The New Slides

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The Role of Investment Banks in the U.S. Bond
Market
Slide version
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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
• IBKs 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 ABCs 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

• 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.

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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
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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

• 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)
• Todays efficient mortgage market means less
  risk for banks and lower borrowing costs for home
  buyers
• CMO - collateralized mortgage obligations

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A Flowchart of Non-Agency MBS Securitization
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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 banks 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
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
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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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