What are agency costs? How do Financial Institutions (FI’s) solve the information and related agency costs experienced when household savers invest directly in securities issued by corporations?

I need you to complete two different assignments.

1st assignment is:

What are agency costs? How do Financial Institutions (FI’s) solve the information and related agency costs experienced when household savers invest directly in securities issued by corporations?

What are five general areas of FI specialness that are caused by providing various services to sectors of the economy?

Explain how a decrease in the discount rate affects credit availability and the money supply.

Describe how expansionary activities conducted by the Federal Reserve impact credit availability, the money supply, interest rates, and security prices. Do the same for contractionary activities.

Why have home equity loans become popular? What are securitized mortgage assets?

How do finance companies make money? What risks does this process entail?

How do these risks differ for a finance company versus a commercial bank?

Writing Requirements

8-10 page research paper excluding title page, abstract, table of contents, list of tables, list of figures and reference page.

Include a minimum of six (6) scholarly/external resources to support your assessment.

Use APA Style for in-text citations, and references

2nd different assignment is:

I need you to write a brief summary of the important concepts learned from the files that are below.

Chapter 21Product and Geographic Expansion© McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.

21-2© McGraw-Hill Education.Overview•Product diversification•Costs and benefits of risk management strategies •Cost and revenue synergies •Market and firm-specific factors impacting geographic expansion

21-3© McGraw-Hill Education.Introduction•Universal FI structure in Germany, Switzerland, and UK•Citicorp/Travelers merger clear indication of the rapidly eroding regulatory barriers separating FI types in U.S.•Financial Services Modernization Act of 1999 has accelerated the reduction in barriers among FIs

21-4© McGraw-Hill Education.Problems Resulting from Restrictions on Diversification•Bank exposure to nonbank competition−Especially from Money Market Mutual Funds (MMMFs)−Growth in commercial paper markets •Lack of diversification−Makes optimization of asset mix more difficult and reduces flexibility

21-5© McGraw-Hill Education.Segmentation in the U.S. •Separation of commercial and investment banking via Glass-SteagallAct, 1933•Banks challenged restrictions, 1963 -1987–Examples:▪Municipal revenue bond underwriting▪Selling annuities•After various challenges, in 1987, the Fed allowed commercial BHCs to establish separate Section 20 affiliates as investment banks–Example: Citigroup

21-6© McGraw-Hill Education.Erosion of Glass-Steagall•Permissible activities of BHCs expanded by Federal Reserve and OCC in 1997–Fed allowed direct acquisition of investment banks rather than establishing Section 20 subsidiaries–Resulted in number of M&As between commercial and investment banks in 1997 through 2000▪Notable example: Citicorp/Travelers Group

21-7© McGraw-Hill Education.Post FSMA•Allowed for creation of “financial services holding companies”–Allowed to engage in banking and securities activities•Bank of America and Wachovia•Financial crisis: –J.P. Morgan acquisition of Bear Stearns–Failure of Lehman Brothers and BOA acquisition of Merrill Lynch

21-8© McGraw-Hill Education.After the Crisis•Only two of the big five remained–Goldman Sachs and Morgan Stanley▪Chose to become bank holding companies▪More direct access to the Fed▪More stringent regulations▪Closer supervision by bank examiners

21-9© McGraw-Hill Education.Banking and Insurance (1 of 2)•Prior to Financial Services Modernization Act of 1999:–Barriers to banks and insurance companies entering one another’s lines of business–Delaware: Liberal laws allowing state-chartered banks to engage in P-C and life insurance▪Encouraged entry by banks such as Chase

21-10© McGraw-Hill Education.Banking and Insurance (2 of 2)▪Nonbank banks were a route for insurance companies and commercial firms to engage in banking−Competitive Equality Banking Act 1987–Challenge to Bank Holding Company Act and CEBA restrictions−Citicorp and Travelers

21-11© McGraw-Hill Education.Financial Services Modernization Act•Financial Services Holding Companies–Functional regulation of holding companies▪Banking activities regulated by bank regulators (e.g., Federal Reserve, FDIC, OCC)▪Securities regulated by SEC▪Insurance functions regulated at state level

