Section 3: U.S. Government Debt

Noncallable

(1) (*Long-term treasury bonds are non-callable*)

Federal home loan bank FHLB

(1) Federal Home Loan Bank (FHLB), was the first mortgage agency created in 1932. (2) Provides funds to savings and loans institutions so they can get homeowners mortgages. (3) They issue discount notes, callable bonds, non-callable bullet bonds

Regular Way Settlement-Next Day For Treasury Issues

(1) Trades of the U.S. Government settle on the business day after trade date.

3d

Collateral mortgage obligations CMOs

3f.

Settlement and Accrued Interest

3h

Tax Status of Government and Agency Debt Interest

3e

Trading of Government Agency Debt

3b.

U.S. government obligations

CMOs

(1) (*CMOs are known as derivative securities because each tranch is derived from the method used to allocate cash flows*) (2) Older CMOs are known as plain vanilla because the repayment scheme is simple; as payments are received from the underlying mortgages, interest is paid pro-rata all tranches (3) (*but principal repayments are paid sequentially to the first, then the second, then the third, etc*)

T-Bill Weekly Auction

(1) (*U.S. government securities that are sold by competitive bidding at a weekly auction conducted by the Federal reserve*) (2) (*Treasury bills are sold and are by far the largest amount of debt issued by the government*) (3) Every four weeks notes, bonds, and tips are sold at auction. (4) The actual amount of debt for each auction depends on the financing needs of the government.

TAC is Single buffered against prepayment risk only

(1) A TAC can be visualized as a tranche that absorbs prepayment risk only- there is no buffer tranche that absorbs extension risk. (2) Both PAC and TAC provide call protection against prepayment during periods of falling interest rates. (3) (*TACs do not offer the same degree of protection against extension risk as do PACs during periods of interest rates hence their prices will me more volatile during such periods*)

Fannie Mae, Freddie Mae, Gennie Mae

(1) Are the primary issuers of mortgage backed pass through certificates. (2) The majority of the debt issuance is in the form of mortgage backed securities. (3) Combined it amounts to 13 trillion as of the end of 2013

Interest Payments Applied Proportionally (Pro Rata); Principal Payments Applied Sequentially

(1) As monthly interest payment are received, the interest is distributed pro-rate across all the tranches (2) (*However, as principal is repaid, the principal payments are applied to Tranche 1 securities first and continue on to Tranche 2, 3, 4, etc*)

Monthly mortgage payments

(1) As mortgage payments are received, payments are funneled to the certificates holders. (2) (*Payments are made monthly, with each payment representing a PORTION OF PRINCIPAL AND INTEREST*) (3) Certificates are self liquidating as a mortgages are paid off.

Prepayment spread assumption (*PSA*)

(1) Based on FHA experience tables, most 30 year mortgages are paid off after 12 years. (2) Most 15 year mortgages are paid off after seven years. (3) (*This is known as the PSA a prepayment speed assumption*)

High level on interest rate risk

(1) Because these are long-term zero-coupon obligations, price swings are very volatile as interest rates move. (2) This security is highly susceptible to interest rate risk. (3) But purchasers are not too worried about this since strips are usually held to maturity

Noncallable bullet bonds

(1) Bonds that are non-callable. (2) They are identified in dealer offering listings with a bullet next to the listing.

Collateralized Debt Obligation (CDO)

(1) Buys Tranches. (2) (*Since the market collapsed there have not been any issues of CDOs, but they must be known for the exam!*)

Fannie Mae

(1) Buys government guaranteed and insured mortgages as well as conventional mortgages from banks (non government insured). (2) (*It derives income from the spread between the rate at which it receives funds from the public and the rate it earns on purchase mortgages*) (3) It earns fees as well for servicing pass through certificates and is privatized

Benefits of Tranche System

(1) By recutting, investors can buy mortgage back securities with a wide range of maturities. (2) Additionally, prepayment risk is reduced, since principal payments are applied sequentially to the tranches.

