Teaching Notes-FMI-342 PDF

Management of Financial Institutions
Anthony Saunders and Marcia Cornett
Teaching Notes
Chapter 01 - Introduction
Chapter One
Introduction
I. Chapter in Perspective
This chapter has three major sections and one minor section. It first provides a general
overview of the major types of U.S. financial markets, focusing primarily on terminology
and descriptions of the major securities, market structures and regulators. Market
microstructure is not discussed. Foreign exchange transactions are also briefly
introduced. The second major goal of the chapter is to describe the various types of
financial institutions, explain the risks they face and the services they provide to funds’
users and funds’ suppliers. The chapter concludes by providing some statistics about the
rapid growth of globalization of both markets and institutions.
II. Notes
1. Why Study Financial Markets and Institutions?

For an economy to achieve its potential growth rate, mechanisms must exist to effectively
allocate capital (a scarce resource) to the best possible uses accounting for the riskiness of
the opportunities available. Markets and institutions have been created to facilitate
transfers of funds from economic agents with surplus funds to economic agents in need of
funds. For an economy to maximize its growth potential it must create methods that
attract savers’ excess funds and then put those funds to the best uses possible, otherwise
idle cash is not used as productively as possible. The funds transfer should occur at as
low a cost as possible to ensure maximum economic growth. Two competing alternative
methods exist: direct and indirect financing. In direct financing the ultimate funds
supplier purchases a claim from the funds demander with or without the help of an
intermediary such as an underwriter. In this case, we rely on primary markets to
initially price the issue and then secondary markets to update the prices, monitor any
contractual conditions and provide liquidity. In indirect financing, the funds demander
obtains financing from a financial intermediary. The intermediary and the borrower
negotiate the terms and cost. The intermediary obtains funds by offering different claims
to fund suppliers. In this case the intermediary is usually responsible for monitoring the
contractual conditions of the financing agreement and perhaps updating the cost if needed
or appropriate.
With the pace of globalization and increasing deregulation of financial institutions,

managing risk and maintaining profits in a rapidly changing, increasingly competitive
global market is of paramount importance. Institutions continue to merge within and
across traditional financial product lines in an attempt to exploit perceived economies of
scale and scope and to prevent others from gaining similar advantages over them. The
pace of innovation of new technology, new financial products and services has not
abated. In particular, we are on the cusp of many technological advances that may
change traditional methods of offering financial services at the wholesale and perhaps
eventually at the retail level. Job opportunities for finance students in markets and
institutions are likely to be excellent in the next twenty years as managing risks at
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intermediaries in increasingly complex and competitive businesses will grow in

importance. The text provides an introductory examination of the functions and
characteristics of markets and risk and profitability management at major financial
institutions in order to help students understand the workings of the financial system in
today’s global economy.
Fallout from corporate and Wall Street scandals continues, underscoring the failure of
corporate governance and regulatory agencies to limit managerial misbehaviors as the
pressure to meet short term earnings targets created need and opportunity for managers of
corporations and financial institutions to act unethically. Measuring the cost of the
resulting loss in investor confidence from managerial misdeeds (often aided by Wall
Street’s elite banking and investment banking firms) is difficult at best, but must be
several billions of dollars at least. The scandals and failure of corporate governance led
to the passage of the Sarbanes-Oxley Act (S-O Act). The S-O Act is an attempt to
reduce conflicts of interest and increase management and board accountability for
financial information disclosed by firms. Laws by themselves are insufficient to ensure
proper behavior. Practitioners and academics also need to increase the emphasis placed
on applications of corporate ethics and individual accountability.
2. Overview of Financial Markets

a. Primary Markets vs Secondary Markets
b. Money Markets vs Capital Markets
The two alternative mechanisms of fund raising are direct financing, where the saver
directly purchases a claim from the ultimate funds user in the primary market, or
indirect financing where savers place their money in a FI and the FI lends money to the
ultimate borrower. In the cases where savers desire to place their money directly in the
markets, institutions such as investment bankers (asset brokers) have evolved to assist in
this process. The first time a firm issues securities to the public is referred to as its initial
public offering (IPO). Issuing additional stock of a firm that already has stock publicly
traded is referred to as a seasoned offering. In some cases firms offer the issue to one or
only a few institutional buyers. This is termed a private placement. Until recently
secondary trading of private placements was restricted. Institutions may now trade
privately placed securities among themselves and high net worth individuals.
The primary markets are the markets where firms (and other borrowers) create and sell
new securities in order to raise cash to fund positive NPV projects (or to meet some other
social goals in the case of non profit fund raisers).
Ethics Tip:
There have been serious breaches of ethics by investment bankers in allocating IPO
business such as ‘spinning’ and ‘laddering.’ Many IPOs are oversubscribed, allowing
the investment banker to choose who will receive the issue. Spinning is allocating the
new issue to firms or private accounts of the CEOs of client firms in exchange for IB
business later on or some other perk. Laddering is allocating IPO shares to those who
agree to buy more shares in the aftermarket, driving IPO prices up, which the buyers then
dump shortly thereafter after the price run-up. Since the short term performance of IPOs
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is often quite good, the favored clients who receive the allocations often get abnormally
high gains. Investment bankers were also apparently guilty of issuing overly optimistic
stock research reports to help support the underwriting business. At some firms bonuses
paid to research analysts were based on the level of underwriting business generated by
the institution.
The secondary markets exist to provide liquidity and price information to investors.
These functions make the primary market more attractive. Investors would be far less
likely to invest in risky long term primary securities unless investors believe they can
remain apprised of the current value of their claims and have the ability to sell these
claims quickly at low cost if they choose. Hence the efficiency of operation of the
secondary markets affects the growth rate in the overall economy through their effect on
the primary markets. Secondary market trading volume has risen dramatically in the last
several decades, particularly with the creation of wholesale and retail electronic trading
mechanisms that have substantially reduced trading costs.
Money markets evolved to meet the short term investment needs (1 year or less) of
corporations and institutions desiring to earn a small positive rate of return on cash that
would be needed shortly, hence they have evolved with high denomination safe securities
that have little risk of principle loss. Capital markets are markets where borrowers raise
cash for long term investment needs. These are generally riskier than money markets and
hence, capital market securities must promise to pay a higher rate of return to attract
funds. Savers willing to take the associated risk are attracted to these markets.
Selected Money Market Instruments, billions of dollars, amounts outstanding

3rd Qtr 2004 % Total 3rd Qtr 2007 % Total
Fed Funds & Repos $1,676.2 32% $2,799.1 35%
Commercial Paper $1,316.4 25% $1,857.3 24%
T-bills $ 961.0 19% $ 954.0 12%
Banker’s Acceptances $ 4.3 0% $ 0.3 0%
Negotiable CDs $1,221.8 24% $2,284.0 29%
Totals $5,179.7 100% $7,894.7 100%
Sources: Federal Reserve Board, Flow of Funds Accounts, Levels Tables and GAO-08-168 Schedules of Federal Debt
Commercial paper has rebounded from declines in the early 2000s while the amount of
negotiable CDs is up appreciably over the period.
Selected Capital Market Instruments, billions of dollars, amounts outstanding

3rd Qtr 2004 % Total 3rd Qtr 2007 % Total
Common Equity $15,627.1 35% $22,445.0 37%
Corporate Bonds $ 6,879.4 16% $10,581.8 18%
Municipal Securities $ 2,012.0 5% $ 2,370.6 4%
Mortgages $10,127.8 23% $14,360.2 24%
Treasury Securities* $ 3,308.2 8% $ 3,473.8 6%
Agency/GSE Securities** $ 6,090.0 14% $ 7,107.1 12%
Totals $44,044.5 100% $60,338.5 100%
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* Marketable, excluding T-bills ** 2004 data for this account is year end
Sources: Federal Reserve Board, Flow of Funds Accounts, Levels Tables and GAO-08-168 Schedules of Federal Debt
While mortgages have grown in absolute terms between 2004 and 2007, as a percentage
of the given capital market instruments mortgages have remained approximately stable.
Equity market values increased by about 44% over the time period.
c. Foreign Exchange Markets

The majority of the world’s business involves international business transactions. It is
increasingly important for firms to recognize that the appropriate investment may be
located in Europe, the lowest cost source of funds may be found in Britain instead of the
U.S., or the highest potential growth rates for sales of a firm’s product may be in Asia.
As corporations and institutions have increased their international transactions, foreign
exchange risk has become a major source of risk for many firms today and much hedging
with spot and forward foreign exchange trades occurs.
Historically, when a nation’s current account deficit surpasses 5% of GDP a correction

occurs in currency value. The U.S. has been able to consistently run current account
deficits above 5% because foreigners have been willing to supply funds to U.S. markets.
For instance, foreign central banks continue to purchase dollars to keep local currencies
down to foster their export sectors. Moreover, the U.S. economy and the dollar remain
key generators of global growth; these factors help the dollar maintain its value in the
global market. Nevertheless over the last six years the dollar has dropped about 40%
against the euro and about 20% against a broader basket of currencies.1 The dollar’s drop
is fueling inflation concerns and increasing commodity prices because most commodities
are priced in dollars regardless of where they are traded globally.
d. Derivative Security Markets

A derivative security is a contract which derives its value from some underlying asset or
market condition. In general, the main purpose of the derivatives markets is to transfer
risk between market participants. Some participants, called hedgers, enter derivatives
contracts to reduce their risk exposure in the underlying cash market. Other participants,
called speculators, use derivative contracts to bet on price movements. Derivatives are
highly leveraged instruments. This allows hedgers to reduce risk with a low capital
investment and the leverage also allows speculators to attempt to earn high rates of return
with low capital investments. The two main types of derivatives markets are the market
for exchange traded derivatives and the over the counter (OTC) derivatives markets.
Exchange traded derivatives are generally liquid and involve no counterparty risk,
whereas OTC contracts are custom contracts negotiated between two counterparties and
have default risk.
e. Financial Market Regulation
1
Dollar's Dive Deepens as Oil Soars: Power of Greenback Faces Severe Test, But No Rivals Loom By
Craig Karmin and Joanna Slater, February 29, 2008; Page A1.
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Financial markets are regulated by the SEC, the exchanges, the Commodity Futures
Trading Commission (CFTC) and the National Association of Security Dealers (NASD).
The primary purposes of regulations are to prevent fraud, to ensure performance as
promised, and to ensure that the public has enough information to evaluate the riskiness
of an investment. The regulators do not attempt to ensure investors earn a minimum rate
of return. Recently, some specialists on the NYSE agreed to pay fines because of
allegations of front running customer orders. In front running, specialists transact their
own orders ahead of customer orders for the specialists’ advantage. Decimalization,
automation and competition from electronic communications networks (ECNs) have
reduced specialist profits creating temptations to find other ways to generate revenue.
3. Overview of Financial Institutions

Many savers today are willing to risk some of their funds in the capital markets, but not
all. For at least some of their wealth, savers typically desire a different type of claim than
the ultimate borrower wishes to offer. Asset transformers, such as banks, have evolved
to meet this need by offering low risk claims to savers while granting higher risk, more
illiquid investments (e.g., loans) to the funds demanders. Other types of institutions have
evolved to meet special needs of savers such as life insurance firms to eliminate certain
risks, pension funds to transfer wealth through time, money market mutual funds to pool
investors’ savings, etc.
NUMBER OF
TOTAL
FEDERALLY
INSTITUTION ASSETS
INSURED
(BILL $)
INSTITUTIONS
Commercial Banks $10,793 7,303
Savings Associations $ 1,914 1,257
Credit Unions $ 748 8,362
Insurance Companies $ 6,334
Private Pension Funds $ 5,875
Finance Companies $ 1,397
Mutual Funds $ 7,967
Money Market Mutual Funds $ 2,802
Investment Bankers $ 3,201
Data from September 2007, data sources include Federal Reserve Board, Flow of
Funds Accounts, Levels Tables, FDIC Stats at a Glance,” and the NCUA website. The
mutual funds category excludes money market funds.
Deposit-Type Institutions -- Offer liquid, government insured claims to savers, such as

demand deposits, savings deposits, time deposits, and share accounts.
• Commercial Banks -- Make a variety of consumer and commercial loans (direct
claims) to borrowers.
• Savings and Loan Associations -- Make mortgage loans (direct claim) to borrowers.
• Mutual Savings Banks -- Purchase various securities and make loans -- mortgages,
consumer loans, government bonds, etc.
• Credit Unions -- Receive share account deposits and make consumer loans.
Membership requires a common bond, such as a church or labor union.
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Non-depository institutions:
• Life Insurance Companies -- Provide life insurance and long-term savings
opportunities for savers.
• Casualty Insurance Companies -- Provide auto, home insurance, purchase direct
financial securities with paid-in-advance premiums from insurance purchasers.
• Pension Funds -- issue claims to savers or provide investment plans that allow savers
to transfer wealth through time and to future generations.
Other Types of Financial Intermediaries:

• Finance Companies -- Borrow (issue liabilities) directly from banks and directly from
savers (commercial paper) and make/purchase riskier consumer and business loans.
• Mutual Funds -- Offer indirect mutual fund shares to savers and purchase direct
financial assets (e.g. stocks and bonds).
• Money Market Mutual Funds -- Offer (indirect) shares and purchase direct
(commercial paper) and indirect (bank CDs) money market financial assets.
• Investment Bankers -- Purchase securities from borrowers and repackage the payment
streams, creating new securities to sell to savers. Assist borrowers in selling direct
claims to savers.
• E-brokers -- E-brokers provide securities trading services over the Internet. Actually,
E-brokers are following one of four business models. A few, such as Schwab, seek to
be an online financial supermarket providing banking, insurance, portfolio
management and brokerage under one brand. Hybrids provide discount commissions
but provide some investment advice and research, some pure discount firms seek to
compete only on price and a few E-brokers are providing specialized services such as
access to special markets or extended credit.
a. Unique Economic Functions Performed by Financial Institutions (FIs)

Relative to the choices available to many savers who invest directly in the markets, FIs
provide savers with very safe, liquid claims with fairly small denominations. FIs then in
turn lend money to funds demanders. The ultimate borrowers, say corporations, issue
risky claims (loans or bonds) held by FIs. The individual savers need not investigate the
riskiness of the corporate borrowers, the FI will do that. Consequently, FIs allocate
capital in an economy. FIs must then be able to accurately assess, price and monitor
risks of borrowers for an economy to achieve its potential growth rate. FIs must also
carefully manage their own risk since they are borrowing money from savers at low risk
and then investing the money in higher risk loans and securities in order to earn a profit.
By carefully evaluating the riskiness of potential investments and by diversifying their
loan and investment portfolios, lending institutions employ the law of large numbers to
reduce their risk exposure.
The instructor should note that both markets and institutions assess, price and monitor
risk. In some cases however, institutions can perform these functions better than the
markets. In this sense the institution is serving as a delegated monitor. For instance, in
situations where the borrower is reluctant to make information public or frequent
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monitoring is needed or when special additional financing requirements may be

necessary, bank loans may be preferable to a public bond issue.
The federal government insures deposits of certain intermediaries. Because of deposit

insurance, depositors do not require a risk premium to place money in an insured
institution. In effect, government insurance subsidizes risk taking at depository
institutions. The government insurance liability requires that insured depository
institutions be regulated to limit the government’s liability and to limit imprudent risk
taking at these institutions.
b. Additional Benefits FIs Provide to Suppliers of Funds

Funds suppliers who place their money in a FI generally get the following benefits:
Reduced transaction costs due to economies of scale in information production2
o Maturity Intermediation (Intermediation is investing in a financial intermediary
(FI) and maturity intermediation is accomplished when a FI grants a saver a
different maturity investment than the maturity of the FI’s own claims on
borrowers)
o Denomination Intermediation
o Improved liquidity
o Reduced default risk due to deposit insurance and/or the FI’s equity.
Note that a low rate of return is the cost of the safety and convenience of investing in a FI
as opposed to a capital market instrument.
c. Economic Functions FIs Provide to The Financial System as a Whole

Depository Institutions (DIs) also have a unique role in the transmission of monetary
policy because their claims are part of the money supply and because they assist in
providing large amounts of payments services such as check clearing and wire transfers
in the economy. As mentioned above, DIs allocate credit in an economy. If DIs perform
the credit allocation function poorly long term economic growth will not be maximized.
Certain FIs are also granted special tax status to assist individuals in transferring wealth
through time or to the next generation.
d. Risks Incurred by Financial Institutions

All FIs face a variety of risks, but generally speaking all FIs face
• Default risk on at least a portion of their assets
• Market risk, or the risk that the value of FI investments may change
• Liquidity risk, due to mismatch in maturity of assets and liabilities
• Interest rate risk due to the same mismatch above
• Foreign exchange risk due to foreign currency assets and liabilities or changing
competitive conditions with foreign FIs as currency values fluctuate
• Operating cost risk because there are fixed costs involved in providing all
financial services
• Insolvency risk, any of the stated risks may result in insolvency at a FI.
2
Economies of scale (EOS) indicate that a firm’s unit profits grow as it becomes larger. Fixed costs lead to
EOS.
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Some FIs face:

• Sovereign risk on overseas investments
• Off balance sheet risks due to contingent assets and liabilities
• Technology and Operational risk due to either overinvestment in a technology
relative to customer demand, or a failure of technology respectively.
e. Regulation of Financial Institutions

FIs hold savers’ funds. Should even one FI default many people’s wealth could be
destroyed unless the government intervenes. Government institutions such as the Federal
Deposit Insurance Corporation (FDIC) can handle a limited number of simultaneous
failures. Systemic risks or system wide failures, perhaps due to contagion, among any
group of FIs could not be handled by our existing regulatory structures. Contagion
occurs when failure of one or a few institutions causes widespread failures, at an extreme
resulting in an economic crash similar to the Depression of the 1930s. Part of the fear of
contagion arises because most FIs are 1) highly leveraged and 2) operate on the principle
that the majority of claimants will not seek to withdraw their funds at the same time as
FIs don’t keep all of the savers’ funds in the vault available for immediate withdrawal.
The government must regulate DIs because of the deposit insurance liability. Regulation
is also necessary to prevent fraud and discriminatory practices. Regulations impose a
cost on society by adding to the cost burden of FIs, which must be passed on to either
borrowers in the form of higher costs, or as reduced rates of savings for investors in FIs.
Recent regulatory changes have allowed FIs to engage in more activities and increased
the level of competition among institutions. As a result regulators have been forced to
develop more sophisticated measures of risk and incentives for institutions to limit risk.
4. Globalization of Financial Markets and Institutions

Recent decades have witnessed the globalization of financial markets to an
unprecedented degree. For instance, at times trading in foreign equities exceeded trading
in U.S. equities and to a greater extent than ever, events ‘there’ affect markets ‘here’ and
vice versa. Although the U.S. markets are still the largest, the advent of the Euro (the
common currency in Europe) has already led to rapid growth in Euro financing. For
instance, Eurobonds are a significant source of financing for many U.S. firms and they
represent an alternative to a domestic bond issue. Eurobonds are bonds issued outside the
home country but are in the home currency. The growth in foreign financial markets has
five ongoing causes:
1. Greater pool of savings in foreign countries.
2. Better investment prospects outside of countries with large savings.
3. The Internet has improved information availability on foreign markets and securities.
4. Low cost methods to invest in foreign securities have proliferated (such as ADRs).
5. Deregulation around the world has allowed investors to purchase more foreign
securities.
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Chapter 02 – Determination of Interest Rates
Chapter Two
Determination of Interest Rates
This is the first of several chapters that familiarize students with the determinants of
valuation of bonds and related securities. In this chapter the authors first focus on the
economic determinants of interest rates using the flow of funds theory of interest rates.
Subsequently, unique characteristics of securities that give rise to different interest rates
are discussed. This chapter has four major sections. The first section provides a review
of basic time value calculations. The authors present the annuity equations in summation
form (they do not present the closed form equations). Closed form versions are provided
in the IM. The second major topic covers interest rate formation in a ‘loanable funds’
framework. The loanable funds theory is the most basic explanation of real interest rate
formation in the economy and is easily understood by students. The loanable funds
theory describes general economic forces in the economy that determine the opportunity
cost of funds which may be thought of as the real, riskless rate. The next section explains
why individual investments have different interest rates because of their unique
characteristics. The effect of maturity on interest rates is explained in greater detail in the
term structure discussion. The three main theories of the term structure are presented.
The chapter concludes with a brief example of using term structure mathematics to
forecast interest rates.
1. Interest Rate Fundamentals: Chapter Overview

The interest rates that you actually see quoted are nominal interest rates; as a result,
nominal rates are sometimes called ‘quoted rates.’ The purpose of the chapter is to
examine the components of the nominal interest rate. They are a) the real riskless rate of
interest that is compensation for the pure time value of money, b) an expected inflation
premium that is time dependent and c) a risk premium for liquidity, default and interest
rate risk.
2. Time Value of Money and Interest Rates

a. Time Value of Money
b. Lump Sum Valuation
c. Annuity Valuation
The real rate of interest is the additional compensation required to forego current
consumption. This is the essence of the time value of money. That is, the value we place
on money depends upon when the money is received (paid) and the time preference for
consumption. Simple interest is earned if the investor spends the interest earnings each
period; compound interest assumes the interest earned per period is reinvested. Present
and future values of lump sums and annuities are covered but the closed form formulas
for the annuities are not presented. If the instructor wishes to include them they are:
PV = PMT × (1 – (1+i/M)–N×M) / i
FV = PMT × ((1 + (i/M))N×M – 1) / i

i = nominal rate PMT = annuity payment
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N = number of years M = number of compounding periods per year
Comparative statics for lump sum and annuity calculations are discussed in the text.
d. Effective Annual Rate

For investments with maturities other than annual one may need to calculate an
equivalent annual return (EAR) in order to compare rates among investments with
different maturities (compounding frequencies). The EAR is the equivalent annual rate
that would give the same future value if the investment had only annual compounding.
3. Determinants of Interest Rates For Individual Securities

a. Inflation
b. Real Interest Rates & Fisher Effect
Inflation is the rate of change in the overall price level. The Consumer Price Index
(CPI) is the most commonly quoted measure of inflation. The CPI purports to measure
the price level of a market basket of goods and services purchased by the typical urban
consumer.
The Fisher effect states that nominal rates equal real rates plus a premium for expected
inflation. This relationship is the basis for the term structure. Differences in annual
expected inflation rates cause differences in bond rates with different maturities.
The nominal interest rate is the additional dollars earned from an investment. The real
interest rate is the additional purchasing power earned from an investment. The real
interest rate refers to the marginal gain in units purchased rather than in dollars.
Sometimes we think that ex-ante real rates cannot be negative, but they can because of
the convenience yield of liquidity. They have been negative in recent years in both the
U.S. and Japan.
The Fisher Effect relates nominal and real interest rates.

