CH-9-10 International Bonds – Bond Markets, Analysis and Strategies : Book Guide

This Document Contains Chapters 9 to 10 CHAPTER 9 INTERNATIONAL BONDS CHAPTER SUMMARY This chapter covers international bond markets from the perspective of U.S. investors. U.S. investors have become increasingly aware of non-U.S. interest-rate movements and their relationship to U.S. interest rates. Foreign countries have liberalized their bond markets, making them more liquid and more accessible to international investors. Futures and options markets have been developed on government bonds in several major countries, permitting more effective implementation of hedging and arbitrage strategies. A powerful reason for a U.S. investor to invest in nondollar bonds is the increased opportunities to find value that multiple markets provide. Another reason given for nondollar bond investing is that the decision not to hedge the currency component can then be regarded as an active currency play. CLASSIFICATION OF GLOBAL BOND MARKETS From the perspective of a given country, the global bond market can be classified into two markets: an internal bond market and an external bond market. The internal bond market is also called the national bond market. It can be decomposed into two parts: the domestic bond market and the foreign bond market. The domestic bond market is where issuers domiciled in the country issue bonds and where those bonds are subsequently traded. The foreign bond market of a country is where bonds of issuers not domiciled in the country are issued and traded. Bonds traded in the U.S. foreign bond market are nicknamed Yankee bonds. Yen-denominated bonds issued by non-Japanese entities are nicknamed Samurai bonds. Foreign bonds in the United Kingdom are referred to as bulldog bonds, in the Netherlands as Rembrandt bonds, and in Spain as matador bonds. The external bond market, also called the international bond market, includes bonds with the following distinguishing features: (i) they are underwritten by an international syndicate; (ii) at issuance they are offered simultaneously to investors in a number of countries; (iii) they are issued outside the jurisdiction of any single country; and, (iv) they are in unregistered form. The external bond market is commonly referred to as the offshore bond market, or, more popularly, the Eurobond market. Another way to classify the world’s bond market is in terms of trading blocs. The trading blocs used by practitioners for this classification are dollar bloc, European bloc, Japan, and emerging markets. The dollar bloc includes the United States, Canada, Australia, and New Zealand. The European bloc is subdivided into two groups: (i) the euro zone market bloc, and (ii) the non-euro zone market bloc. NON-U.S. BOND ISSUERS AND BOND STRUCTURES In this section, we describe the various non-U.S. issuers of international bonds, the type of bond structures, and the currencies in which international bonds are issued. Non-U.S. Bond Issuers Non-U.S. issuers of international bonds include sovereign governments, sub sovereign governments, supranational agencies, financial institutions, and corporations. Sovereign bonds are issued by central governments. Bonds issued by government entities that are below that of central government are referred to as sub-sovereign government bonds. Such issuers include regions, provinces, states, and municipalities. A supranational agency is an entity that is formed by two or more central governments through international treaties. The purpose for creating a supranational agency, referred to also as an international organization, is to promote economic development for the member countries. Financial institutions are primarily banks and corporations are non-financial corporate entities. Organizations that collect data on international debt issuance use different definitions for categorizing the nationality of issuers. An offshore financial center or offshore center is countries or jurisdictions with financial centers that contain financial institutions that deal primarily with nonresidents and/or in foreign currency on a scale out of proportion to the size of the host economy. Bond Structures The vast majority of international bonds are straight fixed-rate bonds. The floating-rate bond security is roughly 30% most of which issued by financial institutions. The largest currency denomination is in euros, followed closely by U.S. dollars. The U.K. pound sterling is a distant third. FOREIGN EXCHANGE RISK AND BOND RETURNS The key factor that impacts the price and the yield of a bond is the currency denomination. In contrast, when a portfolio includes non-dollar denominated issues by non-U.S. entities, there are two additional factors to consider beyond the analysis of the issuer’s credit. The first is the movement of interest rates of all the countries where there is currency exposure. The second is the foreign exchange movement of all the currencies to which the portfolio has exposure. A foreign exchange rate is the amount of one currency that can be exchanged for another currency or the price of one currency in terms of another currency. If the foreign currency depreciates (i.e., declines in value) relative to the U.S. dollar, the dollar value of the cash flows will be proportionately less. This risk is referred to as foreign exchange risk or currency risk. This risk can be hedged with foreign exchange spot, forwards, futures, swaps or options instruments (although there is a cost of hedging). The return on a portfolio that includes non-dollar denominated bonds consists of three components: (1) income, (2) capital gain/loss in the local currency, and (3) foreign currency gain/loss. BONDS ISSUED BY NON-U.S. ENTITIES Bonds issued by non-U.S. entities include: Yankee bonds, Regulation 144a private placements, Eurobonds, Euro medium term notes, Global bonds, Non-U.S. domestic bonds, emerging market bonds. Below we describe each. Yankee bonds Yankee bonds are bonds issued by non-U.S. entities that are registered with the U.S. Securities and Exchange Commission (SEC) and traded in the United States. Issuers in the Yankee bond market are sovereign governments, sub-sovereign entities, supranational agencies, financial institutions, and corporations. Regulation 144a Private Placements SEC Rule 144A allows the trading of privately placed securities among qualified institutional buyers. Because of the reduced reporting requirements, 144a bond issuance has become an important market for non-U.S. borrowers to raise funds. There are no restrictions on the currency denomination; however, the bulk of the outstanding 144a bonds are dollar denominated. Eurobonds The Eurobond market is divided into sectors depending on the currency in which the issue is denominated. For example, when Eurobonds are denominated in U.S. dollars, they are referred to as Eurodollar bonds. The Eurodollar bond market is the largest sector within the Eurobond market. It has become increasingly difficult to classify a bond issue as a foreign bond or a Eurobond based on the distinguishing characteristics. The most important characteristic of a Eurobond offering is the composition of the underwriting syndicate. A bond offering in which there is only one underwriter and in which the issue is placed primarily outside the national market of both the issuer and underwriter would not traditionally be classified as a Eurobond offering. Another characteristic of a Eurobond is that it is not regulated by the single country whose currency is used to pay bondholders. With respect to the purchase of Eurodollar bonds by U.S. investors, there are selling restrictions under U.S. securities law for offerings outside of the United States. There are two fundamental requirements. First, the transaction must be an offshore transaction. Second, there can be no directed selling efforts associated with the offering made in the United States. There are three categories of issuers. Category 1 issuers are non-U.S., non-governmental issuer. Issuers classified as Category 2 have offering restrictions. Debt securities of a non-reporting U.S. issuer fall into Category 3 and there are further restrictions beyond that imposed on issuers that fall into Category 2. Corporate Bonds and Covenants In the Eurobond market, there is a debate regarding the relatively weak protection afforded by covenants. The chief reason for this is that investors in corporate Eurobonds are geographically diverse. For investment-grade corporate issues in the Eurobond market, documentation is somewhat standardized. Key terms and conditions in Eurobond documentation include governing law, security, negative pledges, subordination, cross-default clauses, and prohibition on the sale of material assets. In order to protect bondholders, most documentation prohibits the sale or transfer of material assets or subsidiaries. Securities Issued in the Eurobond Market The Eurobond market has been characterized by new and innovative bond structures to accommodate particular needs of issuers and investors. There are the “plain vanilla,” fixed-rate coupon bonds, referred to as Euro straights. Coupon payments are made annually, rather than semiannually, because of the higher cost of distributing interest to geographically dispersed bondholders. There are also zero-coupon bond issues and deferred-coupon issues. There are a wide variety of floating-rate Eurobond notes. The coupon rate on a floating-rate note is some stated margin over the London interbank offered rate (LIBOR), the bid on LIBOR (referred to as LIBID), or the arithmetic average of LIBOR and LIBID (referred to as LIMEAN). Many issues have either a minimum coupon rate (or floor) that the coupon rate cannot fall below and a maximum coupon rate (or cap) that the coupon rate cannot rise above. An issue that has both a floor and a cap is said to be collared. There are some issues referred to as drop-lock bonds, which automatically change the floating coupon rate into a fixed coupon rate under certain circumstances. A floating-rate note issue will either have a stated maturity date or it may be a perpetual (also called undated) issue (i.e., with no stated maturity date). There are issues that pay coupon interest in one currency but pay the principal in a different currency. Such issues are called dual-currency issues. One type of the latter offers to the investor or the issuer the choice of currency. These bonds are commonly referred to as option currency bonds. Convertible Bonds and Bonds with Warrants A convertible Eurobond is one that can be converted into another asset. Bonds with attached warrants represent a large part of the Eurobond market. A warrant grants the owner of the warrant the right to enter into another financial transaction with the issuer if the owner will benefit as a result of exercising. There is a wide array of bonds with warrants: equity warrants, debt warrants, and currency warrants. An equity warrant permits the warrant owner to buy the common stock of the issuer at a specified price. A debt warrant entitles the warrant owner to buy additional bonds from the issuer at the same price and yield as the host bond. A currency warrant permits the warrant owner to exchange one currency for another at a set price (i.e., a fixed exchange rate). Comparing Yields on U.S. Bonds and Eurodollar Bonds Because Eurodollar bonds pay annually rather than semiannually, an adjustment is required to make a direct comparison between the yield to maturity on a U.S. fixed-rate bond and that on a Eurodollar fixed-rate bond. Given the yield to maturity on a Eurodollar fixed-rate bond, its bond-equivalent yield is computed as follows: bond-equivalent yield of Eurodollar bond = 2[(1 + yield to maturity on Eurodollar bond)1/2 – 1]. To convert the bond-equivalent yield of a U.S. bond issue to an annual-pay basis so that it can be compared to the yield to maturity of a Eurodollar bond, the following formula can be used: yield to maturity on annual-pay basis = (1 + yield to maturity on bond-equivalent basis/2)2 – 1 The yield to maturity on an annual basis is always greater than the yield to maturity on a bond-equivalent basis. Euro Medium-Term Notes Euro medium-term notes (EMTN) are debt obligations that are intended primarily for offerings outside of the United States. Typically, EMTNs are intended for European investors. Their denomination can be any currency. Global Bonds A global bond is one that is issued simultaneously in several bond markets throughout the world and can be issued in any currency. The three characteristics of a global bond are as follows: (i) they are issued and sold simultaneously in multiple bond markets at the same offering price; (ii) they are traded in these markets without restrictions with settlement that is similar to a trade of domestic bonds; and, (iii) the issuance size is large, allowing for multiple tranches by maturity. A tranche means one of several related securities issued simultaneously. Many of the recent issues of global bonds have two tranches that differ by maturity date and coupon rate. Non-U.S. Domestic Markets Domestic bond markets throughout the world offer U.S. investors the opportunity to buy bonds of non-U.S. entities. The difference between the outstanding domestic debt securities issued by all countries and the U.S. domestic debt securities is that of the non-U.S. domestic market. Non-U.S. Government Bond Markets The institutional settings for government bond markets throughout the world vary considerably, and