Chapter 25 - Loan Sales

Chapter 25
Loan Sales

True / False Questions

 

1. Loan sales by an FI are another tool to manage credit risk of the FI. 
TRUE

2. When an FI sells the loan of an individual corporation in the secondary market, the
corporation's stock often decreases in value. 
FALSE

3. FIs discourage borrowers from hedging their own risk of default. 

FALSE

4. Loan sales do not create a new type of security as with other methods to manage credit
risk. 
TRUE

5. The growth of the commercial paper market as well as the increased ability of banks to
underwrite commercial paper has reduced the importance of short-term segment of the loan
sales market. 
TRUE

6. Banks began selling short-term loans only since the passage of the Financial Services
Modernization Act in 1999. 
FALSE

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Chapter 25 - Loan Sales

7. Historically, correspondent banking relationships have been important in the sale of bank
loans. 
TRUE

8. When a portion of a loan is sold from a large bank to a small bank, it is often called a
participation. 
TRUE

9. When an FI sells a loan without recourse, the credit risk of the loan is completely
eliminated from the FIs balance sheet. 
TRUE

10. When an FI sells a loan with recourse, a liability is created on the balance sheet. 
FALSE

11. An FI that sells a loan with recourse retains ownership of the loan. 
FALSE

12. In the sale of a loan to an investor/buyer, there are fewer agency costs associated with loan
participation contracts than with loan assignment contracts. 
FALSE

13. A loan sale occurs when an FI originates a loan and sells the loan without recourse to an
outside buyer. 
TRUE

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Chapter 25 - Loan Sales

14. The loan sales market in which an FI originates and sells a short-term loan of a
corporation can be considered a close substitute to the issuance of commercial paper. 
TRUE

15. Most loans originated and sold in the short-term market are secured loans to below
investment grade entities. 
FALSE

16. Highly leveraged transaction (HLT) loans typically are used to finance new fixed assets of
an ongoing firm. 
FALSE

17. Highly leveraged transaction (HLT) loans are typically unsecured, short-term and have
fixed rates. 
FALSE

18. A distinction between distressed and non-distressed is usually made when selling highly
leveraged transactions loans (HLTs). 
TRUE

19. The definition of a highly leveraged transaction is any transaction that involves a buyout,
acquisition or recapitalization. 
FALSE

20. Most HLT loans are very heterogeneous with respect to the size of the issue, the interest
payment date, interest indexing, and prepayment features. 
TRUE

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Chapter 25 - Loan Sales

21. The buyer of a loan participation benefits because the only risk exposure is to the
borrower. 
FALSE

22. The buyer of a loan participation bears double monitoring costs. 

TRUE

23. Floating-rate loan assignments typically occur on the loan repricing date as an effort to
minimize confusion regarding the calculation and transfer of accrued interest. 
TRUE

24. Assignments of fixed-rate loans typically do not have difficulties in the calculation and
transfer of accrued interest. 
FALSE

25. Investment banks are the predominant buyers of HLT loans because they are more
informed agents in this market than other investors. 
TRUE

26. The traditional interbank loan sale market has been growing rapidly due to an increase in
the number of mergers and acquisitions. 
FALSE

27. Loans originated by domestic U.S. banks cannot be sold to foreign banks. 

FALSE

28. Insurance companies and pension funds are important buyers of long-maturity loans. 
TRUE

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Chapter 25 - Loan Sales

29. Credit derivatives allow FIs to reduce credit risks without removing loan assets from their
balance sheet. 
TRUE

30. Closed-end bank loan mutual funds are restricted to investing in loans only through the
loan resale or secondary market. 
FALSE

31. The primary sellers of domestic loans are medium-sized regional banks. 

FALSE

32. Because a bad bank has a difficult time gaining deposits for funding, it also has a difficult
time devising an optimal strategy to manage and dispose of bad assets. 
FALSE

33. Selling loans without recourse is a way for FIs to remove loans from their balance sheet
for the purpose of reducing the cost associated with reserve requirements. 
TRUE

34. One way to boost the capital to assets ratio of an FI is through loan sales. 
TRUE

35. Some corporate customers that rely on bank loans may see the sale of one of its loan by
the bank as an adverse event in the customer-bank relationship. 
TRUE

