Test 3 Study Guide

What are the characteristics of money market instruments? Why must a financial claim possess these characteristics to function as a money market instrument?

The 3 fundamental characteristics of money market instruments are: (a) low default risk; (b) short-term maturity; and (c) high marketability. Money market investors demand low-risk securities because their cash excesses are only temporary.

If a corporate bond paid 9% interest, and you are in the 28% income tax bracket, what rate would you have to earn on a general obligation municipal bond of equivalent risk and maturity in order to be equally well off? Given that municipal bonds are often not easily marketable, would you want to earn a higher or lower rate than the rate you just calculated?

The after tax yield on the taxable corporate bond is 6.48% or [9%(1-0.28)] and is the comparable rate of a tax-free municipal bond. For any added risk on the muni bond (e.g., lower marketability), the investor would pay less or require a higher rate of return (i.e., above 6.48%).

Suppose Fargood Corporation engages in a repurchase agreement with The National Bank of Nebraska. In the agreement, Fargood sells $9,987,950 worth of Treasury securities to the bank and agrees to repurchase the securities in 30 days for $10,000,000. c. What interest rate (or yield) is earned by the lender?

The annualized yield to the bank (cost to Fargood) would be:

Explain how repurchase agreement transactions provide short-term investments to businesses. In what sense is a repo a collateralized loan?

The corporate treasurer purchases government securities for the amount of the investment from a bank for a specified period. The business would have idle cash deposit balances it would transfer out to invest. The bank retains the funds in a repurchase transaction whereby it sells securities to the business and agrees to buy them back at a higher price, thus paying the money market rate for the business' funds. The purchase price and sale price are agreed upon at the time the deal is made. The interest paid the business is the difference between the purchase and repurchase price of the securities. A repo is a collateralized loan in that the securities sold serve as collateral.

Conventional Loans

loans that do not qualify for a federal guarantee

Why did many asset-backed and financial commercial paper issuers find it difficult to raise funds from 2007 to 2009 but nonfinancial commercial paper issuers did not?

n 2007-2009, many of the assets backing ABCP issues performed poorly, making investors much less willing to purchase ABCP. The bankruptcy of Lehman Brothers in September 2008 raised questions about the viability of major U.S. financial institutions and the federal government's willingness (or lack thereof) to rescue large institutions. Some investors, including money market mutual funds, started avoiding commercial paper issued by financials.

Lenders may require a borrower to secure _______ if they cannot come up with a 20% down payment.

private mortgage insurance (PMI)

Suppose Fargood Corporation engages in a repurchase agreement with The National Bank of Nebraska. In the agreement, Fargood sells $9,987,950 worth of Treasury securities to the bank and agrees to repurchase the securities in 30 days for $10,000,000. b. Is the loan collateralized? What is collateral? Who holds the collateral during the term of the agreement?

The loan is collateralized because the securities serve as collateral. The bank or offsite depository would hold the securities during the contract period.

What did the Federal Reserve do to stabilize the money markets from 2007 to 2009?

The measures that directly impacted the money markets included expanding access to the disocunt window, auctioning short-term loans to depository institutions through the Term Auction Facility (TAF), paying interest on required and excess reserves of depository institutions, and buying commercial paper directly from issuers through the Commercial Paper Funding Facility (CPFF). CPFF was a major departure from the Fed's traditional ways because this facility, which was closed in February 2010, provided funds to firms that included nonfinancial corporations (central banks normally deal only with financial institutions). In December 2008, the Fed set the target federal funds rate as a range between 0 and 0.25% and started acquiring long-term assets.

Suppose you are interested in buying a home valued at $500,000 and 30-year fixed-rate mortgages have an interest rate of 6%. What is your minimum down payment assuming you will borrow with a conventional mortgage? If property taxes and homeowner insurance total $500 per month and that you have other loan payments totaling $300 per month, how much do you need to earn on a monthly basis to qualify for a mortgage?

