Copyright 1999 A. S. Cebenoyan1 Money, Banking, and Financial Markets Professor A. Sinan Cebenoyan Stern School of Business - NYU Set 4

Copyright 1999 A. S. Cebenoyan2 Capital Adequacy Functions of capital –To absorb unanticipated losses with enough margin to inspire confidence and enable the FI to continue as a going concern –To protect uninsured depositors, bondholders, and creditors in the event of insolvency and liquidation –To protect the FI insurance funds and the taxpayers –To acquire the plant and other real investments necessary to provide financial services

Copyright 1999 A. S. Cebenoyan3 The Cost of Equity Capital If dividends are assumed to grow at a known and constant rate g, then Capital and Insolvency Risk Capital Net Worth a market value accounting concept The above can be extended to P/E and D/E ratios

Copyright 1999 A. S. Cebenoyan4 The market value of capital and credit risk Simple examples on declines on Loan values and its effects on Net worth can be easily constructed. The larger the FIs net worth, the more protection The market value of capital and Interest Rate risk Example in Table 20-4 FASB Statement No.115, requires securities classified as ‘available for sale’ to be marked to market. Regulators in 12/94 exempted banks. The Book value of capital Par value of shares Surplus value of shares

Copyright 1999 A. S. Cebenoyan5 Retained Earnings Loan Loss Reserve BV=Par value+Surplus value+Retained Earnings+Loss reserves Book Value of Capital and Credit Risk (reluctance to recognize losses) Table 20-6, recognizes partial loss Book value of capital and Interest rate risk : No change Discrepancy between MV/BV Arguments Against MV Accounting difficult to implement (dubious) Introduces excessive variability to Net Worth (not all is held to maturity) Credit Crunch

Copyright 1999 A. S. Cebenoyan6 Actual Capital Rules Two different capital requirements since 1987 The Capital-Assets ratio (Leverage ratio) L = (Primary or Core Capital) / Assets Core capital=BV of Common + qualifying cumulative preferred stock + minority interests in equity of consolidated subsidiaries Table 20-7 Problems: Market Value (could be massively insolvent) Asset Risk (not all assets have same credit+int.rate risks) Off-balance-sheet activities (no capital required)

Copyright 1999 A. S. Cebenoyan7 Risk Based Capital Ratios (to improve on the previous) The following may be changed in the next couple of years. BIS has proposed to remove the 8% requirement and implement capital adequacy guidelines based on ratings (S&P, Moody’s, etc.) Basel Agreement implemented two new risk-based capital ratios Total risk-based cap ratio= Total cap / Risk-adj.assets > 8% where Total capital= Tier I plus Tier II and Tier I (core) cap ratio = Core cap / Risk-adj. Assets > 4% Table 20-8 summarizes Prompt Corrective Action Provisions of FDICIA of Table 20-9 gives definitions of Tier I and Tier II capital Calculations will be done in class examples

Copyright 1999 A. S. Cebenoyan8 Criticisms of the Risk-based Capital ratio Risk weights Balance sheet incentive problems Portfolio aspects Bank specialness All commercial loans have equal weight Other Risks Competition Capital requirements for securities firms Net Worth / Assets > 2%

Copyright 1999 A. S. Cebenoyan9 Capital Requirements for Life Insurance Firms NAIC model C1= Asset Risk (Table 19-15) C2= Insurance Risk C3= Interest rate Risk C4= Business risk (Total Surplus and capital) / RBC > 1 Capital requirements for Property-Casualty Insurance Firms Tables and will be discussed in class examples

Copyright 1999 A. S. Cebenoyan10 Securitization In % of all residential mortgages securitized. Worldwide value of outstanding securitized issues rapidly approaching $500 billion. Similar to loan sales, but with creation of securities Three major types: –Pass-through security –Collateralized Mortgage Obligation (CMO) –Asset-backed security

