Chapter 9 Mortgage Markets Outline Background on Mortgages How Mortgages Facilitate the Flow of Funds Criteria Used to Measure Creditworthiness Classifications of Mortgages Types of Residential Mortgages Valuation and Risk of Mortgages The Securitization Process Types of Mortgage-Backed Securities Mortgage Credit Crisis Impact of the Crisis on Fannie Mae and Freddie Mac Government Programs Implemented in Response to the Crisis Systemic Risk Due to the Credit Crisis Who Is to Blame? Government Programs in Response to the Crisis Government Bailout of Financial Institutions Financial Reform Act Key Concepts 1. Identify the more popular types of mortgages, and elaborate where necessary. Describe how financial institutions participate in mortgage markets. Explain how the mortgage problems led to the credit crisis. POINT/COUNTER-POINT: Is the Trading of Mortgages Similar to the Trading of Corporate Bonds? POINT: Yes. In both cases, the issuer’s ability to repay the debt is based on income. Both types of debt securities are highly influenced by interest rate movements. COUNTER-POINT: No. The assessment of corporate bonds requires an analysis of financial statements of the firms that issued the bonds. The assessment of mortgages requires an understanding of the structure of the mortgage market (CMOs, etc.). WHO IS CORRECT? Use the Internet to learn more about this issue and then formulate your own opinion. ANSWER: The question is primarily intended to make students compare mortgages to bonds. There are some similarities, but an institutional investor who manages a corporate bond portfolio would not be able manage a mortgage portfolio without adequate training, and vice versa. Questions 1. FHA Mortgages. Distinguish between FHA and conventional mortgages. ANSWER: FHA mortgages guarantee loan repayment, thereby covering against the possibility of default by the borrower. The guarantor is the Federal Housing Administration. Conventional mortgages are not federally insured, but they can be privately insured. 2. Mortgage Rates and Risk. What is the general relationship between mortgage rates and long-term government security rates? Explain how mortgage lenders can be affected by interest rate movements. Also explain how they can insulate against interest rate movements. ANSWER: There is a high positive correlation between mortgage rates and long-term government security rates. Mortgage lenders that provide fixed-rate mortgages could be adversely affected by rising interest rates, because their cost of financing the mortgages would increase while the interest revenues received on mortgages is unchanged. The lenders could reduce their exposure to interest rate risk by offering adjustable-rate mortgages, so that the revenues received from mortgages could change in the same direction as the cost of financing as interest rates change. 3. ARMs. How does the initial rate on adjustable rate mortgages (ARMs) differ from the rate on fixed-rate mortgages? Why? Explain how caps on ARMs can affect a financial institution’s exposure to interest rate risk. ANSWER: An adjustable rate mortgage typically offers a lower initial rate than a fixed-rate mortgage to compensate borrowers for incurring the interest rate risk. Caps on adjustable-rate mortgages (ARMs) limit the degree to which the interest rate charged can move from the original interest rate at the time the mortgage was originated. If interest rates move beyond the boundaries implied by the caps, the mortgage rate will not fully adjust to the market interest rate. Therefore, if interest rates rise substantially, the mortgage rates may not fully offset the increased cost of funds. 4. Mortgage Maturities. Why is the 15-year mortgage attractive to homeowners? Is the interest rate risk to the financial institution higher for a 15-year or a 30-year mortgage? Why? ANSWER: The 15-year mortgage is popular because of the potential reduction in total interest expenses paid on a mortgage with a shorter lifetime. The interest rate risk is higher for a 30-year mortgage than for a 15-year mortgage, because the 15-year mortgage exists for only half the period. 5. Balloon-Payment Mortgage. Explain the use of a balloon-payment mortgage. Why might a financial institution prefer to offer this type of mortgage? ANSWER: A balloon mortgage payment requires interest payments for a three- to five-year period. At the end of the period, full payment (a balloon payment) is required. Financial institutions may desire balloon mortgages because the interest rate risk is lower than for longer term, fixed-rate mortgages. 6. Graduated-Payment Mortgage. Describe the graduated-payment mortgage. What type of homeowners would prefer this type of mortgage? ANSWER: The graduated payment mortgage allows borrowers to repay their loans on a graduated basis over the first 5 to 10 years. They level off after a 5- or 10-year period. Homeowners whose incomes will rise over time may desire this type of a mortgage. 7. Growing-Equity Mortgage. Describe the growing-equity mortgage. How does it differ from a graduated-payment mortgage? ANSWER: A growing-equity mortgage requires continual increasing mortgage payments throughout the life of the mortgage. The mortgage lifetime is reduced because of the accelerated payment schedule, whereas a GPM’s life is not reduced. 