The minimum down payment for a conventional mortgage is 20% of the purchasing price, in this case $100,000. The P&I payment on a $400,000, 30-year, 6% mortgage is $2,398.20. Using the criterion of the P&I payment being no more than 25% of monthly income, your minimum income must be $2,398.20/0.25 = $9,593 a month to qualify. The P&I, taxes and insurance total $2,898.20, and using the criterion of this amount not exceeding 28% of monthly income, your income must be at least $10,351 a month. Your total financial obligations if this loan is made will be $3,198.20; if they are not to exceed 33% of monthly income, the income must be at least $9,692 a month. Thus, monthly income must be at least $10,351 (the largest of the three amounts above) for you to qualify for this mortgage.

If a bond dealer bought a $100,000 municipal bond at 90% of par and sold it at 93% of par, how much money did the dealer make on the bid-ask spread?

The spread of 3% of $100,000 is $3,000.

What is a credit spread? What happened to credit spreads during the financial crisis of 2007-2009 and afterwards?

A credit spread is the difference between yields of otherwise similar debt securities with different credit risk. Spreads started to widen in mid-2007 and peaked in December 2008. The Baa-Treasury spread widened much more than the Aaa-Treasury spread, indicating a "flight to quality". Spreads narrowed in the second half of 2009 and 2010, when the bond markets returned to relative normalcy. Credit spreads have fallen from the crisis era levels but remain elevated relative to pre-crisis levels. This is because the economy has not yet fully recovered and because investors still believe that risk levels are higher than they were in the mid-2000s.

Suppose Fargood Corporation engages in a repurchase agreement with The National Bank of Nebraska. In the agreement, Fargood sells $9,987,950 worth of Treasury securities to the bank and agrees to repurchase the securities in 30 days for $10,000,000. a. Is this transaction a loan, and if so, who is the borrower and who is the lender?

The transaction is a repurchase agreement for Fargood and a reverse repurchase agreement for the bank. The bank is the lender because it is buying (investment of funds) the Treasuries owned by Fargood, the borrower of the funds for the period of the repo. Technically, it is not a loan but a purchase with agreement to resell, but the effect is the same as a loan to a customer.

How are the Treasury and federal agency securities different? What difference primarily explains the yield differential between the two securities?

Agency securities have greater default risk and are less marketable than Treasury securities. As a result, Agency securities sell at lower prices (have higher yield) than similar Treasury securities.

Asset-backed securities

Are the financial claims issued when loans are securitized

Why is a bank line of credit necessary to back up an issue of commercial paper?

Back-up lines of credit would be used if the firm experiences financial difficulties or if credit market conditions tighten. Back-up lines of credit are often required by investors to assure protection of their principal and liquidity.

Why is the banker's acceptance form of financing ideal in foreign transactions?

Banker's acceptance provides two basic services: (a) financing, and (b) services and expertise specifically related to an international transaction. It is the latter that makes banker's acceptances an attractive means of financial international transactions.

Why have mortgage market interest rates become more uniform across the country in recent years?

Because mortgage-backed securities have been able to compete for funds directly in the capital markets, lenders' costs of funds have become more uniform across the country as such securities have developed. Competition then ensures that equal costs of funds will be translated into roughly equal mortgage loan rates in each market area.

General Obligation (MB)

Bonds are backed by the full taxing ability of the states or municipalities

Mortgage-Backed (MB)

Bonds are collateralized by mortgages and provide mortgage loans to individuals at the tax-exempt rate

Industrial Development (MB)

Bonds are essentially loans at the tax-exempt interest rate to businesses

Revenue (MB)

Bonds' defualt risk is determined by the expected revenue from the project the bonds are issued to finance

Explain how mortgage-related securities have become more similar to capital market instruments over time.

They have become more standardized in denomination (GNMAs and PCs initially trade in evenly denominated units). In addition, most are well secured and/or guaranteed by well-known financial entities. Some are even rated by rating services. Finally, CMOs, REMICs and mortgage-backed bonds promise to make fixed payments over their life span, just like conventional bonds.

Why have CMOs and REMICs made it easier for the mortgage markets to compete for funds with corporate bonds? What problems do their residuals pose?

