The Loan Sales Market Part 3

-45FOOТNOTES Knight (1987) provides background оп the evolution of the legal status of loan participations. 2 The American Bankers Association survey is sumrnarized in Banking, Septernber 1978, рр. 49-57, and Ьу Knight (1979). Also see Clark (1976) for an earlier survey. 3 А loan in excess of the bank's legal lending lirnit for an individual borrower is called an overline. The excess rnust Ье rnade in concert with other lenders through the participation process. The Garn-St. Gerrnain Act raised the lirnit of total oЫigations of а single borrowing entity to а national banking association (with certain specified exceptions) frorn ten percent to fifteen percent of the surn of the banking association's unirnpaired capital and unirnpaired surplus. The total allowaЬle lending to а single entity is further raised to 25 percent if the additional ten percent is fully secured Ьу reaily rnarketaЫe collateral for which а price quotation is readily availaЫe. State regulated banks face similar restrictions. An "upstream" participation occurs when а correspondent purchases part of а loan originated Ьу а respondent. The terrn "correspondent" refers to а bank providing services for other banks, namely, srnaller banks called respondents. "Downstream" participations are shares of loans originated Ьу а correspondent and sold in part to the respondent. 4 In the 1977 American Bankers Association survey 76.2 percent of correspondents reported selling loans or participations to respondents, and 92.4 percent of correspondents reported participating in term loans originated Ьу respondents. (See Knight (1979).) Similar activity was reported in а survey done two years earlier (see Clark (1976)). These surveys also indicate that sales of upstream and downstream participations were not viewed among the rnost important activities provided Ьу the correspondent banking network. 5 There are sixty banks in the Lending Practices Survey. The respondents include the six largest banks in the New York Federal Reserve District, six large banks in the San Francisco district, three in the Minneapolis district, and five in each of the other nine districts. 6 Asset Sales Report is puЫished weekly Ьу the American Banker, One State Street Plaza, New York, New York 10004. 7 This ambiguity persists in the Lending Practices Survey (LPS) data. As explained in Section III, in the usual secondary loan participation or loan sale, the loan buyer contracts with the bank to receive а share of the principal and interest payments оп the loan. The selling bank retains the creditor-debtor relationship with the borrower. Thus, if the underlying borrower defaults, the loan buyer must rely оп the selling bank to arrange а possiЫe loan workout. If а loan is sold under an assignment then the creditor-debtor relationship, originally between the bank and the borrower, is transferred. Under an assignment contract the creditor role is fully shifted to the loan buyer so that if the borrower fails, the loan buyer need not rely оп the bank to deal with the proЫem. Sales under assignment contracts are the LPS data. According to the July 24, 1987 LPS survey: "The nine -46money center banks reported that а bit under 10 percent of their outstanding loans sold were done on assignment." 8 As discussed below, this is no longer the maturity structure of the market. 9 In the Call Report data the observations for the first quarter of 1985 may Ье understated because of а change in the instructions for reporting sales of short-term revolving loans extended under written lines of credit. Beginning with the March 1985 Call Report, respondents were instructed to include the highest amount of such loans advanced and sold under each line during the quarter, rather than the sum of all such loans advanced and sold during the quarter. 