Collarteralized Mortgage Obligation (CMOs)

(1) Collateralized mortgage obligations were developed to eliminate or minimize these risks (2) CMOs do not view mortgage pools as a means of passing through payments to certificate holders in exactly as the same form that they were received (3) (*Instead, mortgage payments that are received are looked at on a cash flows basis, on the basis of cash flows to be received over the life of the pool, separate classes called tranches are created*)

Direct treasury debt highest rating

(1) Debt is also issued by agencies of the U.S. government. (2) Agency debt is not backed directly by the government's promise to pay. (3) Instead, there is implicit promise on the part of the government to pay if debt defaults.

Mortgage

(1) Defined as the pledge of property to secure payment of a debt, typically on real estate such as a house

Zero Tranches (Z)/Accrual Branches

(1) Do not receive payment of interest or principal until all preceding tranches are retired. (2) This is in essence, a zero coupon obligations, and has the greatest price volatility of all tranches. (3) Z-bonds are purchased by investors seeking minimum reinvestment and call risk, but they have greater interest rate risk.

Fannie Mae bankruptcy

(1) Due to bankruptcy, its stock was listed under $1.00 per share. (2) However Fannie Mae debt obligations are implicitly backed by the Federal government and are still rated AAA by Moodys and AA by Standard and Poor

$25,000 minimum mortgage ba insert cked passed through certificates

(1) Each agency continuously buys mortgages from banks. (2) Once purchased, they are placed into pool. (3) The pool is divided into $25,000 mortgage that pass through certificates and the agency sell them to investors.

U.S. Government Securities

(1) Each agency has a selling group of firms who market the agency issues. (2) They act s fiscal agents for the agency.

Tranche

(1) Each tranche has an expected life so this pool of 30 year mortgages is transformed into 10 tranches with 10 different expected lives. (2) Can be visualized as a bell curve.

CMOs are non exempt issues

(1) Fannie Mae, Ginnie Mae, and Freddie Mac are held in the trust are exempt securities under the Securities Acts; (2) CMOs are non-exempt securities. (3) CMOs are a form of unit investment trust, a registered investment company type that is not exempt from the Securities Acts meaning each CMO must be registered with the SEC and sold with a prospectus.

Federal farm credit system

(1) Farmers can obtain low rate financing to the Federal farm credit system. (2) The Federal farm credit system issues discount notes, designated bonds, bonds, retail bonds. (3) These agency obligations are offered to banks and brokerage firms. (4) They are giving the same rating as Treasuries due to the implied backing of the U.S. government. (5) However, they yield 25% more than equivalent maturity Treasuriess, because they do not have a direct U.S. government guarantee

Mortgage characteristics

(1) Fixed rate of interest (2) Equal level payments made monthly (3) The loan is self amortizing so each monthly payment combines a portion of principal repayment with the interest payment (4) Standardized maturities: 30 year life

TIPS (*No Purchasing Power Risk*)

(1) For investors that wish to avoid purchasing power risk, the treasury introduced tips

STRIPS (*No Reinvestment Risk*)

(1) For investors that wish to avoid reinvestment risk the treasury introduce treasury strips. (2) These securities are treasury bonds that have been stripped of their coupons. (3) These are zero coupon treasury obligations. (4) The full name is actually a "separate trading of registered interest and principal security", which is an indecipherable phrase.

Regular Way Settlement an Agencies

(1) Generally settle business day after trade date. (2) Trades of mortgage backed securities, settle on pre-established dates each month. (3) Because of the complexity of Agency settlements, these are not tested

Ginnie Mae

(1) Ginnie Mae was created in 1968, the same year that Fannie Mae was spun off by the federal Government. (2) It is the only housing agency owned and backed by the federal government. (3) Created when Mortgage Backed Securities where first introduced to the marketplace.