these variations may affect liquidity and the ways in which strategies are implemented, or, more precisely, affect the tactics of investment strategies. In addition, yields are calculated according to different methods in various countries, and these differences will affect the interpretation of yield spreads. Withholding and transfer tax practices also affect global investment strategies. Outside of the United States, the largest government issuer of inflation-linked bonds is the United Kingdom, followed by France. These bonds, popularly referred to as linkers in Europe, are typically linked to a consumer price index. There are four methods that have been used in distributing new securities of central governments: the regular calendar auction/Dutch style system, the regular calendar auction/minimum-price offering, the ad hoc auction system, and the tap system. In the regular calendar auction/Dutch style auction system, there is a regular calendar auction and winning bidders are allocated securities at the yield (price) they bid. In the regular calendar auction/minimum-price offering system, there is a regular calendar of offering. The price (yield) at which winning bidders are awarded the securities is different from the Dutch style auction. In the ad hoc auction system, governments announce auctions when prevailing market conditions appear favorable. It is only at the time of the auction that the amount to be auctioned and the maturity of the security to be offered are announced. In a tap system, additional bonds of a previously outstanding bond issue are auctioned. Sovereign debt is the obligation of a country’s central government. The debt of national governments is rated by the rating agencies. For the reasons discussed subsequently, there are two sovereign debt ratings assigned by rating agencies: a local currency debt rating and a foreign currency debt rating. Standard & Poor’s, Moody’s, and Fitch all assign ratings to sovereign bonds. The two general categories are economic risk and political risk. Economic risk involves an assessment of the ability of a government to satisfy its obligations. Political risk is an assessment of the willingness of a government to satisfy its obligations. The reason for distinguishing between local debt ratings and foreign currency debt ratings is that historically, the default frequency differs by the currency denomination of the debt. Specifically, defaults have been greater on foreign currency-denominated debt. A significant depreciation of the local currency relative to a foreign currency in which a debt obligation is denominated will impair a national government’s ability to satisfy such obligation. In assessing the credit quality of local currency debt, S&P emphasizes domestic government policies that foster or impede timely debt service. For foreign currency debt, credit analysis by S&P focuses on the interaction of domestic and foreign government policies. S&P analyzes a country’s balance of payments and the structure of its external balance sheet. The European Covered Bond Market One of the largest sectors of the European market is the covered bond market. Covered bonds are issued by banks. They are called “covered bonds” because the pool of loans that is the collateral is referred to as the “cover pool.” The collateral for covered bonds can be either (i) residential mortgage loans, (ii) commercial mortgage loans, or (iii) public sector loans. Investors in covered bonds have two claims. The first is a claim on the cover pool. The second claim is against the issuing bank. Because the covered pool includes high-quality mortgage loans and is issued by strong banks, covered bonds are viewed as highly secure bonds, typically receiving a triple A or double A credit rating. Covered bonds in many countries are created using a securitization process and so can be compared to residential mortgage-backed securities (RMBS), commercial mortgage-backed securities (CMBS), and other asset-backed securities (ABS). Four differences results from this securitization process. First, the bank that originated the loans will issue and sell a pool of loans to a special purpose vehicle (SPV). Second, investors do not have recourse to the bank that sold the pool of loans to the SPV. Third, for RMBS/CMBS/ABS backed by residential and commercial mortgage loans, the group of loans does not change, whereas covered bonds are not static. Fourth, covered bonds typically have a single maturity date. Special legislation is required in a country in order for covered bonds to be issued. The two major issues that laws resulting from the legislation must address are (i) the eligibility of assets that may be included in the cover pool, and (ii) the treatment in bankruptcy of the holders of covered bonds. The German mortgage-bond market, called the Pfandbriefe market, is the largest covered bond market. It is about one-third of the German bond market and the largest asset type in the European bond market. There are two types of Pfandbriefe that differ based on the borrowing entity for the loan. Of entliche Pfandbriefe refers to bonds that are fully collateralized by loans to public-sector entities. When the bonds are fully collateralized by residential and commercial mortgages, they are called Hypotheken Pfandbriefe. The Pfandbriefe market is further divided into Traditional Pfandbriefe and Jumbo Pfandbriefe. The former represents the market for issues of smaller size. The tap method was used for issuing Traditional Pfandbriefe. The sector of the Pfandbriefe market that has received the greatest interest from global institutional bond investors is the Jumbo Pfandbriefe sector. Emerging Market Bonds The financial markets of Latin America, Asia (with the exception of Japan), and Eastern Europe are viewed as emerging markets. A country is classified as an emerging market if it has defaulted at least once on its international debt obligations and not considered industrialized. There is an understanding amongst institutional and retail investors as to what is meant by an emerging market. Governments of emerging market countries have issued Brady bonds, Eurobonds, global bonds, or domestic bonds. Brady bonds are basically bonds that represent a restructuring of nonperforming bank loans of governments into marketable securities. Most countries have retired their outstanding Brady bonds. At one time, the securities issued by governments of emerging market countries were exclusively denominated in U.S. dollars or other major currencies. Today, emerging market local debt issues are denominated in local currency as well in major currencies. The development of the local market has been fostered by both the growth of local pension funds and foreign investor interest. Credit Risk Investing in the government bonds of emerging market countries entails considerably more credit risk than investing in the government bonds of major industrialized countries. Standard & Poor’s and Moody’s rate emerging market sovereign debt. Loucks, Penicook, and Schillhorn discuss macroeconomic fundamentals and political analysis along a timeline: factors that have an immediate, intermediate, and long-term impact on credit quality. Macroeconomic fundamentals include serviceability (immediate impact), solvency (intermediate impact), and structural (long-term impact). Serviceability involves factors that reflect the country’s foreign exchange reserve position relative to its debt obligations and liquidity. Two indicators suggested for gauging serviceability are refinancing risk and basic balance. Refinancing risk = Basic balance = Refinancing risk measures the size of the country’s debt that has to be refinanced by borrowing from external sources. The basic balance measures a country’s inflow of foreign currency relative to its GDP. Solvency involves the ability of a government to service its local and external debt. Ratios that can be used to gauge whether a country can access external financial markets so as to be able to refinance its immediate debt obligations are the domestic credit ratio, external debt ratio, external service ratio, and public sector borrowing requirement. These four solvency measures are given below: Domestic credit ratio = External debt ratio = Debt service ratio = Public sector borrowing requirement = If a government is efficiently allocating the country’s credit to productive investment ventures, over time its GDP growth should exceed its credit growth. The lower the domestic credit ratio, then the lower is the solvency risk. Indicators of the size of a country’s debt and debt burden are captured by the external service ratio and external debt ratio. In the public sector borrowing requirement indicator, the first component of the numerator (primary fiscal balance) indicates a country’s current fiscal problems. The second component of the numerator is interest payments which reflect prior fiscal problems. The lower the public sector borrowing requirement, then the lower the solvency risk. Factors that fall into the structural category involve an assessment of the country’s long-run health and provide guidance as to the likely development of economic problems when there are poor structural fundamentals. The key in the analysis of structural factors is forecasting when the market will focus on them and, as a result, increase serviceability and solvency risks. Unlike economic factors, political factors are difficult to quantify. These factors include: elections (immediate impact), systems/institutions (intermediate impact), and geopolitical significance (long-term impact). Systems/institutions involve political leadership, regional integration, and social composition stability. Geopolitics can be defined as the study of the relationship among politics and geography, demography, and economics, especially with respect to the foreign policy of a nation. When an emerging market country faces a major credit crisis, geopolitical significance becomes important. KEY POINTS The global bond market can be classified into two markets: the internal or national bond market, which consists of a domestic bond market and a foreign bond market, and the external or international bond market (or Eurobond market). Although it is often stated that the primary motivation to investing in non-U.S. bonds is that it provides diversification benefits, such benefits may not be significant. Rather, investing in non-U.S. bonds gives a money manager the opportunity to capitalize on factors that affect bond prices in non-U.S. markets and permits a currency play. Non-U.S. issuers of international bonds include sovereign governments, sub-sovereign governments, supranational agencies, financial institutions, and corporations. Currency denomination is the key factor that impacts the price and the yield of a bond is the currency denomination. When a portfolio includes non-dollar denominated issues by non-U.S. entities, bond returns are impacted by movement of interest rates of all the countries where there is currency exposure and foreign exchange movement of all the currencies to which the portfolio has exposure. The return on a portfolio that includes non-dollar denominated bonds consists of three components: (1) income, (2) capital gain/loss in the local currency, and (3) foreign currency gain/loss. Bonds issued by non-U.S. entities include Yankee bonds, Regulation 144a private placements, Eurobonds, Euro medium term notes, global bonds, non-U.S. domestic bonds, and emerging market bonds. Yankee bonds are bonds issued by non-U.S. entities that are registered with the SEC and traded in the United States. Because of the reduced reporting requirements, 144a bond issuance has become an important market for non-U.S. borrowers to raise funds. The Eurobond market is divided into sectors based on the currency in which the issue is denominated. Many innovative bond structures have been introduced in the Eurobond market. Euro medium-term notes are debt obligations that are intended primarily for offerings outside of the United States. A global bond is one that is issued simultaneously in several bond markets throughout the world and can be issued in any currency. Domestic bond markets throughout the world offer U.S. investors the opportunity to buy bonds of non-U.S. entities. The largest sector of domestic bond markets throughout the world is the government sector. Sovereign debt is the obligation of a country’s central government. Ratings are assigned separately for local currency denominated debt and foreign currency denominated debt. The two general categories analyzed by rating companies in assigning ratings are economic risk and political risk. Covered bonds are issued primarily in Europe by banks using predominately residential and mortgage loans as collateral. While covered bonds are often compared to mortgage and asset-backed securities, there are differences in their credit protection and structure. Governments of emerging market countries have issued Brady bonds, Eurobonds, global bonds, or domestic bonds. The outstanding amount of Brady bonds is small. Instead, emerging market countries issue the other types of bonds. Macroeconomic factors considered in the analysis of emerging market government bonds include serviceability, solvency, and structural. Unlike economic factors, political factors are difficult to quantify. These factors include elections, systems/institutions, and geopolitical significance. ANSWERS TO QUESTIONS FOR CHAPTER 9 (Questions are in bold print followed by answers.) 