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ESSAYS ON ISSUES T H E FEDERAL RESERVE BANK O F C H IC A G O JANUARY 1991 N U M B E R 40 Chicago Fed Letter D isinterm ediation m arches on The process of transferring saving and borrowing activities from banks to nonbanks is known as disinterme diation. Historically, bank disinter mediation has occurred whenever bank borrowers or savers could get a better deal from nonbank alterna tives. Today, bank disintermediation is being driven by increasing deposit insurance premiums, the high cost of raising bank capital, and—in a few instances—an inability to raise capi tal. As a response to these pressures, banks are initiating disintermedia tion, shrinking both to control risk and to remain in compliance with regulatory requirements. This Chicago Fed Letter discusses two recent developments in the disinter mediation of banks’ commercial and industrial (C&I) loans: loan sales to prime rate mutual funds and the securitization of commercial loans. If these substitutes for bank interme diation become successful, they will only serve to accelerate the ongoing decline in the importance of the banking industry. The past as prologue Bank borrowers, especially investment grade corporations, have sought to lower borrowing costs by increasingly financing their activities through nonbank alternatives, most notably the commercial paper market. Nonfinancial commercial paper issuance has increased by 80% over the past five years and by almost 30% in the first ten months of 1990 alone. Since their introduction in 1972, money market mutual funds (MMMFs) have facilitated disinterme proximately one-half the dollar value diation by making it possible for savers of leveraged buyouts and recapitaliza tions reduced banks’ HLT lending. to indirectly purchase small pieces of a large pool of high denomination With this decline in HLT activity, the money market instruments—like com pressure to sell additional loans would mercial paper. This nonbank alterna have been expected to decrease. How tive has increased the return on sav ever, stresses on the banking industry ers’ funds. In 1980, MMMFs held $77 billion in assets, 3.5% of total bank and thrift deposits. Today, MMMFs hold $415 billion in assets, roughly 9.5% of total bank and thrift deposits. Developing pressures Disintermediation continued throughout the 1980s as longer term and non-investment grade borrowers began to bypass banks, directly rais ing funds in the capital markets. In order to offer customers a lower fund ing cost, banks have increasingly sold C&I loans to investors outside the banking system thereby avoiding mandatory capital requirements, re serve requirements, and deposit in surance premiums. While an inter bank loan sales market has been in existence for many decades, the sale of bank loans to nonbanks is a rela tively new phenom enon (see Figure 1). Nonbank C&I loan purchases from commercial banks rose to $19 billion in 1990 as compared to $9 billion in 1987 and only $.7 billion in 1985. The 1990 nonbank loan purchases represent almost 6% of commercial loans held by large U.S. banks and almost 25% of total secon dary market commercial loan sales. 3/31/87 6/30/88 6/30/89 6/30/90 in the last year have resulted in contin ued pressure for banks to sell loans to nonbank investors (see Figure 2). Anticipated losses on loans are erod ing the banking industry’s capital position. As a consequence, loan loss reserves have been soaring and the A substantial portion of these loans average stock price of the 225 largest were used to fund mergers, acquisi publicly traded banks has declined by tions, leveraged buyouts, and recapi almost 30% since the beginning of talizations, so-called highly leveraged transactions (HLTs). The dominance this year. Declining capital causes of these HLT loan sales reflects banks’ banks to grow more slowly than other wise would be the case. efforts to manage their balance sheet risks. During 1990, declines by ap The five retail prime rate funds cur rently hold $7 billion in loans and are expected to surpass $10 billion by 1992. The two privately placed insti tutional loan funds are intended for large institutional investors and ac count for at least another $1 billion in loans. Industry analysts estimate this type of fund may surpass the retail funds in a few years. Rising deposit insurance premiums are generating additional pressure. In 1991, the FDIC insurance pre mium will increase from $0.12 per $100 of domestic deposits to $0,195, more than a 60% increase. However, the Congressional Budget Office estimates that a $.43 premium— more than double the 1991 pre mium—is needed for the fund to meet the m andated funding require m ent in 1995. These higher premi ums increase banks’ expenses, rais ing bank funding costs. New mutual funds promote loan sales The continuing pressure to move loans off banks’ balance sheets is causing financial markets to develop new vehicles for pooling and selling these loans. As purchasers of onethird of commercial paper issued, MMMFs provide a lower cost alterna tive to bank lending. New mutual funds known as retail prime rate funds and privately placed institutional loan funds may play a similar role in the loan sales market. These funds