Copyright 1999 A. S. Cebenoyan11 The Pass-Through Security Securitization of residential mortgage loans: GNMA : Ginnie Mae, Government national Mortgage Assoc., split in 1968 from Fannie Mae, directly owned by government. Sponsors mortgage-backed securities programs of Fis Acts as guarantor to investors regarding the timely pass- through of principal and interest, i.e. provides timing insurance GNMA supports only FHA, VA, FMHA insured pools. FNMA : Fannie Mae 1938, now private, implicit government FNMA creates MBSs by purchasing mortgage packages from FI’s. finances them thru sale of MBSs to Life insurers and pension funds. Engages in swaps of MBSs with original mortgages. Unlike GNMA, FNMA securitizes conventional mortgages. FHLMC : Freddie Mac similar to FNMA but primarily deals with savings banks.

Copyright 1999 A. S. Cebenoyan12 The incentives and mechanics of Pass-through Security Creation The creation of a GNMA pass-through security Bank originates 1,000 new $100,000 mortgages, $100 million total size. Each has 30 year maturity, 12 % coupon. FHA insured. Financed by deposits and equity. Bank faces capital adequacy requirements. Risk adjusted value of residential mortgages is 50% of face value, and the risk-based capital requirement is 8%, bank capital needed to back the mortgage portfolio: Capital requirement= $100 mill. X.5 X.08 =$4 million Bank also faces reserve requirements of 10%. Needs $96 million in deposits after reserves, and the $4 million in equity capital.

Copyright 1999 A. S. Cebenoyan13 Balance sheet may look like: Assets Liabilities Cash Reserves $10.66Demand Deposits$ Long-term mortgages Capital 4.00 Bank also has to pay insurance premium to FDIC (assuming 27 basis points) $ million X.0027 = $287,982 These amount to 3 levels of regulatory taxes (incentive enough?): 1. Capital requirements 2. Reserve Requirements 3. FDIC insurance premiums.

Copyright 1999 A. S. Cebenoyan14 Two more problems: Duration mismatch (core DD generally have a duration of less than 3 years, whereas mortgages depending on prepayment assumptions normally have durations of at least 4.5 years) Illiquidity exposure. May lead mortgage asset fire sales if large unexpected DD withdrawals happen. Bank can deal with the above by a variety of tools, lengthening durations, swaps, etc.. BUT regulatory burden stays, By contrast: creating GNMA pass-through securities can largely resolve the duration, and illiquidity risk problems and reduce the burden of regulatory taxes. Bank packages the loans and places them with a third party, removing them from the B/S. Next gets the GNMA guarantee for a fee, and arranges to service the mortgages for a fee.

Copyright 1999 A. S. Cebenoyan15 The GNMA pass-through securities are issued and sold in the capital markets. These are desirable to investors as they are FHA/VA insured against default by homeowners, and GNMA insured against default by the originating bank or the trustee. The relevant rates: Mortgage coupon rate 12% minus servicing fee0.44 minus GNMA insurance fee0.06 equals GNMA pass-through bond coupon11.50% Barring prepayment, the investor receives a constant stream of monthly payments.

Copyright 1999 A. S. Cebenoyan16 Post-securitization Balance Sheet of the FI: Assets Liabilities Cash reserves$10.66Demand Deposits$ Cash proceeds from mtge securitization Capital 4.00 Dramatic change. Illiquid mortgages replaced by cash. Duration mismatch has been reduced. Regulatory taxes reduced, e.g. capital requirements reduced as cash has 0 risk-adjusted asset value. Reserve requirements and insurance (FDIC) fees will also be reduced if FI retires some DD. More importantly, The FI can generate new mortgages with the new cash and securitize those. Act like a broker. Fee income becomes more important. BUT, prepayment risk may reduce demand for MBSs.

Copyright 1999 A. S. Cebenoyan17 Prepayment Risk Most conventional mortgages are fully amortized: An annuity problem. Given: Size of pool = $100,000,000 Maturity= 30 years (n=30) # of monthly payments= 12 (m=12) r (annual mtge coupon rate)= 12 % R = constant monthly payment To get the monthly payments, we need to solve the following equation for R:

Copyright 1999 A. S. Cebenoyan18 With our numbers, r= 12%, m=12, n=30, we get R= $1,028, This amount fully amortizes the loan, thus each R has a different principal and a different interest component. Table 28-3, page 675.