1. Describe the trading blocs that are used in classifying the world’s bonds markets. The trading blocs used by practitioners to classify the world’s bond market in terms of trading bloc include the four classifications. They are: (i) the dollar bloc, (ii) the European bloc, (iii) the Japan bloc, and (iv) the emerging markets bloc. The trading bloc construct is useful because each bloc has a benchmark market that greatly influences price movements in the other markets. Investors are often focused more on the spread level of, say, Denmark to Germany, than the absolute level of yields in Denmark. More details on are given below. The dollar bloc includes the United States, Canada, Australia, and New Zealand. The European bloc is subdivided into two groups: (i) the euro zone market bloc, which has a common currency (Germany, France, Holland, Belgium, Luxembourg, Austria, Italy, Spain, Finland, Portugal, and Greece), the euro, and (ii) the non-euro zone market bloc (Norway, Denmark, and Sweden). The United Kingdom often trades more on its own, influenced by the euro zone and the United States, as well as its own economic fundamentals. The emerging markets bloc includes Latin America, Asia (with the exception of Japan), and Eastern Europe. 2. What risk is faced by a U.S. life insurance company that buys British government bonds? From the perspective of a U.S. life insurance company investing in British government bonds, the cash flows of assets denominated in a foreign currency expose the investor to uncertainty as to the cash flow in U.S. dollars. The actual U.S. dollars that the investor gets depend on the exchange rate between the U.S. dollar and the foreign currency at the time the nondollar cash flow is received and exchanged for U.S. dollars. For a U.S. life insurance company buying British government bonds, if the British pound depreciates (declines in value) relative to the U.S. dollar, the dollar value of the cash flows will be proportionately less. This risk is referred to as foreign exchange risk. This risk can be hedged with foreign exchange spot, forwards, futures, or options instruments (although there is a cost of hedging). In distributing British government bonds, the Bank of England uses the ad hoc auction system. Under this system, a government announces an auction when prevailing market conditions appear favorable. From the issuing government’s perspective, an ad hoc auction involves less market volatility than a regular calendar auction where yields tend to rise as the announced auction date approaches and then fall afterward. Thus, from the viewpoint of a U.S. life insurance company buying British government bonds, an ad hoc auction would not face rising yields. This would be considered disadvantageous since the U.S. life insurance company could not lock in the rising yield. Second, the U.S. company would only be able to invest in British government bonds on a regular basis. This might also be considered a disadvantage. 3. “The strongest argument for investing in nondollar bonds is that there are diversification benefits.” Explain why you agree or disagree with this statement. There are mixed empirical findings for agreeing with the statement that diversification is the strongest argument for investing in nondollar bonds. The details are supplied below. Several reasons have been offered for why U.S. investors should allocate a portion of their fixed income portfolio to nondollar bonds. First, there is a theoretical argument which states that diversifying bond investments across countries—particularly with the currency hedged—reduces risk. This is generally demonstrated using modern portfolio theory by showing that investors can realize a higher expected return for a given level of risk (as measured by the standard deviation of return) by adding nondollar bonds in a portfolio containing U.S. bonds. Second, researchers have offered evidence that diversification in nondollar bonds can lead to an optimal choice. However, this evidence comes from earlier studies in the 1980s and early 1990s. Recent research suggests that the reduction in risk may not be that great to offset lower portfolio returns. There is another reason for investing in nondollar bonds that competes with diversification. For example, a study by Litterman (1992) suggests that while the diversification benefits may not be that great, a powerful reason for a U.S. investor to invest in nondollar bonds is “the increased opportunities to find value that multiple markets provide.” However, it is hard to quantify such a benefit because it depends on the investor’s talents. That is, nondollar bond investments—with the currency hedged—permits investment strategies based on interest rate changes in various countries. This provides additional dimensions to the actual investment decision or a broader range of investment choices. A final reason given for nondollar bond investing is that the decision not to hedge the currency component can then be regarded as an active currency play. 4. What arguments are offered for investing in nondollar bonds? There are three reasons given for investing in nondollar bonds. These are described below. A first reason for investing in nondollar bonds concerns the notion that diversification maximizes return for a given level of risk. Modern portfolio theory states that the most efficient portfolio, the market or world portfolio, contains all assets and is perfectly diversified. This portfolio is risky but generates the highest possible return for its risk level. If investors want to achieve higher returns they must invest in this portfolio. If their preference is to receive higher returns then they must allocate a portion of their total investments to purchasing this risky world portfolio, which includes nondollar bonds. A second reason (offered for a U.S. investor to invest in nondollar bonds) is the increased opportunities to find value that multiple markets provide. The argument is that nondollar bond investments—with the currency hedged—permits investment strategies based on interest rate changes in various countries. This provides additional dimensions to the actual investment decision or a broader range of investment choices. A third reason (given for nondollar bond investing) is to make what is referred to as an “active play.” This involves investing in nondollar bonds but also making a decision not to hedge the currency component. 5. What is the difference between LIBID and LIMEAN? LIBID refers to the bid on LIBOR while LIMEAN is the arithmetic average of LIBOR and LIBID. More details are given below. LIBOR stands for London interbank offer rate. LIBOR is an important rate in international finance. For example, consider the wide variety of floating-rate Eurobond notes. The coupon rate on a floating-rate note is some stated margin over the London interbank offered rate (LIBOR), the bid on LIBOR (referred to as LIBID), or the arithmetic average of LIBOR and LIBID (referred to as LIMEAN). The size of the spread reflects the perceived credit risk of the issuer, margins available in the syndicated loan market, and the liquidity of the issue. Typical reset periods for the coupon rate are either every six months or every quarter, with the rate tied to six-month or three-month LIBOR, respectively; that is, the length of the reset period and the maturity of the index used to establish the rate for the period are matched. 6. What is the foreign bond market of a country? The foreign bond market of a country is where bonds of issuers not domiciled in the country are issued and traded. For example, in the United States the foreign bond market is the market where bonds are issued by non-U.S. entities and then subsequently traded. Bonds traded in the U.S. foreign bond market are nicknamed Yankee bonds. In Japan, a yen-denominated bond issued by a British corporation and subsequently traded in Japan’s bond market is part of the Japanese foreign bond market. Yen-denominated bonds issued by non-Japanese entities are nicknamed Samurai bonds. Foreign bonds in the United Kingdom are referred to as bulldog bonds, in the Netherlands as Rembrandt bonds, and in Spain as matador bonds. 7. What is the debate regarding covenants in corporate bonds in the Eurobond market? In the Eurobond market, there is a debate regarding the relatively weak protection afforded by covenants. The chief reason for this is that investors in corporate Eurobonds are geographically diverse. As a result, it makes it difficult for potential bond investors to agree on what form of covenants offer true protection. For investment-grade corporate issues in the Eurobond market, documentation is somewhat standardized. Key terms and conditions in Eurobond documentation are: governing law, security, negative pledges, subordination, cross-default clauses, and prohibition on the sale of material assets. These items are described below. Governing law: UK law governs most transactions, although New York state law is an occasional alternative. Security: As a rule, issues are not secured by the company’s assets. Negative pledges: Negative pledges are common. They prohibit an issuer from creating security interests on its assets, unless all bondholders receive the same level of security. Subordination: Except for bank or insurance capital issues, most bonds are sold on a senior basis. Cross-default clauses: Cross-default clauses state that if an issuer defaults on other borrowings, then the bonds will become due and payable. Prohibition on the sale of material assets: In order to protect bondholders, most documentation prohibits the sale or transfer of material assets or subsidiaries. 8. Explain the step-up and step-down structure used in the Eurobond market. The coupon rate of certain securities can either increase or “step up” over time or decrease or “step down” over time. The coupon rate change occurs for either the passage of time or a change in the reference interest rate might. A unique structure in the Eurobond market, particularly for large issues of telecom bonds, has been coupon step-up and step-down provisions where the change in the coupon is triggered by a change in the issuer’s credit rating. A rating upgrade would result in a lower coupon rate while a rating downgrade would result in a higher coupon rate. 9. Suppose that the yield to maturity on a Eurodollar bond is 7.8%. What is the bond-equivalent yield? Because Eurodollar bonds pay annually rather than semiannually, an adjustment is required to make a direct comparison between the yield to maturity on a U.S. fixed rate bond and that on a Eurodollar fixed-rate bond. Given the yield to maturity on a Eurodollar fixed-rate bond, its bond-equivalent yield is computed as follows: bond-equivalent yield of Eurodollar bond = 2[(1 + yield to maturity on Eurodollar bond)1/2 – 1]. If the yield to maturity on a Eurodollar bond is 7.8%, then the bond-equivalent yield is: 2[(1.078)1/2 – 1] = 0.0765355 or about 7.6534%. Notice that the bond-equivalent yield will always be less than the Eurodollar bond’s yield to maturity. To convert the bond-equivalent yield of a U.S. bond issue to an annual-pay basis so that it can be compared to the yield to maturity of a Eurodollar bond, the following formula can be used: The yield to maturity on an annual-pay basis would be: [1 + (yield to maturity on bond-equivalent basis / 2)]2 – 1. For example, suppose that the yield to maturity of a U.S. bond issue quoted on a bond equivalent yield basis is 7.65355%. The yield to maturity on an annual-pay basis would be: [1 + (0.0765355 / 2] 2 – 1 = [1.0382678] 2 – 1 = 0.0780 = 7.80%. The yield to maturity on an annual basis is always greater than the yield to maturity on a bond-equivalent basis. 