allow investors to purchase shares in a diversified pool of bank loans. The retail funds are called prime rate funds because their goal is to offer purchasers a return that is equal to or in excess of the prime rate banks charge to their most creditworthy customers. More than 80% of the prime rate and institutional funds balances are invested in HLT loans. The funds’ $8 billion in loans (see Figure 3) represent almost one-quarter of mid year HLT loans sold by money center banks in 1990. The funds have pur chased loans only with senior, col lateralized features. With loans sen ior in the borrowers’ capital struc tures, much of the potential credit risk is borne by other creditors. Col lateral requirements provide addi tional protection against declines in the value of the borrowers’ assets. The funds purchase these loans un der three legal arrangements: pri mary market syndications, secondary market assignments, or secondary market participations. Most of the loans are purchased as secondary market participations. In contrast to the other legal arrangements, the contractual counterparty to a secon dary market participant is the loan seller, not the underlying borrower. This requires that fund managers 3. Growth in new mutual funds million dollars - 1 __________ 1 __________ 1 __________ 1988 1989 end of year 1990 evaluate the credit risk of the loan seller in addition to the borrower when purchasing a loan. Prime rate funds: Is the price r ig h t? The prime rate funds are registered under the Investment Company Act of 1940 as closed-end investment m anagement companies. However, prime rate funds vary somewhat from the typical closed-end fund. In gen eral, closed-end funds do not issue new shares after the initial share subscription period. Closed-end fund shareholders generally obtain liquidity by selling shares to others. In contrast, the prime rate fund shares are offered on a continual basis by the funds. Further, since the secondary market for most prime rate fund shares is thin or nonexist ent, liquidity is supplied by unguaran teed quarterly tender offers. Determining the appropriate price for the shares is a complex exercise. For example, when making a tender offer, the prime rate fund announces the price it will pay per share in addi tion to the the total num ber of shares to be redeemed. Too high a price will benefit those who tender shares to the detrim ent of those who do not tender shares. Too low a price will reduce the funds’ ability to attract investors for whom liquidity is impor tant. Because most of the loans held by the funds trade infrequently, it can be difficult for fund managers to determine the “ right” price for marking the portfolio to market on a daily basis. Consequently, fund man agers may have considerable discre tion in determining the share price. Currently, the prime rate funds value loans on a daily basis using: (1) the loan par amount, (2) a risk-adjusted credit value, or (3) secondary loan market quotes. Two of the prime rate funds value loans at par. The remaining prime rate funds employ some form of mark-to-market pricing, but there are inconsistencies even among funds that attempt to mark-to-market. For example, one fund recently experi enced a loan default, reducing the reported value of the loan from 95% to 75% of the loan’s par amount. The latter price more accurately re flects the deteriorated credit status of the loan, but even that valuation could be overstated. In two other cases, loans are being carried at par even though the secondary market price is at 60% of par in one case and 75% of par in another. However, this loan valuation dilemma is not isolated to the funds themselves, but is an issue for the entire C&I loan industry. The new securitization frontier: C&I loans The other development that has en couraged disintermediation is the securitization of bank C&I loans. As of November 1990, over $2 billion of HLT loans have been securitized. Se curitization is the process of pooling and repackaging assets as security in struments and has already facilitated the disintermediation of consumer assets, such as credit card receivables and auto loans. Securitization makes the credit risk of the assets easier to evaluate by separating the assets and their associated credit risk from those of the originating bank. Securitiza tion can also be used to repackage cash flows into low-risk and high-risk securities. This alleviates the asymme try of information between the origi nator and less-informed investor, and thereby attracts new investor classes. Securitized pools of HLT loans are much like securitized pools of high yield debt, known as collateralized bond obligations (CBOs). First is sued in 1988, CBOs in turn, mimic collateralized mortgage obligations (CMOs). CBOs pool and repackage the cash flows generated by high yield bonds to create new securities, parti tioned as classes, called tranches, with different risk characteristics. The first tranche is structured for an invest m ent grade rating, while the subordi nated, lower rated tranches pay higher interest rates for bearing the risk of first loss. Often, the CBO capi tal structure includes an equity tran che, which is sometimes retained by the issuer. The first attempt to securitize