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Fin 603 Week 6

Fin 603 Week 6. Mortgage, Municipal and Corporate Bonds. The Agenda for this Class. An overview of where we are in the course Answers to last week’s problems Details for the two course projects This week’s new material. The Google Project In Three Parts.

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Fin 603 Week 6

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  1. Fin 603 Week 6 Mortgage, Municipal and Corporate Bonds

  2. The Agenda for this Class • An overview of where we are in the course • Answers to last week’s problems • Details for the two course projects • This week’s new material Professor Ross Miller • Fall 2005

  3. The Google Project In Three Parts • Predict the closing price of Google: (Nasdaq ticker: GOOG) on December 9, 2005 (5 pts.) • Create a portfolio that includes 10,000 shares of Google for the period from November 14 through December 9, 2005. Portfolios are graded based on the Sharpe ratios they achieve (20 pts.) • Write up an explanation of how you created your portfolio in 500 words or less (75 pts.) Professor Ross Miller • Fall 2005

  4. Key Dates and Times for the Google Project • Both your prediction and your portfolio are due Sunday, November 13, 2005 at 6 p.m. via e-mail in a standard format to rmmiller@uamail.albany.edu. You can use millerrm@nycap.rr.com as a fallback if the first address does not work for you. • Clicking on the above links on a computer running Outlook will create an e-mail message this is properly formatting for submission • The write-up is due Thursday, November 17, 2005 at 5:45pm in class (BA 229) Professor Ross Miller • Fall 2005

  5. Part 1: Google Price Prediction • Prediction is for the price of a single share in $US at the closing of normal Nasdaq trading (usually 4 p.m. or slightly after) on December 9, 2005 as reported on http://finance.yahoo.com. • The object is to come as close as possible. • Guaranteed grades for price prediction accuracy • Within 4% - 5 pts. • Within 8% - 4 pts. • Within 12% - 3 pts. • Grade intervals may be widened at the professor’s discretion Professor Ross Miller • Fall 2005

  6. Part 2: Portfolio Construction • You must hold exactly 10,000 shares of Google • You can supplement these shares with either long or short holdings (in multiples of 100 shares) chosen from any or all of the following six securities: • Nasdaq 100 Trust (QQQQ) • S&P Depository Receipts (SPY) • Yahoo! (YHOO) • Microsoft (MSFT) • Sirius Satellite Radio (SIRI) • Wal-Mart (WMT) Professor Ross Miller • Fall 2005

  7. Part 2: Portfolio Construction (Cash Considerations) • All long positions must be paid for in cash • No purchases on margin • Note that the Google shares alone will cost over $3 million at current stock prices • All short positions will generate 90% of their sale price in cash • This is the typically the best deal any institutional client can get from a broker • Your initial cash investment must be between $500,000 and $5,000,000 Professor Ross Miller • Fall 2005

  8. How Your Portfolios are Evaluated • A Sharpe ratio is computed for each portfolio • The “risk-free” rate is the 30-day T-bill yield available on the afternoon of Friday, November 11, 2005 • The portfolio’s excess return is computed as the daily return in excess of the risk-free rate of return over the four-week period • The portfolio standard deviation is computed as the daily standard deviation over the four-week period • The Sharpe ratio is then the daily excess return divided by the daily standard deviation • A spreadsheet containing a useful example will be available after the midterm exam Professor Ross Miller • Fall 2005

  9. How Portfolios are Evaluated (continued) • Higher Sharpe ratios earn higher grades • Any portfolio with a higher Sharpe ratio than would be obtained by simply holding Google stock is guaranteed at least 17 out of 20 points • The top three Sharpe ratios are guaranteed 20 out of 20 points • The next five highest Sharpe ratios are guaranteed at least 19 out of 20 points Professor Ross Miller • Fall 2005

  10. E-mail Submission Details • Enter your last name after “Last Name: ” (leave at least one space) • Give the price for Google stock in dollars and cents directly after GOOG (leave at least one space) • Give the quantities for your portfolio (the 10000 shares of GOOG are automatically in it) • Again, leave at least one space after the symbol • Quantities must be a multiple of 100 shares and should not include commas • If the automated form does not work for you, create your own version and place “Fin603 GOOG” in the subject of your e-mail addressed to rmmiller@uamail.albany.edu. Professor Ross Miller • Fall 2005

  11. Sample E-Mail Submission Last Name: SquarePants GOOG 300.50 QQQQ -34000 SPY 8600 YHOO -3400 MSFT -500 SIRI WMT -7500 Professor Ross Miller • Fall 2005

