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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
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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)
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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
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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
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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
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Governments’ Need to Borrow Money
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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
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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
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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%)
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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?
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A Flowchart of Agency Securitization
Banks/Mortgage Originators
FNMA, FHLMC, orGNMA: Securitize
Loans
Wall StreetDealers
Sell loans to
Or swap loans forsecurities
Sell securities
InstitutionalInvestor 1
InstitutionalInvestor 2
InstitutionalInvestor 3
InstitutionalInvestor 4
Sell securities
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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
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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
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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
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The Role of Investment Banks in Agency MBS
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• 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
Banks/Mortgage
Originators
Wall StreetDealers
Sell loans or securities
InstitutionalInvestor 1
InstitutionalInvestor 2
InstitutionalInvestor 3
InstitutionalInvestor 4
Sell securitiesSell securities
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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
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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
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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
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Overview of U.S. Fixed Income Markets
Market
Outstanding Debt as of 12/31/03
($Trillions)
Outstanding Debt as of 12/31/02
($Trillions) U.S. Treasury 3.6 3.2 Corporate 4.5 4.1 Mortgage1 5.3 4.7 Money Market 2.5 2.6 Municipal 1.9 1.8 Federal Agency 2.6 2.3 Asset-Backed 1.7 1.5
Total 22.1 20.2
Source: Bond Market Association1 Agency mortgage outstanding was $3.5 trillion as of 12/31/03, and $3.2 trillion as of 12/31/02
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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”
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