C&I loans occurred in December 1988 when Continental Bank securitized $140 million of HLT loans from 25 borrowers as “floating-rate enhanced debt securities” (FRENDS). Imitat ing the CBO structure, the issue was divided into senior and subordinated tranches. FRENDS I was followed by FRENDS II, a $380 million pool is sued in September 1989. Subsequent securitizations have var ied somewhat from the Continental FRENDS issues. These variations represent issuers’ efforts to package the most attractive security offering to new investor classes. For instance, as with the prime rate funds, liquidity is a major consideration in investors’ decisions to purchase securitized C&I loans. In December 1989, a $625 million Banque Nationale de Paris HLT loan securitization ad dressed this concern by listing the issue on the Luxembourg Stock Ex change, providing an organized secondary market for investors seek ing liquidity. An even more recent innovation by Salomon Brothers suggests an impor tant yet more limited role for securi tization in the commercial loan mar ket. Unlike conventional securitiza tion structures, this proposal will create a security backed by a portion of a single loan and will have a single tranche. The chief goal of this struc ture is to tap institutional custom ers—that is, most money and portfo lio managers—that are allowed to buy securities but are not perm itted to buy bank loans. The future role of securitization in the commercial loan market is not yet clear. While the idea of securi tizing C&I loans is appealing, it has proven to be a complex and timeconsuming process that has not been widely imitated. In contrast to the more evolutionary approach wit nessed in other asset-backed markets, C&I loan securitizers have attempted to jum p directly to the relatively so phisticated multi-tranche structures employed for mortgages, credit cards, auto loans, and high yield debt. W hether the commercial loan market can bypass the evolutionary stages of its predecessors is an open question. Conclusion Prior to 1985, the disintermediation of commercial lending was some thing that happened to banks. How ever, in the last half of the 1980s, the escalating pressure to disintermedi ate bank credit has led banks to pro mote disintermediation by selling commercial loans to nonbank pur chasers. Prime rate funds and the bank-sponsored securitization of bank C&I loans are the two newest manifestations of this phenom enon. This controlled disintermediation meets banks’ needs to preserve prof itable customer relationships. Never theless, the reprieve may be only temporary. The standardization of commercial loan contracts and in creasing expertise in pricing bank loans are both necessary to facilitate this managed disintermediation. However, these changes will ulti mately lead to greater competitition in the underwriting of commercial loans and reduce the profitability of the very relationships banks are struggling to preserve. —Janet Napoli and Herbert L. Baer Karl A. S cheld, S en io r Vice P re sid e n t a n d D irecto r o f R esearch; David R. A llardice, Vice P re sid e n t a n d A ssistant D irecto r o f R esearch; J u d ith Goff, E ditor. Chicago Fed Letter is p u b lish e d m o n th ly by th e R esearch D e p a rtm e n t o f th e F ed eral Reserve B ank o f C hicago. T h e views ex p ressed are th e a u th o rs ’ a n d are n o t necessarily th o se o f th e F ed eral Reserve B ank o f C hicago o r th e F ed eral Reserve System. A rticles m ay be r e p rin te d if th e source is c re d ite d a n d th e R esearch D e p a rtm e n t is p ro v id ed with co p ies o f th e rep rin ts. Chicago Fed Letter is available w ith o u t c h arg e from th e P ublic In fo rm a tio n C e n te r, F ed eral Reserve B ank o f C hicago, P.O . Box 834, C hicago, Illinois, 60690, (312) 322-5111. ISSN 0895-0164 Manufacturing activity in the Midwest experienced its third consecutive monthly decline in September, according to the most recent MMI. The de cline was widespread; only food-processing and chemically-related industries expanded. With fourth quarter auto production being cut back, downward pressure on manufacturing activity is likely to continue. Midwest manufacturing activity (down 0.4%) declined more than the nation (down 0.1%) in September and began its decline one m onth before the na tion. Much of the region’s relative weakness in September was centered in employment. However, over the last three months manufacturing employ m ent has been fairly flat, compared to steady declines nationally. Chicago Fed Letter m mmmmm F E D E R A L R E S E R V E B A N K O F C H IC A G O P u b lic In fo rm a tio n C en ter P .O . B ox 834 C h ic a g o , Illin o is 60690 (312) 322-5111 N O T E: T h e MMI a n d th e USMI are co m p o site in d ex es o f 17 m a n u fa c tu rin g in d u stries a n d are d eriv ed fro m e c o n o m e tric m o d els th a t estim ate o u tp u t fro m m o n th ly h o u rs w o rk ed a n d kilow att h o u rs data. F or a discussion o f th e m eth o d o lo g y , see “R eco n sid erin g th e R egional M a n u fac tu rin g In d e x e s,” Economic Perspectives, F ed eral Reserve B ank o f C hicago, Vol. XIII, N o. 4, Ju ly /A u g u s t 1989.
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