21-12© McGraw-Hill Education.Commercial Banking and Commerce•Banks direct holdings of equities constrained since 1863•Restrictions on commercial activities of BHCs are a more recent phenomenon•1956 Bank Holding Company Act required BHC divestiture of nonbank-related subsidiaries•Changes resulting from Financial Services Modernization Act (FSMA) regarding ownership limits imposed on financial services holding companies

21-13© McGraw-Hill Education.Nonbank Financial Service Firms and Banking•Barriers are generally weaker •Shadow banking –Activities of nonfinancial service firms that perform banking services▪E.g. SIVs, SPVs, credit hedge funds, etc.•Wall Street Reform and Consumer Protection Act of 2012–Gave regulators broad authority to monitor and regulate nonbank financial firms that pose risks to the financial system

21-14© McGraw-Hill Education.Nonbank Financial Service Firms and Commerce•Few barriers for entry/exit into various areas of nonbank financial service activity–E.g., Travelers Group/Salomon Brothers, Sears Roebuck, Xerox, and Gulf and Western •FSMA of 1999–Financial services holding company defined as holding a minimum of 85% of its assets in financial assets–Nonfinancial assets exceeding maximum are grandfathered for at least 10 years

21-15© McGraw-Hill Education.Activity Restrictions•Many barriers have been eroded, but commercial banks face the greatest remaining restrictions•Universal banks offer investment banking, commercial lending, foreign exchange, as well as custody and cash management services–Examples: Citigroup, J.P. Morgan Chase, UBS, Deutsche Bank, Credit Suisse, BOA

21-16© McGraw-Hill Education.Issues in Diversification of Product Offerings•Overview–Safety and soundness issues–Economy of scale and scope issues–Conflict of interest issues–Deposit insurance issues–Regulatory oversight issues–Competition issues

21-17© McGraw-Hill Education.Safety and Soundness (1 of 2)•Risk of securities underwriting–Firm commitment offering▪Underwriter purchases securities directly from issuing firm and reoffers to public at higher price–Banks could be harmed by losses of securities affiliate in the following ways:▪Upstreaming▪Interaffiliateloans▪Contagious confidence problem–FDIC bailouts to BHCs in financial crisis provided indirect assistance to affiliates

21-18© McGraw-Hill Education.Safety and Soundness (2 of 2)•Wall Street Reform and Consumer Protection Act: –Calls for Fed to receive new oversight powers and to discourage any type of FI from posing extensive risk to overall financial system•Product diversification benefit–More stable earnings and profit stream over time relative to product-specialized banks

21-19© McGraw-Hill Education.Economies of Scale and Scope•Economies of scale –Large financial services holding companies may have economy of scale advantage over smaller financial firms•Economies of scope–Revenue-based economies of scope may arise for the largest FIs–Pre-1997 restrictions severely limited economies of scope and revenue/cost synergies

21-20© McGraw-Hill Education.Conflicts of Interest•Six potential conflicts–Salesperson’s stake–Stuffing fiduciary accounts▪Alan Bond, CIO of AlbriondCapital–Bankruptcy risk transference▪J.P. Morgan Chase & Citigroup sued–Third-party loans–Tie-ins (coercion to use affiliates)–Information transfer

21-21© McGraw-Hill Education.Reality of Conflicts of Interest•Emphasize on potentialconflicts of interest–“Chinese walls” prohibit internal information transfers•Exploitation requires:–Uncompetitive bank service markets–Imperfect or asymmetric information–Low value placed on reputation

21-22© McGraw-Hill Education.Deposit Insurance•Deposit insurance: –May provide competitive advantage to banks over other FIs–But, FMSA allowed other financial service firms to establish banks that offer deposit insurance coverage, which lessened the advantage

21-23© McGraw-Hill Education.Regulatory Oversight•Large bank holding companies with extensive nonbank subsidiaries face a complex structure of regulation•Federal Reserve serves as umbrella regulator of consolidated organization, gathering input from other regulators•2010: New oversight powers for Fed and stiffer requirements on capital and liquidity for the largest firms