10. This excerpt, which discusses dual currency bonds, is taken from the International Capital Market, published in 1989 by the European Investment Bank: “The generic name of dual-currency bonds hides many different variations which are difficult to characterize in detail. These variations on the same basic concept have given birth to specific names like Index Currency Option Notes (ICON), foreign interest payment bonds (FIPS), forex-linked bonds, heaven and hell bonds, to name but a few. Despite this diversity it is, however, possible to attempt a broad-brush classification of the various types of dual-currency bonds. The first category covers bond issues denominated in one currency but for which coupon and repayment of the principal are made in another designated currency at an exchange rate fixed at the time of issue. A second category comprises dual-currency bonds in which coupon payments and redemption proceeds are made in a currency different from the currency of denomination at the spot exchange rate that will prevail at the time of payment. Within this category, one finds the forex-linked bonds, foreign currency bonds and heaven and hell bonds. A final category includes bonds which offer to issuers or the holder the choice of the currency in which payments and/or redemptions are to be made at the future spot exchange rate. ICONs fall into this latter category because there is an implicit option due to the exchange rate revision formula. Usually, these bonds are referred to as option currency bonds. Irrespective of the above-mentioned categories, all dual-currency bonds expose the issuers and the holders to some form of foreign exchange risk. . . . Pricing dual-currency bonds is therefore an application of option pricing, as the bonds can be looked at as a combination of a straight bond and a currency option. The value of the straight bond component is obtained according to traditional fixed-rate bond valuation models. The pricing of the option component is, ex post, equal to the difference between the dual currency bond price and its straight bond component …” (a) Why do all currency bonds “expose the issuers and the holders to some form of foreign exchange risk” regardless of the category of bond? Foreign exchange risk refers to the risk associated with receiving cash flows in another country’s currency. From the perspective of the holder of a currency bond (the investor), the cash flows denominated in a foreign currency expose the investor to uncertainty as to the cash flow to be received in their country’s currency. This is because the cash flow they actually receive depends on the exchange rate between their country’s currency and the foreign currency received. If the foreign currency depreciates (declines in value) relative to their country’s currency, then they will receive proportionately less. From the issuer’s view, they are at risk since expected depreciation may make their bonds less marketable driving down the price. Dual-currency issues are issues that pay coupon interest in one currency but pay the principal in a different currency. This can expose both the issuer and the holders to foreign exchange risk if both the cash flows paid (by the issuer) and the cash flows received (by the holder) are not known in advance. The exact exposure can depend on the type of dual-currency bond. For a first type of dual-currency bond, the exchange rate that is used to convert the principal and coupon payments into a specific currency is specified at the time the bond is issued. A second type differs from the first in that the applicable exchange rate is the rate that prevails at the time a cash flow is made (i.e., at the spot exchange rate at the time a payment is made). A third type is one that offers to either the investor or the issuer the choice of currency. These bonds are commonly referred to as option currency bonds. (b) Do you agree that the pricing of all dual-currency bonds is an application of option pricing? An option gives the holder the right to future claims conditioned upon contingent outcomes. To be an application of option pricing, an option must be present or embedded in the asset (in this case a dual-currency bond). As discussed in part (a), there are three types of dual-currency bonds. Only the third type is referred to with the description option (implying that a choice can be made that will give the holder the best outcome based upon what contingent outcomes actually unfold). For the first type of dual-currency bond, the exchange rate that is used to convert the principal and coupon payments into a specific currency is specified at the time the bond is issued. Thus, the future claim is already stated and is not contingent upon some other condition occurring. Similarly, the second type does not appear to have any future claim contingent upon some condition occurring. (c) Why should the price of the option component be “equal to the difference between the dual currency bond price and its bond component”? In a perfect capital market environment (with no transaction costs and other frictions), the value of an asset with an embedded option should be equal to the value of the asset without the option plus the value of the option. This is because investors should be indifferent as to how the two investments are packaged. They should pay equally for either (i) the bond with the embedded option packaged together or (ii) the bond and option packaged separately. 11. Answer the below questions. (a) Why do rating agencies assign a different rating to the debt of a sovereign entity based on whether the debt is denominated in a local currency or a foreign currency? The reason for distinguishing between local debt ratings and foreign currency debt ratings is that historically, the default frequency differs by the currency denomination of the debt. Specifically, defaults have been greater on foreign currency-denominated debt. For example, an S&P survey of 113 countries found that since 1970 there were eight defaults by sovereigns on their local currency debt but 69 on foreign currency debt. The reason for the difference in default rates for local currency debt and foreign currency debt is that if a government is willing to raise taxes and control its domestic financial system, it can generate sufficient local currency to meet its local currency debt obligation. This is not the case with foreign currency-denominated debt. A national government must purchase foreign currency to meet a debt obligation in that foreign currency and therefore has less control with respect to its exchange rate. Thus a significant depreciation of the local currency relative to a foreign currency in which a debt obligation is denominated will impair a national government’s ability to satisfy such obligation. (b) What are the two general categories of risk analyzed by rating agencies in assigning a sovereign rating? Sovereign debt is the obligation of a country’s central government. The debt of national governments is rated by the rating agencies. There are two sovereign debt ratings assigned by rating agencies: a local currency debt rating and a foreign currency debt rating. Standard & Poor’s, Moody’s, and Fitch all assign ratings to sovereign bonds. The two general categories are economic risk and political risk. The economic risk category involves an assessment of the ability of a government to satisfy its obligations. Both quantitative and qualitative analyses are used in assessing economic risk. The political risk category involves an assessment of the willingness of a government to satisfy its obligations. A government may have the ability to pay but may be unwilling to pay. Political risk is assessed based on qualitative analysis of the economic and political factors that influence a government’s economic policies. 12. What are the different methods for the issuance of government securities? There are four methods that have been used in distributing new securities of central governments: the regular calendar auction/Dutch style system, the regular calendar auction/minimum-price offering, the ad hoc auction system, and the tap system. In the regular calendar auction/Dutch style auction system, there is a regular calendar auction and winning bidders are allocated securities at the yield (price) they bid. This is a multiple-price auction and the U.S. Department of the Treasury currently uses this method when issuing all U.S. Treasury securities except the two-year and five-year notes. In the regular calendar auction/minimum-price offering system, there is a regular calendar of offering. The price (yield) at which winning bidders are awarded the securities is different from the Dutch style auction. Rather than awarding a winning bidder at the yield (price) they bid, all winning bidders are awarded securities at the highest yield accepted by the government (i.e., the stop-out yield). This auction method is a single-price auction. In the ad hoc auction system, governments announce auctions when prevailing market conditions appear favorable. It is only at the time of the auction that the amount to be auctioned and the maturity of the security to be offered are announced. In a tap system, additional bonds of a previously outstanding bond issue are auctioned. The government announces periodically that it is adding this new supply. 13. Answer the below questions. (a) What are covered bonds? One of the largest sectors of the European market is the covered bonds market. Covered bonds are issued by banks. The collateral for covered bonds can be either (1) residential mortgage loans, (2) commercial mortgage loans, or (3) public sector loans. They are referred to as “covered bonds” because the pool of loans that is the collateral is referred to as the “cover pool.” The cover pool is not static over the life of a covered bond. That is, the composition of the cover pool changes over time. (b) How do covered bonds differ from residential mortgage-backed securities, commercial mortgage-backed securities, and asset-backed securities. Covered bonds work as follows. Investors in covered bonds have two claims. The first is a claim on the cover pool. At issuance, there is no legal separation of the cover pool from the assets of the issuing bank. However, if subsequently the issuing bank becomes insolvent, then at that time, the assets included in the cover pool are separated from the issuing bank’s other assets for the benefit of the investors in the covered bonds. The second claim is against the issuing bank. Because the covered pool includes high-quality mortgage loans and is issued by strong banks, covered bonds are viewed as highly secure bonds, typically receiving a triple A or double A credit rating. Covered bonds can be issued in any currency. Covered bonds in many countries are created using the securitization process. For that reason, covered bonds are often compared to residential mortgage-backed securities (RMBS), commercial mortgage-backed securities (CMBS), and other asset-backed securities (ABS). The difference between these securities created from a securitization is fourfold. First, at issuance, the bank that originated the loans will sell a pool of loans to a special purpose vehicle (SPV). By doing so, the bank has removed the pool of loans from its balance sheet. The SPV is the issuer of the securities. In contrast, with covered bonds, the issuing bank holds the pool of loans on its balance sheet. It is only if the issuing bank becomes insolvent that the assets are segregated for the benefit of the investors in the covered bonds. The second difference is that investors in RMBS/CMBS/ABS do not have recourse to the bank that sold the pool of loans to the SPV. In contrast, covered bond investors have recourse to the issuing bank. The third difference is that for RMBS/CMBS/ABS backed by residential and commercial mortgage loans, the group of loans, once assembled, does not change, whereas covered bonds are not static. Finally, covered bonds typically have a single maturity date (i.e., they are bullet bonds), whereas RMBS/CMBS/ABS typically have time tranched bond classes. (c) What is the Pfandbriefe market? The German mortgage-bond market, called the Pfandbriefe market, is the largest covered bonds market. In fact, it is about one-third of the German bond market and the largest asset in the European bond market. The bonds in this market, Pfandbriefe, are issued by German mortgage banks. There are two types of Pfandbriefe that differ based on the borrowing entity for the loan. Public Pfandbriefe are bonds fully collateralized by loans to public-sector entities. When the bonds are fully collateralized by residential and commercial mortgages, they are called Mortgage Pfandbriefe. The Pfandbriefe market is further divided into Traditional Pfandbriefe and Jumbo Pfandbriefe. The former represents the market for issues of smaller size. Historically, it has been an illiquid and fragmented market and, as a result, has not attracted much interest from non-German investors. 14. In the analysis of emerging market sovereign bonds, what is meant by structural factors? In the analysis of emerging market sovereign bonds, factors structural factors involve an assessment of the country’s long-run health. Although not directly associated with the default of the sovereign entity, poor structural fundamentals provide guidance as to the likely development of economic problems. These factors include dependence on specific commodities to generate earnings from exports, indicators of economic well being such as per capital income, and income distribution measures. Two macroeconomic measures used for gauging structural risks are the five-year average GDP per capital growth and inflation as measured by the average change year-over-year. The key in the analysis of structural factors is forecasting when the market will focus on them and, as a result, increase serviceability and solvency risks. 15. In the analysis of emerging market sovereign bonds, why is geopolitical significance important? Traditionally, the term has applied primarily to the impact of geography on politics, but its usage has evolved over the past century to encompass wider connotations. The Free Dictionary defines geopolitics as “The study of the relationship among politics and geography, demography, and economics, especially with respect to the foreign policy of a nation.” When an emerging market country faces a major credit crisis, geopolitical significance becomes important. When a credit crisis occurs in an emerging market country that is perceived to have major global repercussions, industrialized countries and supranational agencies have stepped in to commit significant resources to prevent an economic collapse and political instability for that country. Therefore, geopolitical significance is an important political factor to consider. 