|
University of New Orleans Tulane University Securities Business & Brokerage Firms Economic Analysis, Industry Analysis, Company Analysis How to set personal and professional goals.
|
As we have studied debt (bonds) issued by corporations, municipalities and the U.S. [Federal] Government, there are agencies of the Federal Government that are for-profit, stock-held corporations that are given charters by the Government to operate. These agencies provide a valuable service to the financial industry called Securitization. This is the act of making an investment security out of something that isn't; and in doing so, they bring liquidity to financial firms. This is how it works: Banks and other financial institutions loan money as one of their primary sources of income. The central problem with lending is that banks would prefer to lend in the short term, but much of their business is comprised of mortgage loans with 30-year maturities. The bank funds these long-term loans with short term deposits (people do not commit themselves to 30-year deposits). This mismatch between assets and liabilities is one of the largest mistakes that a financial institution can make. The bank is concerned about interest rate risk. The risk that interest rates will rise, moving the rate on short-term deposits up beyond the rate on the mortgage loans. Imagine that the savings rate is 3% and the mortgage rate is 6%; so far, so good, the bank makes the difference (the spread) between the two rates. Now imagine that interest rates rise to 7%, now the bank is paying 7% on deposits and the mortgage loans (signed for 30 years) continue to pay 6%. The bank is losing 1% on every deposit......we called this the Savings & Loan crises in the 1980's. The bank uses federal agencies to minimize the interest rate risk that is inherent to mortgage lending. Let's say that a bank makes $1,000,000 of mortgage loans today. Because the loans are made at a similar period of time, the interest rate on the loans are usually similar, say 6.5% in today's market. The bank will immediately sell the loans to federal agency The Federal National Mortgage Association (FNMA, called "Fannie Mae") to minimize the interest rate risk and to bring the million dollars back to the bank to make more loans. Fannie Mae will form a "pool" with these loans and slice the "pool" into slices, $25,000 per slice. In out example, imagine a million dollar pool cut into 40, $25,000 slices. The slices are sold to the investing public as bonds. Investors that are interested in bonds are many times attracted to these Mortgage Backed Securities. They pay more interest than many other debt securities, have 30-year terms and are backed by a Federal Agency (FNMA). Fannie Mae, is called a pass-through agency. The loans pass from the banks through FNMA to the investor. As people make their mortgage payments, the money passes to the bondholder (principal and interest). Other federal agencies are: The Government National Mortgage Association (GNMA, Ginnie Mae) who securitizes mortgages, just like Fannie Mae. The Student Loan Marketing Association (SLMA, Sallie Mae) who securities government guaranteed student loans. If there is a particular problem with these types of investments is that you "get paid when you least want to." Financial institutions are protecting themselves from interest rate risk (the largest single risk in investing in fixed income securities) by selling the bonds. Bonds backed by mortgages. Let's say that you own a mortgage bond at a current rate of 6.5%. If interest rates rise to 7.5%, you want to invest at the new, higher rate but your payments will come in slowly; your payments are dependent on the person(s) that hold the mortgages. When interest rates increase, they do not pre-pay their mortgages but hold them for as long as they can. If interest rates fall to 5.5%, people refinance their homes for the lower interest rate and PAY OFF the 6.5% loan. That means that the bond holder of the 6.5% mortgage is paid off long prior to maturity. Below, is a chart giving us an idea of the characteristics of these securities [do not memorize the chart it is just for reference].
COMPARISON OF MORTGAGE SECURITIES CHARACTERISTICS
|
| |||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||||
