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