10 The only other source of data on the growth of the loan sales market is а widely quoted New York Times article (Ьу Eric Berg, January 20, 1986) which contains а tаЫе showing the amount of loans sold in 1983 to Ье $3 billion with five banks doing the selling; in 1984 the market is $10.5 billion with twelve banks doing the selling; and in 1985 the market is $18 billion with fifteen banks selling. It is not clear how these figures were arrived at and, in particular, whether they are somehow derived from government data. There are, also, other numbers scattered through the financial press, but they suffer from the same proЫem, namely, it is not clear how they were calculated or what they mean. 11 The other seven banks are Bank of America, Chase Manhattan, Chemical Bank, Continental Illinois, First National Bank of Chicago, Manufacturers Hanover Trust, and Toronto Dominion. In the Asset Sales Report survey banks report all participations of С & I loans sold without recourse, of all maturities, though only loans to North American borrowers. Credits sold оп assignment are also reported, but primary loan distributions to syndicate members are not. 12 The wording of the LPS question seemed to imply that the maturity of the underlying loan and the maturity of the participation were identical. Since the maturities need not Ье the same it is not clear which maturity is being reported. In fact, as discussed in the next section, maturity stripping refers to the practice of selling а participation which is а claim оп а borrower's drawing under а longer term commitment. Another possibility is that the participation is а claim оп а loan where the underlying loan is а longer maturity. 13 Only one bank reported that it had separated interest and principal payments of а term loan and sold participations in individual payments. 14 The volume of loans sold with put options was not reported. 15 An assignment is а contract under which the debtor-creditor relationship is transferred. 16 In computing these spreads the Asset Sales Report data were averaged for the month. Only А1/Р1 loan sales spreads were averaged. 17 The data are taken from the Call Reports schedule RC-L. 18 This section draws heavily оп Kizzia (1987), Ryan (1984), Bray (1984), -47Greene and Coles (1984), and Barmore (1986), Both contracts and their interpretations are in а state of rapid flux. The application of existing laws, regulations, and accounting standards to new instruments remains uncertain, while the experience prompts changes in the underlying laws and standards. For example, in 1986 the FASB started а major project addressing the issues of new instruments and off-balance sheet financing. See Knight, 1987, Swieringa, 1988. 19 This follows the terminology of New York law, though English contracts and terms are similar. For more detail, compare Ryan (1984) with Hughes and Palache (1984). The English, for example, геfег to а participation as а sub­ participation. 20 See Бarmore (1986), Tompsett (1984), and Scholl and Weaver (1982). 21 Additional information can Ье found in Melvin (1986), ог Barmore (1986) which provide overviews of the legal issues. 22 The question as to what constitutes а security has received much discussion in the legal literature. The most relevant treatments include Jurman (1976-77), Scholl and Weaver (1982), Green and Coles (1984), and M.A.L. (1978), all of which cite many specific cases. 23 See Asset Sales Report, Dec. 7,1987. 24 25 See Asset Sales Report, Jan. 11,1988. See Asset Sales Report, 1988. 26 See Diamond (1984), Боуd and Prescott (1986), and Campbell and Kracaw ( 1980) . 27 In fact, this has never been rigorously shown. In Diamond (1984) and Boyd and Prescott (1986) the mechanism that ensur es bank per formance is the fact that the bank is fully diversified. The bank offers depositors а debt contract which can Ье paid off in full as long as the bank performs its tasks of monitoring or producing information. If the bank does not make good on promises to perform made to depositor s, the depositors сап detect this. Campbell and Kracaw (1980) do not rely оп this mechanism to ensure bank performance, but instead rely on а contract which resemЫes equity in some respects. 