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  1. 1. The Role of Investment Banks in the U.S. Bond Market Slide version
  2. 2. The Role of Stocks and Bonds in Corporate Capital Formation <ul><li>Companies need capital (i.e. money) to purchase inventory, open new plants, etc. </li></ul><ul><li>Companies w/o an established name usually raise capital by: </li></ul><ul><li>- Getting a loan from a bank, and/or </li></ul><ul><li>- Getting money from some private equity source </li></ul><ul><li>Companies w/an established name can raise capital through the stock and the bond markets at a more attractive level </li></ul>
  3. 3. Stocks and Bonds <ul><li>A stock is a security representing an ownership interest in a company </li></ul><ul><li>A bond is a security whereby the issuer borrows money, called the principal, and agrees to: </li></ul><ul><li>- Pay the lender (the bond holder) interest payments based on the outstanding </li></ul><ul><li>amount of principal. </li></ul><ul><li>- Return the principal through a “lump sum” payment, periodic payments over </li></ul><ul><li>time, or in the case of a “perpetual” bond, not at all </li></ul><ul><li>Publicly traded stocks are actively traded at exchanges as well as </li></ul><ul><li>OTC (Over the Counter) markets </li></ul><ul><li>Publicly traded bonds are actively traded mainly in the OTC market </li></ul><ul><li>(i.e., wall street bond dealers) </li></ul>
  4. 4. Investment Banks’ Role in Corporate Funding (Pg. 1 of 4) <ul><li>Traditionally, investment banking refers to Corporate Finance , </li></ul><ul><ul><li>which is the process of raising money for corporate clients (or public institutions) in the form of equity/stocks, debt, or convertible securities. </li></ul></ul><ul><li>This process involves two steps: </li></ul><ul><ul><li>determining the most efficient funding for the client </li></ul></ul><ul><ul><ul><li>type, amount, and structure </li></ul></ul></ul><ul><ul><li>finding investors to supply those funds </li></ul></ul><ul><ul><ul><li>for larger investment banks, this step will involve other areas of the firm, such as sales, trading, research and a syndicate function </li></ul></ul></ul>4
  5. 5. Investment Banks’ Role in Corporate Funding (Pg. 3 of 4) <ul><li>Example: </li></ul><ul><li>ABC Co. needs money to build a new plant </li></ul><ul><li>ABC Co. decides to employ Investment Bank IBK in this pursuit </li></ul><ul><li>Services IBK provides ABC Co.: </li></ul><ul><li>(1) Corporate Finance expertise: </li></ul><ul><li> + evaluates funding options (amount, type, and structure); options considered: </li></ul><ul><li>- common equity, preferred, </li></ul><ul><li> - debt (fixed-rate and floating rates with various maturities) </li></ul><ul><li>- convertible debt </li></ul><ul><li> + helps decide that a $200MM 7 yr. fixed-rate bond offering is the best option </li></ul>
  6. 6. Investment Banks’ Role in Corporate Funding (Pg. 4 of 4) <ul><li>(2) Pricing & Underwriting, and Distribution Capability: </li></ul><ul><li> + IBK’s sales/trading expertise in the secondary market helps determine fair </li></ul><ul><li>pricing of the bond (new issues are sold in the primary market , issues are </li></ul><ul><li>subsequently traded in the secondary market ) </li></ul><ul><li> + IBK leads an underwriting group, which purchase the bond and sell them to </li></ul><ul><li>investors (over days and sometimes weeks) </li></ul><ul><li> + 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 </li></ul><ul><li>- keep the institutional investors happy which in turn satisfy ABC Co., and </li></ul><ul><li>- keep IBK on “top of the market” and remain competitive </li></ul>
  7. 7. Governments’ Need to Borrow Money <ul><li>The U.S. Government, federal agencies, and state/local governments (municipalities) </li></ul><ul><li>raise money in the capital markets to fund expenditures and other activities, for example: </li></ul><ul><li>The U.S. Government issues Treasury Bills/Notes/Bonds to fund federal programs </li></ul><ul><li>Federal agencies such as FNMA issue debt (bearing its name) so as to help provide funds to home buyers </li></ul><ul><li>State and local governments issue municipal bonds to fund building roads, etc. </li></ul>