8. Second Mortgages. Why are second mortgages offered by some home sellers? ANSWER: A second mortgage is often used when financial institutions provide a first mortgage that does not fully cover the amount of funds the borrower needs. A second mortgage complements the first mortgage. It falls behind the first mortgage in priority claim against the property in the event of default. 9. Shared-Appreciation Mortgage. Describe the shared-appreciation mortgage. ANSWER: A shared-appreciation mortgage allows a home purchaser to obtain a mortgage at an interest rate below market rates. In return, the lender providing the loan will share in the price appreciation of the home. 10. Exposure to Interest Rate Movements. Mortgage lenders with fixed-rate mortgages should benefit when interest rates decline, yet research has shown that this favorable impact is dampened. By what? ANSWER: When interest rates decline, a large proportion of mortgages are refinanced. Therefore, the benefits to lenders that offer fixed-rate mortgages are limited. 11. Mortgage Valuation. Describe the factors that affect mortgage prices. ANSWER: Mortgage prices are affected by changes in interest rates and risk premiums. Factors such as economic growth, money supply and inflation affect interest rates and therefore affect mortgage prices. A change in economic growth may also affect the risk premium. 12. Selling Mortgages. Explain why some financial institutions prefer to sell the mortgages they originate. ANSWER: Financial institutions may sell their mortgages if they desire to enhance liquidity, or if they expect interest rates to increase. Mortgage companies frequently sell mortgages after they are originated and continue to service them. They do not have sufficient funds to maintain all the mortgages they originate. 13. Secondary Market. Compare the secondary market activity for mortgages to the activity for other capital market instruments (such as stocks and bonds). Provide a general explanation for the difference in the activity level. ANSWER: The secondary market for stocks and bonds is facilitated by an organized exchange such as the New York Stock Exchange. The prices of these securities sold in the secondary market are more transparent. The prices of mortgages sold in the secondary market are not transparent. However, the secondary market for mortgages has been enhanced because of securitization. This allows for the sale of smaller loans that could not be as easily sold if they were not packaged. 14. Financing Mortgages. What types of financial institutions finance residential mortgages? What type of financial institution finances the majority of commercial mortgages? ANSWER: Commercial banks and savings and loan associations dominate the one- to four-family mortgages. Commercial banks dominate the commercial mortgages. 15. Mortgage Companies. Explain how a mortgage company’s degree of exposure to interest rate risk differs from other financial institutions. ANSWER: Mortgage companies concentrate on servicing mortgages rather than investing in mortgages. Thus, they are not as concerned about hedging mortgages over the long run. However, they are exposed to interest rate risk during the period from when they originate mortgages until they sell them. If interest rates change over this period, the price at which they can sell the mortgages will change. Advanced Questions 16. Mortgage-Backed Securities. Describe how mortgage-backed securities are used. ANSWER: A financial institution that purchases or originates a portfolio of mortgages can sell mortgages by packaging them and issuing mortgage-backed securities. The mortgages serve as collateral for the debt securities issued. The interest and principal payments on the mortgages are transferred (passed through) to the owners of the securities, after deducting fees for servicing. 17. CMOs. Describe how collateralized mortgage obligations (CMOs) are used and why they have been popular. ANSWER: Collateralized mortgage obligations (CMOs) are mortgage-backed securities that are segmented into classes representing the timing of payback of the principal. Investors can choose a class that fits their maturity preferences. 18. Maturities of MBS. Explain how the maturity on mortgage-backed securities can be affected by interest rate movements. ANSWER: When interest rates decline, prepayments on mortgages occur because some homeowners refinance with a new mortgage with a lower interest rate. If these mortgages were financed with pass-through securities, the payments will be channeled to the investors that purchased the pass-through securities. 