28 According to Asset Sales Report, September 19,1988: "As the market for trading commercial loans in the secondar y market continues to mushroom, some selling banks ar e taking tough measur es to control the activity and keep more of the business to themselves." Apparently, the proЫem is that some banks have been buying loans from other banks and then reselling them. 29 In discussions with bankers, bankers at some banks readily concede that they informally offer to buy loans back, and, in fact, admit that many loans have been bought back. Bankers at other banks vehemently deny that they would buy loans back, and claim never to have bought а loan back.. -48REFERENCES Barmore, Robert L., "Loan Participations: unpuЫished paper, June 1986. Why All the Controversy?" Berg, Eric N., "Loan Sales Market Swelling," New York Times, January 20, 1986, Dl . Board of Governors of the Federal Reserve System, Senior Loan 0fficer Opinion Survey on Bank Lending Practices, various issues. Boyd, John, and Edward С. Prescott, "Financial Intermediary-Coalitions," Journal of Economic Theory 38 (1986), 211-232. Bray, Michael, "Developing а Secondary Market in Loan Assets," International Financial Law Review, 0ctober 1984, 22-25. Campbell, Tim, and William Kracaw, "Information Production, Market Signalling and the Theory of Financial Intermediation," Journal of Finance XXXV(4) (September 1980), 863-881. Clark, John, "New Study Shows Where Correspondent Banking Stands, Where It's Headed," Banking, November 1976, 42ff. Diamond, Douglas W., "Financial Intermediation and Delegated Monitoring," Review of Economic Studies LI (1984). Eisemann, Peter С., and George А. Budd, "Loan Sales: An Alternative to Funding," Journal of Commercial Bank Lending, September 1984, 40-45. Flannery, Mark, "Bank Risk Preferences with Deposit Insurance and Capital Regulation," mimeo, University of North Carolina at Chapel Hill, 1988. Gorton, Gary, and Joseph G. Haubrich, "Bank Deregulation, Credit Markets and the Control of Capital," Carnegie-Rochester Conference Series оп PuЫic Policy, vol. 26 (Spring, 1987). progess. "Loan Sales and Reputation," work in Gorton, Gary, and George Pennacchi, "Аге Loan Sales Really 0ff-Balance Sheet?," Journal of Accounting, Auditing, and Finance, forthcoming. Greenbaum, Stuart and Anjan Thakor, "Bank Funding Modes: Securitization versus Deposits," Journal of Banking and Finance 11 (1987), 379-402. Greene, Edward F., and Kathleen L. Coles, "What is а Security," International Financial Law Review, November 1984, 17-23. Haubrich, Joseph G., and Robert King, "Banking and Insurance," NBER Working Paper No. 1312 (March 1984). Herdman, Robert К., and Mark Sever, "FASB and the EITF: New Rulings on Loan -49Sales, Stock Purchase Plans, Sale of Put Options," Bank Accounting & Finance Vol. 1, по. 4 , Summer 1988, 58-61. Hughes, Martin, and Robert Palache, "Loan Participations--Some English Law Considerations," International Financial Law Review, November 1984, 2127. James, Christopher, "The Use of Loan Sales and Standby Letters of Credit Ву Commercial Banks," University of Oregon Working Paper, 1987. Jurman, Stephen, "Bank Loan Participations as Securities: Notes, Investment Contracts, and the Commercial/Investment Dichotomy," Duguesne Law Review 15(2) (Winter 1976-77), 261-294. Kizzia, Carol, "What's Behind the Growth in Asset Sales?" АВА Banking Journal, March 1987, 32-36. Knight, W.H., "Loan Participation Agreements: Catching Up With Contract Law," Columbia Law Review, Volume 1987, Number 3, 554-87. Lloyd-Davies, Peter R., "Survey of Standby Letters of Credit," Federal Reserve Bulletin, December 1979, 716-719. M.A.L., "International Loan Syndications, the Securities Acts, and the Duties of а Lead Bank," Virginia