The approximate Fisher effect is given as
i = RIR + Expected (IP)
where i = nominal interest rate, RIR = real interest rate and Expected (IP) = expected
inflation.
The actual Fisher Effect is given as
(1+i) = (1+RIR)*(1+Expected(IP))
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The following example illustrates why the actual Fisher Effect is multiplicative:
Suppose “It” originally cost you $1. You have $10 so could buy 10 of “it.”
If inflation is 5%, in one year “it” will cost $1 + .05 =$1.05.
If you invest your $10 and earn 10% + 5% = 15% (the approximate Fisher Effect)
you will get back $10 * 1.15 = $11.50.
Can you buy $10% more of “it?” I.E. can you now buy 10 * 1.1 or 11 of “it?”
11 * $1.05 = $11.55; so you are short 5 cents.
In order to buy 10% more of it you must earn an interest rate equal to (1.10 * 1.05) -
1 = 1.155 - 1 = 15.5% nominal interest.
Then your $10 will grow to $10 * 1.155 = $11.55 and you CAN buy 10% more of it!
Since both P & Q are rising, the rate charged must reflect the increments to both P
and Q.
The difference matters little if inflation is low and/or the time period under
consideration is not very long. In international investing environments where
inflation is much higher than the U.S. is currently experiencing, the difference can
be material.
c. Default or Credit Risk

Default risk premiums (DRPs) are increases in required yield needed to offset the
possibility the borrower will not repay the promised interest and principle in full or as
scheduled. According to the Wall Street Journal Online, May 5 edition, credit risk
premiums on Aa rated corporate debt relative to Treasuries were 1.95% and were 2.77%
on Baa rated debt. DRPs on high grade debt were about 6.60%. DRPs are cyclical, and
rise in periods of weak economic conditions such as the U.S. was experiencing in 2008.
d. Liquidity Risk
Liquidity risk premiums are increases in required or promised yields designed to offset
the risk of not being able to sell the asset in timely fashion at fair value. These are similar
to, but not the same as, the liquidity premiums in the term structure discussion. Liquidity
risk can be more significant for some debt instruments than for stocks as many bonds
trade in thin markets.
e. Special Provisions of Covenants

♦ Municipal bond (Muni) rates are lower than similar corporate bonds because interest
(but not capital gains) is exempt from federal taxation. In most states the holder of a
muni bond issued in that state is also exempt from state taxes.
Why munis are granted special tax status. What do they think about industrial
development bonds which allow private corporations to issue tax advantaged munis
for certain projects? Note that usage of IDBs has been restricted in recent years due
to over usage by private firms seeking to exploit the tax advantage of munis.
♦ Callable bonds have higher required yields than straight bonds because the issuer will
normally call them when rates have dropped, forcing the bondholders to reinvest at
lower interest rates. Although it varies with interest rate expectations the premium on
a callable bond might be 30 to 50 basis points.
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♦ Convertible bonds have lower yields than straight bonds because the bondholder has
the right to convert them to preferred or common stock at their choice. Offering a
conversion feature may save 100 to 200 basis points, ceteris paribus. In most cases
however, the stock has to appreciate 15%-25% over the at issue price in order to
make conversion attractive.
f. Term to Maturity
The term structure depicts the relationship between maturity and yields for bonds
identical in all respects except maturity. In practice, ‘identical’ means same rating,
liquidity and hopefully the same coupon (or differential tax effects will be present). The
graph of the term structure can take on any shape, but upward sloping is most common
(meaning longer term bonds promise higher nominal yields). The yield curve was
inverted in Nov 2000 and in parts of 2006 and 2007. Note that for Treasuries, ‘on the
run’ (newly issued) securities often carry price premiums over ‘off the run’ (previously
issued) securities.
g. Summary
ij* = f(Riskless real rate, Expected inflation, Default risk premium, Liquidity risk
premium, Special covenant premium, Maturity risk premium)
The maturity risk premium is explained in Section 6 where it is defined as the premium
for holding a price volatile asset (confusingly called a liquidity premium).
4. Term Structure of Interest Rates

a. Unbiased Expectations Theory (UET)
The UET states that the long term interest rate is the geometric average of the current and
expected future short term rates. A simple arbitrage proof can be used to show this when
interest rates are known with certainty under perfect markets:
If the expected one year rates are 6%, 7% and 8% for the next three years respectively,
and the three year rate is 5%, how could one make money on this relationship?
Using the text’s terminology: 0R1 = 6%, 1R1=7% and 2R1 = 8% but 0R3=5%
The average of the short term one year rates is 7%, but the three year rate is only 5%.
One could borrow any given amount such as $1000 for the full three years and invest that
money one year at a time and rolling over the investment for three years. The borrowing
cost per year is 5% and the average rate of return is 7%. This is a riskless arbitrage under
the given assumptions that would force the three year rate and the average of the one year
rates to converge.
The instructor may wish to show this relationship first using simpler arithmetic averages
as above since students often seem to struggle with the concept of geometric averages.
Geometric averages are used to account for compounding; for examples of two or three
years where the rates are similar, the use of arithmetic averages will give almost identical
results if the returns are similar to one another.
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For a series of holding period returns (HPRs) the geometric average can be found as:
1/ N
 N 
Geometric Average =  ∏
 T =1
(1 + HPRT )

−1
For example if we have a time series of three returns of 10%, -15% and 12% the
arithmetic and geometric averages are 2.33% and 1.55% respectively:
(10% + −15% + 12%)
Arithmetic Average =
++ = 2.33%
3
Geometric Average = [1.10 × 0.85 × 1.12] − 1 = 1.55%
1/ 3
The critical concept to understand is that under the UET an investor is indifferent
between how one arrives at an N year investment. For example, one can invest for N
years all at once, or invest for 1 year and roll the investment over N-1 times.
b. Liquidity Premium Theory

If investors prefer shorter maturities to long, they will require a premium to invest for N
years all at once instead of investing for 1 year and rolling the investment over N-1 times.
In other words, the long term rate cannot be the average of the expected short term rates.
The long term rate must equal the average of the short term rates plus what is illogically
called a ‘liquidity premium.’ (It is an illiquidity premium.) The rationale for the shorter
maturity preference is that with uncertainty about future rates, it is riskier to invest long
term rather than investing for a shorter time and rolling the investment over because it is
harder to forecast rates further in the future and longer term investments are more price
volatile. This is a modification of the UET, but it does not invalidate the logic of the
UET. It does imply that long term rates are biased forecasters of expected future short
term rates. We don’t know very much about the size of the liquidity premiums. They
increase with maturity, and probably do not get much over 100 to 200 basis points.3
c. Market Segmentation Theory
Market segmentation or preferred habitat theory claims that there are two or three distinct
maturity segments (the segments are ill-defined) and market participants will not venture
out of their preferred segment, even if favorable rates may be found in a different
maturity. A less extreme version posits that a sufficient interest rate premium may
induce investors to switch maturity segments. The idea behind segmentation is that
institutions naturally have liabilities of a distinct maturity, e.g., life insurers have long
term liabilities, so they will not invest short term. Hence, there is no or only a very weak
relationship between interest rates of different maturities and supply and demand of a
given maturity sets the individual interest rates. By inference, there is no reason to
construct a term structure as there is no relationship between long term rates and expected
future short term rates. This is unlikely to strictly hold because it suggests that
opportunities to take advantage of mispricing of securities will not be exploited. For
3
Although not often recognized, it is possible for liquidity premiums to be negative. If investors have long
investment horizons it is actually less risky for them to hold long duration bonds (as opposed to short
duration) to minimize their interest rate risk. If the majority of investors have long time horizons then it
would be riskier to hold short term, low duration investments. This could make long term investments
preferable to short term, implying that the liquidity premium would have to be negative.
2-5
example if the 10 year bond rate is much higher than warranted by expectations, one
could buy the 10 year bond and short a 9 year bond. If the rates on different maturities
get far enough out of line with expectations, some entity will seek to exploit the profit
opportunity. If existing investors will not exploit the opportunity, new investors will
emerge to do so in a capitalist system. On the other hand, daily changes in supply and
demand and changes in non-price conditions can certainly cause long term rates to
diverge from the average of expected future short term rates. These create profit
opportunities for astute bond traders. If bond markets are reasonably efficient, these
profit opportunities should not last long.
5. Forecasting Interest Rates

A forward rate is a rate that can be imputed from the existing term structure. It is a
mathematical tautology that given a set of long term spot rates one can find the set of
individual one year forward rates. For instance using the books terminology:
(1+1R6)6 = (1+1R5)5 * (1+5F1)
(1+1R5)6 = (1+1R4)4 * (1+4F1) …
where 1R6 and 1R5 are the long term spot rates from today to year 6 and 5 respectively and
F stands for a forward rate. The first subscript refers to the loan origination date, but the
textbook confusingly uses 1 instead of 0 as is normal to represent today. The second
subscript refers to the term to maturity. Since all the spot rates are known one can
construct the full set of forward rates, iF1, from them.
Interpreting the forward rates If the UET strictly holds then forward rates are an
unbiased estimate of expected future annual rates. If there are liquidity premiums, one
should subtract the liquidity premium from the forward rate before using it as an estimate
of the expected future spot rate. If segmentation strictly holds, the forward rate has no
economic meaning.
2-6
Chapter 03 - Interest Rates and Security Valuation
Chapter Three
Interest Rates and Security Valuation
This is the second chapter that is designed to familiarize the students with the
determinants of fixed income valuation. This chapter has seven closely related sections
which focus primarily on bond pricing and the bond price formula. From the first three
sections of the chapter readers should learn how to calculate a bond’s price, the
difference between the required rate of return, the expected rate of return and the realized
return and how to calculate each. Efficient markets are briefly introduced by relating the
expected and required rates of return and by comparing market prices to calculated fair
present values. Section 4 introduces bond price volatility and illustrates how changing
interest rates can affect FIs. Sections 5 and 6 discuss the effects of maturity and coupon
on bond price volatility. Section 7 introduces the concept of duration and illustrates how
to calculate Macauley duration. Appendix 3A provides an example of immunization
using duration and Appendix 3B explains more about the concept of convexity and
demonstrates the effect of convexity on bond price predictions.
1. Interest Rates as a Determinant of Financial Security Values: Chapter Overview

This chapter applies the time value of money concepts developed in Chapter 2 to explain
bond pricing and rates. The determinants of bond price volatility, duration and convexity
are also discussed. Financial intermediaries are subject to risk from changing interest
rates (termed interest rate risk) because changing rates can cause changes in profit flows
and in market values of both assets and liabilities. This chapter provides the building
blocks needed to understand how to measure and manage interest rate risk.
2. Various Interest Rate Measures

a. Coupon Rate
b. Required Rate of Return
c. Expected Rate of Return
d. Required Versus Expected Rates of Return: The Role of Efficient Markets
The bond’s coupon rate is the annual dollar coupon divided by the face value. Although
the coupon rate is quoted annually, bonds usually pay interest semiannually. If a bond
has no periodic interest payment it is a zero coupon bond. The required rate of return
(rrr) is the annual compound rate an investor feels they should earn on a bond given the
risk level of the investment. The rrr is used as the discount rate in the bond price formula
to calculate the fair present value (PV) of the security. The PV is then compared to the
existing market price to ascertain whether the security is over, under or correctly valued.
The expected rate of return (Err), or promised yield to maturity, is the annual
compound rate of return the investor can expect to earn if he/she 1) buys the bond at the
current market price, 2) holds the bond to maturity and 3) reinvests each coupon for the
remaining time to maturity and earns the Err on each coupon. The Err may be
calculated using the current market price as the present value and the expected cash flows
in the bond price formula. Note that this definition of the Err assumes that either there is
3-1
zero possibility of default risk, or the expected cash flows used in the bond price formula
are probability weighted according to the expected probability of default. If the Err is
greater than the rrr, the security is overvalued. If the bond markets are efficient any
divergences between the market price and the PV (or the rrr and Err) are quickly
arbitraged away.
Calculating PV:
For a $90 annual payment coupon corporate bond, with rrr = 10% maturing in n = 6
years:
 
 1 
1 1 −
 (1.10)6  $1000
1 − n 
Par
PV = $C × 

(1 + rrr) 
+
 (1 + rrr)n
$956.45 = $90 ×  + 6 Equation 1

rrr
  0.10  (1.10)
   
If this same bond has an actual market price of $945, what is the Err?
 1 
1 − (1 + Err)6  $1000
$945 = $90 ×  + 6
Err = 10.27% Equation 2
 Err  (1 + Err)
 
This bond would be a good buy since the market price is less than the fair PV. If the
appropriate opportunity cost (rrr) is 10%, the investor can expect to earn more than he or
she should (10.27%) for the risk level the investor is bearing.
The third assumption underlying the investor’s expectation of earning the Err is that the
coupons have to be reinvested at the Err. Students may become confused over this point.
For instance, if you buy a $1000, 8% coupon bond at par and receive $80 per year that
appears to be an 8% annual return regardless of what the investor does with the money.
It is in fact an 8% simple interest return, but not an 8% annual compound return. This
concept can be easily demonstrated. If you invest $1000 for 5 years and expect to earn an
8% compound rate of return per year, at the end of five years you must have a pool of
assets worth $1,000 × 1.085 = $1,469.33. If you stash the cash in the mattress and do not
reinvest any coupons you will have only ($80 × 5) + $1,000 = $1,400 at the end of five
years and your realized annual rate of return will be 6.96%. Likewise, at any
reinvestment rate less than 8%, you will wind up with less than $1,469.33 and have less
than an 8% realized return. (See Gardner, Mills and Cooperman, Managing Financial
Institutions: An Asset/Liability Approach 4th ed. Dryden Press, 2000.)
The current yield is the annual dollar coupon divided by the bond’s closing price. It is
akin to the dividend yield on the stock and it measures the simple interest annual rate of
return on the bond if you do not sell the bond. For bond investors who use a buy and
hold strategy and spend the coupons, (the prototypical grandmother living off the coupon
income for example) the current yield is a better measure of the annual rate of return they
are earning than the promised yield to maturity.
3-2
The price calculations are ‘clean’ prices, not ‘dirty’ prices. That is, they do not include
accrued interest.
e. Realized Rate of Return

The realized rate of return (rr) is the rate of return actually earned over the investment
period. It can be above or below the Err and the rrr and can be negative. The naïve
method to calculate the rr is to find the interest rate using the realized cash flows in the
bond price formula. If the investor knows the actual reinvestment rate on the coupons the
modified internal rate of return (MIRR) method should be used to calculate the realized
rate of return.4 For example, suppose an investor buys a par bond at 6% and holds it for
three years before selling it at $1,050. However, each $60 coupon was actually
reinvested at an interest rate of 5%. Solving the bond price formula gives an rr of 7.55%.
The future value of the three $60 coupons is actually $189.15, so the actual future value
of all the cash inflows is $1,050 + $189.15 = $1,239.15. With a $1,000 initial
investment, the actual rate of return is 7.41%, much less than implied by the bond price
formula. Anytime you solve the bond price formula for the discount rate you are
implicitly assuming the cash flows were reinvested at that discount rate. Only by
coincidence will this be correct. Only if you have no other information about the
reinvestment rate is solving the bond price formula to find the realized rate of return
reasonable. Expost, you should know the reinvestment rate; exante, you should use the
term structure to estimate the expected reinvestment rate.
3. Bond Valuation
a. Formula Used to Calculate Fair Present Values
To calculate the PV of a bond with semi-annual compounding, divide the coupon rate and
the rrr by two and multiply the number of periods by two. Note that the rrr (or promised
yield) is an APR for bonds that pay interest semi-annually. The effective annual return
for the bond is larger than the bond’s APR.
For the same bond used above, the PV with semiannual compounding would be:
{$C = 90 per year, rrr = 10%, n = 6 years, m = 2 compounding periods per year}
 1   1 
1 − n
(1 + (rrr/m)) × m 
Par
1 − (1.05)12  $1000
PV = $C/m×  +
$955.68 = $45 ×  +
 rrr/m  (1 + (rrr/m))n × m
   0.05  (1.05)12
   
 
Equation 3
Premium bonds are priced above par, discount bonds are priced below par.
If a fixed income bond is paying a 12% coupon and has a 10% required (and expected)
rate of return, the only way the investor will earn less than the coupon rate in a given year
is if they have a capital loss to offset the extra 2% interest they are earning. This tells us
that when the coupon rate is above the rrr the bond is selling at a premium to par and that
this premium disappears as maturity approaches. Likewise, a bond paying only an 8%
4
The MIRR method is not in the text.
3-3
coupon that has a 9% required yield must be selling below its redemption value (discount
bond), and must be expected to increase in price as maturity approaches because this is
the only way one can expect to get the 8% interest yield up to a 9% total rate of return. If
the bond’s coupon rate and required rate are equal, the price will equal par regardless of
maturity because the entire rate of return is received through the coupon and no price
adjustment is needed.
The normal annual discount or premium amortization due to approaching maturity is

taxed as ordinary income (loss), not as a capital gain or loss.
b. Formula Used to Calculate Yield to Maturity

Assuming away default risk and noting the reinvestment assumption above, this is the
same as calculating the bond’s required rate of return using the bond price formula. It
cannot be solved algebraically in the multiperiod case, but most business calculators are
preprogrammed to find the promised yield. Note that on the Hewlett-Packard and Texas
Instrument business calculators either the left hand side or all of the right hand side of the
bond price formula must be negative. A common mistake students make is to enter only
part of the right hand side as negative (either the coupon or the future value, but not
both.).
c. Equity Valuation Models

The text presents the zero growth, the constant growth and the two stage dividend
discount growth models for equities.
P = D / rrr in the zero growth case (Dt = Dividend in time t)
P = D1 / (rrr – g) in the constant growth case and
Dn +1
n Dt (r − g 2 )
P= ∑ + for the two stage growth model where D1 to Dt must be
t
t = 1(1 + rrr ) (1 + r )n
estimated, using individual growth rates or an average growth rate g1 and g2 is the long
term steady state growth rate that applies from time n through ∞.
4. Impact of Interest Rate Changes on Security Value

Open market interest rates fluctuate daily due to the actions of traders. Buying, selling
and issuing securities all affect interest rates, which in turn affect security prices.
Mathematically, as required rates rise, PVs fall since the required rate is in the
denominator of the bond price formula. Conceptually, the actions of traders force market
prices to act in similar fashion. If you are holding a bond expected to yield 10% and
identical new bonds are issued that pay 12%, you are not happy! Enough traders begin to
sell the low yield bond so that its price begins to fall and at the lower price its yield rate
rises to 12%. Hence, prices and interest rates move inversely. Since the cash flows are
discounted at a compound rate of return (rates raised to an exponent) the bond price is not
linear with respect to interest rates.
Take the same bond above and let the rrr rise to 11%
The new PV is
3-4
 1 
1 −
 (1.055)12  $1000
$913.81 = $45 ×  +
 0.055  (1.055)12
 
 
This is a drop in PV of $41.87 (=$955.68 – $913.81). A financial intermediary (FI)
primarily holds financial assets (such as loans and bonds) and financial liabilities.
Consequently the FI must manage the relative price changes of its financial assets and
liabilities. If interest rates rise and the PV of the assets fall by more than the PV of their
liabilities, the PV of the equity will decline. Because most FIs employ very large
amounts of leverage and little equity, an institution that fails to manage its interest rate
risk can quickly face insolvency due to unfavorable interest rate moves.
5. Impact of Maturity on Security Values

a. Maturity and Security Prices
Fixed income security prices approach par as maturity nears (the so called ‘pull to par’)
even if interest rates don’t change. The discount or premium on non par bonds decreases
slightly each year.
b. Maturity and Security Price Sensitivity to Changes in Interest Rates

Price sensitivity or price volatility is the percentage change in a bond’s price for a given
current change in interest rates. Note the specificity of this definition. Students will often
think that a longer term bond is more price volatile because over a longer time period
rates are more likely to change. Their logic is correct but this belies the definition. Price
sensitivity measures how much a bond’s price will change if rates change right now.
Longer term bonds are more price
Coupon 6.00%
sensitive because the current worth Par $ 1,000
of distant cash flows is very yield rate old
yield rate change
7.00%
0.50%
sensitive to the discount rate. The yield rate new 7.50%
Absolute
price sensitivity increases at a Maturity Price old Price new Rate of change
decreasing rate, so a twenty year 1 $ 990.65 $ 986.05
5 $ 959.00 $ 939.31
0.47%
2.05%
bond is not twice as price sensitive 10 $ 929.76 $ 897.04 3.52%
15 $ 908.92 $ 867.59 4.55%
as a ten year bond. See IM Figure 20 $ 894.06 $ 847.08 5.25%
25 $ 883.46 $ 832.80 5.74%
3.1 below from an Excel 30 $ 875.91 $ 822.84 6.06%
spreadsheet: 35 $ 870.52 $ 815.91 6.27%
40 $ 866.68 $ 811.08 6.42%
45 $ 863.94 $ 807.72 6.51%
50 $ 861.99 $ 805.38 6.57%
IM Figure 3.1 illustrates the limit of 55 $ 860.60 $ 803.75 6.61%
the price change for a given coupon 60 $ 859.61 $ 802.61 6.63%
65 $ 858.90 $ 801.82 6.65%
rate and a yield rate increase of 50 70 $ 858.40 $ 801.27 6.66%
75 $ 858.04 $ 800.88 6.66%
basis points for bonds of different 80 $ 857.78 $ 800.61 6.66%
maturity. Notice that as maturity is 85 $ 857.60 $ 800.43
90 $ 857.47 $ 800.30
6.67%
6.67%
increased from 1 to 5 to 10 years, 95 $ 857.37 $ 800.21 6.67%
100 $ 857.31 $ 800.14 6.67%
the price volatility increase is quite 105 $ 857.26 $ 800.10 6.67%
large on a percentage basis. Predicted limit price change =
1 - (r old / r new) 6.67%
However as maturity is increased IM Figure 3.1
beyond 30 years there are only
3-5
small increases in price volatility.5 At the limit, the price change is equal to 1 – (rr old /
rr new). This limit formula is correct for all coupon paying bonds, with higher coupon
bonds reaching the limit more quickly, and low coupon bonds reaching the limit price
change much more slowly.
Extreme examples often help to illustrate a concept. For example, if you are holding a
5% coupon bond that you can’t get rid of for 30 years and suddenly rates rise from 5% to
10%, you might expect that you and other investors in the bond are not very happy and its
price will drop a large amount. However, if the bond matures tomorrow, would you
expect its price to move much?
Any security that pays more money back sooner, ceteris paribus, will be less price
volatile. Specifically, the value of any security that returns a greater percentage of the
initial investment sooner will be less sensitive to interest rate changes. Text Tables 3-7
through 3-10 can be used to illustrate this simple concept for different coupons and
different maturity.
6. Impact of Coupon Rates on Security Values

a. Coupon Rate and Security Price
Ceteris paribus, the higher the coupon rate the higher the bond’s price. See for instance
the in 3.a.
b. Coupon Rate and Security Price Sensitivity to Changes in Interest Rates

A higher coupon results in lower bond price sensitivity to interest rate changes, ceteris
paribus. The bigger the coupon the greater the percentage of your initial investment that
is recovered in the near term (5.b.), or the bigger the coupon the sooner you recover the
investment. Suppose you are comparing two five year bonds, one with a zero coupon and
one with a 15% coupon. If interest rates rise the 15% coupon bond pays you a much
larger sum of money quickly with which you can reinvest and earn the new higher
interest rate. The zero coupon bond gives you no money with which you can reinvest and
earn the higher rate so the zero drops more in value. IM Figure 2 below illustrates the
effect of coupon on price volatility for a 10 year maturity bond with a yield rate change
from 7% to 6.5% for bonds with different coupons. Notice that lower coupon bonds
exhibit a greater price change for the given rate change. The greatest volatility is
exhibited by the zero coupon bond, but as with maturity, the price change increases at a
decreasing rate for a declining coupon rate. At this point in the development an investor
needs to consider both maturity and coupon to understand their exposure to interest rate
risk. One of the purposes of developing the duration concept in the next section is that
duration reduces the analysis to one dimension by incorporating the effect of coupon into
the maturity effect on price volatility.
5
As maturity increases the bond price formula converges to the present value of a perpetuity where PV = $
Coupon / r. This allows one to develop the predicted limit price change as (C/rnew / C/rold) – 1.
3-6
Coupon Varies Maturity

