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web.mit.edu web.mit.edu Presentation Transcript

  • The Role of Investment Banks in the U.S. Bond Market Slide version
  • The Role of Stocks and Bonds in Corporate Capital Formation
    • Companies need capital (i.e. money) to purchase inventory, open new plants, etc.
    • Companies w/o an established name usually raise capital by:
    • - Getting a loan from a bank, and/or
    • - Getting money from some private equity source
    • Companies w/an established name can raise capital through the stock and the bond markets at a more attractive level
  • Stocks and Bonds
    • A stock is a security representing an ownership interest in a company
    • A bond is a security whereby the issuer borrows money, called the principal, and agrees to:
    • - Pay the lender (the bond holder) interest payments based on the outstanding
    • amount of principal.
    • - Return the principal through a “lump sum” payment, periodic payments over
    • time, or in the case of a “perpetual” bond, not at all
    • Publicly traded stocks are actively traded at exchanges as well as
    • OTC (Over the Counter) markets
    • Publicly traded bonds are actively traded mainly in the OTC market
    • (i.e., wall street bond dealers)
  • Investment Banks’ Role in Corporate Funding (Pg. 1 of 4)
    • Traditionally, investment banking refers to Corporate Finance ,
      • which is the process of raising money for corporate clients (or public institutions) in the form of equity/stocks, debt, or convertible securities.
    • This process involves two steps:
      • determining the most efficient funding for the client
        • type, amount, and structure
      • finding investors to supply those funds
        • for larger investment banks, this step will involve other areas of the firm, such as sales, trading, research and a syndicate function
  • Investment Banks’ Role in Corporate Funding (Pg. 3 of 4)
    • Example:
    • ABC Co. needs money to build a new plant
    • ABC Co. decides to employ Investment Bank IBK in this pursuit
    • Services IBK provides ABC Co.:
    • (1) Corporate Finance expertise:
    • + evaluates funding options (amount, type, and structure); options considered:
    • - common equity, preferred,
    • - debt (fixed-rate and floating rates with various maturities)
    • - convertible debt
    • + helps decide that a $200MM 7 yr. fixed-rate bond offering is the best option
  • Investment Banks’ Role in Corporate Funding (Pg. 4 of 4)
    • (2) Pricing & Underwriting, and Distribution Capability:
    • + IBK’s sales/trading expertise in the secondary market helps determine fair
    • pricing of the bond (new issues are sold in the primary market , issues are
    • subsequently traded in the secondary market )
    • + IBK leads an underwriting group, which purchase the bond and sell them to
    • investors (over days and sometimes weeks)
    • + IBK (and other dealers) are expected to provide 2-way market to buy/sell ABC’s bonds in the secondary market, an important function that would
    • - keep the institutional investors happy which in turn satisfy ABC Co., and
    • - keep IBK on “top of the market” and remain competitive
  • Governments’ Need to Borrow Money
    • The U.S. Government, federal agencies, and state/local governments (municipalities)
    • raise money in the capital markets to fund expenditures and other activities, for example:
    • The U.S. Government issues Treasury Bills/Notes/Bonds to fund federal programs
    • Federal agencies such as FNMA issue debt (bearing its name) so as to help provide funds to home buyers
    • State and local governments issue municipal bonds to fund building roads, etc.
  • Investment Banks’ Role in Government Related Debt
    • The main roles of investment banks in these debt markets are:
    • U.S. Treasury Debt Market: bid in U.S. Treasury auctions (if primary dealers)
    • Agency and Municipal Debt Market:
      • advise on efficient financing: e.g., maturities, call features, the need for credit enhancement (muni bonds)
      • underwrite and distribute debt
    • Secondary Market for the above: provide 2-way market for investors to buy/sell
  • Residential Mortgages: the Need to Securitize (Pg. 1 of 3)
    • Banks lend money to home buyers (a mortgage)
    • Banks borrow money from depositors (checking/savings accounts) and by selling CDs
    • Banks frequently “securitize” and sell these loans because
      • More demand from home buyers to borrow money than supply of funds
      • Risk of holding mortgages
  • Residential Mortgages: the Need to Securitize Pg. (2 of 3)
    • A Simplified Example: Bank ABC
    • has $100mm from checking/saving accounts and CDs, averaging 3% for 3 yrs.;
    • has $100mm 30-yr. fixed-rate mortgage loans (e.g.,1000 loans), averaging 5%
    • Simplistically speaking, the bank can earn a +2% spread, before expense, for 3 years
    • Risk: However, if after 3 years rates rise substantially :
      • the bank will not be able to borrow at 3%, but at a much higher rate, say, 10%;
      • now the bank has a NEGATIVE spread of 5%!! (5% - 10% = -5%)
  • Residential Mortgages: the Need to Securitize Pg. (3 of 3)
    • One way for the bank to manage such risk is to be able to
      • sell their mortgage loans quickly and efficiently
      • and invest in shorter maturity assets (at least temporarily)
    • But it is not easy to sell loans quickly and efficiently
      • Solution: turn the loans into securities
    • Question 1: What is “securitization?”