21-24© McGraw-Hill Education.Web ResourcesFor more information on regulation, visit:•Federal Reserve www.federalreserve.gov•OCC www.occ.treas.gov•FDIC www.fdic.gov•SEC www.sec.gov

21-25© McGraw-Hill Education.Competition•Procompetitiveeffects–Increased capital access for small firms–Lower commissions and fees–Reduce degree of underpricing of new issues•Anticompetitive effects–Long term outcome could be quasi-oligopoly, resulting in a rise in market concentration, as well as long run prices for investment banking services

21-26© McGraw-Hill Education.Domestic Geographic Expansion•Historically, FIs’ ability to expand was constrained by regulation•Regulations also create potential opportunities for new entrants to exploit existing monopoly rents

21-27© McGraw-Hill Education.Attractiveness of Geographic Expansion•Factors that impact commercial firm expansion and acquisition decisions likely to impact decisions of FIs–Regulation and regulatory framework–Cost and revenue synergies–Firm-or market-specific factors

21-28© McGraw-Hill Education.Regulatory Factors (1 of 2)•Insurance companies–State-regulated firms–Establishing subsidiary in one state gives insurer the ability to sell insurance anywhere in that state▪To be successful, insurers may establish physical presence in other states–Most large insurers have physical presence in nearly every state

21-29© McGraw-Hill Education.Regulatory Factors (2 of 2)•Thrifts–Branching ability controlled by Office of Thrift Supervision (1989-2011)–Restrictions loosened by Garn-St. GermainAct of 1982 and FIRREA of 1989–In 1992, OTS permitted interstate branching for federally chartered savings institutions–2010, closure of OTS

21-30© McGraw-Hill Education.Constraints on Domestic Expansion•Commercial Banks–1900s, unit banks–Restrictions on intrastate banking have been liberalized in a piecemeal fashion–Interstate restrictions:▪McFadden Act, 1927▪1927 to 1997, banks relied on establishing subsidiaries rather than branches due to McFadden prohibition▪Multibank holding companies (MBHC)

21-31© McGraw-Hill Education.Stages of Regulation of BHCs•Potential loophole to interstate banking addressed by Douglas Amendment in 1956•In 1978, Maine passed law permitting banks from out of state to acquire banks in Maine–Interstate banking pacts

21-32© McGraw-Hill Education.Erosion of Restrictions (1 of 2)•Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994–U.S. and nondomestic banks allowed to branch interstate–Full interstate banking, with exception of de novo branching, became reality in 1997–Wave of consolidation: “Megamergers”

21-33© McGraw-Hill Education.Erosion of Restrictions (2 of 2)•Nonbank banks–Loophole ended by Competitive Equality Banking Act (CEBA) of 1987–Exemption of Industrial Loan Corporations (ILCs) by CEBA–Wall Street Reform and Consumer Protection (Dodd-Frank) Act of 2010 ▪Established 3-year moratorium on FDIC for approving applications from ILCs for deposit insurance

21-34© McGraw-Hill Education.Synergies from Geographic Expansion•Cost synergies could result from: –Economies of scale–Economies of scope–Managerial efficiency sources (i.e., x-efficiency)

21-35© McGraw-Hill Education.Revenue Synergies•Enhance revenues by expanding into growing market −Success of Wells Fargo/Wachovia due to revenue growth and synergies•More stable revenue stream•Enhance revenues by expanding into less than fully competitive markets−J.P. Morgan Chase/Bank One

21-36© McGraw-Hill Education.Monopoly Power Concerns•Regulators concerned with merger activity that could result in monopoly power•Concentration ratios, such as Herfindahl-HerschmanIndex (HHI), employed to measure the effects of merger–HHI = sum of squared market shares of market participants

21-37© McGraw-Hill Education.Concentration•Problems in interpreting HHI in context of banking and financial services–Relevant geographic scope of the market–Defining institutional scope of the market•Relative shares of small and medium banks have decreased, while largest banks have increased shares–Largest U.S. bank concentration still below that of Canada and Europe

