Unlike bonds, bank loans are difficult to buy and sell (illiquidity). Commercial Banks need sometimes the flexibility
Question:
Unlike bonds, bank loans are difficult to buy and sell (illiquidity). Commercial Banks need sometimes the flexibility to sell some of the loans they hold before maturity. This can be done through securitization.
The process is as follows. Bank B wants to get rid of a loan L it granted to firm F several years ago. B creates a company, called special purpose vehicle (SPV)2, which raises money by issuing several tranches of bonds and equity. With that money, the SPV buys the loan
from bank B.Shareholders and bondholders of the SPV are therefore stakeholders in a company which holds one single asset, the loan L
L has a one year maturity and a face value of €1,000,000. The next interest payment is at maturity. There are three possible scenario for the year to come
- The economy is normal or booming (probability 0.85): F will be able to repay L in one year and will pay a 6% interest rate (on face value).
- The economy is in recession (probability 0.1): F will be able to pay only 75% of L face value in one year and no interests.
- The economy is in depression (probability 0.05): F will be able to pay only 40% of L face value in one year and no interests.
The sole purpose of the SPV is to carry the loan L. When L reaches maturity and pays off, the proceeds are shared among stakeholders and the SPV is dissolved.
To finance the purchase of L, the SPV issues
- 450 Senior Bonds with a face value of €1,000 and a coupon of 3%,
- 250 Junior Bonds with a face value of €1,000 and a coupon of 18%,
Equity.
The SPV's balance sheet is therefore
Assets
Loan L
(€1,000,000 face value, 6% interests)
Liabilities
Equity
Senior bonds (€450,000 face value, 3% interests)
Junior bonds (€250,000 face value, 18% interests)
Junior and Senior bonds are issued at par value (price of one bond is €1,000)
1. Compute the expected return and the volatility of senior bonds and junior bonds. Hint: compute how much each category of bondholder obtains in each state of the economy, use this result to compute bonds returns in each state of the economy, use this result to compute expected return and volatility
2. The market value of L is €920,000. Compute the expected return and volatility of L. Compare with Senior Bonds. Given that certain categories of institutional investors are restricted from buying high-risk debt (say with volatility higher than 10%), why is securitization useful?
3. Compute the expected return and volatility of the equity tranche. Banks sometimes retain some explicit or implicit exposure to this equity tranche, why is this a problem?
Fraud Examination
ISBN: 978-0324560848
3rd edition
Authors: W. Steve Albrecht, Conan C. Albrecht, Chad O. Albrecht, Mark F. Zimbelman