CMOs and REMICs provide predictable cash flows for investors that regular mortgages and pass-throughs do not. Residual claims represent the net after contracted interest and principal are paid. The more varied the residuals, the greater the required rate of return by residual investors.

Callable Securities

Can be retired by the issuer's option prior to their stated maturity at a pre-specified price called the call price. Advantage is to issuers and investors have to be compensated with a call premium in the form of a higher yield.

What is the difference between conventional mortgages and FHA and VA mortgages?

FHA and VA mortgages are insured by the federal government, conventional mortgages are not. As a result of the guarantees, FHA and VA mortgages are often granted with lower down payment requirements than conventional mortgages. However, because of government restrictions, FHA mortgages may be written for smaller maximum amounts than conventional mortgages.

f you expect prices and incomes to rise, would you rather have a conventional mortgage, FRM or ARM? What if you expected prices to fall? Explain your answer. Also explain how your answer would differ if you were a mortgage lender.

FRM. I would put little money down and my equity and income would build up rapidly due to inflation, so I would have little difficulty making future payments or recovering my principal if I sold my house. ARMs would be less desirable because their rates would rise as inflation forced interest rates up. Only if the reduction in rate were greater in present value terms than the expected sacrifice of price appreciation would I break even on a sale. From a lender's perspective, ARMs transfer interest rate risk to borrowers, while FRMs transfer it to lenders.

Convertible

Features of securities are options of the investor to convert the security into another form of securit, typically into an equity security

Some federal agencies like the ________ and the ________ guarantee loans to qualified home buyers for a small fee that covers the cost of the insurance.

Federal Housing Administration (FHA) Veterans Administration (VA)

Describe the different forms of financial guarantees seen in the bond market.

Financial guarantees are credit enhancements offered by low credit risk businesses to those with high credit risk. Insurance companies write insurance policies to back bond issues in case of default; commercial banks back commercial paper with lines of credit (paying off the commercial paper in case of credit deterioration) or swap transactions.

Borrower Income

From all sources gives the lender an idea of the ability of the borrower to meet the monthly mortgage commitment. This commitment includes not only the monthly interest and principal paid, but also the amount needed to pay property tax, homeowners insurance and any mortgage insurance.

How has the government encouraged the development of secondary mortgage markets?

Indirectly, the government has helped such markets through the development of FHA and VA mortgage insurance. Directly, the government has aided the development of second mortgage markets by supporting the development of FNMA and FHLMC, which buy large quantities of mortgages in the secondary markets and issue mortgage-backed bonds and pass-through securities. In addition, the government established GNMA, which initiated government guaranteed pass-through securities specifically so those securities could be sold in the secondary mortgage markets.

What features make municipal bonds attractive to certain groups of investors? Why don't other groups invest much in municipal securities?

Interest income from municipal bonds is tax-exempt at the federal level. All other factors being equal, investors select the security that provides the highest after-tax yield. In general, investors in high tax brackets find municipal bonds attractive investments - they have higher after-tax yields compared to similar taxable securities. Investors in low tax brackets may not find municipal bonds attractive compared to corporate bonds.

Mortgage Insurance

Is necessary for borrowers who are unable to come up with a 20% down payment

Private Placement

Is the sale of bonds to a single investor or small group of sophisticated investors, that meet the guidelines for avoiding registration and disclosure requirements of the SEC and state laws. SEC requires that the issue be sold to no more than 35 investors to qualify as a private placement.

What types of firms issue commercial paper? What are the characteristics critical to being able to issue commercial paper?

Large businesses with high credit ratings issue commercial paper as an inexpensive source of short-term borrowing. Commercial paper is an alternative to borrowing from a commercial. Typically, the rates are lower than rates charged by banks. Because commercial paper is unsecured debt, most investors only want paper with highest credit ratings. Rating agencies will quickly write down or remove their ratings for commercial paper if the financial conditions of a company deteriorate. The number of companies issuing commercial paper in the economic boom of the late 1990's shrunk considerably by 2001 as rating agencies pulled their commercial paper ratings. During the recent crisis, issuers of asset-backed commercial paper (mostly financial institutions) had difficulty rolling over paper because investors questioned both the quality of assets backing the paper and the solvency of the issuing financial institutions.