19. How Secondary Mortgage Prices May Respond to Prevailing Conditions. Consider the prevailing conditions for inflation (including oil prices), the economy, the budget deficit, and the Fed’s monetary policy that could affect interest rates. Based on prevailing conditions, do you think the values of mortgages that are sold in the secondary market will increase or decrease during this semester? Offer some logic to support your answer. Which factor do you think will have the biggest impact on the values of existing mortgages? ANSWER: The values of mortgages sold in the secondary market may respond to prevailing conditions in various ways, particularly in response to factors such as inflation, economic growth, the budget deficit, and the Federal Reserve's monetary policy. Let's analyze the potential impact of these factors on secondary mortgage prices during the semester: 1. Inflation (including oil prices) : Higher inflation expectations can lead to higher interest rates, as investors demand higher yields to compensate for the erosion of purchasing power. This can negatively impact secondary mortgage prices, as higher interest rates reduce the present value of future mortgage payments. As a result, the values of mortgages sold in the secondary market may decrease in response to expectations of higher inflation. 2. Economic Growth : Strong economic growth prospects can contribute to higher interest rates, as central banks may tighten monetary policy to prevent overheating and inflationary pressures. This can also put downward pressure on secondary mortgage prices, as higher interest rates reduce the affordability of mortgages, leading to lower demand for mortgage-backed securities in the secondary market. 3. Budget Deficit : A widening budget deficit can increase the supply of government debt, putting upward pressure on interest rates. Higher interest rates can lead to lower secondary mortgage prices, as the higher cost of borrowing reduces the present value of future mortgage payments. Therefore, efforts to reduce the budget deficit or fiscal discipline may support secondary mortgage prices by reducing the supply of government debt and mitigating upward pressure on interest rates. 4. Federal Reserve's Monetary Policy : The Federal Reserve's monetary policy decisions, particularly changes in the federal funds rate and asset purchase programs, can significantly influence interest rates and secondary mortgage prices. If the Fed signals a hawkish stance by raising interest rates or tapering its asset purchases, secondary mortgage prices may decrease. Conversely, if the Fed maintains or adopts a dovish stance by keeping interest rates low and continuing asset purchases, secondary mortgage prices may be supported. Considering these factors, prevailing conditions suggest that the values of mortgages sold in the secondary market may face downward pressure during the semester, particularly if inflationary pressures persist, economic growth accelerates, and the Federal Reserve takes steps to normalize monetary policy. Of these factors, the Federal Reserve's monetary policy decisions are likely to have the biggest impact on the values of existing mortgages, as they directly influence interest rates and market expectations. Investors and stakeholders in the secondary mortgage market should closely monitor developments in inflation, economic growth, fiscal policy, and the Fed's actions to assess the direction of secondary mortgage prices and adjust their strategies accordingly. 20. CDOs. Explain collateralized debt obligations (CDOs). ANSWER: A CDO represents a package of debt securities backed by collateral that is sold to investors. A CDO commonly combines a variety of debt securities, including subprime mortgages, prime mortgages, automobile loans other credit card loans. It was a popular means by which a creditor could originate a loan and even service it without lending its own funds. 21. Motives for Offering Subprime Mortgages. Explain subprime mortgages. Why were mortgage companies aggressively offering subprime mortgages? ANSWER: Subprime mortgages were provided by mortgage companies to borrowers who would not have qualified for prime loans. Thus, these mortgages enabled more people with relatively lower income, or high existing debt, or a small down payment to purchase homes. Many financial institutions such as mortgage companies were willing to provide subprime loans because it allowed them a way to expand their business. In addition, they could charge higher fees (such as appraisal fees) and higher interest rates on the mortgage in order to compensate for the risk of default. 22. Subprime Versus Prime Mortgages. How did the repayment of subprime mortgages compare to that of prime mortgages during the credit crisis? ANSWER: In 2008, about 25 percent of all outstanding subprime mortgages had late payments of at least 30 days, versus less than 5 percent for prime mortgages. In addition, about 10 percent of outstanding subprime mortgages were subject to foreclosure in 2008, versus less than 3 percent for prime mortgages. 23. MBS Transparency. Explain the problems in valuing MBS. ANSWER: There is no centralized reporting system that reports the trading of MBS in the secondary market, as there is for other securities such as stocks and Treasury bonds. The only participants who know the price of MBS that was traded is the buyer and the seller. 