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Chapter 25 - Loan Sales

36. A loan credit rating is the same as bond credit rating in that it is based solely on the
financial soundness of the underlying corporation. 
FALSE

37. The move by regulators toward market value accounting of the loan portfolios will likely
encourage sales of loans in the secondary markets. 
TRUE

38. An originate-to-sell model when dealing with below investment grade companies is
considered an attractive alternative for FIs, which have specialized credit monitoring skills, as
compared with keeping the loans in their portfolio. 
TRUE

39. Mutual funds are prohibited from purchasing/participating in the FI loan sales market by
the SEC. 
FALSE

40. Most vulture funds are formed by the mutual fund industry as a way around SEC
restrictions from participating in the FI-originated loan sales market. 
FALSE

41. Research has shown that current-year income for an FI is rarely affected by the decision to
sell loans from their balance sheet. 
FALSE

42. Although a loan sale strategy for an FI may reduce or eliminate credit risk, the strategy
does not affect the FI's liquidity risk. 
FALSE

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Chapter 25 - Loan Sales

43. The Resolution Trust Corporation (RTC), a government agency formed to manage failed
S&Ls in the early 1990s, followed a Good Bank/Bad Bank concept in the sale of loans. 
FALSE

44. As of 2010, the Department of Housing and Urban Development (HUD) no longer sells
loans that were used to purchase multifamily apartment properties. 
FALSE

45. As FIs consolidate and expand their range of financial services, customer relationships
with commercial entities are likely to become more important. 
TRUE

 
 

Multiple Choice Questions

 

46. Besides reducing credit risks, an FI has an incentive to sell loans it originates for all of the
following reasons EXCEPT to 
A. geographically diversify.
B. decrease core deposits.
C. lower reserve requirements.
D. lower capital requirements.
E. generate reinvestment income.

47. Which of the following is NOT a contractual mechanism used by FIs to control credit
risks? 
A. Diversifying across different types of risky borrowers.
B. Requiring higher interest rate spreads for higher risk borrowers.
C. Requiring more collateral for the bank over the assets of more risky borrowers.
D. Making lending decisions only in centralized locations.
E. Placing more restrictive covenants on the actions of more risky borrowers.

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Chapter 25 - Loan Sales

48. A loan made to finance a merger and acquisition that usually results in a high leverage
ratio for the borrower is a 
A. loan sold without recourse.
B. highly leveraged transaction loan.
C. loan sold with recourse.
D. loan assignment transaction.
E. loan participation transaction.

49. Which of the following is NOT a reason for an FI to sell loans with recourse? 
A. To reduce capital requirements.
B. To avoid credit risk exposure.
C. To control interest rate risk exposure.
D. To avoid regulatory scrutiny.
E. To make it possible to lend large amounts to an individual borrower.

50. Which of the following is NOT true of a loan that is sold without recourse? 
A. The loan is removed from the FI's balance sheet.
B. The FI has no explicit liability if the loan eventually goes bad.
C. The FI that originated the loan bears all the credit risk.
D. The buyer can put the loan back to the selling FI.
E. None of the options.

51. Which of the following is true concerning loans sold with recourse? 

A. Most loans are sold with recourse.
B. The buyer cannot put the loan back to the selling FI.
C. The FI has no explicit liability if the loan eventually goes bad.
D. The FI that originated the loan retains a contingent credit risk liability.
E. The loan sale is technically removed from the balance sheet.

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Chapter 25 - Loan Sales

52. Which of the following observations is NOT correct? 

A. Most loans are sold with recourse.
B. Loan sales are a primitive substitute for securitization.
C. Selling of a loan creates a secondary market for loans.
D. Ownership of the loan is always transferred to the loan purchaser.
E. Loan sales do not involve the creation of new types of securities.

53. Which of the following refers to a period when a borrower is unable to meet a payment
obligation to lenders and other creditors? 
A. Window.
B. Financial distress.
C. Foreclosure.
D. Recession.
E. Assignment.