  8. 8. Investment Banks’ Role in Government Related Debt <ul><li>The main roles of investment banks in these debt markets are: </li></ul><ul><li>U.S. Treasury Debt Market: bid in U.S. Treasury auctions (if primary dealers) </li></ul><ul><li>Agency and Municipal Debt Market: </li></ul><ul><ul><li>advise on efficient financing: e.g., maturities, call features, the need for credit enhancement (muni bonds) </li></ul></ul><ul><ul><li>underwrite and distribute debt </li></ul></ul><ul><li>Secondary Market for the above: provide 2-way market for investors to buy/sell </li></ul>
  9. 9. Residential Mortgages: the Need to Securitize (Pg. 1 of 3) <ul><li>Banks lend money to home buyers (a mortgage) </li></ul><ul><li>Banks borrow money from depositors (checking/savings accounts) and by selling CDs </li></ul><ul><li>Banks frequently “securitize” and sell these loans because </li></ul><ul><ul><li>More demand from home buyers to borrow money than supply of funds </li></ul></ul><ul><ul><li>Risk of holding mortgages </li></ul></ul>
  10. 10. Residential Mortgages: the Need to Securitize Pg. (2 of 3) <ul><li>A Simplified Example: Bank ABC </li></ul><ul><li>has $100mm from checking/saving accounts and CDs, averaging 3% for 3 yrs.; </li></ul><ul><li>has $100mm 30-yr. fixed-rate mortgage loans (e.g.,1000 loans), averaging 5% </li></ul><ul><li>Simplistically speaking, the bank can earn a +2% spread, before expense, for 3 years </li></ul><ul><li>Risk: However, if after 3 years rates rise substantially : </li></ul><ul><ul><li>the bank will not be able to borrow at 3%, but at a much higher rate, say, 10%; </li></ul></ul><ul><ul><li>now the bank has a NEGATIVE spread of 5%!! (5% - 10% = -5%) </li></ul></ul>
  11. 11. Residential Mortgages: the Need to Securitize Pg. (3 of 3) <ul><li>One way for the bank to manage such risk is to be able to </li></ul><ul><ul><li>sell their mortgage loans quickly and efficiently </li></ul></ul><ul><ul><li>and invest in shorter maturity assets (at least temporarily) </li></ul></ul><ul><li>But it is not easy to sell loans quickly and efficiently </li></ul><ul><ul><li>Solution: turn the loans into securities </li></ul></ul><ul><li>Question 1: What is “securitization?” </li></ul><ul><li>Question 2: Why is it easier to sell securities than loans? </li></ul>
  12. 12. A Flowchart of Agency Securitization
  13. 13. An Example of Securitization: Agency Pass-Through (Pg. 1 of 2) <ul><li>Example 1: </li></ul><ul><li>Bank ABC “pools” $100MM mortgage loans of similar interest rates and criteria </li></ul><ul><ul><li>criteria meeting “FNMA/FHLMC standard” </li></ul></ul><ul><ul><li>such as loan size, loan-to-value ratio, income/debt ratio, etc. </li></ul></ul><ul><li>Bank ABC takes this pool of loans to FHLMC and swaps it with a $100MM FHLMC MBS, pool #1234: </li></ul><ul><ul><li>FHLMC pool #1234 is now a security “backed” by the $100MM loans </li></ul></ul><ul><ul><li>FHLMC “guarantees” principal and interest payments of the security (for a fee); </li></ul></ul><ul><ul><li>Bank ABC “services” the loan (collecting monthly payments) for a fee </li></ul></ul><ul><ul><li>FHLMC pool #1234 is called a “pass-through” security </li></ul></ul>13
  14. 14. An Example of Securitization: Agency Pass-Through (Pg. 2 of 2) <ul><li>The bank can either: </li></ul><ul><ul><li>sell FHLMC pool #1234 immediately to dealers (who then sell to investors) </li></ul></ul><ul><ul><li>keeps it as an asset, but can sell it quickly later when so desire </li></ul></ul><ul><li>Note that instead of swaping the loans for securities, the bank can also sell the loan directly to FHLMC, who </li></ul><ul><ul><li>may keep the loans in their asset portfolio, or </li></ul></ul><ul><ul><li>securitize the loans and sell the securities to wall street dealers at some point </li></ul></ul>14