24. Contagion Effects of Credit Crisis. Explain how the credit crisis adversely affected many other people beyond homeowners and mortgage companies. ANSWER: Mortgage insurers incurred expenses from foreclosures of the property they insured. Individual investors whose investments were pooled by mutual funds, hedge funds, and pension funds and used to purchase MBS experienced losses. Investors who invested in stocks of financial institutions experienced losses. Several financial institutions went bankrupt, and many employees of financial institutions lost their jobs. Home builders went bankrupt and many employees in the home building industry lost their jobs. 25. Blame for Credit Crisis. Many investors that purchased the mortgage-backed securities just before the credit crisis believed that they were misled, because these securities were riskier than they thought. Who is at fault? ANSWER: Answers might include the households that applied for mortgages but could not afford them, the originators of mortgages, the financial institutions that packaged mortgages into tranches, the rating agencies, and the financial institutions that invested in mortgage-backed securities. Each party could be partially accountable for not recognizing the high potential for default risk. 26. Avoiding Another Credit Crisis. Do you think that the U.S. financial system will be able to avoid a credit crisis like this in the future? ANSWER: A credit crisis is triggered by fear of investors that purchase debt securities. A credit crisis could occur again in the future in response to a weak economy or to various events that cause concerns that issuers of debt will not repay their debt. 27. Role of Credit Ratings in Mortgage Market. Explain the role of credit rating agencies in facilitating the flow of funds from investors into the mortgage market (through mortgage-backed securities). ANSWER: Credit rating agencies rate the tranches of mortgage-backed securities based on the mortgages they represent. 28. Fannie and Freddie Problems. Explain why Fannie Mae and Freddie Mac experienced mortgage problems. ANSWER: Fannie Mae and Freddie Mac are major investors in mortgages. However, they made poor investment decisions by using funds to invest in many mortgages that involved high risk. 29. Rescue of Fannie and Freddie. Explain why the rescue of Fannie Mae and Freddie Mac improves the ability of mortgage companies to originate mortgages. ANSWER: Without a strong secondary market for mortgages, financial institutions that originate mortgages would not be able to sell mortgages, and therefore may have to finance them on their own. This would severely limit the amount of funding for new mortgages. Thus, while the government rescue is primarily focused on ensuring a more liquid secondary market, this action indirectly encourages more originations of new mortgages. 30. U.S. Treasury Bailout Plan. The U.S. Treasury attempted to resolve the credit crisis by establishing a plan to buy mortgage-backed securities held by financial institutions. Explain how the plan could improve the situation for mortgage-backed securities. ANSWER: The secondary market for mortgage-backed securities was inactive during the credit crisis, because of the high level of mortgage defaults. Investors were afraid to purchase these securities because of the risk involved. The Treasury’s purchase of the mortgage-backed securities corrected the imbalance (excessive supply) in the secondary market. 31. Assessing the Risk of MBS. Why do you think it is difficult for investors to assess the financial condition of a financial institution that has purchased a large amount of mortgage-backed securities? ANSWER: The risk of mortgage-backed securities is dependent on the underlying mortgages and the details of the mortgages are not disclosed in financial statements. Mortgage Information During the Credit Crisis. Explain why mortgage originators have been criticized for their behavior during the credit crisis. Should other participants in the mortgage securitization process have recognized that lack of complete disclosure in mortgages? ANSWER: Mortgage originators have faced criticism for their behavior during the credit crisis primarily due to irresponsible lending practices and lax underwriting standards. Some key reasons for the criticism include: 1. Subprime Lending : Mortgage originators were heavily involved in the subprime lending market, where loans were extended to borrowers with poor credit histories or limited income verification. These subprime loans often carried higher interest rates and were more susceptible to default, contributing to the eventual collapse of the housing market. 2. Predatory Lending : Some mortgage originators engaged in predatory lending practices, such as deceptive marketing tactics, hidden fees, and steering borrowers into unaffordable loans. These practices exploited vulnerable borrowers and contributed to the proliferation of high-risk mortgage products, such as adjustable-rate mortgages (ARMs) and interest-only loans. 3. Securitization and Risk Transfer : Mortgage originators often sold the loans they originated to financial institutions, which then pooled these mortgages into mortgage-backed securities (MBS) and sold them to investors. In some cases, originators misrepresented the quality of the loans or failed to disclose key information about the borrowers' creditworthiness, leading to mispricing and misperception of risk in the securitization process. Regarding the question of whether other participants in the mortgage securitization process should have recognized the lack of complete disclosure in mortgages, the answer is yes. Other participants, including investment banks, credit rating agencies, and investors, also bear responsibility for failing to adequately assess and mitigate the risks associated with mortgage-backed securities. Some key points to consider include: 1. Due Diligence : Investment banks that packaged and sold MBS should have conducted thorough due diligence on the underlying mortgage loans to ensure their quality and creditworthiness. This includes verifying borrower income, employment history, and assets, as well as assessing the adequacy of underwriting standards employed by mortgage originators. 