54. Which of the following is NOT a key characteristic of loans sold in the short-term loan
sale market? 
A. Issued as a secured loan.
B. Loans to investment grade borrowers or better.
C. Issued with a fixed rate.
D. Sold in units of $1 million and up.
E. Issued for 90 days or less.

55. What are the two basic types of loan sale contracts or mechanisms by which loans can be
transferred between seller and buyer? 
A. Participations and assignments.
B. Participations and originations.
C. Syndications and originations.
D. Transfers and assignments.
E. Exercise and transfers.

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Chapter 25 - Loan Sales

56. Currently, this basic type of loan sale contracts comprises the bulk of loan sales trading. 
A. Participations.
B. Originations.
C. Syndications.
D. Assignments.
E. Transfers.

57. Loan participations 
A. are riskier than loan assignments.
B. are less risky than loan assignments.
C. are always sold without recourse.
D. are always sold with partial recourse.
E. are made in smaller denominations than are loan assignments.

58. In a loan participation 

A. the holder (buyer) is not a party to the underlying credit agreement, so the initial contract
between the loan seller and the borrower remains in place after the sale.
B. the holder (buyer) is a party to the underlying credit agreement, so the initial contract
between the loan seller and the borrower remains in place after the sale.
C. the holder (buyer) can vote only on material changes to the loan contract such as changes
in interest rate or collateral backing the loan.
D. the holder (buyer) is not a party to the underlying credit agreement, so the initial contract
between the loan seller and the borrower remains in place after the sale and the holder (buyer)
can vote only on material changes to the loan contract such as changes in interest rate or
collateral backing the loan.
E. the holder (buyer) is a party to the underlying credit agreement, so the initial contract
between the loan seller and the borrower remains in place after the sale and the holder (buyer)
can vote only on material changes to the loan contract such as changes in interest rate or
collateral backing the loan.

59. Loan participations are typically sold to correspondent banks because 

A. they are insiders and can be trusted.
B. they offer the best prices.
C. the ongoing relationship offers the greatest monitoring opportunities.
D. it is a regulatory requirement.
E. correspondent banks are captive customers.

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60. A buyer of a loan participation is exposed to 

A. risk exposure to the original borrower defaulting.
B. risk exposure to the failure of the selling bank.
C. moral hazard problems because the borrower is no longer monitored by the seller.
D. risk exposure to the original borrower defaulting and risk exposure to the failure of the
selling bank.
E. risk exposure to the original borrower defaulting and moral hazard problems because the
borrower is no longer monitored by the seller.

61. The definition of a highly leveraged transaction (HLT) loan as adopted by U.S. bank
regulators in 1989 includes 
A. doubling the borrower's liabilities which results in a leverage ratio higher than 50 percent.
B. involving a buyout, acquisition, or recapitalization.
C. results in a leverage ratio higher than 75 percent.
D. All of the options.
E. doubling the borrower's liabilities which results in a leverage ratio higher than 50 percent
and involving a buyout, acquisition, or recapitalization.

62. Which of the following transactions meets the legal definition of a highly leveraged
transaction (HLT)? 
A. A buyout that increases debt from $100 million to $150 million resulting in a 25 percent
leverage ratio.
B. An investment project that increases debt from $100 million to $250 million resulting in a
55 percent leverage ratio.
C. An acquisition that increases debt from $100 million to $250 million resulting in a 65
percent leverage ratio.
D. An acquisition that increases debt from $100 million to $150 million resulting in a 70
percent leverage ratio.
E. An investment project that results in an 80 percent leverage ratio.

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Chapter 25 - Loan Sales

63. Which of the following transactions does NOT meet the legal definition of a highly
leveraged transaction (HLT)? 
A. A buyout that increases debt from $100 million to $150 million resulting in a 55 percent
leverage ratio.
B. A recapitalization that increases debt from $100 million to $250 million resulting in a 55
percent leverage ratio.
C. An acquisition that increases debt from $100 million to $250 million resulting in a 65
percent leverage ratio.
D. An acquisition that increases debt from $100 million to $150 million resulting in an 80
percent leverage ratio.
E. An acquisition that results in an 80 percent leverage ratio.