Copyright 1999 A. S. Cebenoyan19 With a 1/2 percent fee (insurance and servicing), the R that is passed through is R = $990, this assumes no prepayment. Prepayment has 2 major sources: Refinancing Housing Turnover Prepayment is a function of the gap spread between mortgage pool rates, and the current mortgage coupon rates. Without prepayments: R1=R2=R3=……….=R360 With prepayments CF1 CF61>……>CF360

Copyright 1999 A. S. Cebenoyan20 Prepayment has : Good News Effects: Lower rates increase present values Lower rates lead to faster principal recovery Bad News effects: Fewer interest payments, and reinvestment risk Prepayment Models WSJ reports Bear Sterns prepayment model based data. Among other thing Weighted Average Life WAL is reported: WAL = [  (time x Expected Principal received)] / Total principal outsd. E.g. Loan with 2 years maturity, $40 year 1, $60 year 2 principal pmts. WAL = 160/100 = 1.6 years.

Copyright 1999 A. S. Cebenoyan21 PSA (public securities association) Model develops and average rate of prepayment based on past experience. PSA behavior assumes: 0.2% per annum in the first month, going up by 0.2 % per month for the first 30 months, leveling off at 6% annualized rate for the remaining life of the pool. A Number of reasons why a specific pass-through may differ from PSA, such as: Age of pool, coupon of pool relative to current coupons, fully amortized R or not, Assumability, Size of pool, Conventional or not, Geographic location, age and jobs of mortgagees. One approach would be to assume a fixed deviation from PSA, like 150% PSA, 50% PSA.. Other Empirical Models the better the prepayment model the more the FI makes. Variations on PSA theme. Considering conditional probabilities, burn-out factors.

Copyright 1999 A. S. Cebenoyan22 Option Models: Use Option Pricing theory to figure out the fair yield spread of pass-throughs over securities (Option-adjusted spread, OAS models). The value of a GNMA bond to an investor is equal to the value of a standard noncallable Treasury bond of the same duration minus the value of the mortgage holder’s prepayment call option. In yield terms: The investors’ required yield on a GNMA should equal the yield on a similar duration T-bond plus an additional yield for writing the valuable call option.

Copyright 1999 A. S. Cebenoyan23 How to calculate the value of the OAS on GNMAs Assume: > Refinancing only reason for prepayment > T-Bond yield curve flat > mortgage coupon rate 10%, principal balance $1 million > mortgages have 3-year maturity, and annual payments > mortgages fully amortized, no servicing fee. > Prepayment only after 3% drop from mortgage coupon rate (10%) > maximum yearly interest rate move is 1% up or down > In any year, CF is either R ($402,114 here), R+repayment of any outstanding principal, or zero if all paid off. We start out with current yields at 9%, GNMA bond sells at a premium. >Cash Flow at end of year 1 is R with certainty, as no prepayment >Cash Flow at end of year 2 is tricky: rates now may have gone down to 7% which is going to trigger prepayment. The probability of that is 25%. So, with 25% chance investor receives R plus Principal balance remaining at end of year 2.

Copyright 1999 A. S. Cebenoyan24 Principal balance remaining at end of year 2 (after 2 payments have been made) is going to be $1,000,000 minus principal paid with first payment and minus principal paid with second payment:

Copyright 1999 A. S. Cebenoyan25 Derivation of the option-adjusted spread:

Copyright 1999 A. S. Cebenoyan26 Collateralized Mortgage Obligations (CMOs): Uncertainties about the maturities of mortgage pass-throughs make them unattractive to market participants. CMOs reduce the uncertainty concerning maturity of mortgage- backed security, thereby provides a risk-return pattern not available with typical mortgage pass-through securities. CMO is a mortgage backed bond issued in multiple classes or tranches. GNMA bonds placed in a trust (REMIC) as collateral CMO with 3-17 classes created. Class A, B, C, thru Z. Value is created, Where n=3,…17. Let’s discuss a 3-class CMO :