2. Credit Ratings : Credit rating agencies assigned ratings to MBS based on their perceived creditworthiness and risk. However, these agencies often relied on flawed assumptions and inadequate information provided by originators, leading to inflated credit ratings on MBS that did not accurately reflect their underlying risk. 3. Investor Due Diligence : Investors who purchased MBS should have conducted their own due diligence and exercised caution in assessing the risks associated with these securities. Many investors, including pension funds, mutual funds, and financial institutions, underestimated the risks inherent in MBS and suffered significant losses as a result. In summary, while mortgage originators bear primary responsibility for their role in the credit crisis, other participants in the mortgage securitization process should have recognized the lack of complete disclosure in mortgages and taken steps to mitigate the associated risks. The failure of multiple parties to exercise due diligence and oversight contributed to the systemic breakdown in the mortgage market and the subsequent financial crisis. Short Sales. Explain short sales in the mortgage markets. Are short sales fair to homeowners? Are they fair to mortgage lenders? ANSWER: In a short sale transaction, the lender allows homeowners to sell the home for less than what is owed on the existing mortgage. The lender appraises the home and informs the homeowner of the price it is willing to accept on the home. Lenders involved in this program do not recover the full amount owed on the mortgage. However, they may minimize their losses because they do not have to go through the foreclosure process, and the homeowners reduce the potential damage to their credit report. In the context of the mortgage market, a short sale occurs when a homeowner sells their property for an amount that is less than the outstanding balance on their mortgage. The proceeds from the sale are used to pay off a portion of the mortgage debt, but the lender typically agrees to forgive the remaining balance. Short sales are often pursued as an alternative to foreclosure when homeowners are unable to continue making mortgage payments and the property's value has declined below the loan amount. Short sales can be beneficial for both homeowners and mortgage lenders, but their fairness can be subjective and depend on individual circumstances: 1. Fairness to Homeowners : - Short sales offer homeowners facing financial hardship an opportunity to avoid foreclosure, which can have severe consequences for their credit score and future financial well-being. - By allowing homeowners to sell their property and settle their debt for less than the full amount owed, short sales provide a means of debt relief and a chance to move on from an unsustainable mortgage burden. - However, short sales can still have negative implications for homeowners, such as potential tax consequences and damage to their credit score, which may hinder their ability to secure future financing or purchase another home. 2. Fairness to Mortgage Lenders : - Short sales can be advantageous for mortgage lenders by allowing them to avoid the costly and time-consuming foreclosure process. Lenders may also recover more of their investment through a short sale compared to a foreclosure auction, where sale prices are often lower. - Additionally, short sales may help lenders mitigate their losses and reduce their exposure to nonperforming loans, thereby preserving their financial stability and liquidity. - However, mortgage lenders may still incur losses in a short sale, especially if the sale price is significantly below the outstanding loan balance. Lenders may also face challenges in negotiating short sales with multiple parties involved and in coordinating the process efficiently. In conclusion, short sales in the mortgage market can be viewed as a pragmatic solution for both homeowners and mortgage lenders facing financial distress and declining property values. While short sales offer homeowners a chance to avoid foreclosure and alleviate their debt burden, they also provide lenders with an alternative to costly foreclosure proceedings and potential losses. However, the fairness of short sales may vary depending on individual circumstances and the outcomes for all parties involved. Government Intervention in Mortgage Markets. The government intervened in order to resolve problems in the mortgage markets during the credit crisis. Summarize the advantages and disadvantages of the government intervention during the credit crisis. Should the government intervene when mortgage market conditions are very weak? ANSWER: Some government programs stabilized the market for mortgage-backed securities, and therefore helped the