  12. Google Project Write-Up • 500-word limit is strictly enforced • Up to 3 optional tables or figures of reasonable size are allowed in addition to the 500 words • Formatting guidelines • Single-spaced within paragraphs and double-spaced between paragraphs • 12-point standard proportional typeface • Left-hand justified • Margins of at least 1 inch on all sides Professor Ross Miller • Fall 2005

  13. Google Project Write-Up (continued) • Should be readable with Microsoft Word or Adobe Acrobat • Restrained use of hyperlinks is fine • Do not include macros in your spreadsheets or files in formats other than DOC, PDF, and XLS • The write-up may be either e-mailed or submitted as hard copy in class on November 17 or both Professor Ross Miller • Fall 2005

  14. Google Project: Final Comments • Write-ups will be graded by Tuesday,November 22 and will be made available through the grading function in WebCT • Predictions/portfolios will be graded by Tuesday, December 13 and all grades (including the final course grade) will be made available through WebCT • You should send a practice e-mail submission to me between Monday November 7 and Thursday, November 10 and I will reply to it Professor Ross Miller • Fall 2005

  15. Three Ways to Do the Final Project • Create an investment strategy/product and “pitch” it to the class • Create a 401(k) plan and “pitch” it to the class • Do any other project of your choice about investments or financial markets that the professor approves Professor Ross Miller • Fall 2005

  16. Main Project Details • Form teams of 3 or 4 students each • The project consists of two parts that count equally • 10-minute class presentation for each student (graded individually, but part of an overall group presentation) during the last two weeks of class • Supporting written documentation (graded jointly) of not more than 1,000 words due at the last class meeting (Thursday, December 8) Professor Ross Miller • Fall 2005

  17. The Error in this Picture is the Consequence of Convexity Professor Ross Miller • Fall 2005

  18. (Positive) Convexity is Usually a Good Thing • There are no convexity questions on the midterm exam, so you can relax • Convexity is good because as interest rates go up, the rate at which your bond drops in price decelerates • Similarly, when interest rates fall, the rate at which your bond rises in price accelerates Professor Ross Miller • Fall 2005

  19. Positive vs. Negative Convexity • Virtually every government and corporate coupon bond has positive convexity • Zero-coupon bonds have zero convexity—their duration is independent of bond price • Mortgages have negative convexity, which makes them dangerous • What’s the problem: Mortgages can prepay at any time, particularly when interest rates drop’ • There is a deep link between options and convexity that we will get to in a few weeks (convexity in options is known as “gamma”) Professor Ross Miller • Fall 2005

  20. Mortgages and Mortgage-Backed Securities • Mortgages are loans to individuals or businesses to purchase a home, land, or other real property • Many mortgages are securitized—packaged and sold as assets backing a publicly traded or privately held debt instrument • Four basic categories of mortgages • Single-family home • Multifamily dwelling • Commercial • Farm Professor Ross Miller • Fall 2005

  21. Major Mortgage Characteristics • Lien - A public record attached to the title of the property that gives the FI the right to sell the property if the mortgage borrower defaults • Down payment - A portion of the purchase price of the property a FI requires the mortgage borrower to pay up front • Private mortgage insurance - Insurance contract purchased by a mortgage borrower guaranteeing to pay the FI the difference between the value of the property and the balance remaining on the mortgage Professor Ross Miller • Fall 2005

  22. Major Mortgage Characteristics (cont’d) • Federally insured mortgages - Originated by FIs with repayment guaranteed by either the Federal Housing Administration (FHA) or the Veterans Administration (VA) • Conventional mortgages - Issued by FIs that are not federally insured • Amortized - when the fixed principal and interest payments fully pay off the mortgage by its maturity date Professor Ross Miller • Fall 2005

  23. Two Main Types of Mortgages • Fixed-rate mortgage - Locks in the borrower’s interest rate and thus the required monthly payment over the life of the mortgage, regardless of market rate changes • Adjustable-rate mortgage - Interest rate is tied to some market interest rate with potential for change in required monthly payments over the life of the mortgage Professor Ross Miller • Fall 2005

  24. Mortgage Fine Points • Discount points • Extra payment made when the loan is issued (at closing). One discount point = 1 percent of the principle value of the mortgage • Point have become unpopular • Amortization schedule • Shows how the monthly mortgage payments are split between principal and interest Professor Ross Miller • Fall 2005

