Two weeks ago, the Sterling Report challenged the minds of our readers to think about “loan trading” as an economically beneficial and viable concept in the Jamaican financial market. We spoke generally about the concept of “loan trading” (i.e. the purchase and sale of loans like an investment instrument) and the benefits that stimulate the activity (an attractive asset class, a source of liquidity, increased access to financing and better terms for borrowers.) However, how does loan trading actually work? In this article we’ll try to introduce you to the logistics of loan trading to highlight just how simple the activity can be.

Loans that are traded in the secondary market are primarily classified according to their price. There are two main categories of loan trading:

Par trading

Par trading is the purchase or sale of loans at or above 90 cents on the dollar. Loans that are trading at “par” are considered to be performing loans where the borrower is making scheduled interest and principal payments. Here’s an example showing how a loan purchase price is calculated.

Example

Commitment Amt: J$10,000,000

Trade Date: February 22, 2010

Purchase price: 98per cent

Loan Price: 98per cent * J$10,000,000

Loan price: J$9,800,000

All loan trade prices are expressed as a percentage of par. To calculate the purchase price for a term loan the purchase rate is multiplied by the funded amount of the loan on the settlement date. Upon purchase of this loan, the purchaser receives all interest and accruing fees that are paid after the settlement date. However, the seller is entitled to keep all accrued but unpaid interest and fees up to the settlement date.

Distressed trading

Distressed trading refers to the purchase or sale of loans at below 90 cents on the dollar. Prices for distressed loans are calculated in the same way as they are for par trades. The example below illustrates how the price of a distressed loan is calculated.

Example

Commitment Amt: J$10,000,000

Trade Date: February 22, 2010

Purchase price: 72per cent

Loan Price: 72per cent * J$10,000,000

Loan price: J$7,200,000

Sellers of distressed debt benefit from

1. Increased capital available for lending

2. Lower costs (i.e. provisions, administrative, collection etc.)

3. A higher credit quality portfolio

Proof of concept

To increase the relevance of loan trading, we’ll look at an example of an institution in the Caribbean that has enjoyed significant success in the secondary loan market.

The Eastern Caribbean Home Mortgage Bank (ECHMB) began operations in 1996 as an independent and privately managed institution by the Eastern Caribbean Central Bank (ECCB) and a variety of financial institutions across the region. Its mandate is to operate in the secondary mortgage market in order to increase resources available for home financing and provide liquidity support to the regional banks. In essence, the ECHMB buys mortgages from commercial banks (referred to as primary lenders) to provide them with liquidity thus enabling them to increase mortgage lending. ECHMB’s mortgage portfolio has increased at a cumulative average growth rate of 30.2 per cent per annum between 2006 and 2010, growing from EC$78,361k in 2006 to EC$224,883k in 2010. According to statistics from the ECCB, in 2009, this represented 13.4 per cent of the total mortgage market in the ECCU. In just over a decade the ECHMB has emerged as a viable and important entity operating in the secondary loan market. The bank is rated CariAA- (by CariCRIS, the region’s credit rating agency) and this is primarily a result of the stringent agreements that govern the relationship between the ECHMB and its Primary Lenders. These agreements control the credit quality of the mortgages in ECHMB’s portfolio. For example, the agreements stipulate that Primary Lenders must replace mortgages that are in arrears in excess of three months with a performing mortgage. This is on example of numerous conditions that preserve the quality of ECHMB’s mortgage portfolio.

It is important to note that the concept of loan trading is not new or unfamiliar to the region. Again we ask, is Jamaica ready for loan trading?

Marian Ross is a business development officer at Sterling Asset Management. Sterling provides investments for the medium to long-term investor. If you wish to have Sterling address your questions, please contact us at info@sterlingasset.net.jm or visit our website at www.sterling.com.jm