Copyright 1999 A. S. Cebenoyan27 Investment bank buys $150 million GNMAs and places them in trust as collateral. Issues CMO with A, B, C classes: Class A: Annual fixed 7% coupon, $50 million size Class B: ……………..8%…………………………. Class C:………………9%………………………… The underlying GNMA may have had 9% coupon, and maybe 25 years to maturity. The logistics of the CMO: Each month R is received by the trustee, which distributes Coupons to all classes, and then principal to Class A first, once A is paid off then Class B and so on… Example: R= $2.5 million A gets coupon of [(.07/12)x50 million]=$291,667. B gets coupon of [(.08/12)x50 million]=$333,333. C gets coupon of [(.09/12)x50 million]=$375,000. Interest adds up to $1,000,000.

Copyright 1999 A. S. Cebenoyan28 Principal payments: Only Class A gets the $1.5 million left after interest payments. Thus class A now has $48.5 million outstanding. After Class A is retired B is paid off, and so on. Most times there is an additional Class Z, which is like a zero but not quite. It starts paying interest and principal only after all preceding classes have been paid off. There is also a residual R class. This gives the owner the right to any collateral remaining in the trust after all other bond classes have been retired PLUS any reinvestment income earned by the trust. This is a high risk bond. It is also a unique bond: as there is more left in the pool, more will be reinvested, and less will be retired, Thus a higher value at end. But this means negative duration! As interest rates rise value of class R goes up. Very attractive for hedging portfolios.

Copyright 1999 A. S. Cebenoyan29 Mortgage Backed Bond (MBB) Mortgage-backed bonds stay on the Balance sheet. MBBs have no direct link to the CFs of underlying mortgages, the relationship is one of collateralization. If the FI fails, MBB bondholders have a first claim to a segment of the FI’s mortgage assets. FIs back most MBB issues with excess collateral, Thus receiving AAA ratings for the MBB, even when the FI may be rated BBB or lower. The cost is thus lower. Example: FI finances $20 million in mortgages with $10 million in uninsured deposits (wholesale, over $100,000), and $10 million in insured deposits (retail, less than$100,000). Duration of assets greater than leverage adjusted duration of liabilities, and uninsured depositors are worried about interest rate and default risk, requiring high risk premiums.

Copyright 1999 A. S. Cebenoyan30 Insured depositors are not worried, and are charging next to risk free rate. Genius strikes!: FI puts up $12 million of its mortgages as collateral backing a $10 million long-term MBB issue. Because of the overcollateralization, MBB will cost less than uninsured deposits. FI uses the MBB to retire the uninsured deposits. Duration Gap improved, costs reduced. At the expense of FDIC! The insured depositors are only backed by $8 million in unpledged assets. If FDIC were not there, these depositors would have required high rates for compensation. FDIC discourages high risk institutions from excessive MBB sales. Other than regulatory interference, MBB are undesirable as they tie up mortgages on the B/S, increasing the illiquidity of the assets. FI still liable for reserve requirements and capital adequacy taxes.

Copyright 1999 A. S. Cebenoyan31 IO Strips A bond whose cash flows reflect the monthly interest payments received from a pool of mortgages. Discount effect: As y falls price rises Prepayment effect: As y falls, more prepayments, value falls. As interest rates fall below coupon, prepayment starts to dominate and value of the bond falls. Again negative duration. Thrifts have been buying Ios to hedge their portfolios. See graphs. Page 697.

Copyright 1999 A. S. Cebenoyan32 PO Strips A bond with cash flows that reflect the monthly principal payments received from a pool of mortgages. Discount effect: As y falls, value rises Prepayment effect: As y falls, more early payoffs, value goes up. Most other assets can and have been securitized.