64. Why do spreads on HLT loans behave more like investment-grade bonds than like high-
yield bonds? 
A. They tend to be more junior in bankruptcy.
B. They tend to have greater collateral backing than do high-yield bonds.
C. Because no bank makes a market in this debt.
D. Because securities firms do not make a market in this debt.
E. They tend to have no covenant protection.

65. HLT loans typically have all of the following characteristics except which of the
following? 
A. They have a short maturity of less than three months.
B. They are secured by assets of the borrowing firm.
C. They have floating rates tied to LIBOR or some other short-term index.
D. They have strong covenant protection.
E. They are term loans.

66. Loan assignments make up more than 90 percent of the U.S. domestic loan sale market
because 
A. they have lower capital requirements than other types of loan sales.
B. they are riskier than are other types of loan sales.
C. monitoring costs are reduced since all rights are transferred upon sale.
D. regulators prefer these transactions to loan participations.
E. there is no secondary market in loan participations.

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Chapter 25 - Loan Sales

67. Which of the following is NOT true of loan assignments? 

A. All rights are transferred on sale.
B. The loan buyer holds a direct claim on the borrower.
C. Transfer of U.S. domestic loans is normally associated with a Uniform Commercial Code
filing.
D. Ownership rights are generally much clearer in a loan sale by assignment.
E. Contract terms are unrestrictive from the seller's perspective.

68. Loan assignments 
A. are common in loan syndications.
B. do not have buyer restrictions.
C. comprise less than 30 percent of the U.S. loan sales market.
D. involve extremely high monitoring costs.
E. expose the buyer to a double risk and involve double monitoring costs.

69. Identify the correct observation. 

A. Most loan sales are completed in less than 30 days.
B. Up to 50 percent of loan sales eventually fail to be completed at all.
C. There is no incentive to renege on a loan sales contract.
D. The tendency to renege on a loan sales contract decrease as market prices move away from
those originally agreed.
E. Contractual problems, trading frictions, and costs rarely affect loan sales.

70. A type of FI that predominantly buys HLT loans because these loans require the kinds of
investment analysis skills used in other parts of the FI's business is 
A. a bank loan mutual fund.
B. a domestic bank.
C. a foreign bank.
D. an investment bank.
E. a vulture fund.

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71. A type of company that recently has moved from only purchasing loans on the secondary
market into primary loan syndication is 
A. a bank loan mutual fund.
B. a domestic bank.
C. a foreign bank.
D. an investment bank.
E. a vulture fund.

72. A type of company that specializes in distressed loans is 

A. a bank loan mutual fund.
B. a domestic bank.
C. a foreign bank.
D. an investment bank.
E. a vulture fund.

73. Which observation is true of vulture funds? 

A. Their decisions based on developing and maintaining long-term relationships.
B. Their sole agenda is to helping the distressed firm to survive.
C. Their investments are always passive.
D. They are relationship based, not transaction driven.
E. In a restructuring, they are looking for a return on capital invested.

74. Which of the following rely on non-distressed HLT loan purchases as a means of

diversifying without the high cost of developing costly nationwide banking networks? 
A. Bank loan mutual funds.
B. Credit unions.
C. Foreign banks.
D. Investment banks.
E. Vulture funds.

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Chapter 25 - Loan Sales

75. The traditional interbank loan sale market has been shrinking for which of the following
reasons? 
A. The barriers to nationwide banking have been largely removed through legislation.
B. Concerns about counterparty risk and moral hazard have increased.
C. The traditional correspondent banking relationships are slowly breaking down.
D. All of the options.
E. Concerns about counterparty risk and moral hazard have increased, and the traditional
correspondent banking relationships are slowly breaking down.

76. Vulture funds are 

A. management consulting firms that employ turn-around specialists.
B. portfolios consisting of stakes in distressed companies.
C. mutual funds that grow by acquiring their competitors.
D. mutual funds that invest only in highly-leveraged transactions.
E. companies offering burial insurance contracts.

77. The major buyers of U.S. domestic loans of non-distressed companies include all of the
following EXCEPT 
A. domestic banks.
B. foreign banks.
C. the Resolution Trust Corporation.
D. non-financial companies.
E. closed-end bank loan mutual funds.