Law Review 64(6) (October 1978), 897-919. Melvin, Donald J., "А Primer for RMA Staff оп Legal and Regulatory Concepts and Standards in the Securitization of Loans," mimeo, Robert Morris Associates, Philadelphia, РА, 1986. Norton, Robert Е., "Secondary Participations: The Newest Market Instrument," The American Banker CXLIX(21) {January 31, 1986), 1. Pennacchi, George, "Loan Sales and the Cost of Bank Capital," Journal of Finance 43 (1988). Rendell, Robert S., "Penn Square Participants Not Entitled to Share in Set­ offs," International Financial Law Review, August 1984, 36. Ryan, Reade Н., "Participations in Loans Under New York Law," International Financial Law Review, October 1984, 40-47. Salem, George, "Loan Selling: А Banking Revolution," Banking, Donaldson, Lufkin and Jenrette, October 10, 1986. _____, "Selling Commercial Loans: А Significant New Activity for Money Center Banks," Journal of Commercial Bank Lending, April 1986, 3-13. _____ , "Commercial Loans for Sale: The Marriage of Commercial Banking and Investment Banking," Banking, Donaldson, Lufkin and Jenrette, September 30, 1985. Scholl, Dennis, and Ronald L. Weaver, "Loan Participations: Аге They 'Securities?"' Florida State University Law Review, Spring 1982, 215-234. -50- Singer, Mark, Funny Money, Alfred А. Knopf, New York, 1985. Tompsett, William С., "Interbank Relations in Loan Participation Agreements: From Structure to Workout," The Banking Law Journal 101(1) (January 1984) , 31-49. Zweig, Phillip, "Major New York Banks Initiate Tactic of Selling Short-Term 'Strips' of Loans," Wall Street Journal CCVII ( 6) ( January 23, 1986), 1 О. ТАВLЕ 1 Loans Sold Outгight Ьу Comrneгcial Banks ($ Ьillions) Date Loans sold to subsidiaгies, foгeign branches, holding companies, and other affiliates Loans sold to all others except banks Nov. Dec. 1970 1970 $3.78 3. 17 $1.82 1. 85 Jan. Feb. Sept. Oct. Nov. Dec. 1971 1971 1971 1971 1971 1971 2.71 2.66 2.90 2.85 2.85 2.85 1 . 91 1. 90 1. 60 1.58 1 . 59 1. 62 Oct. 1972 Nov. 1972 Dec. 1972 2.22 2.4 3 2.60 1. 73 1. 74 1. 78 Jan. Nov. Dec. 1973 1973 1973 2.70 4.33 4.35 1.78 1 .81 1. 80 Jan. Feb. Sept. Oct. Nov. Dec. 1974 1974 1974 1974 1974 1974 4.44 4.81 5.30 5.22 5.08 4.82 Nov. Dec. 1975 1975 4.73 4.48 1.80 1.48 NA NA NA NA Jan. Feb. 1976 1976 4.36 4.42 Source: NA NA NA NA Federal Reseгve Bulletin NA -- Not AvailaЫe Loans Sold Outгight Ьу Comrnercial Banks (Amts. Outstanding; $ �il.) Amts. sold under repurchase agreement are excluded. ТАВLЕ 2 Sales of Loan Paгticipatгons Ьу Fedeгally-Insuгed Commeгcial Banks 1 (Total tгansactions duгing the quaгteг, billions of dollaгs) Date 1983 Q2 QЗ Q4 1984 Q1 Q2 1985 1986 1987 1988 QЗ Q4 Q1 Q2 QЗ Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Souгce: All Banks 26.7 26.8 29. 1 32.8 зз.з 35.5 50.2 54.6 59.9 77.5 75.7 65.4 81 .2 91.З 111 .8 162.9 195.2 188.9 198.О 236.3 Тор 25 Banks 12.5 12. 1 11 . 4 14.7 14.4 20.2 28.О 32.9 39.6 55.З 51.2 43. 1 56.7 64.9 76.6 133.4 165.7 164.1 170.9 210. 1 Тор 50 Banks 14.5 13.4 12.5 16.З 15.З 21. О за.о 33.8 40.5 59.2 54.О 45.8 60.8 69.6 85.7 140.5 170.О 167.7 174.4 214.9 LPS Banks2 12.7 13.8 16 .8 16.6 17.8 17. 1 21 . 1 21. 1 NA NA NA NA NA NA NA NA NA NA NA NA FDIC Call Repoгts, Schedule L NA--Not AvailaЫe 1sales герогtеd аге gгoss and exclude sales of conswneг loans and moгtgage loans. Also excluded аге loans sold subject to repurchase agreements or with recourse to the seller. See the text for а discussion of changes in the definition of а loan participation and other reporting changes. 2тhere are sixty banks in the Lending Practices Survey. The respondents include the six largest banks in the New York Federal Reserve district, six large banks in the San Francisco district, three in the Minneapolis district, and five in each of the other nine districts. The volwne of loan sales for the LPS banks was reported in the June 1985 LPS and was not updated because the bank names were not reported.