Markets and Intstitutions

In Arms: Rates or payment changes mush be

"capped" -for example, the cap on a 5/1 ARM may be stated as 5/2/5 -Initial Adjustment/ Annual Adjustment/ Lifetime Adjustment

Pass through securities

"pass through promised principal and interest payments to investors. q

Primary stock markets

allow suppliers of funds to raise equity capital

A proxy Vote (Common Stock)

allows stockholders to vote by absentee ballot (e.g., by mail)

Dividends

are discretionary and are thus not guaranteed

Primary market

are markets in which corporations raise funds through new issues of stock, most of the time through investment banks

Jumbo Mortgages

are mortgages for loan amounts that exceed the maximum 'conforming' limits allowed by the mortgage agencies Fannie Mae and Freddie Mac (410000 in 2010 with some exceptions

Stockholders

are the legal owners of a corporation

Secondary stock markets

are the most closely watched and reported of all financial markets

A down payment on a mortgage

a portion of the purchase price of the property a financial institution requires the borrower to pay upfront. (PMI insurance)

Banks in Great Britain, Ireland, Iceland, Spain, The Netherlands, Switzerland, and Germany did have substantial Mortgage related

losses that resulted in bailouts and passage of economic stimulus programs

Mortgage sales allow FIs to

manage credit risk achieve better asset diversification improve their liquidity and interest rate risk positions

Problems with subprime market spilled over to the broader mortgage markets and helped fuel nationwide declines in home prices which put

many homeowners underwater and led to the bankruptcies of major financial institutions.

Mortgage sellers

money center banks smaller banks foreign banks investment banks

Subprime Mortgages

mortgages where the borrowers do not qualify for a "prime" credit rating because of a low credit score arising from prior credit problems such as delinquencies and defaults. Or they simply lack sufficient credit history or have insufficient income.

On September 7, 2008 the federal housing finance agency

placed both Fannie Mae and Freddie Mac in government conservatorship

Fannie Mae used to be a

private corporation owned by shareholders, in September 2008, it was placed in conservatorship of the Federal Housing Fianance Agency: -in minds of the most, has always had implicit government backing -It has a line of credit with the Treasury -Fannie Mae bonds typically receive high rating

A loan sale on a mortgage is made with

recourse if the loan buyer can sell the loan back to the originator, should it go bad

Balloon payment mortgages

require fixed monthly interest payments for 3 to 5 years whereupon full payment of the mortgage principal is due

Mortgage Backed Bonds

-Allow FIs to raise long term low cost funds without removing mortgages from their balance sheets -A group of mortgage assets is pledged as collateral against a MBB issue, but there is no direct link between the cash flows of mortgages and the cash flows on the MBB

Other fees in mortgage loan costs include

-Application fee -title search -Title insurance -Appraisal fee -Loan origination fee -Closing agent and review fees other fees

In mortgage refinancing

-Borrower take out a new mortgage and uses the proceeds to pay off an existing mortgage -Mortgages are most often refinanced when an existing mortgage has a higher interest rate than current rates -Borrowers must balance the savings of a lower monthly payment with the costs of refinancing -An often cited rule of thumb is that the new interest rate should be 2 percentage points less than the refinanced mortgage rate

Private Pass through issuers

-Can pool and sell nonconforming mortgages (those that exceed size limit) Includes: -Prudential Home -GE Captial Mortgages -Countrywide -Chase Mortgage Finance -Citigroup/Citibank Housing

Fannie Mae

-Created in 1938 to buy mortgages from thrifts so they could make more mortgage loans.

In Mortgage loans costs: include

-Discount points: which are fees or payments made when a mortgage loan is issued and Other fees:

In discount points :

-Each point costs the borrower 1 percent of the principle value -The lender reduces the interest rate used to determine the payments on the mortgage in exchange for points paid

Ginnie Mae and Freddie Mac Created in the 1960s

-Encouraged continued expansion of the housing market, particularly for lower income housing -Ginnie Mae does not securitize mortgage, rather it provides direct and indirect guarantees that allow private entities to create mortgage backed securities.

In Mortgage Sales:

-FIs have sold mortgages among themselves for over 100 years. -A large part of correspondent banking involves small banks selling parts of large loans to larger banks -Large banks often sell parts of their loans (i.e. participation) to smaller banks -Mortgage sales occur when an FI originates a mortgage and sells it to an outside buyer:

In Secondary Mortgage Markets: Advances of securitization happen by

-FIs reducing the liquidity risk, interest rate risk, and credit risk of their loan portfolios -FIs generate income from origination and service fees.

