Economics 434 Theory of Financial Markets

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Economics 434Theory of Financial Markets
Professor Edwin T Burton Economics
Department The University of Virginia
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News Background

• The Bad News
• Iceland imploding.the country itself may go
  bankrupt
• AIG given an additional 37.5 Billion (on top of
  85 billion earlier
• California Budget Crisis
• Similar problem in virtually all states
• The Good News
• Pending home sales rise 7.4 from July to August
• Massachusetts sells 750 million in bond market

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Dollar Commitment to Bailouts

• Federal Reserve
• 30 billion guarantee of BSC Assets
• 85 billion bridge loan to AIG plus 37.5 billion
  additional loan yesterday
• Estimated 600 billion in added loan facilities
• Treasury
• 700 billion Paulson Plan
• FNM, FRE, 200 billion to protect bonds plus 2
  billion in preferred equity

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Meanwhileback to mortgages
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Constant Mortgage Payments Over Time
1,199.10
Principal payment
Interest expense
time
360 Months of Payments
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Things to Note

• Interest expense is deductible for tax purposes.
  This means the government is providing at 35 to
  40 percent subsidy to the interest expense part
  of the mortgage payment
• Early payments most valuable
• Provides incentive to refinance, even if rates
  have not changed or even if they have gone up
• What if you decide to sell your home? Then you
  would prepay your mortgage.
• GNMA mortgages let you do this without any
  penalty
• If this was a commercial loan (think office
  building), the penalty would be equal to whatever
  the prepayment costs the lender

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Prepayment of mortgages

• If you can do it without penalty, then
• You will do it when new mortgage rates drop
  enough
• You might do it even if rates have gone up
• This means that the lender (the person who owns
  the mortgage) is at risk of a prepayment of the
  mortgage.
• Prepayment risk is at least as big a risk as
  potential default by the borrower.

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Second Mortgages

• Buy a 250,000 house
• 50,000 down payment
• Take out 200,000 (first) mortgage
• Home value rises to 400,000
• Take out second mortgage of 100,000
• Now total debt is 300,000
• Home equity is 100,000
• How about a home equity loan now

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Home Equity Line

• Home worth 400,000 with first and second
  mortgages of 200,000 and 100,000
• Now home price goes to 600,000
• Take out 200,000 Home Equity Line (not cash,
  simply a line of credit that can be accessed
  when you need it or want to use it)
• Buy a car, take a vacation, spend 200,000 by
  drawing down your home equity line
• Now you owe 500,000, home value is 600,000
• Suppose home value now goes to 450,000?

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The idea behind structured debt or
asset-backed securities

• Go back to the stripping of treasury bond example
• 30 year bond
• 60 coupons
• Last payment is both coupon and principal
• So a bond is really 60 different securities
• They can be recombined in many, many different
  ways

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Asset-Backed Security

• Total Misnomer
• Should be Cash-flow structured securities
• A strip is an example of an ABS
• ABS is a way of slicing up cash flows and
  creating new securities out of them

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The End