financial institutions that invested in them. To the extent that the government’s intervention stabilized the housing market, many homeowners benefitted. The government budget deficit increased due to the intervention, although one could argue that the deficit could have been worse due to a more pronounced crisis if the government did not intervene at all. Whether the government should intervene is an open-ended question intended to generate discussion and alternative perspectives. Dodd-Frank Act and Credit Ratings of MBS. Explain how the Dodd-Frank Act of 2010 attempted to prevent biased ratings of mortgage-backed securities by credit rating agencies. ANSWER: The Dodd-Frank Act requires that credit rating agencies publicly disclose data on assumptions used to derive each credit rating. The agencies are also required to provide an annual report about their internal controls used to ensure an unbiased process of rating securities. The act also prevents the SEC from relying on ratings within its regulations, so that it has to use its own assessment of risk. Interpreting Financial News Interpret the following comments made by Wall Street analysts and portfolio managers. a. “If interest rates continue to decline, the interest-only CMOs will take a hit.” When interest rates decline, mortgages are commonly prepaid, and the interest payments on those mortgages are terminated. Therefore, payments to investors holding the interest-only CMOs are terminated as well. b. “Estimating the proper value of CMOs is like estimating the proper value of a baseball player; the proper value is much easier to assess five years later.” The future value of a CMO is dependent on the future interest rate movements. Since interest rate movements are difficult to forecast, it is difficult to properly value a CMO. It would be easier to look back in time after recognizing how interest rates moved to determine what the value of the CMO should have been. c. “When purchasing principal-only (PO) CMOs, be ready for a bumpy ride.” The values of principal-only CMOs adjust abruptly to changes in interest rates. Therefore, they exhibit a high degree of volatility (risk) . Managing in Financial Markets As a manager of a savings institution, you must decide whether to invest in collateralized mortgage obligations (CMOs). You can purchase interest-only (IO) or principal-only (PO) classes. You anticipate that economic conditions will weaken in the future and that government spending (and therefore government demand for funds) will decrease. a. Given your expectations, would IOs or POs be a better investment? POs would be a better investment. Given your expectations, interest rates are likely to decrease. This would result in mortgage prepayments, which causes interest payments on those mortgages to be terminated. Therefore, payments on the IOs are terminated as well. An investment in POs would result in accelerated payment of the principal during a period in which interest rates are declining, as mortgages are prepaid. b. Given the situation, is there any reason why you might not purchase the class of CMOs that you selected in the previous question? If you are not confident about the future interest rate movements, you may prefer to avoid any investment in CMO classes, because the returns on CMO classes are subject to a high degree of interest rate risk. c. Your boss suggests that the value of CMOs at any point in time should be the present value of their future payments. He says that since a CMO represents mortgages, its valuation should be simple. Why is your boss wrong? CMOs are segmented into classes, and each class has a specific payback priority. Yet, the timing of the payback on any particular CMO class is uncertain, which makes it difficult to properly discount the future payments. Problem 1. Monthly Mortgage Payment. Use an amortization table that determines the monthly mortgage payment based on a specific interest rate and principal with a 15-year maturity, and then for a 30-year maturity. Is the monthly payment for the 15-year maturity twice the amount as for the 30-year maturity, or less than twice the amount? Explain. ANSWER: The monthly mortgage payment on a 15-year mortgage is less than twice the payment on a 30-year mortgage, because the principal is paid off at a faster rate. Flow of Funds Exercise Mortgage Financing Carson Company currently has a mortgage on its office building through a savings institution. It is attempting to determine whether it should convert its mortgage from a floating rate to a fixed rate. Recall that the yield curve is currently upward sloping. Also recall that Carson is concerned about a possible slowing of the economy because of potential Fed actions to reduce inflation. The fixed rate that it would pays if it refinances is higher than the prevailing short-term rate, but lower than the rate it would pay from issuing bonds. What macroeconomic factors could affect interest rates and therefore affect the mortgage refinancing decision? Any indicators of economic growth, the budget deficit, and inflation would affect interest rates and therefore could influence the refinancing decision. If Carson refinances its mortgage, it also must decide on the size of a down payment. If it uses more funds for a larger down