Par $1,000 10 years
rate old 7.00%
rate change -0.50%
rate new 6.50% Absolute
Rate of
Coupon rate Price old Price new change
6.00% $ 929.76 $ 964.06 3.69%
5.50% $ 894.65 $ 928.11 3.74%
5.00% $ 859.53 $ 892.17 3.80%
4.50% $ 824.41 $ 856.22 3.86%
4.00% $ 789.29 $ 820.28 3.93%
3.50% $ 754.17 $ 784.34 4.00%
3.00% $ 719.06 $ 748.39 4.08%
2.50% $ 683.94 $ 712.45 4.17%
2.00% $ 648.82 $ 676.50 4.27%
1.50% $ 613.70 $ 640.56 4.38%
1.00% $ 578.59 $ 604.61 4.50%
0.50% $ 543.47 $ 568.67 4.64%
0.00% $ 508.35 $ 532.73 4.80%
IM Figure 2 Coupons and Price Volatility
7. Duration
a. A Simple Illustration for Duration
Duration is the weighted average time to maturity on a financial security using the
relative present values of the cash flows as weights. This definition will initially mean
very little to students. To understand the concept implied by the definition, think of an N
year annual payment coupon bond as a portfolio of N zero coupon bonds where the first
N-1 of the bonds pay the coupon amount and the last one pays the coupon plus the par
amount. The coupon bond’s duration is the average maturity of the portfolio of zero
coupon bonds. However, we cannot take a simple average because not all the cash flows
in each year are identical. Moreover, Chapter 2 tells us that we cannot compare a cash
flow in year 1 with a cash flow in year N. So we construct a series of weights that tell us
what percentage of our money (in today’s dollars) we recover in each year. To do this
take the present value of each cash flow divided by the purchase price of the bond. For
instance, for a 5 year bond suppose we recover in present value terms 5% of our
investment in year one , 4% in year two, 3% in year three, 2% in year four and 86% in
year five. We receive cash in each of the next five years (or a zero matures in each of the
next five years): 1, 2, 3, 4 and 5. Thus, the bond’s duration is the weighted average
maturity of the zeros or (5%×1) + (4%×2) + (3%×3) + (2%×4) + (86%×5) = 4.6 years.
Duration may perhaps be slightly better defined as a weighted average of the times in
which cash is received, a slightly different wording than the more common definition
above.
The above 5 year maturity coupon bond has the same price sensitivity as a 4.6 year
maturity zero coupon bond (ignoring convexity).
b. A General Formula for Duration

 $45 × t  $1045 × 12
11
∑
n CFt × t ∑ t 
+
t =1 (1 + rrr)
t t =1  (1.05)  (1.05)12 Equation 4
Dur = 9.46 years =
PV $955.68
3-7
{$C = 90 per year, rrr = 10%, n = 6 years, m = 2 compounding periods per year, PV =
$955.68}
Closed form duration equation:
 (1 + r)n + 1 − (1 + r) − (r × n)  Par × n
$C ×  +
 r 2 × (1 + r)n  (1 + r)n
Dur = Equation 5
PV
$C = Periodic cash flow in dollars
r = periodic interest rate
n = Number of compounding or payment periods
Par = Maturity Value or Terminal Cash Flow (if any)
Dur = Duration = # Compounding or payment periods
Variations of the basic duration formulae can be used. The versions shown above may be
used for annual or semiannual payment bonds or for amortizing loans. In the case of a
fully amortized loan the Par term must be set to zero and the $C is the loan’s installment
payment. The duration answer obtained from these equations will be in the number of
compounding or payment periods. For instance, if you use Equation 4 or 5 to find the
duration of a semiannual payment bond, you will get an answer in terms of the number of
semi-annual periods, rather than years. If one replaces PV in Equations 4 and 5 with
m*PV, then the resulting duration answer will be in years.6 Alternatively, Equation 4
could be modified as follows to give an annual duration result for a semiannual payment
bond:
n PVCFt × t
Dur = ∑ Equation 4a
t =1 / 2 PV
where PVCFt is the present value of the cash flow in time t, where t = ½, 1, 1½ , … n.
c. Features of Duration
Duration is a time measure, usually presented in years. The greater the coupon; the
shorter the duration. With a greater coupon the percentage weights on the early years are
increased, thus reducing the average maturity. The duration of a zero coupon bond is its
maturity because it has a 100% weight on the year in which the terminal cash flow occurs
and a 0% weight on all other years. Except for certain deep discount bonds, the longer
the maturity of a bond the longer the bond’s duration (see the charts below). Notice that
duration increases at a decreasing rate as maturity increases. Duration has a limit with
respect to maturity for a given interest rate. The maximum duration of a bond can be
found as (1/ r) +1 where r is the periodic rate and the solution is the maximum number of
payment periods. As you can see in the chart, for a premium bond, the duration increases
monotonically towards this maximum (26 periods or 13 years found as (1/0.04)+1) as N
is increased.
6
Recall that m = number of compounding periods per year.
3-8
Premium Bond
Bond Terms Bond
$C 10.00% 10.00% 10.00% 10.00% 10.00% 10.00% 10.00% 10.00%
N (# years) 4 8 16 32 64 128 200 400
m 2 2 2 2 2 2 2 2
# of periods 8 16 32 64 128 256 400 800
ytm or k 8.00% 8.00% 8.00% 8.00% 8.00% 8.00% 8.00% 8.00%
PAR $ 1,000 $ 1,000 $ 1,000 $ 1,000 $ 1,000 $ 1,000 $ 1,000 $ 1,000
PRICE $ 1,067.33 $ 1,116.52 $ 1,178.74 $ 1,229.69 $ 1,248.35 $ 1,249.99 $ 1,250.00 $ 1,250.00
Terms for calculating duration

$C/2 $ 50 $ 50 $ 50 $ 50 $ 50 $ 50 $ 50 $ 50
r or k/2 0.04 0.04 0.04 0.04 0.04 0.04 0.04 0.04
T = n*m 8 16 32 64 128 256 400 800
2
r 0.0016 0.0016 0.0016 0.0016 0.0016 0.0016 0.0016 0.0016
T
(1+r) 1.36856905 1.87298125 3.50805875 12.3064762 151.4493558 22936.9074 6506324.497 4.23323E+13
T+1
(1+r) 1.423311812 1.9479005 3.6483811 12.7987352 157.50733 23854.3837 6766577.477 4.40255E+13
term in brackets 28.91332575 89.3964155 236.665987 467.169434 624.5789609 649.692635 649.9983631 650
$C/2 * bracket 1,445.67 4,469.82 11,833.30 23,358.47 31,228.95 32,484.63 32,499.92 32,500.00
Par term 5845.52164 8542.53081 9121.85408 5200.51387 845.1670155 11.1610513 0.061478643 1.88981E-08
Numerator 7,291.19 13,012.35 20,955.15 28,558.99 32,074.12 32,495.79 32,499.98 32,500.00
Denominator 1067.327449 1116.52296 1178.73551 1229.68549 1248.349283 1249.9891 1249.999962 1250
Duration ( m periods) 6.831257 11.654352 17.777655 23.224626 25.693222 25.996861 25.999985 26.000000
Duration in years 3.41563 5.82718 8.88883 11.61231 12.84661 12.99843 12.99999 13.00000
Duration limit | r 26 periods
Duration limit | r 13 years
For a deep discount bond, the duration initially rises with maturity and then declines as
illustrated below:
Discount Bond
Bond Terms Bond
$C 1.00% 1.00% 1.00% 1.00% 1.00% 1.00% 1.00% 1.00%
N (# years) 4 8 16 32 64 128 200 400
m 2 2 2 2 2 2 2 2
# of periods 8 16 32 64 128 256 400 800
ytm or k 8.00% 8.00% 8.00% 8.00% 8.00% 8.00% 8.00% 8.00%
PAR $ 1,000 $ 1,000 $ 1,000 $ 1,000 $ 1,000 $ 1,000 $ 1,000 $ 1,000
PRICE $ 764.35 $ 592.17 $ 374.43 $ 196.10 $ 130.78 $ 125.04 $ 125.00 $ 125.00
Terms for calculating duration

$C/2 $ 5 $ 5 $ 5 $ 5 $ 5 $ 5 $ 5 $ 5
r or k/2 0.04 0.04 0.04 0.04 0.04 0.04 0.04 0.04
T = n*m 8 16 32 64 128 256 400 800
2
r 0.0016 0.0016 0.0016 0.0016 0.0016 0.0016 0.0016 0.0016
T
(1+r) 1.36856905 1.87298125 3.50805875 12.3064762 151.4493558 22936.9074 6506324.497 4.23323E+13
T+1
(1+r) 1.423311812 1.9479005 3.6483811 12.7987352 157.50733 23854.3837 6766577.477 4.40255E+13
term in brackets 28.91332575 89.3964155 236.665987 467.169434 624.5789609 649.692635 649.9983631 650
$C/2 * bracket 144.57 446.98 1,183.33 2,335.85 3,122.89 3,248.46 3,249.99 3,250.00
Par term 5845.52164 8542.53081 9121.85408 5200.51387 845.1670155 11.1610513 0.061478643 1.88981E-08
Numerator 5,990.09 8,989.51 10,305.18 7,536.36 3,968.06 3,259.62 3,250.05 3,250.00
Denominator 764.3539294 592.169654 374.425698 196.100776 130.7775089 125.038148 125.0001345 125
Duration ( m periods) 7.836799 15.180638 27.522641 38.431062 30.342081 26.069038 26.000398 26.000000
Duration in years 3.91840 7.59032 13.76132 19.21553 15.17104 13.03452 13.00020 13.00000
Duration limit | r 26 periods
Duration limit | r 13 years
Students should be aware that although duration is a modified measure of maturity, it is

still a measure of maturity. The higher the promised yield to maturity the shorter the
duration. Using a higher interest rate decreases the percentages weights on more distant
cash flows (because of the compounding effect the present value of more distant cash
flows drops (%) more than the present value of near term cash flows).
3-9
d. Economic Meaning of Duration

Taking the partial derivative of the bond price formula with respect to interest rates for a
zero coupon bond yields a simple relationship:
%∆ ∆P = - Maturity × ∆r / (1 + r) (r = yield to maturity)
%∆ ∆P = elasticity
Maturity can be used to predict the price change for small interest rate changes when
there are no coupons. This equation does not work for coupon bonds; its use in this case
would overestimate the volatility since coupons dampen a bond’s price volatility.
Duration is however a modified measure of maturity that reflects the reduced maturity
due to the early payment of interest (coupons) prior to maturity. In particular the duration
of a coupon bond has the same price sensitivity as a zero coupon bond that has a maturity
equal to the coupon bond’s duration (ignoring convexity). Thus it follows (without
calculus even) that %∆ ∆P = - Duration × ∆r / (1 + r) for a coupon bond. Duration may
be used to predict price changes for small interest rate changes for coupon bonds. For
convenience, practitioners sometimes calculate what is called ‘modified duration’ which
is Duration / (1 + rsemi) so that the only variable to be added to predict the price change is
∆r.
Important Note: Modified duration is Duration / (1 + rperiod). The ‘period’ would be
semiannual for most bonds and monthly for most loans. However when modified
duration is used to predict the price change in the formula, the rate change used is an
annual rate: %∆ ∆P = - Modified Duration / (1 + rannual). This can be a confusing point
for students.
Why should students have to learn duration when today one can easily predict the bond
price change via a hand calculator, or better yet, with a spreadsheet? Two reasons:
1) Duration can be used as a strategic tool in trying to earn a higher rate of return, or to
minimize the risk associated with earning the promised yield to maturity. For
instance, for a given investment horizon one can try to lock in the current promised
yield to maturity by choosing a bond with a duration equal to the investment horizon.
This is a standard institutional bond investment strategy called immunization and it is
described in Appendix A. However, one can also try to beat the promised yield. If
interest rates are projected to fall one could choose a bond with a duration greater than
the investment horizon. If the investor is correct and rates fall, the gain in sale price of
the bond will more than outweigh the lost reinvestment income caused by the lower
reinvestment rate and the overall realized rate of return will be greater than the
promised yield. Conversely, one who is projecting rising rates can beat the promised
yield by choosing a bond with a duration shorter than the investment horizon.
2) Given the individual bond durations, the duration of a portfolio is a simple linear
weighted average of the durations of the bonds in the portfolio. Using the portfolio’s
duration makes it very easy to predict the net value change of the portfolio for a given
change in interest rates.
3-10
e. Large Interest Rate Changes and Duration

Duration is an accurate predictor of price changes only for very small interest rate
changes. For day to day fluctuations duration works quite well but when interest rates
move significantly, such as when the Fed makes an announcement of a rate change, the
predicted pricing errors can become significant. The prediction errors arise because bond
prices are not linear with respect to interest rates. At lower yield rates, bond prices are
more sensitive to interest rate changes than at higher initial promised yields. A given
percentage change in interest rates will result in a larger bond price change for a low
yield bond than for a high yield bond. Thus, a graph of bond prices versus interest rates
would be convex to the origin. Duration does not capture this change in sensitivity (or
convexity) of bond prices to interest rates. Duration predicts that the price changes of
bonds are linear with respect to changes in interest rates and thus duration predicts
symmetric price changes of a given interest rate increase or decrease. An examination of
Text Figures 3-7 and 3–8 indicates that this is not a true assertion. As mentioned above,
the bond’s price with respect to interest rates is convex to the origin. The duration is the
first derivative or slope of the line in Text Figure 3-7. Hence, the error in the bond price
prediction is due to the curvature of the line, and the degree of curvature is called the
convexity. Greater convexity leads to greater pricing prediction errors. The errors can
be quite economically significant for larger portfolios and for bigger interest rate
changes. Notably, convexity works in the investor’s favor. Duration over-predicts the
price drop that follows from an interest rate increase and under-predicts the price increase
that results from a yield decline. Investors will desire convexity in their bonds.7 The
greater the interest rate change, the greater the error in predicted prices and rates of return
from ignoring convexity. All fixed income securities that have cash flows prior to
maturity exhibit convexity. For more on convexity see Appendix 3C.
Appendix 3A: Duration and Immunization (web only: See www.mhhe.com/sc4e)

Suppose you have a 5 year investment horizon and you are looking to immunize and lock
in the current promised 8% ytm. You find a likely candidate in an 8% coupon, 8% ytm
corporate bond with a 6 year maturity.
Duration: [80/1.08 + (80*2)/1.082 + (80*3)/1.08 3 + (80*4)/1.08 4 +(80*5)/1.085 +

(1080*6)/1.086] / 1000 = 4.9927, approximately 5 years
At the end of 5 years you must have achieved an ending wealth position of $1000 * 1.085
= $1469.33 if you are to have actually earned an 8% compound rate of return per year
(ytm).
Case 1: Rates stay same:

Future value (FV) coupons = $80 * [(1.085 - 1)/.08] = $ 469.33
Price of bond end of 5th year = $1000.00
Total Ending Wealth = $1469.33
7
This assumes that investors are long in bonds.
3-11
Case 2: Rates fall immediately after purchase to 7.5%:

Price of bond end of 5th year = $1080/1.075 = $1004.65
Realistically the investor must sell the bond immediately after the rate change, otherwise
rates may stay low for 4.9 years and then increase at the time of sale at year 5. The sale
will yield a price of $1,023.47, which can be reinvested at 7.5% for five years to give a
future value of $1,469.32
Case 3: Rates rise immediately after purchase to 8.5%:

Price of bond end of 5th year = $1080/1.085 = $ 995.39
Realistically the investor must again sell the bond immediately after the rate change.
This will yield a price of $977.23, which can be reinvested at 8.5% for five years to give
a future value of $1,469.42
If an investor chooses a bond with a duration greater than their investment horizon, their
pretax nominal realized yield will be improved by falling interest rates because the gain
in sale price will more than outweigh the loss in reinvestment income. Likewise, If an
investor chooses a bond with a duration less than their investment horizon, their realized
yield will be improved by rising interest rates because the loss in sale price will be
smaller than the gain in extra reinvestment income. (For more discussion see Gardner,
Mills and Cooperman, Managing Financial Institutions: An Asset/Liability Approach 4th
ed. Dryden Press, 2000.)
Appendix 3B More on Convexity (web only: See www.mhhe.com/sc4e)

I. Measuring Convexity:
There are various ways to measure convexity (CX). Cornett & Saunders measure CX
from the following formula:
CX = Scaling factor * [% loss in bond price from a 1 basis point rise in rates + % gain in
bond price from a 1 basis point drop in rates] written as:
CX = 108 * [(∆P- / P) + (∆P+ / P)] (This is called effective convexity)
8
The scaling factor used is 10 ; the factor is chosen to scale up the result to represent a 100
basis point change in rates.
The instructor may wish to include the following example calculation of CX for a 4 year
bond that pays interest semiannually (8 periods total) with a 10% annual coupon and an
8% annual promised ytm (r):
3-12
Duration and Convexity Version June 05

C% Quote 10.00%
Par $1,000
Bond Terms
$C/2 $50.00
(semi-annual
rannual 8.00%
payment)
m=2 rsemi 4.00%
Years 4 years
Priceold $1,067.33
Semiannual
rate change 0.00005
8
CX = 10 * [(∆P- / P) + (∆P+ / P)] New r 4.0050% 3.9950%
P(Old) = $ 1,067.33 P- P+
8
10 = 100,000,000 $1,066.98 $1,067.68
∆P- / P 0.000328359) ∆P ($0.35047) $0.35061
∆P+ / P 0.000328493
[(∆P-/P) + (∆P+/P)] 1.34315E-07
CX = 13.43145
If your students have had calculus, convexity can be found by taking the second
derivative of the bond price formula with respect to interest rates. The result is:
dP 2 T
t × ( t + 1) × CFt
= ∑
d(r ) 2 t =1 (1 + rsemi )( t + 2 ) (Pr ice old * m 2 )
see for instance, Page 650 in Chapter 21in Investments: A Global Perspective, J.C.
Francis and R. Ibbotson, 2002, Prentice Hall, Upper Saddle River, NJ 07458.
II. Using Convexity

The predicted change in bond price for a given change in interest rates can now be found
from:
∆P / P = -Dursemi*∆rsemi/(1+r) + 1/2*CX*(∆rsemi*2)2
where the first term is the price change based on duration and the second term adds the
correction needed due to convexity. An example is provided below:
With the convexity correction, there is only a negligible pricing prediction error.
Convexity increases
with maturity and is Predicting Price Change with Duration and Convexity
inversely related to the ∆P /P= -Dursemi*∆rsemi/(1+r) + 1/2*CX*(∆rsemi*2)2
coupon rate and rsemi 4.00%
promised yield rates. ∆rsemi -0.005
rsemi new 3.50%
Price ∆ Due to Dur 3.28426%
Price ∆ Due to CX 0.06716%
∆P / P = 3.35142%
Old Price $ 1,067.33
$ Predicted ∆ $ 35.77
Predicted New Price $ 1,103.10
Actual New Price $ 1,103.11
3-13
Chapter 05 - Money Markets
Chapter Five
Money Markets
This is the first of six chapters that cover different securities markets. Most students will have some
familiarity with stock and bond markets (Chapters 9 and 6), but little knowledge of money markets
(Chapter 5), mortgage markets (Chapter 7), foreign exchange markets (Chapter 8) and markets for
derivatives (Chapter 10). Chapter 5 initially covers the purpose and major features of the money markets.
Next, the characteristics of the major money market securities and their primary and secondary markets are
presented. The pricing conventions of money market securities are also reviewed. The predominant
participants and their use of these markets are covered. The chapter concludes with a discussion of
international money markets, with a particular focus on the Euro money markets.
1. Definition of Money Markets: Chapter Overview

Money market securities are generally fixed income securities that have an original issue maturity of one
year or less, thus they have little price risk. Money markets primarily exist to minimize the cost of
maintaining liquidity for financial, non-financial and government institutions and to provide borrowers
with low cost, short term sources of funds. Money market securities should thus provide safety of
principle, liquidity and a predictable, albeit typically modest, yield.
2. Money Markets
Money markets exist because rarely do required cash disbursements occur at the same time and in the
same amounts as cash inflows for corporations and institutions. At times units will have excess cash that is
not immediately needed, and other economic units will need to borrow cash for a short period of time.
Thus, entities must maintain liquid sources of funds. In addition, precautionary amounts of funds beyond
planned liquidity needs must be maintained because expected cash inflows and required cash disbursements
cannot be predicted with perfect accuracy. The opportunity cost of keeping cash on hand can be quite
high. The opportunity cost is the rate of return that could be earned in the highest valued alternative if
liquidity balances did not have to be maintained. Money markets have developed to provide corporations,
governments and institutions with safe, liquid investments (or sources of funds for borrowers) that
minimize the opportunity cost of maintaining liquidity.
Secondary markets, or some other method of quickly recovering the investment at short notice, are of
paramount importance for money market instruments because much of the funds invested in money
markets may be needed by the lender for unexpected liquidity needs. Money market securities also have
little or no default risk. With the focus on liquidity and safety, the rate of return on money market
securities is expected to be significantly less than promised yields on capital market instruments.
3. Yields on Money Market Securities

a. Discount Yields
b. Single-Payment Yields
c. Equivalent Annual Return
Many money market securities use special quoting conventions. Discount rates (or discount yields) quote
the interest rate as an annualized percentage of the sale (redemption) price of the security assuming there
are only 360 days in a year. Even if the security matures in 90 days, the rate quote is as if the security
matured in one year. Single payment securities or loans (also called add ons) quote the rate as an
annualized percentage of the purchase price of the security, assuming there are only 360 days in a year.
The two are not directly comparable. For instance, one cannot directly compare the rate on a 60 day
$10,000 CD (add on) quoted at 6% interest and a 180 day $10,000 T-bill (discount) quoted at 5.9%. One
can calculate the initial price (P0) and face value (Pf) of the two instruments and then calculate a bond
equivalent yield for each in order to see which pays the higher rate.
Single payment (add ons) Pf = P0 × (1 + (a×h/360)) a = add on rate, h = days to maturity
Discount instruments P0 = Pf × (1 – (d×h /360)) where d = discount, h = days to maturity
5-1
For the CD: P0 = $10,000; Pf = $10,000 × (1+(0.06×60/360)) = $10,100

The bond equivalent yield for the CD is ($10,100/$10,000) –1) × (365/60) = 6.08%
For the T-bill: Pf = $10,000; P0 = $10,000 × (1 – (0.059×180/360) = $9,705
The bond equivalent yield for the T-bill is ($10,000/$9,705) –1) × (365/180) = 6.16%
The T-bill pays the higher bond equivalent yield or APR.
If the securities have equivalent maturities the two quotes can be directly compared using the following:
a = d / (1 – (d×h/360))
d = a / (1 + (a×h/360))
Bond equivalent yield BEY = a × (365/360)
The equivalent annual rate or EAR is the annual rate of return with annual compounding. The EAR may be
found two ways:
EAR = (Pf / P0)365/ h –1 or
EAR = (1 + (BEY / m))m – 1 ; where m = 365/h
A complete discussion of money market rates can be found in Stigum, M. The Money Market, 3rd ed.
Homewood, Ill.: Dow-Jones Irwin 1990.
4. Money Market Securities

The total amount of money market securities outstanding in 2007 in the major money markets was over $8
trillion. This represents a compound annual growth rate of % over the period 1990 to 2007. Market rates
as of November 2004 are tabled below. Updates may be easily obtained from the Wall Street Journal
Online, Money Rates section. Rates are for maturities of 3 months except as noted.
Federal Commercial
Instrument Funds* Paper CDs Euro CP
Rate 2.06% 2.38% 3.03% 4.69%
Banker’s
Instrument LIBOR Acceptances Euro$ T–bill**
Rate 2.71875% 2.75% 2.70% 1.80%
Data from Wall Street Journal Online Money Rates Section May 2008,
* Overnight; ** 13 week
Money market securities outstanding in 1990, 2004 and 2007

Billions $
Instrument 1990 2004 2007
Treasury Bills $ 527 $ 982 $1,010
Fed funds & Repos 372 1,585 2,731
Commercial Paper 538 1,310 2,109
Negotiable CDs 547 1,379 2,149
Banker's Acceptances 52 4 1
Total $2,036 $5,260 $8,000
% of Total in Given Year