78. The sellers of domestic loans and HLT loans include all of the following EXCEPT 
A. major money center banks.
B. foreign banks.
C. U.S. government and its agencies.
D. non-financial companies.
E. investment banks.

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Chapter 25 - Loan Sales

79. If an FI embraces the concept of good bank/bad bank, 

A. bad bank assets are passed on to the institutions correspondent bank that is required to
accept the assets.
B. good bank assets are organized into a closed end mutual fund which then sells shares to
raise funds for the bad bank.
C. the bad bank is a special purpose vehicle (SPV) that is organized to liquidate non-
performing loans.
D. the bad bank assets are funded by FDIC insured deposits.
E. the bad bank is placed under the supervision of the Resolution Trust Corporation.

80. The principal objective in the creation of _____ is to maximize asset values by separating
good loans from bad loans. 
A. hedge funds
B. bad banks
C. vulture funds
D. structured banks
E. correspondent banks

81. Which of the following is NOT a reason for using a bad bank as a vehicle to add value in
the loan sale process? 
A. Contracts for managers can be created to maximize the incentives to generate enhanced
values from loan sales.
B. The bad bank enables bad assets to be managed by loan workout specialists.
C. The bad bank does not need to be concerned about liquidity needs since it does not have
any deposits.
D. Moving the bad loans off the balance sheet of the good bank will improve the markets
perception, and thus performance, of the good bank.
E. The good bank-bad bank structure increases information asymmetries regarding the value
of the good bank's assets.

82. Which legislation authorizes federal agencies to sell delinquent and defaulted loan assets? 
A. Federal Debt Collection Improvements Act.
B. Financial Services Modernization Act.
C. The Bank Holding Company Act.
D. Depository Institutions Deregulation and Monetary Control Act.
E. Financial Institutions Reform Recovery and Enforcement Act.

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83. Which of the following is NOT a reason for FIs to sell loans? 

A. Loan diversification.
B. To reduce required reserves.
C. To reduce required capital.
D. To reduce costs of credit risk assessment.
E. To provide liquidity.

84. The implementation of BIS capital requirements may be expected to 

A. increase the downward trend in loan sales because of higher required capital levels.
B. increase the downward trend in loan sales because of the use of risk adjusted assets.
C. decrease the downward trend in loan sales because of the use of risk adjusted assets.
D. decrease the downward trend in loan sales because of higher required capital levels.
E. decrease the downward trend in loan sales because of the use of risk adjusted assets and
because of higher required capital levels.

85. Loan sales do not completely protect the lending FI from credit risk exposure because 
A. defaults may reduce the ability of the lending bank to sell loans in the future.
B. a loan sale contains an implicit quality guarantee by the lending FI.
C. loans are always sold with recourse.
D. regulators require the lending FI to make restitution for defaulted loans.
E. loan sales force the FI to mark its remaining loans to market prices.

86. The growth of the commercial paper market has hurt the market for loan sales by 
A. offering some borrowers alternatives to bank loans.
B. underpricing the banks that sell loans.
C. fostering the credit crunch.
D. adding another regulatory layer since the SEC requires shelf registration of new issues.
E. increasing moral hazard concerns in the market.

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Chapter 25 - Loan Sales

87. Loan sales by foreign banks 

A. are forbidden in the U.S. domestic market.
B. must be of a certain size to be purchased by a domestic FI.
C. are allowed to be purchased by domestic FIs if the loan is to a highly-rated company.
D. must be of a certain duration, and be sold without recourse in order to be purchased by a
domestic FI.
E. have no restrictions placed on them.

88. The move toward market value accounting 

A. increases banks' incentives to sell loans to avoid reporting capital losses.
B. decreases banks' incentives to sell loans to avoid reporting capital losses.
C. increases banks' incentives to sell loans since all assets will automatically be marked to
market.
D. decreases banks' incentives to sell loans since all assets will automatically be marked to
market.
E. has no impact on the banks' incentives to sell loans.

89. Banks that sell many of their loans 

A. utilize more of a dealer intermediation approach.
B. utilize more of a broker intermediation approach.
C. utilize more of a trader intermediation approach.
D. utilize more of a market maker intermediation approach.
E. relinquish some of their roles as financial intermediaries.