    • Question 2: Why is it easier to sell securities than loans?
  • A Flowchart of Agency Securitization
  • An Example of Securitization: Agency Pass-Through (Pg. 1 of 2)
    • Example 1:
    • Bank ABC “pools” $100MM mortgage loans of similar interest rates and criteria
      • criteria meeting “FNMA/FHLMC standard”
      • such as loan size, loan-to-value ratio, income/debt ratio, etc.
    • Bank ABC takes this pool of loans to FHLMC and swaps it with a $100MM FHLMC MBS, pool #1234:
      • FHLMC pool #1234 is now a security “backed” by the $100MM loans
      • FHLMC “guarantees” principal and interest payments of the security (for a fee);
      • Bank ABC “services” the loan (collecting monthly payments) for a fee
      • FHLMC pool #1234 is called a “pass-through” security
  • An Example of Securitization: Agency Pass-Through (Pg. 2 of 2)
    • The bank can either:
      • sell FHLMC pool #1234 immediately to dealers (who then sell to investors)
      • keeps it as an asset, but can sell it quickly later when so desire
    • Note that instead of swaping the loans for securities, the bank can also sell the loan directly to FHLMC, who
      • may keep the loans in their asset portfolio, or
      • securitize the loans and sell the securities to wall street dealers at some point
  • The Advantage of Mortgage Securities over Loans
    • Credit
      • Mortgage loans are not rated;
      • Most securities are rated or bear an agency name (e.g., FNMA)
    • Collecting Interest and Principal Payment (Servicing)
      • Investors are not in the business of chasing/collecting payments from homeowners
    • Liquidity
      • Can be bought and sold easily through numerous wall street dealers
    • Uniformity, Size, and Diversity
      • Can buy one large pool of MBS with the same “net” coupon
  • The Role of Investment Banks in Agency MBS
    • Buy agency pass-throughs from banks and agencies (e.g. FNMA & FHLMC) and sell to institutional investors
    • Maintain active secondary trading to provide liquidity in the pass-through market
    • “ Restructure” agency pass-throughs into CMOs*; provide secondary market
      • CMOs were created to broaden the investor base for mortgage securities
    • Advise agencies regarding new mortgage programs (e.g., hybrid ARMs);
    • Today’s efficient mortgage market means less risk for banks and lower borrowing costs for home buyers
    • * CMO - collateralized mortgage obligations
  • A Flowchart of Non-Agency MBS Securitization
  • The Role of Investment Banks in Non-Agency MBS
    • There are mortgages not eligible to be securitized by agencies.
    • The Role of Investment Banks in creating non-agency MBS:
    • Determine the most efficient securitization “structure”
    • Purchase loans from mortgage originators for the securitization deal
    • Fund mortgage origination for the purpose of securitization
    • Sell the securities to investors
    • Make secondary markets in these MBS
    • Wall Street has played a pivotal role in helping make this mortgage market efficient, which ultimately bring cheaper funding to home buyers
  • Securitizing Other Types of Consumer Loans: Asset Backed Securities (ABS)
    • Just as residential mortgage lenders use the MBS market to help reduce their risk and increase their liquidity, so do other kinds of lenders:
      • credit card companies, auto companies, etc.
    • A process very similar to the process used for securitizing non-agency residential mortgages is used for other consumer loans
      • i.e., credit cards, auto loans, etc.
    • An investment bank’s role in the origination, sale, and secondary trading of asset backed securities is similar to its roll in non-agency residential mortgages
  • Commercial Mortgage Backed Securities (CMBS)
    • Companies that buy commercial real estate (e.g., office buildings, hotels, shopping centers, etc.) look to borrow a significant percentage of the cost (typically 50% - 75%)
    • A number of investment banks (including RBSGC) are in the business of originating these loans.
    • Over time (typically several months) these investment banks will originate commercial loans and then securitize them:
      • loans are larger than residential mortgages
      • Less diversification in a CMBS than MBS
    • Investment banks then sell new CMBS and make secondary markets
  • Overview of U.S. Fixed Income Markets Source: Bond Market Association 1 Agency mortgage outstanding was $3.5 trillion as of 12/31/03, and $3.2 trillion as of 12/31/02
  • Who are the Institutional Investors?
    • Institutional Investors are clients on the sales/trading side, including:
    • Pension Funds
    • Money/Asset/Investment Managers (& Hedge Funds)
    • Insurance companies
    • Banks
    • Mutual Funds
    • Central Banks (in various nations)
    • For our purposes, “investors” means “Institutional Investors”