Instrument 1990 2004 2007
Treasury Bills 26% 19% 13%
Fed funds & Repos 18% 30% 34%
Commercial Paper 26% 25% 26%
Negotiable CDs 27% 26% 27%
Banker's Acceptances 3% 0.1% 0.0%
5-2
Source: Text 100% 100% 100%
a. Treasury Bills
T-bills are short term obligations of the U.S. government used to finance government spending needs. In
2007 there was $1,010 billion outstanding comprising about 13% of total money market securities.
Original issue maturities are 13 or 26 weeks. The minimum denomination is $1,000 and a round lot is $5
million. T-bills are thought to be free of default risk and the 1 year T-Bill rate is often used as a measure of
the short term ‘risk free rate.’ Each week new 13 and 26 week T-bills are offered for sale at competitive
auction. T-bills are sold to the highest bidder at auction, but no one bidder can purchase more than 35% of
the total amount in any one auction. Noncompetitive bids of up to $1 million can be made. The Treasury
is now using a single price auction. Treasury securities used to be sold at a discriminating auction where
high bidders paid higher prices, and lower bidders paid lower prices. Noncompetitive bidders paid the
average price of the accepted bids. The text appendix discusses reasons for the change in bid process.
The secondary market for T-bills is the largest of any money market security. There are 22 primary
government security dealers who purchase the new issues and about 500 smaller dealers who actively
participate in trading T-bills. The FedWire is often used for trades between dealers and other institutions.
In violation of regulations, Salomon Brothers (Chase/Solomon) bought about 80% of one Treasury auction
in an attempt to squeeze the market. Many T-bills are sold on a ‘when issued’ basis by dealers who
anticipate obtaining them at auction (i.e. T-bills are often sold short before they are issued). Since Salomon
obtained so much of the auction, other dealers could not meet their prior short sale obligations and had to
pay a premium price to Salomon to obtain the bills which the dealers had already agreed to deliver to
customers. The government forced Salomon to give up their profits from the squeeze and pay fines. The
biggest loss was to Salomon’s reputation.
T-bills are discount instruments. T-bill prices (P0) are calculated as P0 = PF × (1 – (i*h/360)) where i is the
discount quote, h is the maturity in days and PF is the face value of the bill. One should calculate the bond
equivalent yield in order to compare rate quotes on different instruments that use different quoting
conventions. The bond equivalent yield for a T–bill can be calculated as (PF–P0)/P0 * (365/h).
b. Federal Funds
Fed funds, together with repurchase agreements, comprise about 34% of total money market securities, the
single largest category. Federal funds, or fed funds, are short term unsecured loans of deposits held at the
Federal Reserve (i.e. loans of excess reserves, see Chapter 4). These loans occur largely between
institutions. Small banks often make loans to their correspondent banks when local loan demand is
insufficient. The majority of fed funds are overnight loans, although many are made on ‘continuing
contract.’8 Fed funds are add on loan contracts (single payment or ‘bullet’ loans) and follow the
convention of quoting all rates on an annual basis assuming a 360 day year. To convert a fed funds rate
quote to a bond equivalent yield take the rate quote and multiplied it by 365/360. Many fed fund loans are
arranged through correspondent banks or through brokers such as Garban-Intercapital Ltd. and RMJ
Securities Corp. The typical brokerage fee may be as small as 50 cents per million dollars.
Funds transfers occur over the FedWire and transactions can be completed very quickly (in a matter of
minutes). A FI is not required to hold reserves at the Fed to participate in the fed funds market; deposits at
banks are often used in place of deposits at the Federal Reserve. Typical transactions are $5 million and
up.
Repurchase Agreements
A repurchase agreement (repo or RP) is an agreement where the seller of securities agrees to repurchase the
securities at a preset price at a preset time (typically from 1 to 14 days). Repos are in effect, collateralized
loans akin to fed funds loans. The seller is borrowing money and pledging the securities as collateral and
the buyer (who is said to be engaging in a reverse repo) is lending money. The interest rate is determined
8
Continuing contract (not in text) means that unless the borrower or lender notifies the other party the loan
will automatically be renewed daily.
5-3
by setting the buy and sell price of the securities. The rate of interest paid on the repo is not a function of
the rate of return on the underlying securities. If risky securities are pledged as collateral, the fund’s lender
may require a larger ‘haircut,’ i.e. repos normally have to be slightly overcollateralized. For instance, to
borrow $100 the repo seller would have to sell securities currently worth $102, for a $2 haircut. The repo
is a ‘real’ sale in the sense that title to the securities passes to the lender of funds for the term of the
agreement. Transfers may occur over the FedWire system. Typical denominations on repos of one week
or less are $25 million and longer term repos usually have $10 million denominations. Repos are add on
instruments (single payment loans) with yields that average about 25 basis points less than fed funds loans
due to the repo collateral. Repos take longer to arrange than fed funds and fed funds loans are more likely
to be used when funds are needed immediately.
The repo market was at the center of the credit crunch during early 2008. Wall Street firms finance much
of their security holdings with short term repos. As the subprime mortgage problems began to spread
lenders required greater haircuts to lend. Haircuts of $2 per hundred on safe mortgages rose to $5 in
February 2008 and haircuts on so called ‘Alt-A’ loans, which are loans between prime and subprime credit,
haircuts became as high as $30 per hundred. Some lenders refused to engage in repo loans except with the
safest collateral. Inability to roll over their repo financing of their extensive mortgage holdings was one
factor that led to the collapse of Bear Stearns.9 Problems in the repo and commercial paper markets (see
below) led to the Fed’s actions in assisting in the bailout of Bear Stearns and opening up the Discount
Window to non-banks for the first time.10
c. Commercial Paper
Commercial paper is a short term unsecured promissory note issued by creditworthy corporations and
financial institutions. Because the notes are unsecured and are not very liquid, commercial paper is rated
by ratings agencies. The paper rating strongly affects the cost of financing with commercial paper. Low
quality paper is often secured by bank lines of credit to obtain a better rating. The spread between prime
grade and medium grade paper has averaged about 22 basis points per year. The maximum maturity is 270
days (most are less) because the SEC requires formal registration of securities with maturities greater than
270 days. For this reason some of the paper issued is commonly rolled over at maturity. Commercial
paper comprised about 26% of total money market securities in 2007. Commercial paper is a discount
instrument and uses discount quotes similar to T–bills. The commercial paper market has developed to
provide corporations with an alternative to short term bank loans. Commercial paper outstanding grew
tremendously in the 1990s because large, creditworthy paper issuers were able to obtain lower cost
financing by issuing paper rather than borrowing from banks. Commercial paper is issued in
denominations ranging from $100,000 to $1 million, with the most common maturities in the 20 to 45 day
range. About 15% of issuers directly market their own paper, but the bulk is sold through brokers and
dealers. There is no active secondary market for commercial paper, partly because commercial paper
dealers will redeem paper from the buyers if the buyer needs the money prior to maturity. In 2007 the
market for asset backed commercial paper seized up as lenders refused to roll over maturing paper that was
backed by mortgages. Spreads between prime grade and medium grade paper increased from only a few
basis points to 125 basis points.
d. Negotiable Certificates of Deposit

A negotiable certificate of deposit (hereafter CD) is a bearer certificate indicating that a time deposit has
been made at the issuing bank which the bearer can collect at maturity. Large CDs are negotiable
instruments. Negotiable CDs have a minimum denomination of $100,000, but denominations of $1 million
are the most common. Maturities range from 1, 2, 3 and 6 months out to 1 year. Negotiable CD rates are
add on rates (single-payment loans) quoted using the 360 day convention.11 They comprised about 27% of
9
Data from “Another Source of Quick Cash Dries Up, Firms Rethink Reliance on ‘Repo’ Financing as
Conditions Tighten,” by Serena Ng and Randall Smith, The Wall Street Journal Online, March 17, 2008,
Page C1.
10
“Fed Offers Lifeline for Spurned Debt: New Tack on Bonds Tied to Mortgages Sends Dow Up 3.6%,” by
Greg Ip, The Wall Street Journal Online, March 12, 2008, Page A1.
11
CDs with maturity greater than one year area not bullet loans, rather they usually pay interest
semiannually.
5-4
money market securities in 2007. Large well known banks, particularly New York banks, often can pay
lower interest rates on their CDs than other lesser well known institutions. About 15 dealers make a
secondary market in CDs, although it is not very active. CDs are required to have ‘substantial interest
penalties for early withdrawal.’ The secondary market eliminates the problem of the interest penalty, and
has increased bank’s ability to draw funds that would otherwise be invested in non-bank money market
securities.
Banker’s Acceptances (BAs)

Drafts are often used to facilitate international trade in goods and services. The seller of the goods writes
either a time draft or a sight draft payable by the buyer of the goods or services. A sight draft is a claim
that becomes due and payable upon presentation to the purchaser. A time draft is a claim that becomes
due and payable at a certain future date specified on the draft. Because the seller normally will not know
the creditworthiness of the buyer (and credit investigation costs can be quite high), the seller may be
reluctant to ship the goods unless payment can be guaranteed by a third party. Banker’s acceptances are a
certain kind of time draft where a bank has agreed to pay the seller of the goods the amount owed if the
buyer cannot or will not pay on the date due. The draft is backed by a letter of credit drawn on the buyer’s
bank, ensuring that the bank will “accept” the draft drawn up by the seller. Once the seller can prove that
the goods have been shipped in accordance with the contract and the proper paperwork has been presented
to the buyer, the time draft can be sold as a discount instrument. The seller of the goods can wait until
maturity to receive payment, or more likely can discount the note to the bank and receive the discounted
face amount immediately. The bank can then hold the acceptance or sell it. BAs are bearer instruments
and are fairly actively traded. Maturities range from 30 to 270 days and BAs are bundled into round lots of
$100,000 and $500,000. Interest rates are very close to T-bill rates because the risk of default is quite low
as the BA is backed by the importer and a large bank and the value of the goods. The amount of BAs
outstanding is quite small compared to the other money market instruments (less than 1% of the total
money market securities outstanding). A schematic of how a BA is created is provided in Appendix 5B on
the website.
e. Comparison of Money Market Securities

Most money market securities have high denominations, or high round lots, low default risk, low interest
rates and short maturities. The different instruments have evolved to fill certain niches or needs. The
securities’ secondary markets show more variation. T-bills are the most actively traded money market
security. CDs and BAs are less actively traded, in part because money market mutual funds and other
buyers have been using a buy and hold strategy for these securities. Commercial paper is usually redeemed
by the seller upon the buyer’s request so no secondary market is needed. Fed funds and repos tend to be
short term and so no secondary market has developed for these instruments.
5. Euro Money Markets

Eurocurrency deposits are deposits of currency held outside the home country. Hence, Eurodollar
deposits are dollar denominated deposits held outside the United States.12 Eurodollar deposits are not
subject to U.S. bank regulations. The Eurodollar market has evolved as a source of overnight funding for
international banks, and plays a role similar to fed funds loans in the U.S. The rate offered to lend these
funds is the London InterBank Offer Rate (LIBOR).13 The LIBOR rate is closely related to the U.S. fed
funds rate and the two rates appear to be converging more closely in recent years, but LIBOR tends to be
slightly higher because regulatory costs on Eurodollar accounts are lower than on domestic deposits.
LIBOR also tends to be higher because international bank deposits are perceived as slightly riskier than
U.S. deposits, perhaps in part because the U.S. has not allowed its large banks to fail.
The British Banker’s Association (BBA) publishes daily estimates of LIBOR based on loan rate data
supplied by participating banks. In early 2008 some banks indicated to the BBA a concern that the reported
LIBOR did not truly represent bank borrowing costs. LIBOR had increased sharply with the credit crunch;
12
In reality, the money may never leave the country, but for accounting purposes the money is considered
‘offshore.’
13
The rate at which a bank will pay to obtain these funds is called, not surprisingly, LIBID. According to
the text the spread between LIBOR and LIBID is narrow, usually no more than 12.5 basis points.
5-5
nevertheless, some banks apparently felt that others were underreporting true borrowing costs, fearing that
higher LIBOR would indicate a potential problem obtaining funding. LIBOR is the base rate on literally
trillions of dollars of derivatives. LIBOR also is the base rate for many loans, including adjustable rate
loans. The BBA is improving its estimation method to dampen the effects of outliers as well as pressuring
banks to correctly report their borrowing costs. For more detail see the cited article.14
a. Euro Money Market Securities

Some of the major securities include:
• Eurodollar CDs: Dollar denominated deposits held outside the U.S. The maturity is typically less
than one year. Rates on Eurodollar CDs are sometimes higher than domestic CD rates because of the
lack of explicit deposit insurance and lower regulatory costs.
• Eurocommercial paper issued by commercial paper dealers: Technically, the term means commercial
paper issued outside the borrower’s country of origin, but in their home currency. The term is coming
to mean securities issued in Europe without involving a bank.
With the introduction of the euro currency net issuance of international debt denominated in euros has
grown tremendously rapidly. It is likely that money markets denominated in euros will continue to grow in
importance.
Appendix 5A: Single versus Discriminating Price Auctions, available on the web
In the Treasury single price auction the lowest bid price accepted becomes the price that all winning
bidders pay. There are two purported advantages of a single price auction over a discriminating auction:
1. A greater number of bidders have their bids filled and
2. More aggressive bidding occurs under the single price format resulting in a higher average price paid by
investors.
Appendix 5B: Creation of a Banker’s Acceptance, available on the web
U.S. buyer 1 Chinese seller

(importer) (exporter)
4
2 9 10 3 5 8
6
U.S. bank Chinese bank
(importer’s bank) 7 (exporter’s bank)
1. Purchase order sent by U.S. buyer to Chinese seller

2. Chinese seller requests a letter of credit
3. Notification of letter of credit and draft authorization
4. Order shipped
5. Time draft and shipping papers sent to Chinese seller’s bank
6. Time draft and shipping papers sent to U.S. bank; banker’s acceptance created
7. Payments sent to foreign bank (immediately if Chinese seller wishes to discount the draft and
collect immediately, at maturity if not)
8. Payments sent to Chinese seller (see #7)
9. Payment to U.S. bank by U.S. buyer at maturity, paid in full
10. Shipping papers delivered
14
“LIBOR FOG: Bankers Cast Doubt on Key Rate Amid Crisis, by Carrick Mollenkamp, The Wall Street
Journal Online,” April 16, 2008, Page A1.
5-6
Chapter 06 – Bond Markets
Chapter Six
Bond Markets
This is the second of six chapters that covers different securities markets. This chapter covers the types and
major characteristics of bonds and the markets in which they trade. The student should gain an
understanding of price quoting conventions, typical terms and secondary market trading activity for
Treasury, corporate and municipal bonds. The Treasury STRIP program is discussed in detail and sample
pricing and yield calculations are provided. Students should also be familiar with the major bond market
participants. Brady bonds and sovereign bonds are defined and the risks of international lending are
introduced.
II. Notes
1. Definition of Bond Markets: Chapter Overview
Bonds are capital market instruments with original issue maturities greater than one year. Bonds are
typically fixed income securities that represent nonamortized loans made to corporate or government
borrowers to fund their long term capital needs. Principal is paid at maturity, and interest is typically paid
semiannually at one half the ‘coupon’ rate times the face value of the bond. The major types of bonds
include Treasury bonds and notes, corporate bonds and municipal bonds.
2. Bond Market Securities

In 2007 there were $16.3 trillion in bonds outstanding, excluding mortgages. The size of the total credit
markets is greater than the equity markets. At times, finance classes seem to spend more time discussing
equity markets than debt markets, but the debt markets generally comprise a larger source of funds.
a. Treasury Notes and Bonds

T-notes and bonds comprise about 21% of total bond market securities outstanding (excluding mortgages)
and comprise about 39% of the national debt (excluding T-bills). These instruments are default risk free.
T-notes have an original issue maturity from 1 to 10 years inclusive, whereas T-bonds have original
maturities more than 10 years. Both types pay interest semi-annually. Price quotes are in 32nds as a
percent of par. The minimum par or face value is $1,000. The Treasury also issues inflation indexed bonds
where the principle is adjusted for inflation.
In 1985 the Treasury began its Separate Trading of Registered Interest and Principle Securities (STRIP)
program. A STRIP is a Treasury security where each individual coupon payment and the principle
payment at maturity can be separated and sold individually. STRIPs are registered securities; a private
dealer requests that the Treasury ‘strip’ the individual payments and keep a record of them on the
Treasury’s computer system. Each payment will be given its own CUSIP (identification) number. Only
certain securities are eligible for stripping. The minimum face value of a stripped payment (such as a
single coupon payment) is $1,000. Thus the par amount must be large enough to yield a semi-annual
payment amount of $1,000 (or multiples of $1,000). These stripped payments are then zero coupon bonds
that trade at a discount. Prices and yields on quotes follow similar conventions as T-notes and T-bonds.
The sum of the sale price of the components of STRIPs is often greater than the fair present value of the
original Treasury security. This provides the motivation for dealers to petition the Treasury to create
STRIPs. Investors are willing to pay a small premium because the individual payments can be used in
duration matching or cash matching strategies that limit the investor’s risk. For instance, maintaining a
given duration with coupon paying bonds requires periodic bond trading which generates transaction costs
and perhaps tax consequences whereas use of STRIPs avoids these costs.
Sample Treasury Bond Quote (Source Text Table 6-1)

Maturity Coupon Bid Asked Chg Asked Yld
6-1
2012 Nov 15 10.375 100:24 100:25 -3 3.61
Maturity mo/yr: Month and year, the bond matures November 15, 2012.
Coupon: Coupon rate of 10.375% or $51.875 paid semiannually ($1,000 face)
Bid: The closing price per $100 of par the dealer will pay to buy the bond; the seller would receive
this price from selling to dealer. Prices are quoted in 32nds. In this case, 100:24 = 100 24/32% of
$1,000 or $1,007.50.
Asked: The closing price per $100 of par the dealer requires to sell the bond; the buyer would pay this
price to the dealer. In this case, 100:25 = 100 25/32% of $1,000 or $1,007.8125
The Bid Ask spread is calculated as (Ask – Bid) / Ask = ($1,007.8125 - $1,007.50) / $1,007.8125 =
0.031%. The spread is small because these are wholesale quotes for $1 million dollar order sizes or
larger.
Chg: The change from the prior closing ASKED price in 32nds. In this case the ASKED price fell
three 32nds from the prior quoted closing ask price.
Asked Yld = Promised compound yield rate if purchased at the ASKED price, in this case the yield is
3.61%. Note that the yield is the yield to call if the price is above par and the yield to maturity if
below par. The yield calculation uses semiannual compounding.
Sample Treasury STRIP Quote (Source Text Table 6-1)

Treasury Bond, Stripped Principal
Maturity Bid Asked Chg Asked Yld
2037 May 15 24.222 24.242 .451 4.84
Maturity: May 15, 2037

Bid and Asked prices are a percentage of face value or a Bid price of $24.222 and an Ask price of
$24.242 per $100 of par or face value.
Chg: The change from the prior day’s Ask.
Ask Yld: Promised compound yield rate if purchased at the Asked price, in this case the yield is
4.84%. Note that the yield is yield to call if the price is above par and yield to maturity if below par.
The yield calculation uses semiannual compounding to maintain consistency with T-bond and T-note
quotes.
Accrued interest must be paid by the buyer of a bond to the seller of a bond if the bond is purchased
between interest payment dates. The price of the bond with accrued interest is called the full price or the
dirty price, the price without accounting for accrued interest is the clean price.
Accrued interest may be calculated as:
INT Actual # of days from last coupon payment

Accrued Interest = ×
2 Actual number of days in coupon period
where INT = annual dollar coupon interest.
For example, suppose you buy a 6% coupon $1,000 par T-bond 59 days after the last coupon payment.
Settlement occurs in two days. You become the owner 61 days after the last coupon payment (59+2), and
there are 121 days remaining until the next coupon payment. The bond’s clean price quote is 120:19.
What is the full or dirty price (sometimes called the invoice price)?
$60 61
Accrued Interest = × = $10.05
2 (121 + 61)
The clean price is 120:19 or 120 19/32% of $1,000 or $1,205.9375.
The dirty price is thus $1,205.9375 + $10.05 = $1,215.9875
Treasury Inflation Protection Securities (TIPS)
6-2
The Treasury began issuing TIPS in January 1997. TIPS pay a fixed coupon rate (presumably equal to the
real rate of interest required by investors at the time of issue assuming the bond is issued at par) for the life
of the security. The principle amount of the bond is indexed to inflation however. The principal is adjusted
every six months based on changes in the Consumer Price Index (CPI). Because of the principal
adjustment, investors are protected from unexpected increases in inflation. Investor rates of return will be
reduced by unexpected decreases in inflation.
TIPS Example:
An investor buys a $10,000 1 year TIP security with a 3% coupon at par. Suppose that the CPI increases
by 2% in the first six month the investor holds the bond and the CPI increases by 1.5% in the second six
months. The investor pays or receives the following cash flows:
0 0.5 1
-$10,000 $153 $10,508.295
=($10,000*1.02*1.015 0.03/2) +
=($10,000*1.02* 0.03/2)
($10,000*1.02*1.015)
The modified internal rate of return,15 assuming that the $153 is reinvested at 1.5% can be found as
($10,508.295 + ($153*1.015) - $10,000) / $10,000 = 6.6359%.
Annual inflation = (1.02*1.015) - 1 = 3.53%
Real rate of return = (1+ MIRR) / (1+ Inflation annual) – 1 = (1.066359/ 1.0353) - 1 = 3.00%.
In a standard T-bond the equivalent cash flows and rates of return are:
0 0.5 1
-$10,000 $150 $10,150
= ($10,000* 0.03/2) = $10,000 + $150
IRR semi = 1.5% Note: MIRR = 3.0225%
IRR annual = 3.0225%
Annual inflation = (1.02*1.015) - 1 = 3.53%
Real rate of return = (1+ IRR annual) / (1+ Inflation annual) – 1 = (1.030225 / 1.0353) - 1 = -.49%.
Primary market: Treasury note and bond auctions operate similarly to the T-bill process discussed in
Chapter 5. Regular auction schedules of notes and bonds are provided in Text Table 6-3. Secondary
market activity is large compared to other types of bonds. In September 2007 daily trading activity was
over $605 billion on average. Although the Treasury market is the most liquid bond market in the U.S. “off
the run” (existing) securities may have less liquidity than “on the run” (newly issued) securities.
b. Municipal Bonds
Municipal bonds are bonds issued by state or local governments. The typical par value on a municipal bond
is $5,000. Munis comprise about 16% of total bonds outstanding. Interest income on munis is not taxed at
the federal level and is usually exempt from state and local taxes if the investor lives in the state in which
the muni is issued. Capital gains are taxable. The tax exemption allows municipal governments to obtain
lower cost financing. With the tax exemption, investors require lower yields on munis than on equivalent
risk taxable bonds. General obligation (G.O.) bonds are munis that are backed by the full taxing power of
the municipality (i.e. the general fund). Revenue bonds are backed only by the revenues of a specific
project. General tax revenues cannot be used to make payments on revenue bonds; thus a revenue bond is
riskier than a G.O. G.O.s are only about 30% of total municipal bonds.
One cannot directly compare muni bond rates with taxable corporate bond rates without adjusting one or
the other. The formula to adjust for taxes is straightforward:
15
Using the IRR does not work because the reinvestment assumption of solving for the promised
yield as the IRR is violated. That is, you cannot reinvest the intermediate coupon and earn the IRR rate.
6-3
ia = ib * (1 - t) where the a and b stand for after tax and before tax respectively. Hence a 4% muni bond
rate cannot be directly compared to a 6% equivalent risk corporate bond rate. Both rates must be on the
same tax basis. If one is in a 28% tax bracket, the after tax corporate bond rate ia = 6%*(1- 0.28) = 4.32%.
Now one can see that the investor is better off with the corporate bond rather than the muni. In the May
2008, many municipal bond rates were between 2% and 6% depending on credit quality.
Muni bond offerings are generally underwritten by investment bankers in a firm commitment offer. Best
efforts are occasionally utilized.16 The investment bank may be chosen on the basis of a bid process,
where the banker that submits the highest bid price will be selected, or on a negotiated basis. Municipal
issuers generally consider multiple investment bankers before choosing a lead underwriter. G.O. bonds
usually must be issued via competitive bid. Sometimes bonds are privately placed (usually sold to 10 or
fewer large (i.e., those with assets over $100 million), usually institutional, investors). In this case the
bonds need not be registered. Smaller to mid-size municipal and corporate borrowers typically use private
placements. Private placements can now be traded among large investors, but the market is very thin as is
the secondary market for publicly issued munis.
c. Corporate Bonds
Corporate bonds comprise about 63% of outstanding bonds. The minimum denomination is $1,000 on
publicly traded bonds. Corporate bonds are debt instruments issued by corporations to fund long term
capital needs. The funds raised can be used for very risky purposes and default risk is measured by one or
more ratings agencies. The rights of the bondholders are protected by the bond indenture (contract). The
indenture specifies a trustee to ensure enforcement of the contract and specific terms and provisions of the
contract (called covenants). The covenants will stipulate collateral, if any, the call features and
convertibility features (if any), the interest rate, the interest payment and maturity dates and other
restrictions on the bond issuer while the issue is outstanding. There will usually be a maximum dividend
specified, a limit on additional debt of equal or higher seniority and limits on certain ratios such as times
interest earned and the current ratio.
Corporate bond quotes (Source: Text)

