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Structured Finance and Commercial Banks as Conduits

Over the past ten to fifteen years, the role of commercial banks has shifted dramatically where they have migrated into collateralized 'structured finance' loan portfolio products, including home mortgage loans, for sale into the securities markets. This article addresses this market phenomenon.

Structured Finance and Commercial Banks as Loan Conduits

The emergence of structured finance products over twenty-five years ago enabled major commercial banks and investment houses to develop higher volumes of real estate, credit card, automobile and other asset-based loans in new and often more profitable ways. Historically, lenders normally generated these types of loans as portfolio loans, where the bank would hold and monitor these loans on its own balance sheet and at its own risk.

But beginning in the late 1980’s, banks began to investigate taking an intermediary or conduit role for certain types of loan portfolios. When generating loans which met the advance underwriting criteria of large investors, banks and loan originators recognized they could simultaneously generate large fees and also promptly move these ‘tailored’ loan portfolios off the bank’s books, by pre-packaging them for third party investors.

Commercial Banks Move Structured Finance Loans Off-Balance Sheet

Rather than generating a loan and holding it many years to maturity, banks were now able to adopt a new conduit role by repeating the loan generation process many times and within shorter timeframes. Very importantly, banks were thus able to shift many loan and credit risks off of their own balance sheets to the ultimate buyers. Given the change in underwriting procedures, banks sometimes took a very different view of risks than before.

Through the process, participating banks were also able to enhance their internal returns and to provide more liquidity and credit products into the debt markets. Independent rating agencies took on a growing role in weighing in on risk assessments. They aided in the risk evaluation process by conferring investment grades on types of portfolios and to specific tranches or sections within those portfolios. In some cases, the priorities of the original borrower’s cash flows which were dedicated to certain portions of loan portfolios became a measure of determining their risk ratings. With the added benefit of both credit default swap (CDS) insurance and interest rate ‘swap’ products (for example, whereby the parties could address protections under fixed rate loans if interest rates were to rise under variable-rate loans) an enormous new debt market need was met, albeit with significant added complexity.

Tradable securitized loans helped to reduce the ultimate cost to borrow by affording access to broader and deeper capital and investor pools. Overall, asset-backed bank loans which were underwritten and structured in specific ways could be ‘packaged’ and re-sold though securities markets. Collateralized structured finance loan portfolios helped to feed the so-called loan securitization markets.

Thus, the collateralized loan obligation (CLO) industry emerged, with banks using their existing staffing and resources to generate asset-backed loans, with independent rating agencies helping to measure the default risks of various types and pools of loans, and with large investors finding major and reliable pools of ‘securitized’ interest-yielding assets to acquire. Borrowers benefitted by realizing lower interest rates. Beginning in the mid-1980s and extending to a recent surge during the residential and commercial real estate booms, the US CLO markets grew to a recent peak level of nearly $100 Billion in annual transaction volume by 2006. By 2014, market demand had again returned to nearly $100 Billion/year within the U.S. CLO markets.

By Doug Johnston, Managing Director, Five Management, LLC
Banking, Lending and Due Diligence Finance Expert Witness
ABOUT THE AUTHOR: Douglas E. Johnston, Jr.
Doug Johnston is an expert witness specializing in Commercial Banking & Lending, Private Equity, and Mergers & Acquisitions. Early in his career he was named as the youngest bank president in Texas, and thereafter he established multiple full-service bank offices in both Texas and California. Expanding into Corporate Finance, he became EVP-Finance and a ‘Founding Father’ of the largest private company in Los Angeles. He has direct due diligence and documentation experience in hundreds of transactions totaling well over $2 Billion with bank lenders, investors, buyers and sellers involving hundreds of businesses engaged in the technology, service, commercial real estate, entertainment, and manufacturing sectors across the US.

Copyright Doug Johnston, Managing Director, Five Management, LLC

Disclaimer: While every effort has been made to ensure the accuracy of this publication, it is not intended to provide legal advice as individual situations will differ and should be discussed with an expert and/or lawyer.For specific technical or legal advice on the information provided and related topics, please contact the author.

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