16. What can one consider alleged corruption in a presidential election in an emerging market country or the change in finance minister in an emerging market country headline risk? (Headline risk was described in a prior chapter.) Headline risk refers to the possibility that a news story will adversely affect a stock’s price. This type of risk can also impact the performance of the stock market as a whole. With respect to elections in an emerging market country, corruption factors to consider include the fairness of elections and the political opposition programs. An example of the immediate impact of these factors is provided by Loucks, Penicook, and Schillhorn. In the May 2000 presidential election in Peru, the incumbent, Alberto Fujimori, won the election. However, there were allegations of fraud. During the election period, the spread on Peruvian bonds increased by 200 basis points compared to the spread on a popular emerging bond market index. In early September 2000, it was found that Fujimori’s top security advisor had paid opposition members in congress to switch sides. Shortly thereafter, Fujimori called for new presidential and parliamentary elections and renounced his power. After a series of other scandals associated with the top security advisory, in June 2001 presidential runoffs were held, with one of the candidates being Alan Garcia, former president of Peru. During his administration, he pushed Peru into a debt crisis in 1987. Because of the uncertainty associated with his possible election to president, the spread on Peruvian bonds once again increased by 200 basis points relative to the same emerging bond market index. 17. On January 9, Reuters announced a US$2.6 billion bond offering by the Australia and New Zealand Banking Group. The following is reproduced from the announcement: Issue: US$2.6 bln 144a reg S 2, 3-year The offer comprised US$1.9 bln 3-year at 100bp/swap and US$700 mln 2-yr at 70bp/Libor. Participants: (Before the offer was increased) 45 investors. For the 3-year tranche, 65% from North America, 10% from Europe, 20% Asia, 10% others. For the 2-year tranche: 40% from North America, 20% from Europe, 40% from Asia. Describe this bond offering. According to the Reuters announcement, an Australian and New Zealand Banking group is offering in US dollars, $2.6 billion in bonds. It is being offered under Rule 144A that provides a safe harbor from the registration requirements of the Securities Act of 1933 for certain private resale of restricted securities to qualified institutional buyers. It can be noted that Rule 144A has become the principal safe harbor on which non-U.S. companies rely when accessing the U.S. capital markets. It can be further noted that Regulation S is a “safe harbor” that defines when an offering of securities is deemed to be executed in another country and therefore not be subject to the registration requirement under section 5 of the 1933 Act. The regulation includes two safe harbor provisions: an issuer safe harbor and a resale safe harbor. In each case, the regulation demands that offers and sales of the securities be made outside the United States and that no offering participant (which includes the issuer, the banks assisting with the offer and their respective affiliates) engage in “directed selling efforts”. In the case of issuers for whose securities there is substantial U.S. market interest, the regulation also requires that no offers and sales be made to U.S. persons (including U.S. persons physically located outside the United States). According to the Reuters announcement, the offer involves $1.9 billion in 3-year bonds with a 100 basis point swap and $0.6 billion in 2-year bonds at 70 basis points above LIBOR. A basis swap is a swap in which two streams of money market floating rates of two different currencies are exchanged. To further illustrate, a company lends money to individuals at a variable rate that is tied to the London Interbank Offer (LIBOR) rate but they borrow money based on the Treasury bill rate. This difference between the borrowing and lending rates (the spread) leads to interest-rate risk. By entering into a basis rate swap, where they exchange the T-bill rate for the LIBOR rate, they eliminate this interest-rate risk. According to the Reuters announcement, there were initially 45 investors involves in the offer (later the number of investors increased). The offering consists of two tranches. All the tranches together make up what is referred to as the deal’s capital structure or liability structure. According to the information in the Reuters announcement, 65% of the 3-year tranche was placed with investors in North America, 10% with investors in Europe, 20% with investors in Asia and 10% with investors in other countries. Forty percent of the 2-year tranche was placed with investors in North America, 20% in Europe, and 40% in Asia. 18. On January 9, Reuters announced a US$3.075 billion bond offering by the Commonwealth Bank of Australia. The following is reproduced from the announcement: Issue: US$3.075 bln of 144a reg S bonds priced on Jan. 9. The offer included US$2.5 bln 3-yr bonds at 78bp/swap and US$575 mln 5-yr bonds at 85bp/swap. Participants: Nearly 100 investors in Asia, the U.S. and Europe. Buyers mostly included asset managers and banks. Describe this bond offering. According to the Reuters announcement, the Commonwealth bank of Australia is offering (in US dollars) $3.075 billion in bonds. It is being offered under Rule 144A that provides a safe harbor from the registration requirements of the Securities Act of 1933 for certain private resale of restricted securities to qualified institutional buyers. It can be further noted that it is offered under Regulation S, which defines when an offering of securities is deemed to be executed in another country and therefore not be subject to the U.S.A. registration requirement under section 5 of the 1933 Act. According to the Reuters announcement, the offer involves $2.5 billion in 3-year bonds with a 78 basis point swap and $0.585 billion in 5-year bonds with an 85 basis point swap. According to the Reuters announcement, there were initially 100 investors in Asia, the U.S. and Europe with buyers most including asset managers and banks. CHAPTER 10 RESIDENTIAL MORTGAGE LOANS CHAPTER SUMMARY Although the American dream may be to own a home, the major portion of the funds to purchase one must be borrowed. The market where these funds are borrowed is called the mortgage market. A mortgage is a pledge of property to secure payment of a debt. Typically, property refers to real estate. If the property owner (the mortgagor) fails to pay the lender (the mortgagee), the lender has the right to foreclose the loan and seize the property in order to ensure that it is repaid. The types of real estate properties that can be mortgaged are divided into two broad categories: single-family (one- to four-family) residential and commercial properties. This chapter describes residential mortgage loans, and the three chapters to follow describe securities created by using residential mortgage loans as collateral. In Chapter 14, we cover commercial loans and securities backed by commercial loans. ORIGINATION OF RESIDENTIAL MORTGAGE LOANS The original lender is called the mortgage originator. The principal originators of residential mortgage loans are thrifts, commercial banks, and mortgage bankers. Mortgage originators may service the mortgages they originate, for which they obtain a servicing fee. When a mortgage originator intends to sell the mortgage, it will obtain a commitment from the potential investor (buyer). Two government-sponsored enterprises (GSEs) and several private companies buy mortgages. Because these entities pool these mortgages and sell them to investors, they are called conduits. When a mortgage is used as collateral for the issuance of a security, the mortgage is said to be securitized. Underwriting Standards Originators may generate income for themselves in one or more ways. First, they typically charge an origination fee. The second source of revenue is the profit that might be generated from selling a mortgage at a higher price than it originally cost. This profit is called secondary marketing profit. Third, the mortgage originator may hold the mortgage in its investment portfolio. Mortgage originators can either (i) hold the mortgage in their portfolio, (ii) sell the mortgage to an investor who wishes to hold the mortgage or who will place the mortgage in a pool of mortgages to be used as collateral for the issuance of a security, or (iii) use the mortgage themselves as collateral for the issuance of a security. When a mortgage is used as collateral for the issuance of a security, the mortgage is said to be securitized. A conforming mortgage is one that meets the underwriting standards established by these agencies for being in a pool of mortgages underlying a security that they guarantee. If an applicant does not satisfy the underwriting standards, the mortgage is called a nonconforming mortgage. Mortgages acquired by the agency may be held as investments in their portfolio or securitized. Payment-to-Income Ratio The payment-to-income ratio (PTI) is the ratio of monthly payments to monthly income, which measures the ability of the applicant to make monthly payments (both mortgage and real estate tax payments). The lower the PTI, the greater the likelihood that the applicant will be able to meet the required monthly mortgage payments. Loan-to-Value Ratio The loan-to-value ratio (LTV) is the ratio of the amount of the loan to the market (or appraised) value of the property. The lower this ratio is, the greater the protection for the lender if the applicant defaults on the payments and the lender must repossess and sell the property. The LTV has been found in numerous studies to be the single most important determinant of the likelihood of default. The rationale is straightforward: Homeowners with large amounts of equity in their properties are unlikely to default. Data on the behavior of borrowers indicate that they have an increased propensity to voluntarily stop making their mortgage payments once the current LTV exceeds 125%, even if they can afford making monthly payments. This behavior is referred to as a “strategic default.” TYPES OF RESIDENTIAL MORTGAGE LOANS There are different types of residential mortgage loans. They can be classified according to the following attributes: lien status; credit classification; interest rate type; amortization type; credit guarantees; loan balances; and, prepayments and prepayment penalties. Lien Status The lien status of a mortgage loan indicates the loan’s seniority in the event of the forced liquidation of the property due to default by the obligor. Credit Classification A loan that is originated where the borrower is viewed to have a high credit quality is classified as a prime loan. A loan that is originated where the borrower is of lower credit quality or where the loan is not a first lien on the property is classified as a subprime loan. While the credit scores have different underlying methodologies, the scores generically are referred to as “FICO scores.” FICO scores range from 350 to 850. The higher the FICO score is, the lower the credit risk. The LTV has proven to be a good predictor of default: a higher LTV implies a greater likelihood of default. When the loan amount requested exceeds the original loan amount, the transaction is referred to as a cash-out-refinancing. If instead, there is financing where the loan balance remains unchanged, the transaction is said to be a rate-and-term refinancing or no-cash refinancing. The front ratio is computed by dividing the total monthly payments (which include interest and principal on the loan plus property taxes and homeowner insurance) by the applicant’s pre-tax monthly income. The back ratio is computed in a similar manner. The modification is that it adds other debt payments such as auto loan and credit card payments to the total payments. The credit score is the primary attribute used to characterize loans as either prime or subprime. Prime (or A-grade) loans generally have FICO scores of 660 or higher, front and back ratios with the above-noted maximum of 28% and 36%, and LTVs less than 95%. Interest Rate Type The interest rate that the borrower agrees to pay, referred to as the note rate, can be fixed or change over the life of the loan. For a fixed-rate mortgage (FRM), the interest rate is set at the closing of the loan and remains unchanged over the life of the loan. For an adjustable-rate mortgage (ARM), as the name implies, the note rate changes over the life of the loan. The note rate is based on both the movement of an underlying rate, called the index or reference rate, and a spread over the index called the margin. Two categories of reference rates have been used in ARMs: (1) market-determined rates and (2) calculated rates based on the cost of funds for thrifts. The basic ARM is one that resets periodically and has no other terms that affect the monthly mortgage payment. Typically, the mortgage rate is affected by other terms. These include (1) periodic rate caps, and (2) lifetime rate caps and floors. Amortization Type The amount of the monthly loan payment that represents the repayment of the principal borrowed is called the amortization. Traditionally, both FRMs and ARMs are fully amortizing loans. Fully amortizing fixed-rate loans have a payment that is constant over the life of the loan. For example, suppose a loan has an original balance of $200,000, a note rate of 7.5%, and a term of 30 years. Then the monthly mortgage payment would be $1,398.43. The formula for calculating the monthly mortgage payment is MP = MB0 . where MP = monthly mortgage payment ($), MB0 = original mortgage balance ($), i = note rate divided by 12 (in decimal), and n = number of months of the mortgage loan. To calculate the remaining mortgage