21-38© McGraw-Hill Education.Other Factors•Solvency and asset quality–Leverage, loss reserves, NPLs•Attractiveness of merger measured by merger bid premiums–States with most restrictive regulations–Target banks with high-quality loan portfolios

21-39© McGraw-Hill Education.Global and International Expansions•Three ways to establish global presence:–Sell financial services from domestic offices to foreign customers–Sell financial services through a branch, agency, or representative office, in foreign customer’s country–Sell financial services through subsidiary company in foreign customer’s country

21-40© McGraw-Hill Education.U.S. Banks Abroad•J.P. Morgan/Chase have had offices abroad since beginning of twentieth century–Major growth began in 1960s▪Overseas Direct Investment Control Act, 1964▪Offshore funding and lending in dollars forged beginnings of the Eurodollar market▪Assets of U.S. bank activities abroad increased from $353.8 billion in 1980 to $1,542.6 billion in 2008

21-41© McGraw-Hill Education.Factors Encouraging U.S. Bank Expansions Abroad•Dollar as international medium of exchange•Political risk concerns•Domestic regulatory restrictions/foreign regulatory relaxations•Improvements in technology and communications

21-42© McGraw-Hill Education.Factors Deterring Expansion•Capital constraints•Emerging and European market problems•Competition

21-43© McGraw-Hill Education.Foreign Banks In U.S.•In 1980, foreign banks had assets in the U.S. of $166.7 billion (10.8 percent of total U.S. bank assets)•1992: $514.3 billion (16.4 percent)•1994: $471.1 billion (13.8 percent)–Retrenchments due to several factors, including competition, declining loan quality, and FBSEA•2005: $938.5 billion •2010: $1,539.9 billion•2015: $2,381.7 billion

21-44© McGraw-Hill Education.Regulation of Foreign Banks in U.S.•Prior to 1978, foreign branches and agencies were licensed mostly at state level–1978: federal regulators started exerting more control

21-45© McGraw-Hill Education.Regulation of Foreign Banks•Foreign Bank Supervision Enhancement Act of 1991–Entry –Closure –Examination–Deposit taking –Activity powers

21-46© McGraw-Hill Education.Advantages to International Expansion•Revenue and risk diversification•Economies of scale•Innovations•Funds source•Customer relationships•Regulatory avoidance

21-47© McGraw-Hill Education.Disadvantages to International Expansion•Information/monitoring costs•Nationalization/expropriation•Fixed costs

21-48© McGraw-Hill Education.Pertinent Websites•Federal Reserve www.federalreserve.gov•FDIC www.fdic.gov•OCC www.occ.treas.gov•SEC www.sec.gov

© McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.21-49End of Presentation

Chapter 24Swaps© McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.

24-2© McGraw-Hill Education.Overview•Generic swaps in order of quantitative importance:–Interest rate–Currency–Credit•Swaps and credit risk concerns

24-3© McGraw-Hill Education.Swap Markets•Swaps are different from most other derivatives–Portfolio of forward contracts–Marked to market at coupon payment dates–Intermediary should reduce counterparty risk▪AIG’s exposure to the credit default swap market

24-4© McGraw-Hill Education.Interest Rate Swaps•Interest rate swap as succession of forwards–Swap buyer agrees to pay fixed-rate–Swap seller agrees to pay floating-rate•Purpose of interest rate swap–Allows FIs to economically convert variable-rate instruments into fixed-rate (or vice versa) in order to better match the duration of assets and liabilities

24-5© McGraw-Hill Education.Simple Interest Rate Swap Example (1 of 2)•Consider money center bank that has raised $100 million by issuing 4-year notes with fixed coupons•On asset side: C&I loans linked to LIBOR; Duration gap is negative:•Second party is savings bank with $100 million in fixed-rate mortgages of long duration funded with CDs having duration of 1 year:

24-6© McGraw-Hill Education.Simple Interest Rate Swap Example (2 of 2)•Savings bank can reduce duration gap by buying a swap (taking fixed-payment side)•Notional value of the swap is $100 million•Maturity is 4 years with 10% fixed-payments•Suppose that LIBOR currently equals 8% and MC bank agrees to pay LIBOR + 2%

24-7© McGraw-Hill Education.Realized Cash Flows on Swap•Suppose realized rates are as followsEndof YearLIBOR19%29%37%46%

24-8© McGraw-Hill Education.Swap PaymentsEnd of YearLIBOR +2%MCB Payment SavingsBankMCB Net111%$11$10+12111110+139910-148810-2Total$39$40$-1

24-9© McGraw-Hill Education.Off-market Swaps•Swaps can be molded to suit needs–Special interest terms–Varying notional value▪Increasing or decreasing over life of swap

24-10© McGraw-Hill Education.Macrohedgingwith Swaps (1 of 2)•Assume a thrift has positive gap such that: •Suppose it chooses to hedge with 10-year swaps. Fixed-rate payments are equivalent to payments on a 10-year T-bond. Floating-rate payments are repricedto LIBOR every year. Changes in swap value DS depend on duration difference (D10-D1).

24-11© McGraw-Hill Education.Macrohedgingwith Swaps (2 of 2)•Optimal national value requires:

24-12© McGraw-Hill Education.Currency Swaps•Fixed-rate–Example: U.S. bank with fixed-rate assets denominated in dollars, partly financed with £50 million in 4-year 10 percent (fixed) notes–By comparison, U.K. bank has assets funded by $100 million 4-year 10 percent notes–Solution: Enter into currency swap

24-13© McGraw-Hill Education.Financing Costs from Fixed-Fixed Currency SwapU.S.FIU.K. FICash outflows from balance sheet financing-10% ×£50-10% ×$80Cash inflows from swap10% ×£5010% ×$80Cash outflows from swap-10% ×£80-10% ×$50Net cash flows-10% ×£80-10% ×$50Rate available on:Dollar-denominated notes10.5%Pound-denominated notes10.5%

24-14© McGraw-Hill Education.Fixed-Floating Currency Swaps•Fixed-floating currency swaps.–Allows hedging of interest rate and currency exposures simultaneously –Combined Interest Rate and Currency Swap (CIRCUS)

24-15© McGraw-Hill Education.Credit Swaps•Credit swaps to hedge credit risk–Involvement of other FIs in the credit risk shift–Greenspan recognized that these swaps were prone to induce speculative excesses•Total return swap –Swap interest payments for total return to a bond or loan, hedging possible change in credit risk exposure•Pure credit swap–Interest-rate sensitive element stripped out, leaving only the credit risk

24-16© McGraw-Hill Education.Swaps and Credit Risk Concerns•Credit risk concerns partly mitigated by netting of swap payments, but financial crisis elevated concerns–Scale of individual firm exposures is large–Example: Lehman Brothers $700 billion and large exposure to AIG in particular•Due to the role of swaps in the crisis, greater regulation resulted–Over-the-Counter Derivatives Market Act passed in October 2009

24-17© McGraw-Hill Education.Swaps and Credit Risk•Netting by novation–Occurs when there are many contracts between parties–Often formalized through master netting agreement in U.S.•Payment flows are interest and not principal•Standby letters of credit may be required

24-18© McGraw-Hill Education.Pertinent Websites•BIS www.bis.org•Federal Reserve www.federalreserve.gov•FDIC www.fdic.gov•International Swaps & Derivatives Assoc. www.isda.org

24-19© McGraw-Hill Education.Pricing an Interest Rate Swap•Example:–Assume 4-year swap with fixed payments at end of year–We derive expected one-year rates from the on-the-run Treasury yield curve treating the individual payments as separate zero-coupon bonds and iterating forward

24-20© McGraw-Hill Education.Solving Implied Forward Rates

© McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.24-21End of Presentation

Chapter 25Loan Sales© McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.