Issuer Moody’s/S&P/ Yield
Name Symbol Coupon Maturity Fitch High Low Last Change %
AT&T T.KC 6.500% Sep 2037 A2/A/A 102.849 102.520 102.849 1.558 6.286
The quote lists the issuing company name and ticker, the annual coupon rate (6.5%), the maturity date, the
bond rating by the three agencies, the high, low and closing price as a % of face value, followed by the
change from the prior day’s last, and finally the promised yield to maturity using the closing or last price.
Bond terminology:
• Bearer bonds versus registered bonds: Payments are made automatically to the owner of record of a
registered bond. Bearer bond payments are made at the request of the bearer, usually the investor clips
a coupon and mails it to the borrower. In the U.S. borrowers may no longer issue bearer bonds.
• Term vs serial bonds: Term bonds mature all at once at maturity. Serial bonds mature sequentially.
For instance with a ten year overall maturity, some serial bonds would mature in five years, some in
six years, etc, so that a portion of the outstanding debt is paid off each year.
• Mortgage bonds: With a mortgage bond specific collateral has been pledged as security for the
bondholders. In the event of non-payment of interest or principle, the trustee can seize the collateral
on behalf of the bondholders and sell it to recover their money.
• Debentures and subordinated (junior) debentures: Debentures have no specific asset pledged as
collateral. They are riskier than mortgage bonds and carry higher yields. Subordinated debentures are
riskier yet as they are not paid off until debenture holders are paid off.
16
In a firm commitment the underwriter buys the issue from the firm paying the bid price and
reselling the issue at the offer price. In a best efforts the underwriter assists in the sale of the securities but
does not buy the issue.
6-4
Courts have not always strictly followed the standard bankruptcy priority schedule. The courts have often
decided that it is better for junior claimants to get a part of their money back even if this means that senior
claimants must bear larger losses than warranted by their priority.
• Convertible bonds: Bonds convertible at the option of the bondholder into either preferred or common
stock as the contract states. The conversion option allows the issuer to issue the bond at a lower
required yield, ceteris paribus. Usually the stock price must increase 15% to 25% before the
conversion option becomes profitable to the bondholder. If the stock price increases the convertible
bond’s price will begin to act like the stock price.
Example: A firm issues annual payment 6% convertible bonds at par. Each bond can be converted into
250 shares of common stock and the firm’s common stock is trading at $3.20. What percentage
increase in share price is needed to justify conversion? If the bondholder gave up 30 basis points in
coupon and yield rate in order to get the conversion feature, and was not able to profitably convert the
bonds for three years, how did the investor do relative to a stockholder and an investor who bought an
equivalent nonconvertible bond?
What percentage increase in price is needed to make conversion profitable? Common stock price
required to make conversion profit neutral: $1,000 bond value / 250 shares = $4.00 per share
Required increase in stock price = $4.00/$3.20 -1 = 25%
The investor received a 6% annual rate of return. An investor in the stock would have received an
average annual rate of return of 7.72%, excluding dividends.17 An investor in an equivalent
nonconvertible bond would have received an annual rate of return of 6.3% (30 basis points more the
convertible). Ask students to think through the value of the convertible option. Is it worth it and if so
then in what situations? Is buying a convertible an aggressive or a defensive strategy?
Virtually all convertible bonds are callable. The issuer often uses the call feature to force conversion and
eliminate the fixed interest payments. Students almost invariably believe that convertible bonds are good
deals because they combine the protection of a bond’s fixed income with the stock’s upside potential. In an
efficient market however, the embedded option in the bond is priced according to the prospects of the
firm’s stock. There is little reason to think that the investor is getting a particularly good deal. For
instance, agency theory tells us that convertible bonds will normally be a preferred financing instrument
when the bondholders are worried that management will favor stockholders over the bondholders. In the
event of a takeover that benefited shareholders and hurt bondholders the conversion option may be a
valuable feature but the conversion option doesn’t necessarily mean the convertible is a better deal than
straight bonds.
• Callable bonds: Bonds that may be redeemed at the option of the issuer at a predetermined price
above par (call premium), or according to a predetermined price schedule (the call price often drops as
maturity approaches). The call feature results in higher required yields. incb = icb -opcb where incb is the
required yield on a noncallable bond and icb is the required yield on a callable band and opcb is the
value of the issuer’s option to call the debt early.
Issuers typically call the bonds after interest rates have fallen, which can leave the investor with an
overall lower realized yield over a given investment horizon.
Here is a simple example:

You have a five year investment horizon. You buy a callable 7% coupon five year bond at par. Rates drop
to 5%, the bond is called at a call price of $1,075. You reinvest your funds in 5% coupon bonds for the five
years. A 7% annual compound rate of return on a $1,000 initial investment over five years should yield:
$1,000 × 1.075 = $1,402.55. You actually earned $1,075 × 1.055 = $1,372 or you earned a 6.53% rate of
return from your original $1,000 investment.
• Sinking fund: A sinking fund requires the bond issuer to ensure that enough money will be available
to retire the debt at maturity. This can be done by having the borrower deposit funds with the trustee
17
Found as 1.250.3333-1
6-5
each year so that at maturity enough money is available to pay off the principle. This is an added
safety feature to the bond that allows the bond issuer to offer a lower required rate of return.
Sometimes sinking funds allow the bond issuer to randomly select and redeem a given percentage of the
bonds each year. Issuers prefer this method because it terminates the interest owed on the retired bonds.
This type of sinking fund however may leave the bondholder whose bond is selected for redemption worse
off if interest rates have fallen since the bond was issued Sinking funds of this nature can thus be a mixed
blessing to bondholders.
• Stock warrants: Warrants are call options attached to the bond that can be detached and exercised or
sold separately, unlike the convertible bond which requires the bondholder to give up the bond to
acquire the stock. Warrants are often used as ‘sweeteners’ to bond deals to obtain a lower interest rate
on the bond.
The primary market for corporate bonds operates similarly to the primary market for municipal securities.
Both corporates and municipal bonds have lower secondary market activity than Treasuries. There are two
secondary markets for corporate bonds, the NYSE Fixed Income Market and the over the counter (OTC)
market. Less than 1% of corporate bonds are exchange traded (primarily on the bond division of the
NYSE). Trading on the NYSE bond market is mostly automated and occurs through the Automated Bond
System (ABS). On the ABS order execution is fully automated. The OTC market consists of large bank
dealers and contains most of the actual trading done in bonds. Hence exchange bond price quotes are often
behind or inaccurate for large deals.
d. Bond Ratings
Most bonds are rated in terms of default risk by at least one of the major ratings agencies, typically
Moody’s and/or Standard and Poors. Many institutions can hold only limited amounts of unrated or low
rated debt, so a favorable rating lowers the interest yield required and increases the amount of potential
buyers. Junk bonds are bonds rated below Baa by Moody’s or BBB by S&P. Higher ratings are termed
investment grade bonds. Explanations of the ratings may be found in the text. In general ratings agencies
evaluate the industry strength, the firm’s position in the industry, liquidity, profitability, debt capacity and
since Sarbanes-Oxley, corporate governance. Each specific rated issue is also examined for protection
provided to investors and the firm’s ability to pay.
According to Bloomberg and the Wall Street Journal, in May 2008 the average yield on AA rated bonds
was 5.35% while the average yield on Baa was 6.44%, for a default yield spread of 109 basis points. On a
$50 million bond issue, the lower grade debt would cost $545,000 more in pre-tax interest expense per
year. The average for high yield debt was 10.14%. This yield gives an additional credit spread over the
medium grade of 370 basis points. On the same $50 million bond issue, having a junk rating would add an
additional $1,850,000 in pre-tax interest expense per year. As you can see, the rating substantially affects
bond financing costs. Ratings spreads tend to vary inversely with the phase in the cycle of the economy.
From 1980 to 2002 the cumulative default rate (CDFs) on 10 year Aaa rated bonds was 0.03% and the CDF
was 9.63% on Baa rated bonds.
The CDF for any year t of an N year bond can be calculated as

 t 
CDFt = 1 − ∏ Pr ob Survival j 
 j 
6-6
To find the CDF after two years for an N year bond that has a 98% chance of survival in year 1 and a 97%
chance of survival thereafter:
 2 
CDFt = 1 − ∏ Pr ob Survival j  = 1 − (0.98 * 0.97) = 4.94%
 j 
Survive
97%
Survive
Year 1 98% Year 2 CDF
Decision
3% Tree
2% Don’t Survive
Don’t
Survive
In May 2005, Standard & Poor’s downgraded almost $300 billion of General Motor’s debt to junk status.
GM stock dropped 4% when the news came out. Nissan has been attempting to improve its bond rating out
of the medium grade to better compete with Toyota, which has the highest rating. In 2005, Toyota had
more than twice the cash reserves of Nissan. Sources: Wall Street Journal email news bulletin, May 5,
2005, and “Heard in Asia, Nissan to Rev Up its Liquidity to Win Higher Credit Ratings,” J Sapsford, Staff
Reporter, Wall Street Journal Online, C5, May 3, 2005.
Ratings agencies have been criticized for failing to downgrade firms quickly when conditions deteriorate.18
It is likely that some change in regulation of ratings agencies may be needed. In hindsight, the ratings
agencies granted too high ratings to issuers of mortgage backed securities. The text discusses a possible
motivation for the ratings firms. The high ratings granted to certain tranches of collateralized debt
obligations (CDOs) allowed excessive issuance and excessive leverage to be employed by hedge funds,
banks and investment banks. This leverage eventually led to the credit crunch and the demise of Bear
Stearns.
Junk bonds (also called speculative grade or high yield bonds are those rated below Baa3 or BBB-) carry
considerably more risk and higher yields. The higher yields may be necessary because many institutions
are limited in the extent to which they can hold junk debt. Junk bonds have been used to finance takeovers,
limiting the amount of equity required by the acquirer.
18
For more information see Frank Portnoy’s testimony before a U.S. Senate Committee on January
24, 2002 on the Enron affair, available in Financial Engineering News June/July 2002, No. 26. Professor
Portnoy is a law professor at the University Of San Diego School Of Law.
6-7
Bond Credit Ratings (Source: Text Table 6-10)

Explanation Moody’s S&P
Best quality; smallest degree of risk Aaa AAA
Aa1 AA+
High quality; slightly more long-term risk than top rating Aa2 AA
Aa3 AA-
A1 A+
Upper medium grade; possible impairment in the future A2 A
A3 A-
Baa1 BBB+
Medium grade; lacks outstanding investment characteristics Baa2 BBB
Baa3 BBB-
Ba1 BB+
Speculative issues; protection may be very moderate Ba2 BB
Ba3 BB-
B1 B+
Very speculative; may have small assurance of interest and principal
B2 B
payments
B3 B-
Issues in poor standing; may be in default Caa CCC
Speculative in a high degree; with marked shortcomings Ca CC
C C
Lowest quality; poor prospects of attaining real investment standing
D
e. Bond Market Indexes

Bond market indexes are published daily in the Wall Street Journal; indexes are available for the major
bond sectors. Table 6-12 in the text highlights the major indexes.
3. Bond Market Participants

Governments and foreign investors hold the bulk of Treasuries (see table below). Municipal and corporate
bonds are predominantly held by business financial institutions although individuals hold 36.1% of
municipals.
Bond market participants by type 2007 (See Text Figure 6–11)

Business Business
Financial Nonfinancial Governments Households Foreign
Treasuries 12.7% 2.3% 31.3% 9.1% 44.6%
Municipals 58.9% 1.9% 1.5% 36.1% 1.6%
Corporate 52.8% <1% 8.2% 9.9% 29.1%
4. Comparison of Bond Market Securities

Yield rates on the three major bond types are presented in Text Figure 6-10. Yield rates are highly
correlated among the three types, but default risk premiums on muni and corporate bonds can vary over
time. In particular, default spreads increased in the early 2000s recession.
6-8
5. International Aspects of Bond Markets

From 1995 to 2004 the quantity of international debt securities outstanding grew 500% in total, or at an
average annual growth rate of 25.11%. In terms of dollar volume, there are now more euro denominated
floating rate and fixed rate debt instruments outstanding than dollar denominated instruments.19
International bonds are usually bearer bonds placed in multiple countries or in a country other than the
issuer’s home country. Financial institutions are the largest issuers of international bonds, other than equity
related bonds which are dominated by corporate issuers.
In 2007 China was holding about $1.3 trillion in U.S. Treasuries. Ask your students what the effect would
be if China sold their Treasury holdings. Is China likely to do so? Why has China acquired so many
Treasuries? The Chinese central bank has acquired the Treasuries as a result of their attempts to keep the
yuan low relative to the dollar, albeit at the cost of domestic inflation in China.
6. Eurobonds, Foreign Bonds, and Brady and Sovereign Bonds

a. Eurobonds
Eurobonds are long-term bonds sold outside the country of the currency in which they are denominated.
This need not be in Europe. For instance Eurodollar bonds may be dollar denominated bonds sold in
Japan. They typically have denominations of $5,000 and $10,000 and are traded mostly OTC in London
and Luxembourg. Eurobonds are typically placed by an investment banking syndicate, traditionally the
issue costs have been higher than for domestic bonds.
b. Foreign Bonds
Foreign bonds are bonds issued outside the home country and are denominated in the host country’s
currency. For example, Samurai bonds are dollar denominated bonds issued by Japanese borrowers in the
U.S.
c. Brady Bonds and Sovereign Bonds

Brady bonds were created when a bank restructured an existing loan made to a less developed country
(LDC) that could not be repaid in full. The loan was eliminated and in exchange the borrower agreed to
accept the liability of the Brady bond. The Brady bonds have longer maturities and lower interest rates
than the original loans. The banks were willing to accept the Brady bonds in place of the original loan
because 1) the U.S. government strongly urged them to do so, and in some cases borrowers agreed to back
the bonds by holding U.S. Treasury assets, 2) the alternative was to receive no payments from the
borrowers and, 3) the Brady bonds were saleable, so that the banks could cut their losses if they chose. As
some LDC’s credit ratings have improved, countries have removed the backing of U.S. Treasury Bonds,
and the bonds then become priced according to the creditworthiness of the respective country. These bonds
are called sovereign bonds.
19
In equity related bonds and notes the U.S. dollar still dominates.
6-9
Chapter 07 - Mortgage Markets
Chapter Seven
Mortgage Markets
I. Notes
1. Mortgages and Mortgage-Backed Securities: Chapter Overview
Mortgages are loans to purchase a home, land or other real property. In 2007 there were over $13 trillion
of mortgages outstanding. About 76% of mortgages are single family (1-4 family) mortgages. The rest are
divided between commercial mortgages (17%), multifamily dwelling mortgages (≈ 6%) and a small
amount of farm mortgages (under 1%). This chapter covers the primary and secondary market
characteristics of single family mortgages.
There is a well developed and active secondary market for mortgages, unlike many other loan types.
Government involvement in the single family secondary mortgage market through insurance and promoting
securitization has led to the active secondary market for mortgages. Securitization is the process of
transforming individual loan contracts into marketable securities. About 60% of single family mortgages
are securitized. Mortgage contracts by themselves would not be particularly saleable because they have
nonstandard, fairly small denominations and unique, potentially substantial credit risk. A saleable contract
should have a standard, large denomination to appeal to institutional buyers, a low cost method of
assessment of credit risk, good collateral, a standard maturity, and a standard interest rate.20 Mortgages
have generally good collateral, standard lengthy maturities and standard interest rates. The small and
variable denomination of individual mortgages implies that mortgages should be pooled to create a typical
large denomination. Credit risk analysis of the many individual borrowers in the pool would be quite
costly and would severely limit the usefulness of the securitization process if not alleviated. Thus, for most
mortgages that are securitized either the government provides insurance for mortgages (for a fee of 0.5%
of the loan amount), an 80% loan to value ratio is required, or the mortgage must be privately insured
perhaps by a firm such as PMI Mortgage Insurance.
Securitization brings many benefits to FIs. Securitization allows FIs to a) become more liquid, b) reduce
interest rate and credit risk, c) reduce capital and reserve requirements, and d) generate fee income from
servicing more mortgages than they could otherwise.
The mortgage markets are huge (they are larger than the corporate debt market), rapidly growing (from
1995 through 2007 the amount of single family home mortgages grew by about 211%) and are becoming
increasingly sophisticated. As a result, students may wish to consider pursuing careers in mortgage related
areas. Even with the downturn in mortgages in the late 2000s mortgage markets are likely to generate long
term growth. In some areas home prices have advanced more rapidly than income growth, leading to
slowed growth in housing prices and even declines in some markets such as Florida. Nevertheless,
Greenspan had indicated that he did not foresee problems of this nature in the housing market.21 In other
countries and in our own past, severe collapses in housing prices have presaged protracted periods of low
economic growth or even a prolonged recession so we hope he is correct.
In 2006, 2007 and 2008 problems in the subprime mortgage market led to the credit crunch of 2007 and
2008. A subprime mortgage is a mortgage made to a borrower with a below normal credit rating. I have
not yet seen many solid statistics on the size of the subprime sector although it is likely to be only a few
percent of the total mortgage market. Nevertheless credit problems in the sector nearly bankrupted
Countrywide Financial, the largest mortgage issuer, in the summer of 2007. Countrywide had to draw
down its entire credit line of $11.5 billion to survive. The subprime mess spread to the broader mortgage
markets and undoubtedly resulted in a weakening of stock markets throughout 2007 and on into 2008.
20
Standardization improves salability. Standard terms improve the ability to market an issue to
buyers because they are more familiar with the terms and risks of the investment.
21
Former Fed Chairman Greenspan did indicate that rapid growth in two housing related
government sponsored enterprises, FNMA and FHLMC, was generating systemic risk to the economy. See
the discussion on FNMA and FHLMC below.
7-1
According to the Mortgage Bankers Association (MBAA) delinquency rates for mortgages in the second
quarter of 2007 were at 5.12% of all loans, up from prior quarters and the prior year. The percentage of
loans in foreclosures in the same time period was 1.40%, also up. The rate of loans entering the foreclosure
process was 0.65%, also an increase. Interestingly however, these numbers were driven by mortgage
markets in a relatively small number of states. National foreclosure rates would have fallen if one excluded
California, Florida, Nevada and Arizona. Delinquencies and foreclosures in mortgages and falling home
prices were also problems in Ohio, Michigan, Indiana, Illinois, Kentucky, Tennessee and Pennsylvania.
Delinquencies and foreclosure rates were higher for ARMs than for fixed rate mortgages.22
Ethics The ability to sell and securitize mortgages coupled with a lack of regulation of mortgage
originators, particularly mortgage companies, helped create the subprime crisis. Mortgage originators
knew they would quickly sell the loans and pocket the origination fee. They may or may not retain the
servicing contract which would generate more fee income. Nevertheless, since the mortgages were sold
without recourse to the originator increasingly lax credit standards were undoubtedly applied. Lax
standards led to poor lending practices such as ‘Low Doc” or “No Doc” loans referring to either low or no
documentation required demonstrating the borrower’s ability to repay the mortgage. These loans were
even given the appellation “Liar’s Loans” because allegedly mortgage lenders coached applicants to fill
out applications to ensure the mortgage would be approved and could be resold with little regard to the
veracity of the statements made. As long as the borrower made three payments on the mortgage after
origination, the originator was free and clear from recourse. Hence, there was little reason to apply tight
credit standards.
What hindsight reveals as excessive risk taking has happened over and over in periods of booming markets.
In these cases people underestimate risk and reduce risk aversion to the point where excessive risks are
engendered. Whether this results from hubris, its twin overconfidence, a lack of economic training and
experience, or just poor ethics no one knows for sure. Undoubtedly it is a result of all these elements
combined. The laws of financial gravity, particularly with respect to long periods of price increases, have
not been repealed by financial innovation and the many risk sharing contracts now being promulgated. For
all our sophistication in finance we should remember two things: 1) It is impossible to eliminate systemic
risk in the aggregate, although you can share it among an increasing number of participants with the many
derivatives we now have; and 2) Policies promoting both solid ethics and conservative financing
principles are always needed. The more ethics failures we endure, the tighter regulations will have to
become, with all the inefficiencies and increase in regulatory burdens this entails. It is also becoming
increasingly obvious to me that regulations/regulators have not kept up with financial innovation. Whether
this is due to inherent conflicts of interest, lack of funding or training or other reasons cannot be
determined. When you include overseas markets it becomes apparent that we have been moving from one
crisis to another every few years as capital markets have grown at such a rapid pace with extensive
innovation. Perhaps this is nothing new, the capital markets have always operated under the premise of
“caveat emptor.”
2. The Primary Mortgage Market