balance at the end of any month, the following formula is used: MBt = MB0 . where MBt = mortgage balance after t months. To calculate the portion of the monthly mortgage payment that is the scheduled principal payment for a month, the following formula is used: SPt = MB0 . where SPt = scheduled principal repayment for month t. For an ARM, the monthly mortgage payment adjusts periodically. Thus, the monthly mortgage payments must be recalculated at each reset date. This process of resetting the mortgage loan payment is referred to as recasting the loan. During 2001−2007, several types of nontraditional amortization schemes have become popular in the mortgage market. The most popular was the interest-only product (or IO product). With this type of loan, only interest is paid for a predetermined period of time called the lockout period. Credit Guarantees Mortgage loans can be classified based on whether a credit guarantee associated with the loan is provided by the federal government, a government-sponsored enterprise, or a private entity. Loans that are backed by agencies of the federal government are referred to under the generic term of government loans and are guaranteed by the full faith and credit of the U.S. government. The Department of Housing and Urban Development (HUD) oversees two agencies that guarantee government loans. The first is the Federal Housing Administration (FHA. The second is the Veterans Administration (VA). In contrast to government loans, there are loans that have no explicit guarantee from the federal government. Such loans are said to be obtained from “conventional financing” and therefore are referred to in the market as conventional loans. A conventional loan can be insured by a private mortgage insurer. Loan Balances For government loans and the loans guaranteed by Freddie Mac and Fannie Mae, there are limits on the loan balance. The loan limits, referred to as conforming limits, for Freddie Mac and Fannie Mae are identical because they are specified by the same statute. Loans larger than the conforming limit for a given property type are referred to as jumbo loans. Prepayments and Prepayment Penalties Homeowners often repay all or part of their mortgage balance prior to the scheduled maturity date. The amount of the payment made in excess of the monthly mortgage payment is called a prepayment. This type of prepayment in which the entire mortgage balance is not paid off is called a partial payment or curtailment. When a curtailment is made, the loan is not recast. Instead, the borrower continues to make the same monthly mortgage payment. The more common type of prepayment is one where the entire mortgage balance is paid off. All mortgage loans have a “due on sale” clause, which means that the remaining balance of the loan must be paid when the house is sold. Effectively, the borrower’s right to prepay a loan in whole or in part without a penalty is a called an option. A mortgage design that mitigates the borrower’s right to prepay is the prepayment penalty mortgage. CONFORMING LOANS Freddie Mac and Fannie Mae are government-sponsored enterprises (GSEs) whose mission is to provide liquidity and support to the mortgage market. While Fannie Mae and Freddie Mac can buy or sell any type of residential mortgage, the mortgages that are packaged into securities are restricted to government loans and those that satisfy their underwriting guidelines. The conventional loans that qualify are referred to as conforming loans. A conforming loan is simply a conventional loan that meets the underwriting standard of Fannie Mae and Freddie Mac. Thus, conventional loans in the market are referred to as conforming conventional loans and nonconforming conventional loans. Qualifying for a conforming loan is important for both the borrower and the mortgage originator. This is because the two GSEs are the largest buyers of mortgages in the United States. Hence, loans that qualify as conforming loans have a greater probability of being purchased by Fannie Mae and Freddie Mac to be packaged into an MBS. As a result, they have lower interest rates than nonconforming conventional loans. RISKS ASSOCIATED WITH INVESTING IN MORTGAGE LOANS The principal investors in mortgage loans include thrifts and commercial banks. Pension funds and life insurance companies also invest in these loans, but their ownership is small compared to that of the banks and thrifts. Investors face four main risks by investing in residential mortgage loans: (1) credit risk, (2) liquidity risk, (3) price risk, and (4) prepayment risk. Credit Risk Credit risk is the risk that the homeowner/borrower will default. For FHA- and VA-insured mortgages, this risk is minimal. The LTV ratio provides a useful measure of the risk of loss of principal in case of default. At one time, investors considered the LTV only at the time of origination (called the original LTV) in their analysis of credit risk. For periods in which there are declines in housing prices, the current LTV becomes the focus of attention. Liquidity Risk Although there is a secondary market for mortgage loans, the fact is that bid-ask spreads are large compared to other debt instruments. That is, mortgage loans tend to be rather illiquid because they are large and indivisible. The degree of liquidity determines the liquidity risk. Price Risk The price of a fixed-income instrument will move in an opposite direction from market interest rates. Thus, a rise in interest rates will decrease the price of a mortgage loan. Prepayments and Cash Flow Uncertainty The three components of the cash flow are: interest; principal repayment (scheduled principal repayment or amortization); and, prepayment. Prepayment risk is the risk associated with a mortgage’s cash flow due to prepayments. More specifically, investors are concerned that borrowers will pay off a mortgage when prevailing mortgage rates fall below the loan’s note rate. KEY POINTS A mortgage is a pledge of property to secure payment of a debt with the property typically being a form of real estate. The two general types of real estate properties that can be mortgaged are single-family (one- to four-family) residential and commercial properties. Residential mortgage loans can be classified according to lien status (first and second liens), credit classification (prime and subprime), interest rate type (fixed-rate and adjustable-rate), amortization type (fully amortizing and interest-only), credit guarantees (government loans and conventional loans), loan balances, and prepayments and prepayment penalties. The two GSEs, Fannie Mae and Freddie Mac, can purchase any type of loan; however, the only conventional loans that they can securitize to create a mortgage-backed security are conforming loans, that is, conventional loans that satisfy their underwriting standards. The cash flow of a mortgage loan consists of interest, scheduled principal repayment, and prepayments. The lender faces four main risks by investing in residential mortgage loans: (1) credit risk, (2) liquidity risk, (3) price risk, and (4) prepayment risk. Prepayment risk is the risk associated with a mortgage’s cash flow due to prepayments. ANSWERS TO QUESTIONS FOR CHAPTER 10 (Questions are in bold print followed by answers.) 1. What type of property is security for a residential mortgage loan? Typically, property refers to real estate. If the property owner (the mortgagor) fails to pay the lender (the mortgagee), the lender has the right to foreclose the loan and seize the property in order to ensure that it is repaid. The types of real estate properties that can be mortgaged are divided into two broad categories: single-family (one-to four-family) residential and commercial properties. The latter (residential mortgage loan) category includes houses, condominiums, cooperatives, and apartments. Commercial properties are income-producing properties: multifamily properties (i.e., apartment buildings), office buildings, industrial properties (including warehouses). 2. What are the two primary factors in determining whether or not funds will be lent to an applicant for a residential mortgage loan? A potential homeowner who wants to borrow funds to purchase a home will apply for a loan from a mortgage originator and supply financial information used to perform a credit evaluation. The two primary factors in determining whether the funds will be lent are the payment-to-income (PTI) ratio and the loan-to-value (LTV) ratio. The PTI, the ratio of monthly payments (both mortgage and real estate tax payments) to monthly income, is a measure of the ability of the applicant to make monthly payments. A lower ratio indicates a greater likelihood that the applicant will be able to meet the required payments. The difference between the purchase price of the property and the amount borrowed is the borrower’s down payment. The LTV is the ratio of the amount of the loan to the market (or appraised) value of the property. The lower this ratio, the more protection the lender has if the applicant defaults and the property must be repossessed and sold. 3. Explain why the higher the loan-to-value ratio is, the greater the credit risk is to which the lender is exposed. The loan-to-value ratio (LTV) is the ratio of the amount of the loan to the market (or appraised) value of the property. The higher this ratio is, the less the protection (and the greater the credit risk) for the lender if the applicant defaults on the payments and the lender must repossess and sell the property. Below are more details. If an applicant wants to borrow $225,000 on property with an appraised value of $300,000, the LTV is 75%. Suppose the applicant subsequently defaults on the mortgage. The lender can then repossess the property and sell it to recover the amount owed. But the amount that will be received by the lender depends on the market value of the property. In our example, even if conditions in the housing market are weak, the lender will still be able to recover the proceeds lent if the value of the property declines by $75,000. Suppose, instead, that the applicant wanted to borrow $270,000 for the same property. The LTV would then be 90%. If the lender had to foreclose on the property and then sell it because the applicant defaults, there is less protection for the lender. The LTV has been found in numerous studies to be the single most important determinant of the likelihood of default. The rationale is straightforward: Homeowners with large amounts of equity in their properties are unlikely to default. They will either try to protect this equity by remaining current or, if they fail, sell the house or refinance it to unlock the equity. In any case, the lender is protected by the buyer’s self-interest. On the other hand, if the borrower has little or no equity in the property, the value of the default option is much greater. 4. What is the difference between a cash-out refinancing and a rate-and-term refinancing? When a lender is evaluating an application from a borrower who is refinancing, the loan-to-value ratio (LTV) is dependent upon the requested amount of the new loan and the market value of the property as determined by an appraisal. When the loan amount requested exceeds the original loan amount, the transaction is referred to as a cash-out-refinancing. If instead, there is financing where the loan balance remains unchanged, the transaction is said to be a rate-and-term refinancing or no-cash refinancing. That is, the purpose of refinancing the loan is to either obtain a better note rate or change the term of the loan. 5. What are the front ratio and back ratio, and how do they differ? Lenders calculate income ratios such as the payment-to-income ratio (PTI) to assess the applicant’s ability to pay. These ratios compare the monthly payment that the applicant would have to pay if the loan is granted to the applicant’s monthly income. The most common measures are the front ratio and the back ratio. The front ratio is computed by dividing the total monthly payments (which include interest and principal on the loan plus property taxes and homeowner insurance) by the applicant’s pre-tax monthly income. The back ratio is computed in a similar manner. The modification is that it adds other debt payments such as auto loan and credit card payments to the total payments. In order for a loan to be classified as “prime,” the front and back ratios should be no more than 28% and 36%, respectively. 