Extension risk

(1) If interest rates rise sharply, homeowners will not prepay their mortgages at the expected rate. (2) Instead, they will hold onto their old lower rate mortgages. (3) In this case, a 30- year mortgage pool would last much closer to the full 30-year life, rather than the average life of 15 years. (4) Certificate holders will receive lower than market return for a much longer time than expected.(Extension Risk)

TIPS: Principal Repayment The higher of Par Or The Inflation Adjusted AMount

(1) If the principal amount is adjusted upwards due to inflation, the bondholders receives the higher amount at maturity. (2) Thus the bond is protected against purchasing power risk. (3) On the other hand, if the principal amount is decreased into deflation, the bondholder will always receive par at maturity

Not a pass through

(1) Instead of passing through monthly mortgage payment to holders, a formula is used to recut the mortgage up payments into appropriate payments for each tranche. (2) Each tranche is offered at an appropriate you for that expected maturity, creating a variety of maturities to meet differing investor needs.

Privatized Agency Debt Fully Taxable

(1) Interest Income from securities issued by agency such as Fannie Mae and Freddie Mac is fully taxable similar to regular corporate obligations

Ginnie Mae Pass Throughs Fully Taxable

(1) Interest income from Ginnie Mae pass through certificate is fully taxable.

Government vs. State Taxation

(1) Interest income from U.S. government securities is subject to federal income tax but not state tax and local income tax, because (*one level of government does not the other*) (2) Bonds and notes pay interest semi-annually so two interest payments are included on each years federal income tax return

Treasury notes

(1) Intermediate securities issued with maturities ranging from over 1 to 10 years. (2) The notes are issued a minimum denominations of $100 and pay interest semi-annually to registered holders. (3) Treasury notes are quoted as a percentage of par value in 32nds (4) Notes are non-callable

Callable bonds

(1) Issued up to a 30 day maturity and pay interest semi-annually. (2) These are fixed rate bonds issued in $10,000 minimum face amounts.

Companion Tranches

(1) Known as the shock absorbers that surround the PAC trances. (2) They absorb prepayment risk and extension risk out of the PAC. (3) (*Have the highest risk and are offered at higher yields*) (4) In the companion CMO structure, interest payments are still made pro-rata to all tranches, but principal payments made earlier than that required to retire the PAC are applied the the Companion class,*thus, the companion absorb any prepayment risk before the PAC is hit with the prepayments* (6) Principal payments that are made later than required are applied to the PAC maturity before payments are made Companion class, *thus the companion class absorbs any extension risk before the PAC is hit with this risk*

Agency Debt Trading Less Active that U.S. Governments

(1) Less Active because most are bought by institutions and then held. (2) Most agency securities are bought by institutions that hold onto them

Federal Reserve as a Dealer

(1) Maintains its own trading account and buy and sells securities in the market to control interest rates known as (*open market operations*)

Pass through problems

(1) Mortgage pools have a long fixed life: 30 year mortgages for 15 year mortgages. (2) Cuts out many investors looking for shorter maturities

Secondary Dealers

(1) Most smaller secondary dealers are banks and brokerage firms that buy and sell in the market through primary dealers.

Interest Only (IO) Price Movements

(1) Moves the same as the market. (2) If market interest rates rise, prepayments speed decrease, the maturity will lengthen. (3) Thus, the holder will be receiving interest rates payments of a longer period of time (extension risk). Vice-versa if interest rates decrease (prepayment risk).

Planned Amortization Class

(1) Newer version of a CMO has as a more sophisticated scheme for allocating cash flows. (2) Newer CMOs divide the tranches into PAC Tranches and Companion Tranches (3) The PAC tranche is a Planned Amortization Class (4) Surrounding this tranche are 1 or 2 companion trances

Ginnie Mae Government Mortgages

(1) Only buys government insured mortgages from FHA, VA, and Farmers Home Administration (FmHa) from banks and places them into mortgage pools, which are then securitized and sold to investors.