The origination and financing of mortgages are now largely separate functions. One of the primary
purposes of the government’s presence in the mortgage markets is to ensure the availability of mortgage
credit wherever it is demanded. Government mortgage insurance and the securitization process have
created a national market for financing mortgages. Thus, the financing of mortgages is national, or even
international, in scope. The origination (creation) of mortgages is still primarily a local market, for
instance, typically one does not go to another state to obtain a mortgage. The originators, however often
sell the mortgage (individually or in a pool).23 Electronic mortgage origination has not grown as
dramatically as predicted. Applying for a mortgage online remains a cumbersome task, hurting this area of
business.
22
“Delinquencies Increase in Latest MBA Delinquency Survey,” by Angela Waugaman, Mortgage Bankers
Association website, 9/6/07 Press releases, http://www.mbaa.org/NewsandMedia/PressCenter/56555.htm
23
The origination market is itself however becoming increasingly national because mortgage
companies (a local originating institution) often obtain mortgage financing from institutions around the
country.
7-2
Government involvement has accomplished at least two socially desirable outcomes. One, it has allowed
younger, less wealthy people to own homes by eliminating the large down payment, thus facilitating a part
of the “American dream” of home ownership. Second, it has helped poorer regions of the country such as
West Virginia, Montana, etc that would not have had enough mortgage credit available to meet the demand
for funds.
For many people, home ownership is one of the most satisfying assets they obtain. It is a person’s major
hedge against personal disasters and inflation. Even in low inflation times it is usually (but not always) an
appreciating asset and, unlike automobiles, should be considered an investment. Homes are an illiquid
investment and living in the wrong house for you in the wrong area can make you miserable for a long
time, so please advise students to shop wisely.
a. Mortgage Characteristics
Although mortgages can have unique terms, the demands of the secondary market increasingly determine
the guidelines for accepting or rejecting a mortgage application.
Collateral
All mortgage loans are backed by collateral that will have a lien placed against it. A lien is a public record
attached to the title of the property that gives the financial institution the right to sell the property if the
mortgage borrower defaults. A lien prevents sale of the property until the mortgage is paid off and the lien
removed.
Down Payment
In the absence of government insurance, a down payment is required to minimize default risk. An 80%
loan to value ratio is standard. If a borrower cannot pay the required 20% down payment they may obtain
FHA insurance. FHA insurance has a maximum borrowing amount that varies according to regional
housing costs. The borrower may instead apply for private mortgage insurance (PMI). Most PMI
requires a monthly payment that is added to the principle and interest payment. Although it can vary from
lender to lender, the typical monthly mortgage insurance payment if the borrower pays only 10% down can
be found by multiplying the loan amount times a constant factor equal to 0.0051 and then dividing the
result by 12. For instance, on a $100,000 mortgage with 10% down, the monthly PMI premium would be
($100,000*0.0051)/12 = $42.50. If you finance 97% the constant is 0.0090 and the monthly PMI payment
would be $75.24
Once the homeowner reduces the principle amount to 80% or less of the house value, either through
payments and/or appreciation of the value of the home, the homeowner may wish to have the house
reappraised and apply for termination of the mortgage insurance. The appraisal cost may be as low as
$500-$600.
Insured vs Conventional Mortgages

Conventional mortgages are mortgages not insured by the Federal government. The term insured
mortgages refers to mortgages insured by the Federal government, not privately insured mortgages.
Mortgage Maturities
The two standard maturities are 15 year and 30 year, with 30 year mortgages predominating. Some
contracts call for balloon payments at the end of three to five years. These contracts may require interest
only payments during the interim period. Most borrowers will not be able to pay off the balloon so the
borrower is essentially agreeing to refinance the mortgage when the balloon is due.
A balloon payment mortgage is riskier to the borrower because there is no guarantee that refinancing will
be granted. An injury or illness, a layoff, etc. can endanger an individual’s primary asset, their home.
Interest Rates
24
Thanks to Chuck Schmautz of Schmautz & Smith Mortgage LLC for providing this information.
7-3
Mortgage rates are a function of the fed funds rate, discount points paid, whether the loan is a FHA or a
conventional mortgage, maturity, whether the mortgage is fixed or adjustable rate, regional demand for
funds and the level of competition of suppliers of mortgage credit. Regional credit availability is not an
issue due to the national financing market.
Fixed versus Adjustable Rate Mortgages

Fixed rate mortgages (FRMs) remain the most popular mortgage type, although a significant number of
mortgages are adjustable rate. With the low rates of the early 2000s, adjustable rate mortgages (ARMs)
have not been as popular as in prior periods (at one point several years ago 50% of new originations were
adjustable rate). The payment on ARMs can vary as the applicable interest rate index changes. The index
used cannot be the lender’s cost of funds and is often an index of lenders’ fund costs (termed a COFI or
cost of funds index). The rate change per year and over the life of the mortgage is capped and
prepayment penalties are not allowed on ARMs. With a fixed rate mortgage the lender bears the interest
rate risk, with an ARM the borrower bears the interest rate risk.25 As we have seen in 2007 and 2008
ARMs result in higher default risk for lenders in periods of rising interest rates. When rates rise,
borrowers have more difficulty making the payments on their mortgage. The share of ARMs as a
percentage of new originations has fallen dramatically and is at about 11% and projected to remain in the 9-
11% range through 2009 according to the MBA Mortgage Finance Forecast in May 2008.26
A home mortgage is usually the largest single monthly payout of the individual. It may be prudent to
know with certainty what this amount will be. If a borrower wishes to use an ARM he or she should ensure
they fully understand all the details, indeed, having a lawyer review the loan contract is an excellent idea.
An ARM borrower should determine the maximum monthly payment and ensure that they can comfortably
handle that amount. The two most common types ARMs are fixed for 5 years, then floating and adjustable
every year. The borrower must take care when purchasing an ARM that is fixed for 5 years to ensure that
they can handle the maximum payments when the mortgage is recast and to be aware of any possibility of
negative amortization. ARMs offer teaser rates to entice borrowers to purchase them. The size of the rate
difference between an ARM and a FRM varies between rate environments. Recently the fixed for 5 year
ARM offered a 50-75 basis point advantage over 30 year FRM rates. The annual adjustment ARM usually
offers a much larger advantage, sometimes as high as 200 basis points over 30 year FRMs. These spreads
vary as rate expectations change however.
A buyer should ascertain the type of home that is easily saleable in their area. They should not be in a
hurry when purchasing a home. “Shop till you drop” is good advice in a major, often illiquid investment.
Typically, a home buyer should not buy a home where the total monthly payment will be more than 25%-
35% of their current take home pay. One won’t enjoy a home that one can never afford to leave, and
financial frictions are a major source of stress on relationships.
The borrower can often obtain a conversion option which allows the borrower to convert the ARM to a
fixed rate mortgage. This option is usually granted within a narrow time window, say from year 3 to year
5. It is usually not a good deal because the conversion will typically occur at a markup over fixed rates at
the time of the conversion, not at today’s fixed rates.
Because of the annual caps ARMs can be good deals if you believe you will either move or refinance in 3
to 5 years as long as the borrower is aware that there is a possibility of not being able to refinance due to
changes in the borrower’s condition or changes in the housing and mortgage markets.
Discount Points
A borrower can buy a lower interest rate by paying points up front. A discount point is 1% of the loan
amount. Lenders periodically establish point schedules that show what interest rate they are willing to offer
if the borrower pays a certain amount of points. A simple breakeven analysis can be used to determine
whether the borrower should pay the points. The dollar value of the points / monthly payment savings =
25
The cap implies that even in an ARM the lender still bears some interest rate risk.
26
See the Mortgage Bankers Association website at www.mbaa.org.
7-4
number of months required to recoup the points. If the borrower expects to live in the house for the
breakeven number of months or longer, it is worthwhile to pay the points. This example ignores taxes.
When should you pay points? You are thinking of purchasing a $100,000 home and making a 20% down
payment. The 30 year mortgage rate is 8 1/4% at par, but you can get an 8% rate by paying 5/8s of a point.
What should you do? (Ignore taxes)
If you don’t pay the points (r = 8 1/4% / 12 = 0.6875%):
$80,000 = $PMT * [1 - 1.006875-360] / 0.006875
$PMT = $601.01
If you pay the points (r = 8% / 12 = .6667%)

$80,000 = $PMT * [1 - 1.006667-360] / 0.006667
$PMT = $587.01
Payment Savings = $601.01 - $587.01 = $14 / month
Cost: 5/8s of a point = 0.625% * $80,000 = $500

Would you pay $500 today to save $14 a month?
What is the breakeven?
W/ Payments $500 = $14 * [1 - 1.006667–N ] / 0.006667]
Reinvested27 Solve for N (r = 8%/12)
N = 40.93 months or 3.4 years
W/O Payments Easy way: $500 / $14 = 35.71 months or 2.98 years
Reinvested
Pay the points if you believe you will keep the mortgage for at least as long as the breakeven time period.
The refinancing decision is similar, instead of the points cost the refinancing (refi) cost will be the present
value and the payment savings will be payment. One can also calculate the net present value of paying the
points or of the refi decision.
You might wish to advise your students that if the breakeven is 5 years or longer, it is probably not worth
paying the points because most people’s life circumstances are likely to have changed by 5 years, and one
cannot tell whether one will still wish to remain in the same house after that time.
Other Fees
A homebuyer will normally face a host of fees (payable at closing or before) including:
• Application fee
• Title search fee
• Title insurance fee
• Appraisal fee
• Loan origination fee (usually 1% of the loan amount)
• Closing agent/review fee
• Costs to obtain mortgage insurance (FHA, VA or private) if needed
Closing costs average from 3%-5% of the mortgage amount (excluding points), with 3% the most
common.
Mortgage Refinancing
Due to low interest rates in the 2000s, mortgage refinancing business boomed. In the early 2000s
refinancings comprised 70% of all originations, but more recently have comprised between 40% and 60%.
A typical rule of thumb is that the new mortgage rate should be 200 basis points below the old rate, but
27
This method assumes the $14 per month savings is invested at the monthly rate of .6667% per month. If
the money is not reinvested, the ‘without payments reinvested’ method is correct.
7-5
with ARMs and reduced refinancing costs refinancings can be worthwhile at smaller rate reductions. A
breakeven similar to that mentioned above can be used to determine if refinancing is worthwhile.
Some homeowners have refinanced at lower rates but increased the principle amount owed in order to
generate cash for spending or investing. These loans are also available for up to 5 years or more as interest
only. If the economy weakens as it has in 2007 and 2008 and home prices continue to fall, defaults on
these loans may increase and lenders may then be less willing to continue this practice. Indeed the
Mortgage Bankers Association predicts declines in median home prices on existing homes to fall from the
2007 level of $219,000 to $200,100 by 2009 and median prices of new homes to fall from the 2007 level of
$247,300 to $228,900 in 2009.28
b. Mortgage amortization
The typical mortgage is fully amortized at the original maturity so that the principle is reduced with each
payment and no balloon remains at maturity. Amortizing payments are calculated using the present value
of annuity formula. An amortization schedule depicts the amount of each payment that goes to principle
and to interest.
Example 1:
A borrower agrees to a $200,000, thirty year fixed rate mortgage with a 5.75% (or 0.4792% per month)
quoted interest rate. What is the payment amount and how much of each payment goes to principle and
interest?
Payment = $200,000 / (1-1.004792-360)/0.004792 = $1,167.15. The amortization schedule below provides

the breakdown of each payment into principle and interest on a dollar and a percentage basis. The first 24
and the last 25 months of payments are shown.
Notice that the total interest paid on the mortgage ($220,172.46) is greater than the original balance.
Example 2: Recent sample of rates on a $175,000 Mortgage (current quotes are available at
http://mortgage-x.com/x/rates.asp and are searchable by state)29
15 yr FRM 5.50% Par
30 yr FRM 5.875% Par; 5.625% 1.035 pts
P&I Payment on the 30 year (Par): ($214,000 mortg.) $1,265.89

P&I Payment on the 15 year (Par): ($214,000 mortg.) $1,748.56
Payment Difference – $ 482.67
Total Interest paid on the 30 yr FRM: $ 241,721
Total Interest paid on the 15 yr FRM: $ 100,741
Interest Difference $ 140,980
With the 15 year mortgage, a borrower would make $86,881 more in payments and save about $1.62 in
interest per extra dollar paid.30
Be sure that students understand that their total monthly payment will normally be about $100-$200
higher than the principle and interest payment due to insurance and taxes. …
28
Mortgage Finance Forecast, May 2008, found at www.mbaa.org.
29
Rates are higher on ‘jumbo’ mortgages of more than $250,000 -$300,000.
30
This ratio varies with different interest rate spreads.
7-6
Payment# Payment Interest Principle Balance % Interest % Principle

0 $200,000.00
1 $1,167.15 $958.33 $208.81 $199,791.19 82.1% 17.9%
2 $1,167.15 $957.33 $209.81 $199,581.37 82.0% 18.0%
3 $1,167.15 $956.33 $210.82 $199,370.56 81.9% 18.1%
4 $1,167.15 $955.32 $211.83 $199,158.73 81.9% 18.1%
5 $1,167.15 $954.30 $212.84 $198,945.88 81.8% 18.2%
6 $1,167.15 $953.28 $213.86 $198,732.02 81.7% 18.3%
7 $1,167.15 $952.26 $214.89 $198,517.13 81.6% 18.4%
8 $1,167.15 $951.23 $215.92 $198,301.22 81.5% 18.5%
9 $1,167.15 $950.19 $216.95 $198,084.26 81.4% 18.6%
10 $1,167.15 $949.15 $217.99 $197,866.27 81.3% 18.7%
11 $1,167.15 $948.11 $219.04 $197,647.23 81.2% 18.8%
12 $1,167.15 $947.06 $220.09 $197,427.15 81.1% 18.9%
13 $1,167.15 $946.01 $221.14 $197,206.01 81.1% 18.9%
14 $1,167.15 $944.95 $222.20 $196,983.81 81.0% 19.0%
15 $1,167.15 $943.88 $223.26 $196,760.54 80.9% 19.1%
16 $1,167.15 $942.81 $224.33 $196,536.21 80.8% 19.2%
17 $1,167.15 $941.74 $225.41 $196,310.80 80.7% 19.3%
18 $1,167.15 $940.66 $226.49 $196,084.31 80.6% 19.4%
19 $1,167.15 $939.57 $227.58 $195,856.73 80.5% 19.5%
20 $1,167.15 $938.48 $228.67 $195,628.07 80.4% 19.6%
21 $1,167.15 $937.38 $229.76 $195,398.31 80.3% 19.7%
22 $1,167.15 $936.28 $230.86 $195,167.44 80.2% 19.8%
23 $1,167.15 $935.18 $231.97 $194,935.48 80.1% 19.9%
24 $1,167.15 $934.07 $233.08 $194,702.40 80.0% 20.0%
…. …
336 $1,167.15 $131.47 $1,035.68 $26,401.20 11.3% 88.7%
337 $1,167.15 $126.51 $1,040.64 $25,360.56 10.8% 89.2%
338 $1,167.15 $121.52 $1,045.63 $24,314.94 10.4% 89.6%
339 $1,167.15 $116.51 $1,050.64 $23,264.30 10.0% 90.0%
340 $1,167.15 $111.47 $1,055.67 $22,208.63 9.6% 90.4%
341 $1,167.15 $106.42 $1,060.73 $21,147.90 9.1% 90.9%
342 $1,167.15 $101.33 $1,065.81 $20,082.09 8.7% 91.3%
343 $1,167.15 $96.23 $1,070.92 $19,011.17 8.2% 91.8%
344 $1,167.15 $91.10 $1,076.05 $17,935.12 7.8% 92.2%
345 $1,167.15 $85.94 $1,081.21 $16,853.91 7.4% 92.6%
346 $1,167.15 $80.76 $1,086.39 $15,767.53 6.9% 93.1%
347 $1,167.15 $75.55 $1,091.59 $14,675.93 6.5% 93.5%
348 $1,167.15 $70.32 $1,096.82 $13,579.11 6.0% 94.0%
349 $1,167.15 $65.07 $1,102.08 $12,477.03 5.6% 94.4%
350 $1,167.15 $59.79 $1,107.36 $11,369.67 5.1% 94.9%
351 $1,167.15 $54.48 $1,112.67 $10,257.00 4.7% 95.3%
352 $1,167.15 $49.15 $1,118.00 $9,139.01 4.2% 95.8%
353 $1,167.15 $43.79 $1,123.35 $8,015.65 3.8% 96.2%
354 $1,167.15 $38.41 $1,128.74 $6,886.91 3.3% 96.7%
355 $1,167.15 $33.00 $1,134.15 $5,752.77 2.8% 97.2%
356 $1,167.15 $27.57 $1,139.58 $4,613.19 2.4% 97.6%
357 $1,167.15 $22.10 $1,145.04 $3,468.15 1.9% 98.1%
358 $1,167.15 $16.62 $1,150.53 $2,317.62 1.4% 98.6%
359 $1,167.15 $11.11 $1,156.04 $1,161.58 1.0% 99.0%
360 $1,167.15 $5.57 $1,161.58 $0.00 0.5% 99.5%
Totals $420,172.46 $220,172.46 $200,000.00
7-7
c. Other Types of Mortgages

Automatic Rate-Reduction Mortgages
When interest rates fall the lender automatically lowers the existing mortgage interest rate; however the rate
is never adjusted upward. This type of mortgage is designed to discourage refinancing with another lender
if rates fall.
Graduated Payment Mortgages GPMs

GPMs allow borrowers to initially make low monthly payments which rise for the next 5 to 10 years before
leveling off. GPMs are designed to allow homebuyers to purchase more house than they can currently
afford under the assumption that their income will rise to match the growing house payment. Relative to a
standard fixed rate mortgage, the borrower will pay more interest overall. This type of mortgage is riskier
than a standard fixed rate mortgage with a payment that the borrower can currently afford.
Growing Equity Mortgages (GEMs)

GEMs are mortgages where the payments increase according to a fixed schedule over the entire life of the
mortgage. GEMs result in faster amortization which shortens the maturity of the mortgage; thus they are a
way to more quickly pay down the debt.
A fifteen year mortgage is an alternative to a GEM. Also, a borrower could simply take out a 30 year
fixed rate mortgage and make extra payments each year. The latter strategy is probably the least risky
alternative for the borrower if they have the discipline to stick to the extra payments. In any case, GEMs
are increasingly being replaced with 5 year interest only (IO) loans.
Some financial planners indicate that young people probably should NOT prepay their mortgages by
making extra principal payments, but should rather invest the money in their retirement accounts.
Nevertheless, conservative people may wish to make extra payments to their mortgages as this is the more
conservative strategy.
Second Mortgages
Second mortgages are subordinated claims to senior mortgages. About 15% of primary mortgage holders
have a second mortgage. Seconds totaled about $1.09 trillion in 2007. Home equity loans allow customers
to borrow on a line of credit secured with a second mortgage. Interest on home equity loans is normally tax
deductible whereas credit card interest is not. Home equity loans have been running about 97 basis points
above the 15 year fixed rate, but this varies.
Be careful advising individuals to use a home equity loan to pay off credit card debt. Theoretically, an
expensive vacation or even a shopping spree could endanger your home ownership if the buyer cannot
manage credit properly. Under today’s bankruptcy laws, unpaid credit card debts will not normally result
in the loss of home ownership, whereas default on a home equity loan will cause the loss of the home.
Citigroup and Household International came under fire in 2002 for their aggressive marketing tactics used
in selling mortgages to subprime borrowers.
Shared Appreciation Mortgages (SAMs)

SAMs allow home owners to obtain a loan at up to 200 basis points below market rates. In exchange, the
homeowner must give a portion of the appreciation in value of the home to the lender upon sale or
refinancing of the home. Many SAMs have a refinancing requirement in 5 to 7 years if the home has not
already been sold. SAMs are another form of mortgage that allows a homebuyer to buy more house than
they can afford at current interest rates. They have not been very popular in recent years; they were
primarily used in the 1980s.
Equity Participation Mortgages

An equity participation mortgage is the same as a SAM except that a third party (other than the lender) gets
a share in the appreciation of the house.
7-8
Reverse Annuity Mortgages (RAMs)

RAMs are for homeowners with a substantial amount of equity in their home who wish to supplement their
income, usually retirees. With a RAM the FI makes a monthly payment to the homeowner. The FI is in
effect buying out the homeowner’s equity over time. At maturity the house is sold and the proceeds are
used to pay off the FI. RAM maturities are usually set up so that the homeowner will die before maturity.
As the population ages and health care costs increase RAMs are likely to grow in popularity. In the short
term the housing market continues to soften and home prices fall, RAMS may not be attractive to lenders.
Don’t want to leave anything to the kids? They never visit anyway? Use a RAM and enjoy your
retirement!
New Types of Mortgages (from Smart Money Column: Mortgages Get More Exotic, by Stacey Bradford,
Wall Street Journal Online, July 25, 2004)
• 40 year mortgages
• Negative Amortization Mortgage
• Flex-ARM mortgage
• Piggyback Mortgage or Combo loan
• 103s and 107s
Details are available from the article. Most of these alternative mortgage types are riskier for home buyers,
they are generally methods to buy more house than you could otherwise afford.
3. The Secondary Mortgage Markets

a. History And Background Of Secondary Mortgage Markets
In 2004 over 60% of all residential mortgages were securitized. Originators often keep the servicing
contract. Servicing fees range from ¼% to ½% of the loan amount. Securitization also allows FIs to
remove the mortgages from the balance sheet which improves liquidity, reduces interest rate risk and
reduces capital and other regulatory costs. More details and calculations of savings are provided in Chapter
24.
b. Mortgage Sales
Traditionally, mortgage and loan sales were conducted between correspondent banks. Correspondent
banks are banks that have ongoing service, loan and deposit relationships with each other. Prototypically, a
small bank has a correspondent relationship with a larger bank. The small bank keeps deposits at the larger
bank and uses the larger bank to clear checks, obtain loans and invest extra funds. Small banks often also
create loans too large for them to finance and they may sell all or part of the loan to their correspondent
bank. The large bank may also sell loan participations to the small bank if local loan demand is weak at the
smaller bank’s locale. This practice improves diversification at the smaller bank. Mortgage (or other loan)
sales may be with or without recourse, most are without recourse and may or may not lead to
securitization. If a loan is sold with recourse the loan seller remains liable to the loan buyer if the borrower
defaults. The five primary buyers of mortgages are banks, insurance firms, pension funds, closed end bank
loan funds and nonfinancial corporations. A major advantage of selling the mortgages is the reduction in
capital required by the selling institution. A bank that finances a mortgage must hold 2.8¢ in equity capital
per dollar of mortgage loans. Selling the loan reduces the required equity. The seller may keep the
servicing contract or may not, preferring to earn origination fees on new mortgages.
c. Mortgage-Backed Securities
Securitization is the process of transforming individual loan contracts into marketable securities. This is
accomplished by depositing a pool of mortgages with a trustee and then selling some type of marketable
security to investors. It is a form of intermediation. Mortgage backed bonds and CMOs (REMICs) are
examples of asset transformations (see Chapter 1). As of 2007, there were $6.93 trillion of mortgage
securities outstanding. The main types are illustrated below (many variations exist) and more detail in
provided in Chapter 24.
Pass-Through Securities
On a pass-through security, the pool organizer simply passes through all mortgage payments made by the
homeowners, including prepayments, to the holders of the pass-through securities on a pro-rata basis.
7-9
Payments are thus monthly, and are variable based on how many homeowners pay off their mortgages
early. The pool organizer or the government usually provides insurance for the mortgages in the pool.
Default risk is not generally a worry for a government or agency backed pass-through security holder (such
as a GNMA pass-through). These securities carry substantial prepayment risk however.
Prepayment risk can be illustrated with a simple example. If an investor holds a relatively high interest
rate pass-through it will be priced above par. The investor is willing to pay a premium above par because
the claim pays a high level of interest relative to current rates. If the mortgages are prepaid the investor will
receive the par amount but they will have paid a premium over par that will be lost because the investor
will be cashed out at par.
Mortgage Backed Pass Through Securities Outstanding (2007)