90. Banks and other FIs sell loans because of all of the following EXCEPT 
A. loan diversification benefits.
B. reduction in reserve requirements.
C. lowering of capital costs.
D. reduction of liquid assets of the institution.
E. increase in fee income through brokerage functions.

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91. Which of the following aided in allowing Federal Government Agencies (such as the
FDIC) to sell loans of institutions for which the agency has become responsible? 
A. National Banking Act.
B. Financial Services Modernization Act.
C. Savings Institutions Reform Act.
D. Glass-Steagall Act.
E. Federal Debt Collection Improvement Act.

92. Which of the following is NOT a factor that may tend to increase loan sales in the future? 
A. There is an increased trend to apply credit ratings to loans offered for sale, increasing the
attractiveness to secondary market purchasers.
B. The federal government takeover of Fannie Mae and Freddie Mac means that the loans
held by these agencies can never be sold to other entities.
C. Because of their special credit monitoring skills, FIs have a comparative advantage in
making loans to below-investment grade companies and then selling the loan.
D. The trend toward marked-to-market accounting for assets makes bank loans more like
securities so they may be easier to sell.
E. The risk-based capital requirements of the Bank for International Settlements give banks a
strong incentive to sell commercial loans to decrease their amount of risky assets.

93. Which of the following is a reason for an FI to sell a residential real estate loan rather than
securitize it through GNMA? 
A. The loan is too large to meet securitization standards.
B. The loan is not insured by FHA or guaranteed by the VA.
C. The loan recipient's income cannot be verified.
D. The loan carries a non-standard adjustable interest rate.
E. All of the options.

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Chapter 25 - Loan Sales

94. 

    

Good Bank:

Cash $200 Deposits $1,000

Good loans $1,000 Purchased funds $300
Bad Loans $380 Equity $280
Total $1,580   $1,580
Bad Bank:     
Cash $240 Bonds $120
Loans 0 Preferred stock $40
    Common stock $80
Total $240   $240

Bad Bank buys the bad loans for $232. The proceeds of the loan sale are used by Good Bank to pay off purchased funds.

What will be the total assets of Good Bank after the sale of the loans?  
A. $1,200.
B. $232.
C. $132.
D. $68.
E. $0.
Bad loans will fall to $0. Total assets - $380 = $1,580 - $380 = $1,200.
 

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Chapter 25 - Loan Sales

95. 

    

Good Bank:

Cash $200 Deposits $1,000

Good loans $1,000 Purchased funds $300
Bad Loans $380 Equity $280
Total $1,580   $1,580
Bad Bank:     
Cash $240 Bonds $120
Loans 0 Preferred stock $40
    Common stock $80
Total $240   $240

Bad Bank buys the bad loans for $232. The proceeds of the loan sale are used by Good Bank to pay off purchased funds.

What will be the amount of equity on the balance sheet of Good Bank after the sale of the loans?  
A. $1,200.
B. $232.
C. $132.
D. $68.
E. $0.
Loss on the loan sale will be deducted from Equity
Equity - (Bad loans - sales receipts) = $280 - ($380 - $232) = $280 - $148 = $132.
 

25-25
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McGraw-Hill Education.
Chapter 25 - Loan Sales

96. 

    

Good Bank:

Cash $200 Deposits $1,000

Good loans $1,000 Purchased funds $300
Bad Loans $380 Equity $280
Total $1,580   $1,580
Bad Bank:     
Cash $240 Bonds $120
Loans 0 Preferred stock $40
    Common stock $80
Total $240   $240

Bad Bank buys the bad loans for $232. The proceeds of the loan sale are used by Good Bank to pay off purchased funds.

If the proceeds of the loan sale are used to pay off purchased funds, what will be the balance of the purchased funds for
Good Bank after the transaction? 
A. $1,200.
B. $232.
C. $132.
D. $68.
E. $0.
Purchased funds - loan sale proceeds = $300 - $232 = $68.
 

25-26
Copyright © 2018 McGraw-Hill Education. All rights reserved. No reproduction or distribution without the prior written consent of
McGraw-Hill Education.