  15. 15. The Advantage of Mortgage Securities over Loans <ul><li>Credit </li></ul><ul><ul><li>Mortgage loans are not rated; </li></ul></ul><ul><ul><li>Most securities are rated or bear an agency name (e.g., FNMA) </li></ul></ul><ul><li>Collecting Interest and Principal Payment (Servicing) </li></ul><ul><ul><li>Investors are not in the business of chasing/collecting payments from homeowners </li></ul></ul><ul><li>Liquidity </li></ul><ul><ul><li>Can be bought and sold easily through numerous wall street dealers </li></ul></ul><ul><li>Uniformity, Size, and Diversity </li></ul><ul><ul><li>Can buy one large pool of MBS with the same “net” coupon </li></ul></ul>
  16. 16. The Role of Investment Banks in Agency MBS <ul><li>Buy agency pass-throughs from banks and agencies (e.g. FNMA & FHLMC) and sell to institutional investors </li></ul><ul><li>Maintain active secondary trading to provide liquidity in the pass-through market </li></ul><ul><li>“ Restructure” agency pass-throughs into CMOs*; provide secondary market </li></ul><ul><ul><li>CMOs were created to broaden the investor base for mortgage securities </li></ul></ul><ul><li>Advise agencies regarding new mortgage programs (e.g., hybrid ARMs); </li></ul><ul><li>Today’s efficient mortgage market means less risk for banks and lower borrowing costs for home buyers </li></ul><ul><li>* CMO - collateralized mortgage obligations </li></ul>
  17. 17. A Flowchart of Non-Agency MBS Securitization
  18. 18. The Role of Investment Banks in Non-Agency MBS <ul><li>There are mortgages not eligible to be securitized by agencies. </li></ul><ul><li>The Role of Investment Banks in creating non-agency MBS: </li></ul><ul><li>Determine the most efficient securitization “structure” </li></ul><ul><li>Purchase loans from mortgage originators for the securitization deal </li></ul><ul><li>Fund mortgage origination for the purpose of securitization </li></ul><ul><li>Sell the securities to investors </li></ul><ul><li>Make secondary markets in these MBS </li></ul><ul><li>Wall Street has played a pivotal role in helping make this mortgage market efficient, which ultimately bring cheaper funding to home buyers </li></ul>
  19. 19. Securitizing Other Types of Consumer Loans: Asset Backed Securities (ABS) <ul><li>Just as residential mortgage lenders use the MBS market to help reduce their risk and increase their liquidity, so do other kinds of lenders: </li></ul><ul><ul><li>credit card companies, auto companies, etc. </li></ul></ul><ul><li>A process very similar to the process used for securitizing non-agency residential mortgages is used for other consumer loans </li></ul><ul><ul><li>i.e., credit cards, auto loans, etc. </li></ul></ul><ul><li>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 </li></ul>
  20. 20. Commercial Mortgage Backed Securities (CMBS) <ul><li>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%) </li></ul><ul><li>A number of investment banks (including RBSGC) are in the business of originating these loans. </li></ul><ul><li>Over time (typically several months) these investment banks will originate commercial loans and then securitize them: </li></ul><ul><ul><li>loans are larger than residential mortgages </li></ul></ul><ul><ul><li>Less diversification in a CMBS than MBS </li></ul></ul><ul><li>Investment banks then sell new CMBS and make secondary markets </li></ul>
  21. 21. 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
  22. 22. Who are the Institutional Investors? <ul><li>Institutional Investors are clients on the sales/trading side, including: </li></ul><ul><li>Pension Funds </li></ul><ul><li>Money/Asset/Investment Managers (& Hedge Funds) </li></ul><ul><li>Insurance companies </li></ul><ul><li>Banks </li></ul><ul><li>Mutual Funds </li></ul><ul><li>Central Banks (in various nations) </li></ul><ul><li>For our purposes, “investors” means “Institutional Investors” </li></ul>