  25. Amortization • Shorter maturity means higher mortgage payments • 15-year vs. 30-year fixed-rate mortgages • Some mortgages start with zero or even negative amortization • Even a fully-amortized loan pays back very little principal early in the life of the mortgage • Only the interest part of mortgage payments can be deducted from income taxes Professor Ross Miller • Fall 2005

  26. How to Think About Standard Amortization • Get the number of periods and periodic interest rate straight first • The standard 30-year mortgage has T = 360 (monthly periods) • The monthly interest rate is often (but not always) the quoted annual rate divided by 12 • The PV of the mortgage cash flows is just the mortgage amount • In a fully amortizing mortgage, the “face value” or “principal amount” is 0 Professor Ross Miller • Fall 2005

  27. Getting the Mortgage Payment in a Fully Amortizing Mortgage or Other Loan Excel has the PMT function. It does use not magic; instead it uses Par Value=0 as follows: Annuity Factor Professor Ross Miller • Fall 2005

  28. Interpreting the Previous Slide • “Coupon” is just the periodic mortgage payment • “Bond Value” is just the size of the mortgage Professor Ross Miller • Fall 2005

  29. Amortization Schedules Can Be Deceptive • One a tiny fraction of mortgages pay out for their entire term • The standard curve for prepayment is known as PSA Professor Ross Miller • Fall 2005

  30. The Big Deal About Mortgages—Prepayment • Mortgages can be prepaid with little or no penalty at any time during the life of the mortgage • Reasons to prepay • A drop in interest rates allows the borrower to enter into a new mortgage at a lower interest rate • Moving to a new home (mortgages stopped being assumable by the new owner in the 1970s) • Life-cycle considerations (Wall Street bonuses, etc.) Professor Ross Miller • Fall 2005

  31. Mortgage Prepayments According to the PSA (Public Securities Assn.) Schedule Professor Ross Miller • Fall 2005

  32. Features of 100% PSA Prepayment • Prepayments ramp up over the first 30 months • Start with CPR (Conditional payment rate) of 0.2% annual rate in the first month and increase by 0.2% each month until it hits 6% in the 30th month • For the remainder of the mortgage CPR stays at a 6% annual rate • CPR converts to a single-month “mortality” rate (SMM) via the following formula: SMM = 1 – (1 – CPR)1/12 Professor Ross Miller • Fall 2005

  33. PSA Speed • Typically, mortgages prepay at least 150% of PSA and can go much higher than that • At 150% PSA, in the 15th month we have the following: • CPR = 150% x 15 x 0.2% = 4.5% annual rate of prepayments • SMM = 1 – (1 – CPR)1/12 = 1 – (1 – 0.045) 1/12 = 0.38% of mortgages prepay in the 15th month • Low interest rates increase PSA speed and high interest rates decrease it Professor Ross Miller • Fall 2005

  34. The Big Problem with Mortgages:Prepayment Means Negative Convexity • Duration and the Typical Treasury Note or Bond • A drop in prices caused by an increase in interest rates causes duration to drop • Hence, further increases in rates do not generate as large a proportional drop in prices • A rise in prices caused by a decrease in interest rates causes duration to rise • Hence, further decreases in rates generate even larger increases in prices • As former stock broker Martha Stewart would say about such positive convexity: “This is a good thing.” Professor Ross Miller • Fall 2005

  35. More on Negative Convexity • Mortgages do not work this way • Key differences • A rise in interest rates slows prepayments, which increases duration • A decline in interest rates accelerates prepayments, which decrease duration • These two differences (negative convexity) easily outweigh the positive convexity that is natural in a bond that does not prepay Professor Ross Miller • Fall 2005

  36. Investors Prefer “Bundles” of Mortgages to Single Mortgages • Spreads out risk • Prepayment • Default (though mortgage insurance deals with most of this) • Mortgage bundlers have an incentive to standardize the bundles • Unfortunately, they also have an incentive to “cherry pick” them • Bundles are easier to analyze and track than individual mortgages Professor Ross Miller • Fall 2005

  37. Mortgage Pass-Throughs • The simplest from of mortgage-backed securities (securities based on bundles of mortgages) • Investors in mortgage pass-throughs receive the interest and principal payments from the mortgages in the pools • Various servicing and other fees are assessed • Payments are usually monthly and there is some delay between the time the servicer receives payments and they go out to investors Professor Ross Miller • Fall 2005

