EOC solutions Chapter 24

EOC solutions Chapter 24 - Answers to Chapter 24 Questions...

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Answers to Chapter 24 Questions: 1. Loan securitization has increased in volume as a result of the creation of an active secondary market and the implicit and explicit government guarantees on pass-through securities. The loan sales market has suffered from credit risk exposure, high information and monitoring costs, and costly validation and transactions costs. Loan sales have only been dominant in loan categories such as commercial and industrial loans that are too large and heterogenous to package into securities. 2. Loans sold without recourse means that after selling the loan the originator of the loan can take it off the balance sheet. In the event the loan is defaulted, the buyer of the loan has no recourse to the seller for any claims, transferring the credit risk entirely to the buyer. For the originator, it has completely eliminated this loan from its books. In the case of a sale with recourse, credit risk is still present for the originator because the buyer could transfer ownership of the loan back to the originator. Thus, from the perspective of the buyer, loans with recourse bear the least credit risk. 3. Short-term loan sales usually consist of maturities between one and three months and are secured by the assets of a firm. They are usually sold in units of $1 million or more and are made to firms that have investment grade credit ratings. Banks have originated and disposed of short-term loans as an effective substitute for commercial paper, which have similar characteristics to short-term loans. The accessibility of commercial paper by more and more corporations has reduced the volume of these short-term loans for loan sales purposes. 4. Commercial paper issuers are generally blue chip corporations that have the best credit ratings. Banks may sell the loans of less creditworthy borrowers, thereby raising required yields. Indeed, since commercial paper issuers tend to be well-known companies, information, monitoring, and credit assessment costs are lower for commercial paper issues than for loan sales. Moreover, since there is an active secondary market in commercial paper, but not for loan sales, the commercial paper buyer takes on less liquidity risk than does the buyer of a loan sale. 5. In a loan participation, the buyer does not obtain total control over the loan, while in an assignment, all rights are transferred upon sale, thereby giving the buyer a direct claim on the borrower. Transactions costs are higher for loan assignments than for loan participations since the loan must be transferred via a Uniform Commercial Code filing. Moreover, current holders of the loan must be verified as well as any impediments to transfer, thereby further increasing transactions costs upon loan sale under assignment. Monitoring incentives are higher and costs are lower under loan assignments as opposed to loan participations. This is because the buyer is the sole holder of the loan and thus there is no free-rider problem. Monitoring costs are lower since the loan assignment buyer need only monitor
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