Freddie Mac is similar to Fannie Mae in

-Its stockholder owned -Has line of credit with Treasury -Bonds are rated AAA -Buys mortgages and issued MBS

In Secondary Mortgages, the mechanisms that FIs remove mortgages from balance sheets is by:

-Pooling recently originated mortgages together and selling them in the secondary market. -Securing mortgages: (issuing securities backed by newly originated mortgages)

FIs are encouraged to sell loans for economic and regulatory reasons

-Sold mortgages can still generate fee income for the bank -Sold mortgages reduce the cost of reserve and capital requirements

Europe is the worlds second largest and most developed securitization market

-The United Kingdom is the biggest MBS issuer in the european market, followed by Germany -The advent of the Euro has accentuated the increased trend in securitization in Europe

Adjustable rate Mortgages:

-Tie the borrowers interest rate to some market interest rate index -Required monthly payments can change over the life of the mortgage, although they may initially be fixed for a set time period. For example 5/1 ARMs and 3/1 ARMs are popular. -Borrowers assume interest rate risk with an ARM -ARMS can increase default risk

Ginnie Mae serves two major functions:

-To sponsor MBS securities programs by Financial Institutions -Guarantees timing of investments

Collateralized Mortgage Obligations

-are multiclass pass through with multiple bond holder classes or tranches: (each bond holder class has a different guaranteed coupon, Mortgage prepayments retire only one tranche at a time, so all other trances are sequentially prepayment protected

Ginnie Mae

-started in 1968, when it split off from Fannie Mae -Government owned Agency -Only supports pools of mortgage loans that are insured against default FHA,VA, or FHA Main function is timing insurance

How much do underwriters typically charge?

7% fee of issue amount, shared with underwriting syndicate members

How do amortized mortgages usually last

15 or 30 years

Alt A mortgages

Alternative A papers are mortgages that are riskier than prime but not as risky as subprime -Interest rates on Alt-A loans are usually between prime and subprime rates.

Private Mortgage Pass Through Issuers

Create pass through from nonconforming mortgages

What are the functions of IPOs

Develop prospectus and file it with the SEC Road show: Send (red herring) prospectus to potential institutional investors; Visit them and put on a presentation to convince them to purchase IPO shares A red herring prospectus is a preliminary version of the prospectus that describes a new security issue -Book Building

Secondary Mortgage Markets

FIs remove mortgages from their balance sheets through one of two mechanisms Advantages of securitization

Secondary Mortgage Markets include:

Federal National Mortgage Association (FNMA, Fannie Mae) Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac)

Mortgage Buyers

Foreign and domestic banks insurance companies pension funds closed end bank loan mutual funds non financial corporations

What are the 3 agencies directly involved in the creation of the pass through securities?

Ginnie Mae Fannie Mae Freddie Mac

Stockholder Rights

Have a right to share in the firm's profits (e.g., through dividends) Are residual claimants Have limited liability Have voting rights (e.g., to elect board of directors)

Amortized Mortgages

Have fixed principle and interest payments that fully pay off the mortgage by its maturity date

What 4 basic types of mortgages are issued by financial institutions in the primary mortgage markets

Home mortgages Multifamily dewllings Commercial mortgages Farm mortgages

Examples of Primary markets

IPOs SEOs

Assets (Bank Example)

If business is a bank: Loans Investments Buildings Manufacturing facilities Human capital? Crops

Freddie Mac was established

In 1968 to facilitate financing of conventional mortgages

Mortgages

Loans to individuals or businesses to purchase homes, land or other real property

Fannie Mae was established

In the 1930s to buy FHA and VA mortgages from thrifts so they could make more mortgage loans.

investment banks

Investment banks act as distribution agents in best efforts underwriting Investment banks act as principals in firm commitment underwriting gross proceeds - net proceeds = underwriter's spread

What is the main function of Fannie Mae

Issues MBS and guarantees full and timely principle and interest payments.

What is the main difference that Freddie Mac has when comparison with Freddie mac

It primarily deals with thrifts

Collateral on a mortgage

Lenders place liens against properties that remain in place until the loans are fully paid off

Fixed rate mortgages

Lock in the borrowers interest rate -Require monthly payments are fixed over the life of the mortgage -Lenders Assume interest rate risk

Option ARMs: Pick n Pay mortgages. Give homebuyers an initial choice of payment options

Minimum payment: 1% interest rate for 12 months then variable rate, capitalization of unpaid interest, growing loan balance -Interest only payment: usually 5-10 years, payments usually increase after 10 years 15 year or 30 year fully amortizing payment

How to mortgages differ from stocks and bonds

Mortgages are backed by a specific piece of real property Primary mortgages have no set size or denomination Comparatively little information exists on mortgage borrowers

Conventional Mortgages

Mortgages that are not federally insured

Liabilities

People to whom you owe money Nature of claims Debt (loans, bonds, etc.) Equity (stock, preferred stock, etc.)