  38. Ginnie Mae (GNMA: An Abbreviation, Not a Stock Symbol) • A federal government agency that bundles FHA and VA mortgages and creates securities from those bundles • Payments are fully insured by the federal government • The securities issued by Ginnie Mae tend to have the lowest yields because of the government guarantee Professor Ross Miller • Fall 2005

  39. Fannie Mae (FNM) and Freddie Mac (FRE) • Perform the same function as Ginnie Mae, but with private mortgages with principal amounts less than a pre-determined cutoff level • Both are government-sponsored entitites (GSE) that trade as private companies • Fannie Mae is the largest player in the mortgage market and Freddie Mae is number two • Both have been involved in accounting and other irregularities and are in the process of shrinking their balance sheets Professor Ross Miller • Fall 2005

  40. Quotes of Mortgage-Backed Securities from wsj.com Professor Ross Miller • Fall 2005

  41. The Butcher’s View of Bundled Mortgages Professor Ross Miller • Fall 2005

  42. Lewis Ranieri: The Father of Mortgage-Backed Securities • Headed group at Salomon Brothersthat was made (in)famous by the bookLiar’s Poker by Michael Lewis • Went on to become Vice Chairman of Salomon Brothers • Now primarily a venture capitalist, he was brought as chairman to clean up Computer Associates Professor Ross Miller • Fall 2005

  43. Pension Funds and Insurance Companies Want the “Prime Cuts” of Mortgage Bundles • The idea: Create a security from bundled mortgages that looks as much like Treasury securities as possible • Eliminate default risk • Eliminate prepayment risk • Have cash flows that are insensitive to changes in interest rates • The bottom line: Turn negative convexity back into positive convexity Professor Ross Miller • Fall 2005

  44. Less-than-Prime Cuts Also Have Their Uses • Slices of bundled mortgages (known as tranches), can be useful in offsetting certain liabilities on the balance sheets of FIs • As with anything, there are always undesirable “leftovers” • Default risk is always present • Insurance gets rid of it (assuming the insurer does not go under) • Overcollaterization moves it into a residual tranche • The worst mortgage leftover are known as “toxic waste” Professor Ross Miller • Fall 2005

  45. PAC Bond:The Filet Mignon of Mortgages • PAC stands for Planned Amortization Class • PAC bonds are designed to have reliable cash flows over a wide range of prepayment behavior • PAC bonds work by having support bonds that handle the irregularities in prepayment Professor Ross Miller • Fall 2005

  46. Using Overcollateralization to Shape Cash Flows • Basic Idea: Create $50 Million face value of securities using $53 Million worth of mortgages • The extra $3 Million is an “equity cushion” • If all defaults are fully covered by mortgage insurance, this cushion pays off big • If defaults are larger than expected, this cushion is gobbled up • Overcollateralization is used in a variety of asset-backed securitizations Professor Ross Miller • Fall 2005

  47. Mortgages Live in a Pipeline Before They Are Carved Up • Mortgage originators let borrowers “lock in” a particular interest rate for a fixed period of time • Standard “rate locks” are 30 to 60 days, but longer and shorter ones are also available • Assembling completed mortgages into bundles also takes time • Financial institutions involved in the mortgage creation process are exposed to interest-rate risk while all of this is going on Professor Ross Miller • Fall 2005

  48. Coping with Pipeline Interest-Rate Risk • Fortunately, at issue the typical mortgage has a duration this is relatively close to that of the 10-year Treasury note • Mortgage lenders can hedge the risk in the mortgage pipeline by selling 10-year Treasury notes short • Increases in mortgage activity raise put price pressure on 10-year Treasury notes (and related securities), which increases their yields Professor Ross Miller • Fall 2005

  49. Some Places Mortgage Cash Flows Go Other Than To Mortgage Investors • Originators • Mortgage brokers are paid a fee for originating mortgages • Many large FIs originate mortgages and then sell them to bundlers • Bundlers • Ginnie Mae, Fannie Mae, Freddie Mac, and various FIs (GE Capital, Citigroup, etc.) • Servicers • Collect principal and interest payments Professor Ross Miller • Fall 2005

  50. Municipal Bonds (Munis) • Securities issued by state and local governments to fund either temporary imbalances between operating expenditures and receipts or to finance long-term capital outlays for activities such as school construction, public utility construction or transportation systems • Tax receipts or revenues generated by the project are the source of repayment • Attractive to household investors because interest (but not capital gains) are tax exempt Professor Ross Miller • Fall 2005

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