25-2© McGraw-Hill Education.Overview•The bank loan sales market•Why banks and other FIs sell loans •Factors affecting loan sales growth

25-3© McGraw-Hill Education.Bank Loan Sale Market•May be sold with or without recourse•Types of loan sales–Domestic▪Traditional short term▪HLT Loan sales–Emerging market

25-4© McGraw-Hill Education.Traditional Short-Term•Key characteristics–Secured by assets of borrowing firm–Loans to investment grade borrowers or higher–Short term–Yield closely tied to commercial paper–Denominations of $1 million +•Importance has declined with emergence of HLT and emerging market loan sales–Growth of commercial paper markets

25-5© McGraw-Hill Education.HLT Loan Sales•Key characteristics–Term loans–Usually senior secured–Long maturity (often 3-to 6-year maturities)–Floating at rates tied to LIBOR, prime, or a CD rate–Strong covenant protection–Usually distinguished as distressed/nondistressed

25-6© McGraw-Hill Education.Types of Loan Sales Contracts•Participations–Limited contractual control–Dual risk exposure and monitoring cost•Assignments–Currently form bulk of the market (90% +)–All rights transferred on sale of loan–Normally associated with Uniform Commercial Code filing–Complexity associated with accrued interest

25-7© McGraw-Hill Education.Trends in Loan Sales (1 of 2)•Loan sales have taken place for over 100 years•Correspondent banking–Small banks selling parts of loans to larger banks–Participations•Expansion of loan sales during 1980s

25-8© McGraw-Hill Education.Trends in Loan Sales (2 of 2)•Early 1990s decline in loan sales followed by expansion–Expanding economy and resurgence in M&As–Early 2000s, economic slowdown triggered growth in distressed loan sales–Effects of the crisis on loan sales and the proportion of distressed loan sales

25-9© McGraw-Hill Education.The Buyers•Often segmented–Example: Distressed HLT loan buyers generally investment banks, hedge funds, vulture funds•Foreign banks important buyer of domestic loans•Insurance companies and pension funds in long-term loans•Mutual funds and nonfinancials

25-10© McGraw-Hill Education.The Sellers•Major money center banks, U.S. government, and government agencies•Good Bank -Bad Bank:–Establishment of subsidiary banks specializing in handling nonperforming loans (NPLs)–Increases value of Good Bank–Allows structuring of Bad Bank to improve management incentives and operating efficiency–Proposed to remove toxic assets in the crisis

25-11© McGraw-Hill Education.Other Sellers•Foreign banks–Japanese banks in California•Investment Banks–Merrill Lynch, generally large HLTs•U.S. government and agencies (HUD, for example)–Increased due to Federal Debt Collection Improvements Act, 1996–Largest sales to date, RTC

25-12© McGraw-Hill Education.Web ResourcesFor more information on loans, visit:•FDIC www.fdic.gov•Dept. of Housing and Urban Development www.hud.gov

25-13© McGraw-Hill Education.Why Banks and Other FIs Sell Loans (1 of 2)•Credit risk management•Reserve requirements–If sold without recourse, removed from balance sheet•Fee income –Boosts reported earnings under current accounting rules

25-14© McGraw-Hill Education.Why Banks and Other FIs Sell Loans (2 of 2)•Capital costs–Meet capital requirements by reducing assets•Liquidity risk reduced by loan sales

25-15© McGraw-Hill Education.Factors Deterring Future Loan Sales Growth•Access to commercial paper market•Customer relationship effects–Customers may take negative view of having their loan sold to another party•Legal concerns–Fraudulent conveyance

25-16© McGraw-Hill Education.Factors Encouraging Future Loan Sales Growth•BIS capital requirements•Market value accounting•Asset brokerage and loan trading•Government loan sales•Credit rating of loans offered for sale•Purchase and sale of foreign bank loans–Goldman Sachs fund to buy troubled loans from Japan’s second largest bank, SMFG

25-17© McGraw-Hill Education.Pertinent Websites•BIS www.bis.org•HUD www.hud.gov•FDIC www.fdic.gov•FASB www.fasb.org•Thomson Reuters Loan Pricing Corp. www.loanpricing.com•SEC www.sec.gov•Wall Street Journal www.wsj.com

© McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.25-18End of Presentation

Chapter 26Securitization© McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.