Fannie Mae creates MBS by

Purchasing packages of mortgages from originators and/or banks and thrifts. -it also swaps MBS with a bank of thrift for mortgages

Federally issued mortgages

Repayment is guaranteed by either the Federal Housing Administration or the Veterans Administration

How does the Underwriter attempt to stabilize price in the secondary market

Requiring lockup provisions (usually 6 months) for original owners of firm and VCs who retain shares Discourage flipping by institutional investors In reality, lockup provisions simply move the downward selling pressure out 6 months to expiration of lockups

Reverse Annuity Mortgages:

Retirees or homeowners with a substantial amount of equity in their home can sell the equity back to the bank over time. -Various payment options are available -Costs and servicing fees are high

Second Mortgages and Home equity loans

Second mortgages are subordinated claims to senior mortgages

Many mortgages are

Secularized

Liabilities (Bank Example)

Senior secured debt Senior unsecured debt Junior debt Preferred stock Common stock (equity)

Between May 2005 and February 2007,

Subprime mortgage default rates increased from 5.37%-10.09% -Subprime mortgage holder 60 days or more behind in their payments hit 17.1% in June 2007 and was over 20% in August of the same years

Beginning in 2006, Problems in the sub prime mortgage market led to

The financial crisis of 2007 and 2008

Assets

Things that generate income

Why should firms go public slide

To get cash to make investments! This is the main reason for most financing -Allow VCs to cash out (sell shares in secondary market between 6 and 24 months after IPO) -Easier access to capital (IPO and SEO funds) -Shareholder monitoring benefits (reduce moral hazard problems) -Obtain analyst coverage to improve brand awareness

Underwriters in IPO

Underwriter sets the price (low enough to ensure strong demand), issues shares to institutional investors at offer price on the IPO date

Book building

Underwriter solicits indications of interest from institutional investors, aggregates this information, and constructs a demand schedule for number of shares demanded at various prices

Home mortgages

Used to purchase 1-4 family dwellings (single family)

In Secondary Mortgage Markets: Securitization and Congressional goals to increase funding for housing to lower income individuals led to

Weakening credit standards and increases in the number of high risk loans (Subprime Mortgages)

Fannie Mae buys and holds mortgages on its

balance sheet and issue bonds directly to finance purchases: - Can be conventional mortgage loans or FHA/VA insured loans -Conventional loans must have at least 80% loan to value ratio

Internationally, Securitization has

declined due to the crisis buy will continue in the future.

Dual-class (Common Stock)

firms have two classes of common shares outstanding, with different voting rights assigned to each class

Private Mortgage insurance (PMI)

generally required when the loan to value ratio is more than 80%

Common stockholders

have the lowest priority claim in the event of bankruptcy (i.e., a residual claim) After debt holders get paid, owners get whatever is left over

in Mortgage amortization: An amortization schedule shows

how the fixed monthly payments are split between principal and interest

Limited liability

implies that common stockholders can lose no more than their original investment

syndicate

is a group of investment banks working in concert to issue stock; the lead underwriter is the originating house

Preferred stock

is a hybrid security that has characteristics of both bonds and common stock Generally has fixed dividends that are paid quarterly does not have voting rights unless dividend payments are missed Nonparticipating versus participating Cumulative versus noncumulative

An initial public offering (IPO

is the first public issue of financial instruments by a firm

Common stock

is the fundamental ownership claim in a public or private corporation

Many mortgages are pooled and sold and then

the mortgage payments are used to collaborated Mortgage backed securities

cumulative voting (Common Stock)

the number of votes assigned to each stockholder equals the number of shares held multiplied by the number of directors to be elected

In mortgage amortization: Each fixed monthly payment consists party of

the repayment of the principal and partly of the interest on the outstanding mortgage balance

Parts of Europe and Asian real estate markets were not as affected by the mortgage crisis because

they lacked substantial subprime lending.

Farm mortgages

used to finance the purchase of farms

Commercial mortgages

used to finance the purchase of real estate for business purposes

Multifamily Dwellings

used to purchase apartment complexes, townhomes, and condos

Common stockholders control the firm's activities indirectly by exercising their

voting rights in the election of the board of directors