Planned Amortization Class (PAC)

(1) PAC Tranche is given the most certain repayment dates by being buffered against (*prepayment risk and extension risk*) (2) Because it is being relieved of these risks, it is the safes tranche and is offered at a (*lower yield*)

PACS double buffered

(1) PAC class is given a more certain maturity date while the companion classes have a (*high level prepayment risk if interest rates fall; and a higher level of so-called extension risk*) (2) Extension risk - the risk that thematurity may be longer than expected if interest rates fall

Interest Only (IO)

(1) Pays out only on interest payments made-larger payments upfront and smaller payments in the back. (2) Sells at a discount. (3) Exhibits lesser price volatility since most payments are made in the early years.

Principal Only

(1) Pays out only on the principal amounts made; smaller upfront larger in the back. (2) Sells at a deep discount because of price volatility.

Quoted Through Computer Screens

(1) Placed by primary dealers on a computer quotation systems through service such as Bloomberg and Reuters

Prepayment risk

(1) Prepayment risk is higher with mortgage pools having high stated interest rates on the mortgages. (2) When the mortgages are paid early, the effect is the same as a bond being called. (3) (*The investors no longer get the high interest rate and must reinvest at lower current rates. (Similar to call risk)*)

Sallie Mae

(1) Privatized company whose stock is listed on the NASDAQ and is not bankrupt! (Test question) (2) Makes profit from the spread between the interest rate charged on lonas to students verse the lower interest rate at which it can borrow funds

Quoting CMOs

(1) Quoted in 32nds. (2) Dealers quotes CMOs on a yield spread basis meaning that they dealer quotes the CMO at the same yield as an equivalent maturity Treasury Issue plus a spread. (3) The amount of the spread depends on the liquidity of the CMO. The makeup of the pool, the coupon rate, etc. (4) Typical spreads range from 50 to 100 basis points over Treasuries. (5) $1,000 denominations

Discount Notes

(1) Short-term obligations of one year less, sold at a discount from minimum of $100,000 face amount, with $1000 increments thereafter. (2) Because these are in agency obligation with no government guarantee, they yield more than t bills.

Treasury bills

(1) Short-term securities issued with 1, 3. 6 and 12 month maturities (they should be known as for weeks 13 weeks 26 and 52 weeks as well). (2) Issue at a discount from par and mature at par. (3) The discount earned is considered to be interest income. (4) (*Quoted on discount yield basis*)

New Issues-Book Entry

(1) Short-term treasury bills, intermediate term notes and long-term loans are typically issued in book entry form. (2) No certificates are issued for book entry securities; the only ownership record is the book of owner kept by the transfer agent. (3) No physical certificates have been issued since 1983. (4) Prior to that date, notes and bonds were available in fully registered form-physical certificates were issued. (*These outstanding securities continue to trade until their redemption date*)

Sallie Mae

(1) Student loan marketing association. (2) Sallie Mae purchases student loans from qualified living institutions. (3) Loans are purchased from colleges university state agencies and banks. (4) Sallie Mae sells debentures paying interest semi-annually backed by these loans

Targeted amortization class (*TAC*)

(1) TAC is a bond that is designed to pay for a target amount principle of each month. (2) (*A targeted amortization class bond protects against prepayment risk, but does not protect against extension risk*) (3) If prepayments increase they're made to the companion class first. (4) However it prepared rates slow, the TAC absorbs the available cash flow and goes in areas for the balance.

TIPS: Lower Interest Rate Than Regular Treasury Isues

(1) TIPS have a lower interest rate than similar maturity regular treasury issues because of their inflation protection feature (2) TIPS are only available for long term Treasury issues

Over-the-Counter-Trading

(1) Takes place in the solely over the counter market: banks, foreign banks, us government securities dealers, full service brokerage firms, as well as the federal reserve.