26-2© McGraw-Hill Education.Overview•Securitization is another mechanism that may be employed by FIs to manage their risk exposure and improve liquidity. •This chapter explores the role of securitization in improving the risk-return trade-off. •The three major forms of asset securitization, and its mortgage lending origins, are also explained.

26-3© McGraw-Hill Education.Introduction•Securitization: Packaging and selling of loans and other assets backed by securities–Many types of loans and assets are being repackaged in this fashion–Original use was to enhance the liquidity of the residential mortgage market–Separates the risk of assets from lending▪Perverse incentive effects instrumental in creating the financial crisis

26-4© McGraw-Hill Education.Conversion of On-Balance-Sheet Assets to Securities•Creation of special purpose vehicle, or SPV, to facilitate the removal of assets from the balance sheet•SPV earns fees from creation and servicing•All cash flows pass through the SPV according to terms of the ABS contract•SPV exists until cash flows from the assets are fully distributed•Structured investment vehicle, or SIV, issues commercial paper to purchase bank loans–SIV essentially an asset-backed security

26-5© McGraw-Hill Education.Traditional Process using SPV

26-6© McGraw-Hill Education.Structured Investment Vehicles•SIV responsible for payments on its ABCP obligations even if underlying assets do not generate sufficient cash flows–When the cash flows exceed costs, the SIV keeps the spread–Usually has lines of credit or loan commitments from sponsoring bank–Liquidity risk implications & exposure to runs

26-7© McGraw-Hill Education.Traditional Process using SIV

26-8© McGraw-Hill Education.Special Purpose Entities•Profitability of SPVs and SIVs hinges on maintaining high credit rating•Prominent role in the 2008-2009 financial crisis–Subprime market–Misperceptions of the credit risk–Complexity encouraged regulator reliance on the banks’ complex models▪Abdication of responsibility

26-9© McGraw-Hill Education.The Pass-Through Security•Government National Mortgage Association (GNMA)–Sponsors MBS programs and acts as a guarantor–Timing insurance•FNMA actually creates MBSs by purchasing packages of mortgage loans–Fully guarantees the securities

26-10© McGraw-Hill Education.Freddie Mac•Federal Home Loan Mortgage Corporation–Similar function to FNMA except major role has involved savings institutions–Stockholder owned with line of credit from the Treasury–In conservatorship with the FHFA–Sponsors conventional loan pools as well as FHA/VA mortgage pools

26-11© McGraw-Hill Education.Web Resources•For more information on mortgage loans, visit:GNMA www.ginniemae.govFNMA www.fanniemae.comFHLMC www.freddiemac.com

26-12© McGraw-Hill Education.Incentives & Mechanics of Pass-Through Security Creation•Example: Create a mortgage pool from one-thousand $100,000 mortgages (results in $100 million mortgage pool)•Each mortgage receives credit risk protection from FHA•Capital requirement: $4 million•Must issue more than $96 million in liabilities due to reserve requirements (+ FDIC premia)•Reduces regulatory tax burden

26-13© McGraw-Hill Education.Further Incentives•Gap exposure•Illiquidity exposure•Default risk by mortgagees–FHA/VA bears the default risk •Default risk by bank/trustee–GNMA responsible for payments to bondholders

26-14© McGraw-Hill Education.Present Value of the Pass-through•Because of the servicing fees, the present value of the payments to the holder of the pass-through will be less than the present value of the underlying mortgage payments, assuming zero prepayments

26-15© McGraw-Hill Education.Present Value of a Mortgage•For monthly payments (PMT), the monthly interest rate equals r/m, where r is the APR and m = 12 months•For a mortgage with a remaining time to maturity of n years, the present value is calculated as:•Recognizable as the product of PMT and PVAF