6. What is the difference between a prime loan and a subprime loan? A loan that is originated where the borrower is viewed to have a high credit quality (i.e., where the borrower has strong employment and credit histories, income sufficient to pay the loan obligation without compromising the borrower’s creditworthiness, and substantial equity in the underlying property) is classified as a prime loan. A loan that is originated where the borrower is of lower credit quality or where the loan is not a first lien on the property is classified as a subprime loan. 7. How are FICO scores used in classifying loans? In assessing the credit quality of a mortgage applicant, lenders look at a FICO score in order to a classify loan. A FICO score refers to how financial institutions rank the credit worthiness of a borrower. FICO scores range from 350 to 850. There is an inverse relation between a FICO score and a firm’s credit risk. Thus, if a firm receives a high FICO score this means it has low credit risk. More details are given below. In assessing the credit quality of a mortgage applicant, lenders look at various measures. The starting point is the applicant’s credit score. There are several firms that collect data on the payment histories of individuals from lending institutions and, using statistical models, evaluate and quantify individual credit worthiness in terms of a credit score. Basically, a credit score is a numerical grade of the credit history of the borrower. The three most popular credit reporting companies that compute credit scores are Experian, Transunion, and Equifax. While the credit scores have different underlying methodologies, the scores generically are referred to as “FICO scores.” Typically, a lender will obtain more than one score in order to minimize the impact of variations in credit scores across providers. FICO scores range from 350 to 850. The higher the FICO score is, the lower the credit risk. The credit score is the primary attribute used to characterize loans as either prime or subprime. Prime (or A-grade) loans generally have FICO scores of 660 or higher, front and back ratios with the above-noted maximum of 28% and 36%, and LTVs less than 95%. Alt-A loans may vary in a number of important ways. While subprime loans typically have FICO scores below 660, the loan programs and grades are highly lender-specific. One lender might consider a loan with a 620 FICO score to be a “B-rated loan,” while another lender would grade the same loan higher or lower, especially if the other attributes of the loan (such as the LTV) are higher or lower than average levels. 8. What is an alternative-A loan? Between the prime and subprime sector is a somewhat nebulous category referred to as an alternative-A loan or, more commonly, alt-A-loan. These loans are considered to be prime loans (the “A” refers to the A grade assigned by underwriting systems), but they have some attributes that either increase their perceived credit riskiness or cause them to be difficult to categorize and evaluate. 9. What is an FHA-insured loan? An FHA-insured loan is a government loan by virtue of being backed by an agency of the federal government. As such it is guaranteed by the U.S. government. More details are given below. Mortgage loans can be classified based on whether a credit guarantee associated with the loan is provided by the federal government, a government-sponsored enterprise, or a private entity. Loans that are backed by agencies of the federal government are referred to under the generic term of government loans and are guaranteed by the full faith and credit of the U.S. government. The Department of Housing and Urban Development (HUD) oversees two agencies that guarantee government loans. The first is the Federal Housing Administration (FHA), a governmental entity created by Congress in 1934 that become part of HUD in 1965. FHA provides loan guarantees for those borrowers who can afford only a low down payment and generally also have relatively low levels of income. 10. What is a conventional loan? In contrast to government loans, there are loans that have no explicit guarantee from the federal government. Such loans are obtained from “conventional financing” and therefore are referred to in the market as conventional loans. Although a conventional loan may not be insured when it is originated, a loan may qualify to be insured when it is included in a pool of mortgage loans that backs a mortgage-backed security (MBS). 11. Answer the below questions. (a) What is meant by conforming limits? For government loans and the loans guaranteed by Freddie Mac and Fannie Mae, there are limits on the loan balance. The maximum loan size for one- to four-family homes changes every year. The change is based on the percentage change in the average home price published by the Federal Housing Finance Board. The loan limits, referred to as conforming limits, for Freddie Mac and Fannie Mae are identical because they are specified by the same statute. It can also be noted that one of the underwriting standards is the loan balance at the time of origination. Conventional loans that meet the underwriting standards of the two government-sponsored enterprises (GSEs) are called conforming limits. But there are other important underwriting standards that must be satisfied such as the type of property, loan type, transaction type, loan-to-value ratio by loan type, loan-to-value ratio by loan type and transaction type, borrower credit history, and documentation. (b) What is a jumbo loan? For government loans and the loans guaranteed by Freddie Mac and Fannie Mae, there are limits on the loan balance. The loan limits, referred to as conforming limits, for Freddie Mac and Fannie Mae are identical because they are specified by the same statute. Loans larger than the conforming limit for a given property type are referred to as jumbo loans. 12. Answer the below questions. (a) When a prepayment is made that is less than the full amount to completely pay off the loan, what happens to future monthly mortgage payments for a fixed-rate mortgage loan? Homeowners often repay all or part of their mortgage balance prior to the scheduled maturity date. The amount of the payment made in excess of the monthly mortgage payment is called a prepayment. This type of prepayment in which the entire mortgage balance is not paid off is called a partial payment or curtailment. When a curtailment is made, the loan is not recast. Instead, the borrower continues to make the same monthly mortgage payment. The effect of the prepayment is that more of the subsequent monthly mortgage payment is applied to the principal. The net effect of the prepayment is that the loan is paid off faster than the scheduled maturity date. That is, the maturity of the loan is “curtailed.” More details are the types prepayments are given below. The more common type of prepayment is one where the entire mortgage balance is paid off. All mortgage loans have a “due on sale” clause, which means that the remaining balance of the loan must be paid when the house is sold. Existing mortgages can also be refinanced by the obligor if the prevailing level of mortgage rates declines or if a more attractive financing vehicle is proposed to them. Effectively, the borrower’s right to prepay a loan in whole or in part without a penalty is a called an option. A mortgage design that mitigates the borrower’s right to prepay is the prepayment penalty mortgage. This mortgage design imposes penalties if borrowers prepay. The penalties are designed to discourage refinancing activity and require a fee to be paid if the loan is prepaid within a certain amount of time after funding. The laws and regulations governing the imposition of prepayment penalties are established at the federal and state levels. Usually, the applicable laws for fixed-rate mortgages are specified at the state level. There are states that do not permit prepayment penalties on fixed-rate mortgages with a first lien. There are states that do permit prepayment penalties but restrict the type of penalty. (b) What is the impact of a prepayment that is less than the amount required to completely pay off a loan? The impact on the borrower is that the principal (or amount required to completely pay off a loan) is reduced by the amount paid off that period that goes beyond the interest due. The impact on the lender can involve risk and is captured by the concept of prepayment risk, which is the risk associated with a mortgage’s cash flow due to prepayments. More specifically, investors are concerned that borrowers will pay off a mortgage when prevailing mortgage rates fall below the loan’s note rate. For example, if the note rate on a mortgage originated five years ago is 8% and the prevailing mortgage rate (i.e., rate at which a new loan can be obtained) is 5.5%, then there is an incentive for the borrower to refinance the loan. The decision to refinance will depend on several factors, but the single most important one is the prevailing mortgage rate compared to the note rate. The disadvantage to the investor is that the proceeds received from the repayment of the loan must be reinvested at a lower interest rate than the note rate. This risk is the same as that faced by an investor in a callable corporate or municipal bond. However, unlike a callable bond, there is no premium that must be paid by the borrower in the case of a residential mortgage loan. Any principal repaid in advance of the scheduled due date is paid at par value. The exception, of course, is if the loan is a prepayment penalty mortgage loan. 13. Consider the following fixed-rate, level-payment mortgage: maturity = 360 months amount borrowed = $100,000 annual mortgage rate = 10% (a) Construct an amortization schedule for the first 10 months. Fully amortizing fixed-rate loans have a payment that is constant over the life of the loan. For our problem, we have a loan with an original balance of $100,000, an annual mortgage rate of 10%, and a term of 360 months. The formula for calculating the monthly mortgage payment is MP = MB0 where MP = monthly mortgage payment ($), MB0 = original mortgage balance ($), i = note rate divided by 12 (in decimal), and n = number of months of the mortgage loan. Inserting in our values, we have: MB0 = $100,000, i = 0.10/12 = 0.083333, n = 12 × 30 = 360 months. Insert these values into our MP equation gives: MP = $100,000 = $100,000 = $877.57 To calculate the remaining mortgage balance at the end of any month, the following formula is used: MBt = MB0 where MBt = mortgage balance after t months. For month 12 (t = 12), we have MB0 = $100,000; i = 0.008333; n = 360. The mortgage balance at the end of month 12 is MB12 = $100,000 = $100,000 = $100,000 = $99,444.12 To calculate the portion of the monthly mortgage payment that is the scheduled principal payment for a month, the following formula is used: SP12 = MB0 where SPt = scheduled principal repayment for month t. For example, suppose that for month 12 (t = 12), we have MB0 = $100,000; i = 0.008333; n = 360, then the scheduled principal repayment for month 12 is 0.008333(1.008333)12–1 = 0.00912986 SPt = $100,000 = $100,000 = $48.47 Following the above procedure for t = 1 through 10, we get the following amortization schedule: Exhibit: Amortization Schedule of a Level Payment Fixed-Rate Mortgage Mortgage loan: $100,000 Mortgage rate: 10.00% Monthly payment: $877.57 Term of loan: 30 years (360 months) Month Beginning Mortgage Balance Monthly Interest Scheduled Principal Repayment Ending Mortgage Balance 1 $100,000.00 $833.33 $44.24 $99,955.76 2 $99,955.76 $832.96 $44.61 $99,911.15 3 $99,911.15 $832.59 $44.98 $99,866.18 4 $99,866.18 $832.22 $45.35 $99,820.82 5 $99,820.82 $831.84 $45.73 $99,775.09 6 $99,775.09 $831.46 $46.11 $99,728.98 7 $99,728.98 $831.07 $46.50 $99,682.48 8 $99,682.48 $830.69 $46.88 $99,635.60 9 $99,635.60 $830.30 $47.27 $99,588.32 10 $99,588.32 $829.90 $47.67 $99,540.65 NOTE. At the beginning of month 1, the mortgage balance is $100,000, the amount of the original loan. The mortgage payment for month 1 includes interest on the $100,000 borrowed for the month. Because the annual interest rate is 8.00%, the monthly interest rate is 0.10 / 12 = 0.0083333. Interest for month 1 is therefore $100,000 (0.0083333) = $833.33. The $44.24 difference between the monthly mortgage payment of $877.57 and the interest of $833.33 is the portion of the monthly mortgage payment that represents repayment of principal. The monthly mortgage payment of $877.57 is computed using the equation for MP given above. The $44.24 difference in month 1 reduces the mortgage balance. The mortgage balance at the end of month 1 (beginning of month 2) is then $100,000 – $44.24 = $99,955.76. The interest for the second monthly mortgage payment is the monthly interest rate (0.00833333) times the mortgage balance at the beginning of month 2 ($99,955.76). We have: 0.083333 ($99,955.76) = $832.96. The difference between the $877.57 monthly mortgage payment and the $832.96 interest is $44.61, representing the amount of the mortgage balance paid off with that monthly mortgage payment. Similarly, we can compute the remaining numbers shown in the exhibit where the problem tells us to stop after ten months. (b) What will the mortgage balance be at the end of the 360th month assuming no prepayments? At the end of the 360th month and assuming no prepayments, we know the balance should be zero. This can be confirmed by repeating the earlier use of the equations where we used t = 12 except we not use t = 360. Doing this gives: MBt = $0. (c) Without constructing an amortization schedule, what is the mortgage balance at the end of month 270 assuming no prepayments? Repeating the earlier equations illustrated for t = 12 but now using t = 270, we get: MBt = $55,409.50. (d) Without constructing an amortization schedule, what is the scheduled principal payment at the end of month 270 assuming no prepayments? The scheduled principal payment at the end of month 270 assuming no prepayments (and using the SPt formula as illustrated previously for when t = 12 but now using t = 270) gives $412.39. 14. Explain why, in a fixed-rate mortgage, the amount of the mortgage payment applied to interest declines over time, while the amount applied to the repayment of principal increases. With each monthly payment, an excess above the interest owed is paid. This extra serves to reduce the outstanding principal (or balance owed). With a reduced balance owed, the next monthly mortgage payment will consist of a lower amount of interest paid since the interest rate is multiplied times a lower balance. Since the payment is fixed, this means that more of the fixed payment can be applied to lower the principal. Hence, the monthly interest declines over time, while an increasing amount is applied to the repayment of the principal. 