Sep 2011 q 1 vi

Discussion in 'SA5' started by Ivanhoe, Sep 6, 2014.

  1. Ivanhoe

    Ivanhoe Member

    Sept 2011 Q 1
    The bank estimates that it will not have sufficient capital to operate under the new Basel II requirements because it manages a large fund of corporate loans (the Fund) which do not attract a capital charge at the present time but will do so under Basel II. Under the current arrangement the bank sells corporate loans to the Fund. The Fund issues short term (30 day) securities to capital market investors to fund the purchase of the corporate loans. The bank manages the loans for the Fund and charges a fee. The bank provides to the Fund a large undrawn loan facility in order to satisfy the investors that they will be repaid by the Fund at maturity.

    The Fund is both the fund of corporate loans the bank has made and the entity to which corporate loans are sold. Does not really make much sense to me.

    Also,what does it mean to say "bank sells loans to the fund"? Is the idea that the fund hopes to gain from the loan portfolio because it expects to be yielding a rate higher than the underlying default risk?


    Main risk to the bank (part vi Response)
    The main risk is that the Fund is unable to re-borrow in the capital markets to fund the maturing short term securities. In this case the Fund will not be able to sell its corporate loan assets in time and will need to draw on the loan facility. This circumstance is most likely to result at a time when the riskiness of the underlying portfolio of corporate loans is relatively high meaning the bank will be lending to the Fund against relatively poor quality assets. The estimated cost of the risk to the bank will depend on the size of the loan facility relative to the total size of the fund and the credit ranking of the drawn bank loan versus the short term securities.


    I construed this transaction as the corporate loans cash flows being used to repay the short term investors. Why would the fund need to borrow from the capital market unless the cash flows are not sufficient due to mismatch or default risk? The explanation that they have stated have given priority to capital market finance in order to satisfy the short term obligation. Could some one explain?
     
    Last edited by a moderator: Sep 8, 2014
    Ivanhoe, Sep 6, 2014
    #1
  2. Colin McKee

    Colin McKee ActEd Tutor Staff Member

    This was a tricky question - as you say, getting to the bottom of the transaction was the key. the basic idea I think is that the bank sets up (as you say) a separate fund, which borrows on a short term (30 day) basis from investors and "buys" the corporate loan portfolio from the bank. the bank is then appointed manager, for a management fee. As the 30 day loans mature, the fund simply borrows again, for 30 days, and uses the funds to repay the maturing 30 day loans. The question doesnt realy go into the motivation, but holding long term bonds and funding it with short loans, usually makes an interest profit. the danger is that in a crisis, the fund is not able to borrow 30 days, and so cannot repay the maturing 30 day loans. It would need to borrow from the bank using the credit line that the bank has made available.


    I construed this transaction as the corporate loans cash flows being used to repay the short term investors. Why would the fund need to borrow from the capital market unless the cash flows are not sufficient due to mismatch or default risk?


    I dont think this was the intended meaning by the examiners.


    The explanation that they have stated have given priority to capital market finance in order to satisfy the short term obligation. Could some one explain?

    the main risk that the examiner saw was a liquidity risk if the short term borrowing ability dried up. Default of the loans was not seen as a big risk.
     
    Colin McKee, Sep 12, 2014
    #2
  3. Ivanhoe

    Ivanhoe Member

    Thank you!:)
     
    Ivanhoe, Sep 12, 2014
    #3
  4. Edwin

    Edwin Member

    Again, Colin, was this Northern Rock?

    Also, does it mean stating credit risk was going to receive zero marks, sometimes it's really hard to get the "MAIN" thing in a question...and I am sure different people will have different views.

    For questions requiring the main thing, if you argue your points well can you get credit even if the examiners' "main" is not your "main''?
     
    Edwin, Mar 31, 2015
    #4
  5. r_v.s

    r_v.s Member

    Sept 2011 qn 3 iii)

    What exactly do they mean by "entirely debt financed"? Does that mean raising debt to buy back all shares? So how does return on equity arise in that case? Wouldn't there be only debt-holders?
     
    r_v.s, Apr 8, 2015
    #5
  6. Colin McKee

    Colin McKee ActEd Tutor Staff Member

    I am not sure if this was meant to be Northern Rock. I hadnt heard anything that happened in that case which was similar to the deal described in the question. I think it was just a situation that the examiner dreamt up to test candidates.


    What exactly do they mean by "entirely debt financed"? Does that mean raising debt to buy back all shares? So how does return on equity arise in that case? Wouldn't there be only debt-holders    ?

    Yes - this was another odd concept. It means exactly that - buy back all the shares using a large bond issue. No shares left. Although the examiner also described a situation where the company becomes ALMOST entirely debt. When there are a few equity shares, but the company is very highly geared, the return on equity would be very high (as would the risk).
     
    Colin McKee, Apr 8, 2015
    #6

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