Home ownership not backed directlyby U.S. government

(1) The agencies obtain funds to buy mortgages by selling bonds to the public. (2) The U.S. government does not back these issues with the exception of the Government National Mortgage Association (Ginnie Mae)

Discount on T-Bills

(1) The discount on short-term treasury bills and short-term unprivatized agency notes is taxed as interest income (*in the year the obligation matures*) (2) This interest is subject to federal income tax but is exempt from state and local tax

Primary Dealers

(1) The largest participants in the market are primary dealers of U.S. Government Securities of about 20 Firms!

Prepayment risk

(1) The length of certificate depends on the underlying mortgages in the pool. (2) In reality, the life of the certificate is shorter because mortgage prepayment occur when homes are sold or when mortgages are refinanced (3) These prepayments are passed through to the certificate holder (4) Because of prepayment risk, the real maturiy is unknown.

Predecessor to Strip is Treasury Receipt

(1) The treasury first started selling strips in 1986. (2) Before this, brokerage firms would by conventional treasury bonds and strip them to sell to pension fund investors. (3) They are no longer created because the treasury cut out the middle man by stripping bonds itself. (4) For the exam, treasury receipts must still be known remember that they are zero-coupon treasury bonds.

Home Ownership: Secondary market for home mortgages

(1) These agencies make a secondary market in home mortgages (2) They purchase the mortgages from the local banks that originated the loans (3) This injects new funds into the local banks, allowing them to give out more mortgages

Cash management bill

(1) These are very short term treasury securities that range from (*five days to six months*) (2) They are sold at a regular schedule auction and are sold on a as needed basis when the treasury is running low on cash. (3) Sold in $100 amounts on a slightly higher interest rate than T bills sold on a regular auction schedule

Securitized mortgage

(1) These were the first pass-through certificates issued by Ginne Mae (2) Theses first originated in the late 1960s. (3) Ginne Mae purchased mortgages from lenders with the same interest rate and term, and assemble them into a pool (4) The mortgages purchase have a higher interest rate than what they yield. (5) (*The point difference is a gross profit out which selling operating expenses are paid*)

TIPS: Treasury inflation protection securities

(1) They have a fixed interest rate over the life of the bond. (2) (*However the price will be adjusted every six months by an amount equal to the change in the consumer price index*) (3) The bond pays interest semiannually and the interest amount will increase if the principal amount is adjusted upwards due to inflation and will decrease if the principal amount is decreased due to deflation

Strip: No Reinvestment Risk

(1) This investment was designed for pension fund managers who want a safe, long term investment and who do not want to worry about having to reinvest semi-annual interest payment that could be subject to reinvestment risk

Trades Settle in (*Fed Funds*)

(1) Trades of U.S. Govt and Agencies clear through the Federal Reserve Wire System. (2) These trades settle in Fed Funds; good funds immediately payable at a Federal Reserve Branch member institution (3) Accrued interest on government/agency issue that make semi-annual interest payments is computed on an actual day/actual year basis, with interest accruing up to, but not including settlement.

Cash Same Day

(1) Trades the same business day before 2:30 pm

Floating Rate Tranches

(1) Tranches that have interest rates tied to a recognized index. (2) The interest rate on the tranche moves the same direction as the rate of the index that it follows

Treasury bonds

(1) Treasury Bonds: long-term securities issued with maturities of 30 years. (2) The bonds are issued a minimum denominations of $100 and pay interest semiannually to register holders. (3) Bonds are typically sold in $1000 minimums . (4) (*For the exam bond quotes will still be at $1000 amounts Treasury bonds are quoted as a percentage of par, in minimum increments of 1/32*)

TIPS Annual Upward Adjustment Is Taxable That Year

(1) Treasury Inflation Protection Securities; if the inflation amount is adjusted upward due to inflation, the adjustment amount is treated as taxable interest income for that year (2) Conversely, if the principal amount is adjusted downwards due to deflation, the adjustment amount is treated as deductible interest expense for that year

U.S. Government Securities and Securities Act

(1) U.S. Securities are exempt from the (*Securities Act of 1933*) and 1934 (2) (*However the Federal Reserve that monitors banks has an oversight role*)