Issuer Trillions $ %
GNMA $0.42 6.1%
FNMA 1.59 22.9%
FHLMC 2.09 30.2%
Privately Issued Pass-Throughs (PIPs) 2.83 40.8%
Total $6.93 100.0%
GNMA: The Government National Mortgage Association (GNMA) is a government agency that was
formed in 1968 to provide mortgage credit to veterans, farmers and lower income individuals. Rather than
provide direct financing for mortgages, GNMA will guarantee payment on mortgage pools that are created
by private pool organizers. Originators submit a pool of mortgages for GNMA approval. All mortgages in
the pool must have the same interest rate and maturity and have FHA, FmHA or VA insurance so GNMA
insurance is really only timing insurance (ensures that the payments are made in a timely fashion).31
GNMA does not form mortgage pools but allows pool organizers to sell securities which use the pool as
collateral and carry GNMA's name. These are called GNMA pass-throughs. These securities have
minimum denominations of $25,000. The pass-through holders receive the amounts paid in by the
homeowners minus a 50 basis point fee. GNMA and the mortgage servicers share those basis points.
Mortgage companies are the largest issuer of GNMA pass-throughs.
FNMA: Fannie Mae was formed in 1938 as a government agency and charged with creating a secondary
market for FHA and VA insured mortgages. FNMA did so by making and honoring forward commitments
to purchase mortgages from originators. FNMA raises money by issuing its own securities to the public.
FNMA has an emergency line of credit with the Treasury if needed although FNMA was privatized in
1968. Privatization occurred so that FNMA could expand into conventional mortgages and because they
were profitable on their own and no longer needed government agency status.
FHLMC: Freddie Mac was created in 1970 as a private company with the purpose of improving the
liquidity of mortgages originated by thrifts. FHLMC buys both FHA, VA and conventional mortgages,
puts the mortgages into pools, and then sells claims (securities) collateralized by the mortgage pool. Thus
FHLMC does not provide the ultimate financing for the bulk of their mortgages.
Government Sponsorship of FNMA and Freddie Mac and recent problems at both
Both FNMA and FHLMC are implicitly backed by the U.S. government, indeed both have a credit line
with the Treasury. The government backing reduces FNMA’s and FHLMC’s borrowing costs and both
companies have been consistently profitable. Because the government backing lowers these government
sponsored enterprises’ (GSEs) funding costs, either the GSEs can consistently generate monopoly profits
and/or more funds are channeled into mortgage investments that otherwise would have gone elsewhere,
probably to corporate bond or equity investments. A second concern is the government’s liability that
would occur if these GSEs experienced financial difficulties, as both organizations are quite large. Other
problems that have recently arisen include:
31
The government places caps on the insurable amount of an individual mortgage. These caps vary
according to the cost of housing in a given area and housing costs through time, but according to the text
authors the maximum was $417,000 in 2007.
7-10
• Problems with derivatives positions: The Office of Federal Housing Enterprise Oversight (OFHEO)
regulates both corporations. OFHEO has indicated that both organizations are at risk from large
positions in derivatives, supposedly designed to hedge their interest rate risk. If these institutions are
hedging appropriately, then the derivatives positions should not add to bankruptcy risk to the
organizations. However, hedging reduces both return and risk and few hedgers can resist the
temptation to use derivatives to try to increase return rather than to reduce risk. In 2003, Freddie Mac
experienced a 52% drop in income due to derivatives losses.
• Both institutions have been accused of overcharging lenders for mortgage insurance. Freddie and
Fannie constitute an oligopoly. Oligopolistic competition should prevent the firms from earning
monopoly rents unless implicit or explicit price fixing is occurring. Because these are GSEs and have
subsidized funds costs, they may not be aggressively pricing their services.
• In 2003 both institutions restated earnings or equity. Fannie Mae restated equity by $1.1 billion.
Freddie Mac restated earnings by $4.5 billion. Both were claimed to be computational errors. Both
have since been found to have been manipulating accounts to smooth earnings and in one case increase
a bonus to an executive.
• In February 2004, Alan Greenspan stated that both institutions pose serious risks to the U.S. financial
system. His concern is that their status as GSEs allows Fannie and Freddie to borrow excessively. The
result is that the Treasury department must now approve new debt issues by both institutions. A new
regulator of the industry has also been proposed.
• In early 2007 Freddie Mac and Fannie Mae proposed buying billions of dollars of subprime mortgages
to ease credit problems in that sector. However, their public statements may have only encouraged
originators to increase lending into this sector, thereby perhaps worsening the subprime problems
experienced since.
Private Mortgage Pass-Throughs

A limited number of private mortgage pass-through issuers deal with nonconforming mortgages that do not
qualify for government insurance. Prudential Home, Residential Funding Corporation, GE Capital
Mortgages, Countrywide, and a few other companies create private mortgage pass-throughs. The acronym
for private mortgage pass-throughs is Privately Issued Pass-Throughs or PIPs. PIPs must be registered with
the SEC and normally are rated by one or more of the ratings agencies.
Mortgage Backed Pass-Through Quotes

Mortgage instruments are priced according to some assumed level of prepayments. The
Public Securities Association (PSA) has developed what is known as the “Standard
Prepayment Model:” The PSA model of prepayments on home mortgages is 0.2%
initially with prepayments rising at 0.2% per month until month 30, after which
prepayments remain at 6% per year. See
www.psa.com/publications/igabs/prepayment.htm for various prepayment models on
different loan types.
It is important to understand that with a pass-through the investor bears all the prepayment risk and the
pool organizer has no prepayment risk. GNMA pass-through securities are often sold as ‘guaranteed’
because of the government backing but investors should understand that the rate of return on the pass-
through is not guaranteed and can vary widely with different prepayment patterns.
Collateralized Mortgage Obligations (CMOs)

CMOs were created to allow investors to better choose and control the level of prepayment risk they face.
CMOs are a hybrid between a pass-through and a bond. CMOs have different payment classes called
tranches.32 Suppose the CMO has three classes, A, B and C. The Class A CMO holder would receive all
the initial principal payments (on the entire pool), including all prepayments, whenever they occur, until all
32
According to the Bond Market Association, tranche is the French word for slice.
7-11
the Class A holders have been paid off.33 Buyers of Class A CMOs are interested in short duration
investments. Initially, Class B and C holders would receive no principle, just interest payments until all of
the principle of Class A holders has been paid off. Likewise, Class C is not affected by any prepayments
until Class B holders have been paid off. The multiple classes allow investors to better choose the level of
prepayment risk desired. CMOS can be used for other purposes such as credit enhancement as well.
The REMIC (Real Estate Mortgage Investment Conduit) is essentially a legal form of CMO that avoids tax
complications. The IRS normally does not allow an intermediary to transform cash flows without taxing
the activity. In 1986 Congress set up the REMIC as a trust form that is exempt from IRS taxation.
Mortgage Backed Bonds (MBBs)

With MBBs, mortgages are pledged as collateral backing the bond issue. The MBB is in all other respects
similar to standard corporate bonds. In this case the bond issuer bears the prepayment risk, and as a result
the bonds normally have to be significantly overcollateralized to obtain a favorable bond rating. MBBs are
not technically a method of securitization in that the bond issuer does not remove the mortgages from their
balance sheet; thus, issuing MBBs does not provide some of the aforementioned benefits of securitization
to the FI.
4. Participants in the Mortgage Markets

Who originates single family mortgages? (2007)
• Banks 28%
• Thrifts 29%
• Mortgage companies 32%
• Other 11%
Who finances mortgages?
• Depository Institutions 35%
• Held in pools 54%
• Life Insurers 2%
• Mortgage companies 4%
• Other 5%
There is a very large difference in the amount of mortgages originated by mortgage companies and the
amount financed. Most mortgage companies quickly sell the mortgages they originate.
5. International Trends in Securitization

a. Demand by international investors for U.S. mortgage backed securities
b. International Mortgage Securitization
Foreign banks hold an insignificant amount of U.S. mortgages and have reduced their holdings of U.S.
mortgages as a result of the subprime crisis. Although Europe and Asia have not been as hard hit as the
U.S. because they lacked substantial subprime lending, Great Britain has experienced similar problems,
resulting in the bailout of Northern Rock, a large mortgage lender. Foreign banks with large U.S.
operations such as UBS have had large losses related to subprime mortgages.
Outside the U.S., Europe has engaged in the most securitization. The conversion to the Euro has increased
the growth of securitization in Euroland. Securitization is running at about $400 billion per year in Europe.
The United Kingdom has more securitization than any other European country. France and Germany have
not progressed in securitization to the same degree. Russian mortgage markets continue to grow, apparently
unaffected by the turmoil in the U.S. mortgage markets.
33
This discussion applies to ‘sequential pay’ CMOS, other types exist. Two other common types are
‘planned amortization classes’ or PACs and ‘tactical amortization classes or TACs.
7-12
Chapter 11 - Commercial Banks: Industry Overview
Chapter Eleven
Commercial Banks: Industry Overview
This is the first of three chapters that cover commercial banks. Banks are the largest type of depository
institution (DI). Traditionally, commercial banks made working capital loans to businesses and accepted
commercial and individual checking and savings deposits. Today banks and other DIs are much more
diversified and offer many new types of services. For example, large banks now engage in a variety of
non-traditional banking activities ranging from underwriting securities to selling insurance and offering
complex derivative products to customers. The chapter presents a common size bank balance sheet and a
discussion of off balance sheet activities and current performance measures. Most readers will be familiar
with some of the recent bank mergers and this chapter succinctly explains the cost and revenue efficiencies
that underlie the mergers. Current profit trends in banking are discussed and the chapter concludes with
coverage of the primary regulators of the banking industry and a good discussion of global events in
banking in Japan, China, Russia and Germany. Details of types of bank accounts, profit analysis and
capital and risk management are relegated to later chapters.
I. Notes
1. Commercial Banks as a Sector of the Financial Institutions Industry: Chapter Overview
Loans are the major asset of all banks and deposits are the primary funds source. The composition of the
loan portfolio has changed over time and deposits are not as great a percentage of financing as in the past.
In other words, their chief assets and liabilities are pieces of paper. This means that banks and other FIs
will typically have a difficult time differentiating their product from one another, and intense competition
and low margins can be expected particularly as previous significant competitive barriers such as
regulations, time and distance between banks, etc. have been eroded by periods of deregulation and
technological growth in information services.
2. Definition of a Commercial Bank

Banks are a subset of the three main types of DIs: banks, savings institutions, and credit unions. All three
offer similar services. Banks will normally be larger, have a more diversified loan portfolio that includes
more business lending and will have more sources of funds beyond deposits. Banks also play a unique role
in our economy. The banking system is the conduit for monetary policy and banks are involved in much of
the payments system and in credit allocation. Banks provide risk, maturity, denomination, and liquidity
intermediation services to savers, helping to maximize the amount of funds available to potential
borrowers.
3. Balance Sheet and Recent Trends

a. Assets: Major categories (2007 data) (Total Assets = $10,411 billion)
• Liquid assets - Total cash assets (primarily vault cash, currency in the process of collection,
correspondent balances and reserves at the Fed) comprised 4.39% of assets.
• Investment securities comprised about 28% of assets. U.S. government securities made up about
36% of the investment portfolio and about 10% of total assets. This investment portfolio is very safe
and liquid.
• Loans - Loans are the highest earning asset on the bank balance sheet. They are also the largest
category. As of 2007 loans comprised 59% of total assets. The major loan types include:
Bank loans by type % of Loans % of Assets
Commercial and industrial loans 20.0% 11.7%
Real estate loans 57.6% 33.7%
Consumer loans 14.4% 8.4%
Other loans 9.3% 5.4%
Reserve for loan losses (1.2%) (0.69%)
Reserves for unearned income (0.05%) (0.03%)
11-1
The primary risk a bank faces is credit risk, and a bank is unlikely to be able to remain profitable if
there are significant problems in the loan portfolio.
Mortgage lending is increasing at most banks and C&I loans are declining. The former has occurred
because of the demise of S&Ls and growth in the mortgage markets, particularly securitization. The
latter is occurring because businesses have been able to procure alternative financing through the
commercial paper market at rates below bank loans and because the public debt markets have grown
rapidly.
• Other assets, primarily non-earning assets accounted for about 9.2% of total assets.
(Numbers are rounded slightly, includes reserve for loan losses as per the text)
In the 1950s cash and securities comprised some 70% of total assets and loans were about 26%. What
does this imply about how the industry has changed? Obviously, liquidity risk and credit risk are much
higher than in the past. However, banks now have more funds sources and the loan portfolio is better
analyzed and better diversified than in the past.
b. Liabilities
Major categories (2007 data)
• Deposits: Deposits are the largest source of funds. As of 2007 deposits comprised almost 66% of total
funding. Transaction accounts are checking accounts (such as NOWs that pay interest or demand
deposits that do not pay interest).
• Transaction deposits comprised 11% of total deposits. Transactions deposits are declining as a
source of funding at banks.
• Nontransaction deposits include savings account, MMDAs and CDs. Nontransaction accounts
made up 89% of total deposits.
• Passbook savings and retail CDs comprised 75% of total deposits, negotiable CDs ($100,000 or
greater) were about 13.8% of total deposits.
In the 1950s interest bearing sources of funds were under 25% of total funding; today most funds
sources are interest bearing. What does this imply about the sensitivity of bank profits to interest rates
today as compared to the past? This also illustrates why banks have sought to increase fee based
sources of income.
• Borrowings and Other Liabilities include notes and bonds outstanding, fed funds borrowed, and
repurchase liabilities and were 21% of total funding.
The liabilities of banks tend to have less default risk than the assets and typically have a shorter maturity
than the assets. That is, banks normally provide maturity and credit risk intermediation services to savers
by providing savers with safer, shorter maturity accounts while purchasing or creating longer term riskier
claims. The banks in turn earn the interest rate spread between the rates charged on the assets and the
rates paid on the liabilities.
c. Equity
Capital requirements specify the minimum amount of capital a bank must maintain (see Chapter 13 for
specific requirements) under the Basle Accord. Information on the Basle Accord and recent changes can be
found at the website of the Bank of International Settlements (BIS). In 2007 equity comprised 10.08% of
total funding. Equity consists of common stock (par and surplus), preferred stock and retained earnings.
Regulators define other accounts that may serve as equity for the purposes of calculating minimum capital
requirements.
Students should be surprised to learn that banks typically employ about 90% debt in their capital structure.
Few nonfinancial firms allow their debt ratios to get over 50% (other than in Highly Levered Transactions).
Nonfinancial firms in volatile industries often use little or no debt. DIs must employ a high amount of
leverage to offer stockholders a satisfactory rate of return since their ROA is generally very low (in the
0.5%-2% range). Their ROA is low because they primarily have paper assets and liabilities. Recall from
microeconomics that in industries with non-differentiable products, competition will force economic rents
11-2
(NPVs) to zero. The ability of banks to use such high debt ratios arises from a) banks’ ability to closely
manage and hedge risk and b) deposit insurance. Banks that do not learn to manage risk appropriately
quickly fail when environmental factors change. Moreover, most bank creditors do not demand a risk
premium in the form of higher deposit rates at risky banks because the government guarantees their
deposits. This is an example of a market failure and the problem of moral hazard engendered by deposit
insurance.
d. Off Balance Sheet Activities

Off balance sheet (OBS) assets and liabilities are activities that may lead to changes in on balance sheet
assets and liabilities respectively, contingent upon some event occurring.
Example of OBS activities include (ranked by size in 2007):34
• Swap agreements • Commitments to buy or sell foreign
exchange (spot or forward)
• Written or purchased options contracts • Loan commitments
• Credit derivatives • Securities borrowed or lent
• Forward & futures contracts other than for • Standby letters of credit
foreign exchange
e. Other Fee Generating Activities

Much of this material is not in the text.
• Correspondent banking - larger banks serve as agents for smaller banks, assisting in
♦ check clearing
♦ purchasing securities
♦ foreign exchange
♦ loan participations (both ways)
♦ obtaining and placing fed funds
♦ trust services
♦ obtaining brokered deposits (Jumbo C.D.s, Euro$)
• Leasing - Banks may be able to use tax breaks from purchasing equipment that small/medium size
businesses cannot.
• Trust operations – Trust functions are offered only by larger banks, but trust services are made
available at most banks through correspondent relationships. Trust operations are providing fiduciary
services for a third party.
• Swap brokers - Many larger banks act as swap brokers/swap partners helping financial institutions
better match the interest sensitivity of their assets and liabilities. They take a fee for this service.
• Brokerage services
• Underwriting- Underwriting income via bank subsidiaries.
• Banks can advise and manage mutual funds but cannot sponsor the fund.
4. Size, Structure, and Composition of the Industry

As of December 2007 there were 7,282 commercial banks. This number has declined 42.86% since 1989.
The decline is somewhat misleading because the number of bank offices including branches grew from
60,000 in 1984 to 83,000 in 2007. Industry consolidation has been occurring rapidly, largely via
unassisted mergers, but total bank assets and the total number of banking facilities have grown at
significant rates. Banking remains a growth industry.
a. Economies of Scale and Scope
34
It is questionable whether the size of these commitments can be compared in this way since the risks and
likelihood of becoming an on balance sheet commitment varies dramatically for the different activities.
11-3
The last few years have seen many megamergers (mergers of banks with over $1 billion in total assets).
Text Table 11-3 contains a list. Primary reasons include cost and revenue economies and regulatory
changes.
• Economies of scale and scope are generated by declines in unit costs required to produce bank
activities as the bank gets larger or adds more services respectively.
• Cost economies of scale result from fixed costs spread over larger output as the bank grows.
• Institutions such as J.P. Morgan and Chase Manhattan estimated that their merger would
result in cost savings of $1.5 billion.
• Cost economies of scope result from cost sharing when multiple products are offered. That is, as
more products are added, costs do not rise proportionally with revenues.
• The Financial Services Modernization Act of 1999 (FSMA) allows banks to merge with
insurance firms and investment banks for the first time since 1934. The 1998 merger of
Citicorp and Travelers (a bank and an insurance firm) prompted the change.
• The merger of UBS and Paine Webber is another example of a merger that may exploit cost
economies of scope.
• Both of these economies derive from fixed costs arising from technology. As more customers
and/or more services are added the cost per unit to provide the service (such as brokerage,
financial planning, underwriting insurance, etc,) drops, improving profitability.
• Revenue economies of scale and scope also provide motives for mergers. Additional revenues
can be generated via mergers by adding additional customers, moving into less competitive
markets and stabilizing revenue by serving customers in different regions. The 2004 J.P. Morgan
Chase acquisition of Bank One, added Bank One’s large credit card operations and retail network
in an attempt to broaden Chase’s revenue sources.
• X efficiencies are cost savings that occur which are not attributable to economies of scale and
scope. They may include managerial learning processes or other unspecified cost savings.
• Diseconomies of scale may also arise from mergers. It is notoriously difficult to manage large
institutions that have different organizational cultures. Managerial hubris cannot be overlooked in
discussing mergers. Managers tend to over estimate their ability to generate revenue and cost
economies and tend to underestimate the complexities involved, including loss of employee
morale when jobs are cut, technological problems in integrating different computer systems,
problems in corporate culture, etc.
It remains to be seen whether these cost economies will turn out to be illusory or real. This author is
skeptical. Academic studies identify large economies of scale up to the $10-$25 billion range in asset size.
It is likely that overcapacity, integration problems and difficulties in merging corporate cultures will result
in lower synergies than anticipated. Recall the conglomerate boom of the 1960s that led to the divestiture
boom of the 1970s and 1980s. Note that Citigroup decided to partially divest Traveler’s, reversing their
prior merger. Only time will tell.
In 2006 Wal-Mart and Target applied for Industrial Loan Corporation (ILC) charters to provide certain
banking services. ILCs are chartered in Utah and are not directly regulated by any banking regulator. ILCs
may make commercial loans, and typically lend to higher risk corporate borrowers. Wal-Mart’s stated
rationale was to lower the cost of processing electronic payments and Target hoped to issue business credit
cards. There were many vocal opponents of these applications and the FDIC established a moratorium on
all ILC applications while Congress considers banning them. Allowing ILCs of this type further blurs the
separation between commercial enterprises and banking and could potentially increase the risk of the
banking system significantly. Wal-Mart withdrew its application in 2007.
b. Bank Size and Concentration

The largest banks increasingly dominate the industry (see text or below) and the largest banks control the
vast majority of industry assets. This is now true in all aspects of the financial services industries. Banks
are often classified as
• money center banks which include the largest banks, typically located in New York city. Size alone
however does not make a money center bank. These banks generally rely on nondeposit sources of
11-4
funds and are heavily engaged in wholesale banking (with or without a retail banking presence) and
involved in international markets. Wholesale banking refers to providing loans services to
corporations and other institutions as well as acquiring nondeposit sources of funds. Retail banking is
providing consumer oriented banking services such as loans and deposits. Money center banks include
Bank of New York, Citigroup, J.P. Morgan Chase, HSBC Bank USA and Bankers Trust (owned by
Deutsche Bank).
• superregional or regional banks that operate primarily in one or more regions of the country
• community banks that operate in local markets
Summary of Text Figure 11-6
Size & Type % of total # banks % of total banks
2007 assets
Community banks 93.2% 11.7%
$1-10 billion 5.6% 10.4%
≥ $10 billion 1.2% 77.9%
100.0% 100.0%
Notice the heavy concentration of assets among the largest banks. Nevertheless, thousands of small banks
remain throughout the country, although more and more of these small institutions are being absorbed by
mergers. Absorptions are running higher than new charters so the trend toward increasing concentration
will continue.
c. Bank Size and Activities

Large banks generally are less liquid, are more heavily concentrated in loans and use more purchased
sources of funds. They have greater access to brokered deposits and non-deposit liabilities and they tend to
hold less equity.
Large banks lend to more sophisticated corporate customers which means that their profit margins are often
lower than for smaller banks that operate in more isolated, less competitive circumstances. A key ratio for
bank management includes the net interest margin which is equal to the interest rate spread divided by
earning assets. The interest rate spread is the interest earned on assets minus the interest paid on liabilities.
Large banks typically pay higher salaries than smaller banks and have greater investments in facilities and
in the provision of services. On the other hand large banks generate substantially more fee income than
small banks.
At times small banks have been more profitable than large banks, but this has not always been the case.
The higher profitability at smaller banks is often due to a lack of local competition. As large banks gain the
ability to enter local markets it is questionable whether the smaller banks’ profitability can be maintained.
5. Industry Performance
Banks enjoyed excellent profitability during most of the 1990s, weaker performance in the early 2000s, but
record high performance in 2003 and on into 2004.35 In 2004 banks had an average ROA of 1.31% and a
ROE of 14.01%, both figures were good. Bank ROA’s vary from 0.5% to 2% typically. Bank profitability
had been high because of higher noninterest income and lower loan loss provisions. Consumer loan
demand and demand for mortgage credit remained high in this time period as well. Banks also benefited
from a long period of low interest rates and good economic growth with low inflation which encouraged
borrowing. Credit card rates in particular did not fall as quickly as bank costs, improving bank margins.
Better information technology helped reduce costs and the growth of credit derivatives and mortgage
securitization helped banks to continue high lending volume while shifting risks to other entities. The yield
on earning assets in 2004 was 5.18% and the cost of funding earning assets was 1.56%, giving a net interest
margin of 3.62%which is quite good.36
35
U.S. banks had less exposure to the late 1990s Russian and Asian crises than banks of other
countries, presumably having learned their lesson from the LDC debt fiascoes of the 1970s and 1980s.
36
Source FDIC Quarterly Banking Profile, Third Quarter 2004.
11-5
As interest rates rose in 2005 and 2006 bank profitability remained strong although increasing loan loss
provisions and weaker trading revenue and servicing income kept 2006 profitability from reaching record
highs. However the flattening yield curve, competitive pricing and increases in fund costs contributed to
falling profit rates at banks. In late 2006 and in 2007 problems in mortgages also began to hurt banks.
Foreclosure filings jumped 93% in July 2007 from July 2006. In the fourth quarter of 2007 loan loss
provisions reached $31.3 billion, their highest level since 1991. This was a 300% increase from the fourth
quarter in the prior year although seven large institutions accounted for over half the increase in loss
provisions. Trading losses were $10.6 billion; the first ever quarterly net trading loss. Ten large institutions
accounted for all the decline in trading earnings. Net interest income rose 11.8% from the prior year
quarter. In all, net income for the fourth quarter of 2007 was the lowest reported since the same quarter in
1991. Earnings problems were widespread with 51% of all institutions reporting lower net income, but the
depth of the decline was driven by a few large institutions. ROA for the quarter was only 0.18%, down
from 1.20% in the 4th quarter of the prior year. This was the lowest ROA since 1990 and ROE was only a
dismal 1.74%.37
The provision for loan losses is a charge to earnings based on management’s expectation of how many
loans will go bad in the current quarter. Net charge offs are actual write offs. Net charges offs have
reached five year highs in 2007, at $16.2 2 billion as compared to $8.5 billion in the fourth quarter of 2006.
This yields an annualized net charge off rate of 0.83%, the highest since 2002.38
Over the longer term, the industry probably still remains stronger today than it was in the late 1980s and
early 1990s. For instance, two hundred and six banks failed in 1989; only three failed in 2007 although 76
are on the “Problem List,” the highest number since 2004. As of September 2007 about 56% of institutions
were in the minimum risk Category and only 2.6% of institutions were in categories II, II or IV, with none
in Category IV.39
Improvements in risk management, still low interest rates and the additional oversight brought about by the
FDIC Improvement Act of 1990 helped turn the banking industry around in the last decade.
6. Technology in Commercial Banking

