agreement specifies that the Lead Bank consult with Participants prior to modifying any loan documents and before waiving any defaults or taking any enforcement action on defaulted loans.
Defining the relationship between the Lead Bank and borrower is a critical component of the agreement. This step should include prohibitions on the Lead Bank’s ability to change the basic loan terms, including the interest rate; principal balance of the loan; or the maturity date.
Furthermore, the Lead Bank should not be unilaterally permitted to consent to changes in the structure of any entity borrower or guarantor; waive material events of default; permit partial or full transfer of collateral; or other similar major modifications.
In the event of a default, the Lead Bank should be obligated to pursue remedies outlined in the underlying loan documents and to alert Participants of the default and the planned course of conduct in the enforcement action.
The rights and remedies available to the Lead Bank and Participants upon the borrower’s default should be unambiguously described in the participation agreement.
Courts have held that the terms in a participation agreement are not necessarily limited to those explicitly set forth in the agreement itself, but may also include terms found in the commitment letter, participation certificate, or other loan documents.
Thus, a potential participant and its counsel should carefully review all of the loan documents, including preliminary documents such as the term sheet, approval memorandum, and commitment letter, to obtain a full picture of the terms and conditions of the loan to the borrower.
(d) Distressed debt and credit is a comparatively small but growing sector of the private equity and hedge fund market with approximately $250B in AUM spread across approximately 120 US based funds1. The sector is focused on investment opportunities that involve any credit instrument that is trading at a significant discount with a greater than average spread for its industry. A substantial number of these opportunities represent securities that are in outright default and as a result, the investment takes the form of loans or bonds intended to aid companies facing significant challenges2. These distressed securities are, therefore “below investment grade” as the distressed organization is usually in or near bankruptcy
(e)
A value fund is a fund that follows a value investing strategy and seeks to invest in stocks that are deemed to be undervalued in price based on fundamental characteristics. Value investing is often compared with growth investing which focuses on emerging companies with high growth prospects.
(f)
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