Largest Debt Market

(1) U.S. debt market is the largest and most active trading market in the world. (2) Currently, there is over 17 trillion in debt outstanding. (3) Negotiable government debt takes the form of long term bonds, intermediate term notes, short term notes known as treasury bills

Agency debt highest rating

(1) U.S. government debt is considered to be the highest rating debt. (2) (*Essentially free of credit risk*) (3) (note that this is still the case, regardless of the Standard and Poor;s credit downgrades to AA space that occurred in 2011; the other credit rating agencies back at the rating at AAA). (4) Agency debt is also highly rated (AAA) but is considered less safe than direct debt.

Freddie Mac

(1) Was the final mortgage agency created (1970). (2) Its purpose is to buy conventional mortgages that do not carry government insurance or a government guarantee. (3) Buy mortgages from banks and places them into mortgage pools, which are securitized and sold to investors. (4) Made to buy sub-prime mortgages in mid 1990;s that led to their bankruptcy in 2007; same as Fannie Mae. (5) (*Stock trades in the pink sheets since 2008*)

Agency Debt Initially Offered By Fiscal Agents

(1) When an issue is coming into the market, the firms collect customers for the issue and receive a fee of about 1% for placing the issue. (2) The firm may also buy part of the issues for its own inventory at a later date.

Fed Loosening

(1) When the FED wants to loosen credit, they buy Treasury Securities from the primary dealers, which in turn places more money in the hands of banks. (2) Thereby, the market interest rates are lower since the banks have more cash on hand

Fed Tightening

(1) When the FED wishes to tighten credit, it will sell treasury securities to the primary dealers, which removes cash from the dealers (2) This raises market interest rates, since banks have less cash to lend

Fixed rate mortgages

(1) With a fixed rate mortgage, the mortgagor pays a fixed monthly amount with each payment being a combination payment of principal and interest (2) The early payments are mostly interest, with very little principal repayment. (3) (*As payments progress, the interest components shrinks and the principal repayment component increases*) (4) The final payments are mostly principal and very little interest, (*large principal payments at the end causes the outstanding balance to decline steeply*)

Principal Only (PO) Price Movements

(1) Works the same as a long-term bonds relationship with interest rates. (2) Inverse relationship with market interest rates. (3) If the market rates rise (extension risk), if the market rates fall (prepayment risk).

Discount on STRIPS

(1) the discount on long-ter so called oroginal issue disocunt obligations such as STRIPS are treated as annual taxable interest income, pro-rated over the life of the bond (2) The annual accretion amount is taxable each year, even though no interest payment is being received from the issuer (3) Since people don't like to pay tax on income that is not actually received, the securities (*are typically held in retirement plans, so that tax is not paid until the monies are withdrawn from the retirement plan*)

Principal Repayed faster than PSA

(1)When interest rates fall, mortgages are paid off faster than expected. (2) These principal payments come in much faster than the PSA used when the pool was created and the shape of the repayment curve shifts to an earlier date (*graph chapter 2-pg76*)

Federal Home Loan Mortgage Corporation

Freddie Mac

TIPs- Annual Upwards Adjustment is Taxable in that Year

Is adjusted upward due to inflation, the adjustment amount is treated as taxable interest income for that year. Conversely, if the principal amount is adjusted downards due to deflation, the adjustment amount is treated as deductible interest expense for that year.

Principal Only (PO) and Interest Only (IO)

Mortgage backed securities that are created by breaking apart the stream of interest payments from the principal repayments generated by the underlying collateral. These can be created directly from the mortgaged backed security or can be created in the form of CMO branches.

Home ownership

The U.S. government promotes home ownership to the activities of the: (1) Federal Home Loan Banks (FHLB) (2) Federal National Mortgage Associtaion (Fannie Mae) (3) Government National Mortgage Association (Ginne Mae) (4) Federal home loan mortgage corporation (Freddie Mac)

3c

U.S. government agency obligations