15. Why is the cash flow of a residential mortgage loan unknown? There are many factors that can the cash flow of a residential mortgage unknown. These include: (1) credit risk, (2) liquidity risk, (3) price risk, and (4) prepayment risk. Credit risk is the risk that the homeowner/borrower will default. Liquidity risk refers to the degree of liquidity in the secondary market for mortgage loans where the bid-ask spreads are large compared to other debt instruments. Price risk refers to the fact that the price of a fixed-income instrument will move in an opposite direction from market interest rates. Thus, a rise in interest rates will decrease the price of a mortgage loan. Prepayment risk is the risk associated with a mortgage’s cash flow due to prepayments. More specifically, investors are concerned that borrowers will pay off a mortgage when prevailing mortgage rates fall below the loan’s note rate. 16. In what sense has the investor in a residential mortgage loan granted the borrower (homeowner) a loan similar to a callable bond? Prepayment risk is the risk associated with a mortgage’s cash flow due to prepayments. More specifically, investors are concerned that borrowers will pay off a mortgage when prevailing mortgage rates fall below the loan’s note rate. For example, if the note rate on a mortgage originated five years ago is 8% and the prevailing mortgage rate (i.e., rate at which a new loan can be obtained) is 5.5%, then there is an incentive for the borrower to refinance the loan. The decision to refinance will depend on several factors, but the single most important one is the prevailing mortgage rate compared to the note rate. The disadvantage to the investor is that the proceeds received from the repayment of the loan must be reinvested at a lower interest rate than the note rate. This risk is the same as that faced by an investor in a callable corporate or municipal bond. However, unlike a callable bond, there is no premium that must be paid by the borrower in the case of a residential mortgage loan. Any principal repaid in advance of the scheduled due date is paid at par. 17. What is meant by strategic default behavior? The concept of strategic default behavior relates to LTV (which is defined as the ratio of the current loan balance divided by the estimated market value). Let us explain. First, the LTV has been found in numerous studies to be the single most important determinant of the likelihood of default. This is because homeowners with large amounts of equity in their properties are unlikely to default. Data on the behavior of these borrowers indicate that they have an increased propensity to voluntarily stop making their mortgage payments once the current LTV exceeds 125%, even if they can afford making monthly payments. This behavior is referred to as a “strategic default” behavior as borrowers consciously default when it is to their advantage. 18. What is the advantage of a prepayment penalty mortgage from the perspective of the lender? The advantage of a prepayment penalty mortgage from the perspective of the lender is that the lender can reduce losses if the borrower chooses to pay off the mortgage when rates fall. More details are given below. Effectively, the borrower’s right to prepay a loan in whole or in part without a penalty is a called an option. A mortgage design that mitigates the borrower’s right to prepay is the prepayment penalty mortgage. This mortgage design imposes penalties if borrowers prepay. The penalties are designed to discourage refinancing activity and require a fee to be paid if the loan is prepaid within a certain amount of time after funding. Penalties are typically structured to allow borrowers to partially prepay up to 20% of their loan each year the penalty is in effect and charge the borrower six months of interest for prepayments on the remaining 80% of their balance. Some penalties are waived if the home is sold and are described as “soft” penalties; hard penalties require the penalty to be paid even if the prepayment occurs as the sale of the underlying property. The laws and regulations governing the imposition of prepayment penalties are established at the federal and state levels. Usually, the applicable laws for fixed-rate mortgages are specified at the state level. There are states that do not permit prepayment penalties on fixed-rate mortgages with a first lien. There are states that do permit prepayment penalties but restrict the type of penalty. For some mortgage designs, such as adjustable-rate and balloon mortgages, there are federal laws that override state laws. 19. Explain whether you agree or disagree with the following statements: a. “Freddie Mac and Fannie Mae are only allowed to purchase conforming conventional loans.” The two GSEs, Fannie Mae and Freddie Mac, can purchase any type of loan; however, the only conventional loans that they can securitize to create a mortgage-backed security are conforming loans, that is conventional loans that satisfy their underwriting standards. More details are given below. One of the ways that GSEs fulfill their mission is by buying and selling mortgages. The loans they purchase can be held in their portfolios or packaged to create an MBS. Fannie Mae and Freddie Mac can buy or sell any type of residential mortgage, but the mortgages that are packaged into securities are restricted to government loans and those that satisfy their underwriting guidelines. The conventional loans that qualify are referred to as conforming loans. A conforming loan is simply a conventional loan that meets the underwriting standard of Fannie Mae and Freddie Mac. Thus, conventional loans in the market are referred to as conforming conventional loans and nonconforming conventional loans. One of the underwriting standards is the loan balance at the time of origination. As noted in the previous section, conventional loans that meet the underwriting standards of the two GSEs are called conforming limits. But there are other important underwriting standards that must be satisfied. b. “In packaging loans to create a mortgage-backed security, Freddie Mac and Fannie Mae can only use government loans.” In contrast to government loans, there are loans that have no explicit guarantee from the federal government. Such loans are said to be obtained from “conventional financing” and therefore are referred to in the market as conventional loans. Although a conventional loan may not be insured when it is originated, a loan may qualify to be insured when it is included in a pool of mortgage loans that backs a mortgage-backed security (MBS). More specifically, MBSs are those issued by two government-sponsored enterprises, Freddie Mac and Fannie Mae. Because the guarantees of Freddie Mac and Fannie Mae do not carry the full faith and credit of the U.S. government, they are not classified as government loans. 20. Answer the below questions. (a) What features of an adjustable-rate mortgage will affect its cash flow? For an adjustable-rate mortgage (ARM), as the name implies, the note rate changes over the life of the loan. The note rate is based on both the movement of an underlying rate, called the index or reference rate, and a spread over the index called the margin. The basic ARM is one that resets periodically and has no other terms that affect the monthly mortgage payment. Typically, the mortgage rate is affected by other terms. These include (1) periodic rate caps and (2) lifetime rate cap and floor. A periodic rate cap limits the amount that the interest rate may increase or decrease at the reset date. The periodic rate cap is expressed in percentage points. Most ARMs have an upper limit on the mortgage rate that can be charged over the life of the loan. This lifetime rate cap is expressed in terms of the initial rate. ARMs may also have a lower limit (floor) on the interest rate that can be charged over the life of the loan. A popular form of an ARM is the hybrid ARM. For this loan type, for a specified number of years (three, five to seven, and 10 years), the note rate is fixed. At the end of the initial fixed-rate period, the loan resets in a fashion very similar to that of more traditional ARM loans. (b) What are the two categories of benchmark indexes used in adjustable-rate mortgages? Two categories of reference rates have been used in adjustable-rate mortgages (ARMs): (1) market-determined rates and (2) calculated rates based on the cost of funds for thrifts. Market-determined rates include the London Interbank Offered Rate (LIBOR), the 1-year Constant Maturity Treasury (CMT), and the 12-month Moving Treasury Average (MTA), a rate calculated from monthly averages of the 1-year CMT. The two most popular calculated rates are the Eleventh Federal Home Loan Bank Board District Cost of Funds Index (COFI) and the National Cost of Funds Index. Depository institutions prefer to hold ARMs in their portfolios rather than FRMs because ARMs provide a better matching with their liabilities. 21. Answer the below questions. (a) What is the original LTV of a mortgage loan? The original LTV of a mortgage loan is the LTV at the time of origination. The LTV is the ratio of the amount of the loan to the market (or appraised) value of the property. The lower this ratio, the more protection the lender has if the applicant defaults and the property must be repossessed and sold. (b) What is the current LTV of a mortgage loan? The current LTV is the LTV based on the current unpaid mortgage balance and the estimated current market value of the property. (c) What is the problem with using the original LTV to assess the likelihood that a seasoned mortgage will default? At one time, investors considered only the original LTV in their analysis of credit risk. Because of periods in which there has been a decline in housing prices, the current LTV has become the focus of attention. The current LTV is the LTV based on the current unpaid mortgage balance and the estimated current market value of the property. Specifically, the concern is that a decline in housing prices can result in a current LTV that is considerably greater than the original LTV. This would result in greater credit risk for such mortgage loans than at the time of origination. Thus, the current LTV (as opposed to the original LTV) is much better equipped to assess the likelihood that a seasoned mortgage will default. 22. Answer the below questions. (a) What is a home equity loan? A popular mortgage product backed by residential property that is classified as a subprime mortgage loan is the home equity loan (HEL). Typically the borrower has either an impaired credit history and/or the payment-to-income ratio is too high for the loan to qualify as a conforming loan for securitization by Ginnie Mae, Fannie Mae, or Freddie Mac. (b) What is the difference between a closed-end and open-end home equity loan? While home equity loans can be either closed end or open end, most home equity loan securitizations are backed by closed-end HELs. A closed-end HEL is designed the same way as a fully amortizing residential mortgage loan. That is, it has a fixed maturity, and the payments are structured to fully amortize the loan by the maturity date. An open-end HEL is a line of credit. There are both fixed-rate and variable-rate closed-end HELs. Typically, variable-rate loans have a reference rate that is LIBOR and have periodic caps and lifetime caps. 23. For mortgage loans, what is prepayment risk? Prepayment risk is the risk associated with a mortgage’s cash flow due to prepayments. More specifically, investors are concerned that borrowers will pay off a mortgage when prevailing mortgage rates fall below the loan’s note rate. More details are given below. The impact on the borrower is that the principal (or amount required to completely pay off a loan) is reduced by the amount paid off that period that goes beyond the interest due. The impact on the lender can involve risk and is captured by the concept of prepayment risk, which is the risk associated with a mortgage’s cash flow due to prepayments. More specifically, investors are concerned that borrowers will pay off a mortgage when prevailing mortgage rates fall below the loan’s note rate. For example, if the note rate on a mortgage originated five years ago is 8% and the prevailing mortgage rate (i.e., rate at which a new loan can be obtained) is 5.5%, then there is an incentive for the borrower to refinance the loan. The decision to refinance will depend on several factors, but the single most important one is the prevailing mortgage rate compared to the note rate. The disadvantage to the investor is that the proceeds received from the repayment of the loan must be reinvested at a lower interest rate than the note rate. This risk is the same as that faced by an investor in a callable corporate or municipal bond. However, unlike a callable bond, there is no premium that must be paid by the borrower in the case of a residential mortgage loan. Any principal repaid in advance of the scheduled due date is paid at par value. The exception, of course, is if the loan is a prepayment penalty mortgage loan. Solution Manual for Bond Markets, Analysis and Strategies Frank J. Fabozzi 9780132743549, 9780133796773