How has the development of secondary mortgage markets allowed mortgage issuers to attract additional funds from the capital markets?

Many mortgage-backed securities have characteristics similar to government bonds. Pass-throughs, participation certificates, and collateralized mortgage obligations are sold in standard denominations. Because they are guaranteed, they can be resold easily. Mortgage-backed bonds and CMOs not only are of standard denomination, but also provide guaranteed repayment schedules. As these securities come to resemble bonds, they become more readily interchangeable with bonds in investors' portfolios, and compete more effectively with bonds for investors' funds.

Suppose your gross monthly income is $5,000. Assume that property taxes, homeowner's insurance, and mortgage insurance payments total $200 a month. In addition, assume you have automobile and student loan payments that total $400 a month. If 30-year fixed rate mortgages have a current annual percentage rate of 6 percent, how much do you qualify to borrow based on the payment-to-income ratios described in the chapter?

Monthly mortgage payment (P&I) @ 25% of gross income: 0.25*$5,000 = $1,250Additional payments for insurance & taxes = $200Taking both payments into consideration,Monthly mortgage payment (P&I, T, HI, MI) @ 28% of gross income: 0.28*$5,000 = $1,400Additional monthly debt obligations = $400Taking all payments into considerationMonthly mortgage payment (P&I, T, HI, MI) @ 33% of gross income: 0.33*$5,000 = $1,650To figure out the amount you will be qualify to borrow based on the ratio of monthly payment to all debt obligations (33%), you would use the amount of $1,650 as the maximum amount you would pay towards P&I, tax and insurance and other debt obligations. Using the equation given below, you can compute the PV of the loan amount.

If mortgage bankers originate more mortgages than other types of financial institutions, why don't they also hold more mortgages in their asset accounts?

Mortgage bankers specialize in mortgage origination, packaging and selling mortgages to mortgage funds providers, like life insurance companies, pension funds, and banks, who have built their mortgage investment portfolio in the 1990s. Mortgage bankers often retain service rights, but economies of scale in loan servicing have led toward larger loan servicing organizations. Because mortgage bankers do not hold mortgages they originate and face no credit or interest rate risk, they have reduced incentive to manage these risks in their loan originations. This may have led some unscrupulous mortgage bankers during the credit boom of the early and mid-2000s to mass produce risky loans in pursuit of higher fee income. This may have contributed to the ensuing housing market bubble burst and financial crisis.

Why was the development of mortgage insurance necessary before secondary mortgage markets could develop?

Potential buyers of mortgage debt could not afford to assess the credit-worthiness of every mortgagor, but could afford to assess the worth of governmental (or private) debt guarantees. Thus, more people are willing to buy mortgage debt instruments in the secondary market if these are insured.

Explain why mortgage investors demand a higher yield for investing in securities with call risk and extension risk. Why would a mortgage investor view mortgage prepayments negatively?

Prepayment (call) and extension risks are of concern to investors because of their impact on mortgage valuations. Unlike noncallable bonds, which increase in value at an increasing rate when yields fall and decrease in value at a decreasing rate when yields rise, mortgage portfolios increase in value at a decreasing rate when yields fall (because mortgage borrowers refinance more to take advantage of lower rates) and decrease in value at an increasing rate when yields rise (because very few mortgage borrowers refinance, and investors receive cash flows based on mortgage rates that are below the current rates).

Why are private placements of securities often popular with both the buyer and the seller of the securities?

Private placements are direct sales between borrowers and the ultimate investors. The costly and time-consuming SEC registration is not required for private placements. In general, both issuers and investors believe they can negotiate a better deal than if they transacted in the public market.

Sinking Fund

Provisions require the issuer to retire a percentage of a bond issue on an annual basis. It reduces the risk of default to investors.

Down Payment

Refers to the amount of cash the borrower can contribute towards the cost of the house as their equity. Traditionally this has been 20% of the cost of the house, allowing the buyer to seek a mortgage loan on the remaining 80 percent.