26-16© McGraw-Hill Education.Prepayment Effects (1 of 2)•Prepayments result of:–Refinancing▪Prepayment penalties and points–Housing turnover•Most GNMA pools allow assumable mortgages–Not the case for FNMA or FHLMC pass-throughs

26-17© McGraw-Hill Education.Prepayment Effects (2 of 2)•Good news effects–Lower market yields increase present value of cash flows–Principal received sooner•Bad news effects–Fewer interest payments in total–Reinvestment at lower rates

26-18© McGraw-Hill Education.Prepayment Models•Since prepayment affects the cash flows to MBS, pricing models require estimates of the prepayment rates•Weighted-average life:•Methods:–Public Securities Association (PSA) model–Other empirical models–Option models

26-19© McGraw-Hill Education.PSA Model•Assumes 0.2 percent per annum in first month, increasing by 0.2 percent per month for first 30 months, until annualized prepayment rate equals 6 percent–Actual outcomes affected by relative coupon level, age of mortgage pool, amortization, assumability, size of pool, conventional/non-conventional, location, and demographics of mortgagees

26-20© McGraw-Hill Education.Other Empirical Models•Generally proprietary variants of PSA model•Incorporate: –Economic variables–Burn-out factor variables–Idiosyncratic factors

26-21© McGraw-Hill Education.Option Models•Use option pricing theory to figure fair yield spread of pass-throughsover Treasuries•Fair price on pass-through, decomposable into two parts:

26-22© McGraw-Hill Education.FNMA and FHLMC Concerns •Gained too much market share and pose a serious risk to financial system•Credit losses and high debt to equity•Excessive interest rate risk exposure FNMA•Overcharging lenders•Freddie Mac misstatement of earnings•FNMA $1.1 billion restatement of equity•Perception of complete federal backing •Threat to the financial system during the crisis•Delisting of Fannie and Freddie

26-23© McGraw-Hill Education.Collateralized Mortgage Obligation (CMO)•CMO structure–Prepayment effects differ across tranches (classes)–Z Class–R Class–Improves marketability of the bonds

26-24© McGraw-Hill Education.Mortgage-Backed Bonds (MBBs)•Normally remain on the balance sheet•Regulatory concerns•Other drawbacks to MBBs

26-25© McGraw-Hill Education.Innovations in Securitization•Pass-through strips–IO strips▪Negative duration–PO strips▪Effect of prepayments ▪Highly sensitive to interest rate changes

26-26© McGraw-Hill Education.Securitization of Other Assets•Securitization of other assets–CARDs–Various receivables, loans, junk bonds, ARMs•Bounds on securitization:–Degree of homogeneity of underlying assets–Credit quality of underlying assets▪If difficult to value, costs of securitizing are higher

26-27© McGraw-Hill Education.Bounds on Securitization•Serious damage to SIVs, the FIs that owned them, and to financial markets delivered by CDOs backed by subprime and alt-A CMO tranches–Most investors did no analysis–Homogeneous assets are better assets for the purpose of securitization

26-28© McGraw-Hill Education.Pertinent Websites•Federal Reserve www.federalreserve.gov•FHLMC www.freddiemac.com•FNMA www.fanniemae.com•GNMA www.ginniemae.gov •Securities Industry and Financial Markets Assoc. www.sifma.org

© McGraw-Hill Education. All rights reserved. Authorized only for instructor use in the classroom. No reproduction or further distribution permitted without the prior written consent of McGraw-Hill Education.26-29End of Presentation

Collepals.com Plagiarism Free Papers

Are you looking for custom essay writing service or even dissertation writing services? Just request for our write my paper service, and we'll match you with the best essay writer in your subject! With an exceptional team of professional academic experts in a wide range of subjects, we can guarantee you an unrivaled quality of custom-written papers.

Get ZERO PLAGIARISM, HUMAN WRITTEN ESSAYS

Why Hire Collepals.com writers to do your paper?

Quality- We are experienced and have access to ample research materials.

We write plagiarism Free Content

Confidential- We never share or sell your personal information to third parties.

Support-Chat with us today! We are always waiting to answer all your questions.