payment, it will need to borrow more funds to finance its expansion. Should Carson use a minimum down payment or a larger down payment if it refinances the mortgage? Why? It should use a minimum down payment, because it can obtain long-term funds through the mortgage at a lower rate than if it issued bonds. Thus, it should obtain as much funding as possible from the mortgage so that it does not have to obtain as much funding from other sources in which the cost of funds is higher. Who is indirectly providing the money that is used by companies such as Carson to purchase office buildings? That is, where does the money that the savings institutions channel into mortgages come from? The money comes from individual depositors and is pooled by savings institutions to provide mortgage loans. Solution to Integrative Problem for Part III Asset Allocation 1. The supply of available funds in the United States will decline. Given a smaller supply of funds in the United States, and the same demand for loanable funds, the equilibrium interest rate in the United States should rise. 2. If U.S. interest rates rise, the quantity of loanable funds demanded will decline. Consequently, the amount of spending by businesses and households will decline. If interest rates rise, the values of existing securities may decline because the required return by investors would have increased. 3. If the event causes a net decrease in the Japanese investment in U.S. Treasury securities, the Japanese demand for U.S. dollars is reduced, which should place downward pressure on the value of the dollar with respect to the Japanese yen. One may try to argue that once U.S. interest rates are higher, Japanese investment will flow back to the U.S. However, the case assumes that a flow of funds back to the U.S. will not occur for at least a few years. Currencies other than the Japanese yen may also be affected. Once U.S. interest rates rise, investors from other countries could attempt to capitalize on the high interest rates, which would place upward pressure on the value of the dollar against those currencies. 4. An increase in U.S. interest rates results in an increase in the required rate of return by U.S. investors on all types of securities. The market value of existing U.S. securities should decrease in response to the higher required rate of return. Yet, the prices of some securities will be affected more than others. For example, prices of bonds will be affected more than prices of money market securities. 5. If the U.S. economy weakens (in response to higher U.S. interest rates), the risk premium would increase, causing an even higher required rate of return on risky securities. This would further reduce the present value of risky securities. Thus, risky securities would be more adversely affected than risk-free securities with a similar maturity. A weaker economy also affects the expected cash flows to be received by a firm. The value of a stock is the discounted value of future cash flows. The value would not only be affected by a higher required rate of return (resulting from the higher interest rate and possibly a higher risk premium), but also by lower expected cash flows. 6. The answer is somewhat subjective. However, there is some rationale for prescribing only the minimum 20 percent to bonds and to stocks. Both types of securities will be more adversely affected by the increased required rate of return than money market securities. Therefore, the remaining 60 percent of funds could be allocated to money market securities. 7. Investment in low-risk bonds and money market securities is more appropriate, since the risk premium is expected to increase, which will have a greater adverse impact on prices of riskier securities. 8. Based on expectations that the dollar will weaken against the yen and strengthen against other currencies, it may be feasible to invest in Japanese securities. In particular, it would be wise to invest in the type of Japanese securities that will be purchased by Japanese investors who would have normally purchased U.S. Treasury securities. Investment in any type of Japanese securities should benefit from the expected appreciation of the yen (from a U.S. investor’s perspective). Japanese bonds would probably be a good investment because the expected increase in the supply of funds in Japan (resulting from the expected decrease in investment in U.S. Treasury securities) will place downward pressure in Japanese interest rates in the future. 9. An increase in the demand for loanable funds in the United States would also have placed upward pressure on U.S. interest rates. However, the impact on economic conditions could have been different, because the interest rates would have been driven by a strong demand, which reflects a high level of borrowing and spending. The equilibrium quantity of loanable funds would have been larger in this case. The bond prices would still be expected to decline because of the expectation of higher interest rates. However, there would not be an increase in the risk premium since economic conditions are still favorable. Solution Manual for Financial Markets and Institutions Jeff Madura 9781133947875, 9781305257191, 9780538482172
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