Technology is profoundly changing the banking industry, and the major changes are still ahead.
Technology investments can generate operating efficiencies and economies of scale and scope. Internet
and wireless communications constitute new methods of offering both existing and new financial services
to current and potential customers at much lower costs than currently available.
a. Products Available in Wholesale Banking

Cash management services: Technology is allowing banks to offer corporate customers real time
information of cash balances related to the following services:
• Controlled disbursement accounts – Accounts that allow the customer to know exactly which
checks or payments will be withdrawn that day from the account.
• Real time account reconciliation
• Electronic lockboxes allow corporate customers to reduce the float time, in this context float is the
time between when the customer pays the check and the corporation collects.
• Funds concentration allows sweeping of funds from various accounts into one centrally managed
account.
• Electronic funds transfer via CHIPS or Fedwire, automated payments via ACHs and automated
message transfers via SWIFT
• Automated check deposit services
• Electronically generated letters of credit
• Access to treasury management software
• Electronic invoicing interchange between businesses
37
Data and analysis not in the text are from the FDIC Quarterly Banking Profile, Fourth Quarter 2007.
38
Ibid
39
Ibid
11-6
• Electronic B2B commerce

• Electronic billing
• Verification of identities in transactions
b. Products Available in Retail Banking

• ATMs and ATM networks • Paying bills by phone
• Point of sale cards • E-mail billing
• Home banking • Online banking
• Preapproved debits or credits • Smart
• cards
Online banking services are beginning to grow at a much more rapid pace. By the mid 2000s about 77% of
Wachovia’s customers used online banking services followed by J.P. Morgan Chase at 60%, Citigroup and
Bank of America with 53% and Washington Mutual with 25%. I suspect that this usage is somewhat
limited. Availability, security and cost of high speed Internet remain issues, but the younger generation in
particular seems increasingly willing to use online bank services. This area will probably continue to suffer
from overcapacity and customer resistance for some time. Internet only banks have not thrived.
Customers still desire to interact with people for many transactions and appear to prefer to deal with
established banks, even if they plan to use electronic banking functions.
7. Regulators
a. Federal Deposit Insurance Corporation
The FDIC, created in 1933, manages the deposit insurance funds for the thrift and banking industries. The
FDIC examines banks and disposes of failed bank and savings association assets.
b. Office of the Comptroller of the Currency
The OCC has been around since the Civil War. The OCC grants national charters, although banks may be
state chartered instead. The OCC examines national banks and approves or disapproves their merger
applications.
Prior to 1863 the U.S. had only state chartered banks. In an attempt to help finance the Civil War, the
National Banking Acts of 1863 and 1864 created nationally chartered banks that the federal government
could more tightly regulate. The laws required nationally chartered banks to hold U.S. government bonds
to collateralize their bank notes. This allowed the government to finance the rest of the war. The acts did
not outlaw state banking and as a result we have a dual banking system today.
About twenty-three percent of federally insured banks are nationally chartered banks; the remainder is state
chartered. Nationally chartered banks must be members of the Fed and must be FDIC insured. State
chartered banks have a choice on both. State chartered banks may have less regulations imposed upon
them and state chartered banks cannot use the word ‘national’ in their name.
c. The Federal Reserve System
About 35% of federally insured banks are members of the Federal Reserve and 65% are
not. Fed membership allows banks direct access to the FedWire system. The Fed
regulates bank holding company activities.
d. State Authorities
State chartered banks are regulated by state banking authorities. Federally insured state chartered banks
pass into receivership of the FDIC if they fail.
8. Global Issues
Of the top 20 global banks in the world ranked by asset size, only 3 are U.S. banks (Citigroup, J.P. Morgan
Chase and Bank America). In 2007 Royal Bank of Scotland Group, Banco Santander of Spain and Fortis
NV jointly purchased ABN Amro Holdings for $101 billion, the largest bank acquisition ever. The three
buyers will split up ABN Amro into three pieces over the next three years.
This result is an artifact of U.S. bank regulations that have promoted small community banks. If one
looked at lists of the most profitable and sophisticated banks, one would find more U.S. banks on that list.
11-7
The advantages of globalizing operations include:

• Additional risk diversification by including operations in other economies
• Economies of scale and scope
• U.S. banks have been global industry leaders in generating innovative new products such as OTC
derivatives not developed by overseas banks
• Expanded funds sources
• Maintenance of customer relationships as many corporate customers have gone global and have
needed banking services for their overseas operations
• Avoidance of domestic regulations - The U.S. tends to be the most tightly regulated market and
engaging in overseas operations allows U.S. banks to operate with less scrutiny
Disadvantages of globalization of banking services include:

• Greater information production and monitoring costs involved in evaluating overseas loans and
investments. The U.S. generally has higher disclosure requirements than most other countries.
• Overseas operations may face expropriation or repatriation problems.
• The fixed costs to enter foreign markets may be quite high and may not be easily recovered once an
investment is made.
Global Banking Performance

Overall European bank performance remained strong throughout the mid 2000s; however the same
structural forces affecting U.S. banks such as the flattening yield curve and competitive pressures on NIMs
eventually slowed profit growth. Mortgage demand remained high through much of the period and boosted
growth in Spain and France and generally good growth in the euro area helped.
Japan
The Japanese banking industry has been bailed out three times since 1998. Japanese banks have had
difficulty since Basel I revealed inadequate levels of equity at many Japanese banks. Japan’s problems
have extended well beyond the banking industry however. Traditionally, Japanese banks have been the
center piece of a corporate structure termed the keiretsu. The keiretsu featured a tight nexus of ownership
among the corporate members and the bank. The bank provided major funding to the corporations. When
these corporations became less competitive in the 1990s, the banks continued to make loans to these firms
rather than forcing the changes that were required to restore the companies to competitiveness. In the latest
bailout, private firms such as Goldman Sachs, Merrill Lynch and Deutsche Bank have become involved.
This is a positive sign for growth in Japan as it indicates a greater openness to competition in both the
corporate and financial sectors.
In July 2006 the Bank of Japan began to increase interest rates for the first time since 2001. Rates
remained low in 2007 and 2008 and perhaps as a result, profit margins on lending from Japanese banks
have remained low, encouraging banks such as Mitsubishi and Mizuho to expand into other areas such as
investment banking and asset management.
China
According to official figures, at China’s four state run banks about 1/5 of loans are nonperforming. Some
economists put the rate as high as 50%. At a U.S. bank, when about 5% of loans go bad the institution is
usually on the verge of bankruptcy. Similar to Japan, China is now allowing more foreign interests in its
banking industry in order to improve performance.40 Although Citigroup operated 13 branches in China in
2007 with a a larger ATM network, Citi may not dispense cash to Chinese, nor take deposits from locals.
Indeed Citi’s own Chinese employees had to be paid through Chinese banks. In late 2007, China froze all
bank lending for the rest of the year, forcing banks to cancel loans already promised to customers in an
attempt to curb inflation.
40
Only in a limited fashion however, for instance, foreign ownership of a Chinese bank is limited to 20%.
11-8
Chapter 12 - Commercial Banks’ Financial Statements and Analysis
Chapter Twelve
Commercial Banks’ Financial Statements and
Analysis
This is the second of three chapters that cover commercial banks. This chapter builds the tools necessary
to analyze the performance of a bank. The chapter reviews the major on and off balance sheet assets and
liabilities in greater detail than in Chapter 11 and then shows the linkage between the income statement and
the balance sheet. A detailed analysis of ROE and ROA is presented. The chapter concludes by indicating
how a bank’s competitive conditions affect performance. If the instructor is focusing more on markets, risk
management or financial engineering this chapter can be skipped with little loss of continuity. If the
instructor prefers to delve into more detail about managing institutions, then this chapter will be useful to
introduce students to the tools necessary to analyze bank financial statements.
I. Notes
1. Why Evaluate Performance of Depository Institutions: Chapter Overview
The chapter uses a ROE framework to analyze the major aspects of performance of banks. The analysis
could also be applied to thrifts and credit unions.
2. Financial Statements of Commercial Banks

Financial statements of banks and other DIs must be submitted to regulatory authorities quarterly. The
statement of condition (balance sheet) and the report of income (income statement) are required. The
Federal Financial Institutions Examination Council (FFIEC) prescribes uniform principals, standards and
report forms for DIs. The results of off-balance sheet activities are shown on the report of income. The
chapter compares two bank holding companies of different size and market placement: Webster Financial
Services (WFS) and Bank of America (BOA). WFS is a publicly traded bank holding company
headquartered in Connecticut. WFS is primarily a retail bank (focused on individual consumers) but it
offers both consumer and business banking services. The holding company owns Webster Business Credit
Corporation, an asset based lending firm and several other financial firms. BOA is more of a wholesale
bank. Wholesale banks focus primarily on business banking relationships including correspondent
banking relationships. BOA also has extensive retail banking services however. WFS is a $17 billion
bank with 175 branches. BOA is the nation’s second largest bank with (2007) assets of $1,582 billion and
over 5,700 offices in 35 countries. BOA has the nation’s largest ATM network with 17,000 ATMs serving
20 million users. It is the largest debit card issuer, the top small business lender and boasts of the largest
number of relationships with mid-size companies. BOA has trust services, investment management and
credit cards businesses as well and is the leading small business lender in the counry.
CAMELS Evaluations:
Banks and other depository institutions are evaluated by the appropriate regulators on six major areas,
depicted by the CAMELS acronym. Each component is discussed below:
C: Capital Adequacy – Risk based capital requirements are now used. The regulators also evaluate the
bank’s loss experience, amount of problem assets in relation to capital and the institution’s access to
capital.
A: Asset Quality – Banks are required to classify assets according to soundness and to allocate loss
reserves based on their evaluation of the quality of their assets. Regulators can require bank managers to
reassess the loan or other assets and may require the bank to increase loss reserves. Adequacy of internal
controls and the loan policy are also evaluated. Over concentrations of credits in certain loan or investment
types or concentrations in geographic areas can lead to lower evaluations of asset quality.
12-1
M: Management – The technical competence of management, their history of past compliance, the
adequacy of internal controls, management compensation and experience level are all components of the
evaluation of management.
E: Earnings – The stability and growth rate of earnings are important elements of this evaluation. Peer
group comparisons of profitability and interest rate risk exposure are normally used to evaluate earnings, as
is the adequacy of the loan loss reserve.
L: Liquidity – Estimating liquidity risk requires knowledge of the turnover rates of the bank’s sources of
funds, particularly deposit turnover. Measures for this category would include the percentage of core
deposits versus “hot money” sources, the amount of loan commitments and the volume of liquid assets held
by the bank.
S: Sensitivity to Market Risk – This category attempts to measure the bank’s exposure to changes in
interest rates, foreign exchange rates, and commodity or equity prices. Capital adequacy, the extent of
formal risk management plans and the stability of earnings are considered.
CAMELS composites are constructed by regulators ranging from 1 to 5 with 1 being the safest. Banks with
a composite rating of 4 or 5 are considered ‘problem banks.’
Composite “1” - Institutions that are sound in all aspects of performance

Composite “2” - Institutions that are fundamentally sound but have modest weaknesses correctable in
the normal course of business
Composite “3” - Institutions that have financial operational or compliance weaknesses ranging from
moderately severe to unsatisfactory
Composite “4” - Institutions that have an immoderate volume of serious financial weaknesses or a
combination of other conditions that are unsatisfactory
Composite “5” - Institutions that have an extremely high immediate or near term probability of failure
Asking the students whether CAMELS ratings should be made public can generate an interesting class
discussion.
3. Balance Sheet Structure (Typical percentage breakdowns are provided in Chapter 11)
Major Assets:
• Cash and balances due from other DIs
Consist of vault cash, currency in the process of collection (CIPC), correspondent balances and reserves at
the Fed. These are sometimes called primary reserves.
• Investment Securities
Short term:
Interest bearing deposits at other FIs,
Fed funds sold
Reverse Repos
U.S. Treasury and agency securities
These securities are described in detail in Chapter 5 and the major features are reviewed in this chapter of
the text as well.
Long term:
Municipal bonds
Mortgage backed securities
Other securities (long and short term): These include corporate bonds, foreign bonds, Brady
bonds and short term securities held for sale (see Tip below)
Detailed descriptions of these securities can be found in the appropriate markets chapters.
12-2
Short term investments are safe liquid assets held to assist in liquidity management. Rates of return are
usually significantly lower than on loans. Long term securities are held for income and are typically
investment grade.
Banks designate their investment securities as held for income (to maturity) or available for sale. Securities
held for income are normally carried at book value; those available for sale are carried at the lower of
current market or book value. Securities held for sale and other short term investments are sometimes
called ‘secondary reserves.’
Not all municipal bonds/loans are independently evaluated or rated. State chartered banks in particular
may face some pressure to invest in munis of the state that regulates their activities.
• Loans and leases

Commercial and industrial (C&I) loans: C&I loans may be working capital loans, loans for capital
equipment, bridge loans, etc. They may be secured or unsecured. Traditionally, banks only made
well collateralized working capital loans, but now they may finance start up businesses without
tangible collateral. Analysis of C&I loans varies by type of borrower. Today loans of more than
one year maturity are likely to be floating rate.
Loans secured by real estate: Primarily single family mortgage and home equity loans, although
banks engage in commercial real estate development and multifamily housing.
• Consumer loans
Auto loans are a major component of consumer loans. Others include credit card loans, signature
loans and loans collateralized by consumer durables.
Other loans
Other loans include loans to domestic and foreign FIs, and loans to state, federal and foreign
government entities.
Loans are the largest category on the balance sheet and generate the majority of revenue; hence, the quality
and pricing of the loan portfolio are paramount determinants of a bank’s success. Unearned income and the
allowance for loan and lease losses are contra asset accounts that are subtracted from total (gross) loans to
calculate net loans. Unearned income is income that the bank has received on a loan but has not yet
earned nor recorded on the income statement. The allowance account is management’s estimate of the
total amount of loans that will not be repaid.
• Other assets
Other assets include nonearning assets such as the physical structures and property owned,
collateral seized on defaulted items, intangible assets, such as goodwill and mortgage servicing
rights, deferred and prepaid items, etc.
Major liabilities:
• Demand deposits
Corporations cannot hold NOW accounts so they hold demand deposits for their transaction
needs.41
• NOW accounts
Negotiable Order of Withdrawals are checking accounts that pay interest if the owner maintains the
minimum balance required.
• MMDAs
Money Market Deposit Accounts are accounts with limited checking privileges that pay rates of
interest comparable to money market mutual funds. MMDAs are not reservable and they are
insured. They typically require higher minimum balances than NOW accounts.
41
This is a Depression era restriction that still exists although there is a bill before Congress to
eliminate the restriction.
12-3
• Other savings accounts

These are primarily passbook savings accounts. Checks cannot be written on savings accounts
although they can be accessed by ATM.42
• Retail CDs
These are time deposits with denominations under $100,000.
• Wholesale CDs
Wholesale CDs are time deposits with denominations of $100,000 or more. These are negotiable
(saleable) instruments. Banks may obtain wholesale CDs by paying other banks or investment
banks a small finder’s fee to locate corporate or institutional investors willing to deposit money in
the bank for a set time. Deposits obtained in this manner are called brokered deposits. Time
deposits held in dollars outside the U.S. are called Eurodollar deposits.
Most Eurodollar accounts are time deposits of 6 months or less; many carry a variable
rate of interest tied to Libor. Eurodollar accounts pay slightly higher rates than similar
domestic deposits because these accounts avoid some regulatory costs. They are not
subject to reserve requirements or deposit insurance (even though they have defacto been
insured).
• Purchased funds
Fed funds borrowings
Repurchases
Banker’s Acceptances sold
Commercial paper issued by the holding company parent (banks cannot issue commercial paper)
Medium term subordinated notes and debentures
Discount window loans
Brokered deposits
Purchased funds can be more expensive sources of funds than deposits, particularly core deposits. Core
deposits are deposits that are at the bank for reasons other than earning interest. Earning interest may still
be important but convenience, a relationship with the bank, customer satisfaction, etc. keep the customer at
the bank even if the bank does not pay the highest rate of interest available on similar accounts at other
banks.
• Non-interest bearing liabilities

Accrued interest owed
Deferred taxes
Dividends payable
Minority interest in consolidated subsidiaries, etc.
• Equity capital
Preferred stock (paid in capital and surplus if any)
Common stock (paid in capital and surplus)
Retained earnings
The minimum capital requirements are covered in Chapter 13.
a. Off Balance Sheet Assets and Liabilities

Off balance sheet (OBS) assets and liabilities are contingent assets and liabilities or accounts that may end
up on the balance sheet depending on what events transpire. They are disclosed in footnotes to the
financial statements.
• Loan commitments
42
Banks can impose a fourteen day wait before granting a request for a withdrawal on a savings
account. Most do not impose any wait although they typically limit the number of free withdrawals in a
given period.
12-4
Most C&I loans are draw downs of prearranged lines of credit. The line of credit is a commitment to
make a loan, and it is a contingent liability of the bank. Once the loan is made it becomes an asset. An
up-front fee (or facility fee) is often charged, it may be 1/8 of 1% of the commitment amount. The
borrower may also be charged a back-end fee at the end of the period on the unused portion of the
credit line.
• Commercial letters of credit
Commercial letters of credit are a commitment by a bank to pay a seller of goods if the buyer of the
goods cannot pay. The creditworthiness of the bank is substituted for the creditworthiness of the
buyer. They are frequently used in international trade where sellers would find credit investigation of
buyers to be costly.
Letters of credit of this type are used less frequently in trade between developed economies where
information about firms is widely available and trade problems have historically been low. Using
letters of credit adds significantly to the cost of trade for corporations and in the majority of cases the
bank does not have to pay anything.
• Standby letters of credit
Sometimes called performance letters of credit or financial letters of credit, these cover less predictable
risks, and are usually for higher amounts than commercial letters of credit. Examples of financial
letters include a bank’s promise to pay if a commercial paper borrower fails to repay the amount owed,
or if a municipal borrower cannot make scheduled interest and principle payments. Financial letters
are often used by commercial paper issuers to obtain higher credit ratings on the paper. Commercial
paper rating spreads may be 40 basis points or more; thus, if the bank’s fee is less than this amount, the
issuer of marginal quality paper can reduce their borrowing costs by procuring a standby letter of
credit. A loan commitment may be a less costly alternative to the standby letter.
Performance letters may be issued where banks agree to pay if a construction project is not completed
on time, or if goods do not meet certain specifications, etc. Both commercial and standby letters are
forms of insurance, and it should not be surprising that property and casualty insurers (and also some
foreign institutions) issue standby letters. One reason banks have not issued more standby letters is
their own lack of a high credit rating. This has left an opening for higher rated non-bank FIs and
foreign banks to issue more attractive standby letters.
• Loans sold
Loans may be sold in part or as a whole. Sales may be with or without recourse.43 Most are without
recourse.
• Derivative contracts
Derivatives include futures, forwards, swaps and options positions. Their use is heavily concentrated
among the largest banks. These positions may create contingent risk to the institution depending upon
whether they are used for hedging other bank positions or speculating. Forward contracts and other
OTC contracts also expose the institution to credit risk, but exchange traded options and futures do not.
b. Other Fee Generating Activities

• Correspondent banking and trust services
Trust services constitute the management of assets for individuals and corporations. Individual trusts
and pension funds comprise the bulk of this activity and it is dominated by large banks. Large banks
also provide correspondent services for smaller banks including services such as check clearing,
foreign exchange, hedging and loan participations.
• Processing Services
Many banks provide data processing services for business customers. They may help manage a firm’s
accounts receivables and payables, assist in cash management and in information technology services
for customers.
c. Income Statement
• Interest income
43 A loan sale made without recourse means that if the borrower defaults the seller of the loan is not liable for repayment to the loan buyer.
12-5
Interest income is the largest component of income. It is comprised of interest and fee income on
loans and securities. For the year 2007 interest income comprised 74% of total income (down from
72% in 2006). (All the data in this segment are from the FDIC: FDIC insured banks, average for all
banks.)
• Interest expense
Interest expense is composed of interest on deposits, interest on purchased funds and interest on other
borrowings. For the year 2007 interest expense comprised 49.5% of total expense.
• Net interest income is interest income less interest expense. Net interest income was 49% of interest
income in 2007.
Provision for loan losses (PLL)
The PLL is a deduction from current earnings made by management to offset loans that management
believes will go bad in the upcoming quarter. The PLL was 58% of net income (up dramatically from
20% in the 2006). Recall that actual write offs are called net charge offs (NCOs). NCOs were 62%
higher than in 2006. Both these increases reflect problems in the mortgage markets.
• Noninterest income
Noninterest income includes income from service charges on deposits, income from fiduciary
activities, gains and losses and fees from trading activities and fees from commitments and letters of
credit, etc. Noninterest income comprised 26% of total income for 2007.
Interest income plus noninterest income equals total operating income. This is equivalent to the sales
revenue figure for a nonfinancial firm.
• Noninterest expense
This component consists of salaries and benefits, expenses for the premises and equipment and other
expenses and was 50% of total expenses in 2007.
• Income before taxes and extraordinary items
Operating profit before taxes and extraordinary items: Operating profit before tax was 17% of total
income (interest and noninterest income) in the 2007.
• Extraordinary items
One off events, including changes in accounting rules, major asset liquidations, lawsuit damages, etc.
These were about -0.2% of total income in 2007.
• Net income
The bottom line: Net income was 11.89% of total revenue for 2007. This represents a decline from
the higher levels of prior years. For example this ratio was 16.75% in 2006.
d. The Direct Relationship Between the Income Statement and the Balance Sheet
NI = Interest revenue – Interest expense – P + (NII – NIE) – T or
N M
NI = ∑ rnAn − ∑ rmLm − P + NII − NIE − T
n =1 m =1
NI = Net Income
An = Value of the bank’s nth asset ($)
Lm = Value of the bank’s mth liability ($)
rn = rate earned on the bank’s nth asset
rm = rate earned on the bank’s mth liability
P = Provision for loan losses
NII = Noninterest income
NIE = Noninterest expense
T = bank taxes
N = number of assets and M = number of liabilities
This equation states that the bank’s net income is the product of the interest rate of return on an asset
times the number of dollars invested in that asset less the interest cost on a fund’s source times the
12-6
dollars raised in that category less the provision for loan loss, plus the net noninterest income minus
taxes.
One can use the above equation to find the required dollar interest spread in order to hit a given ROE target.
Suppose that a bank has equity of $200, interest expense of $90, P = $20, net noninterest income of -$15
and a tax rate of 34%. What is the minimum total interest revenue required to give a ROE of 15%?
(Numbers in millions)
Required NI = NI/$200 = 0.15 or NI = $30
NI = [Interest revenue– Interest expense – P + (NII – NIE)] × (1 – Tax rate) or
$30 = [Interest revenue – $90 – $20 + –$15] × (1 – 0.34)
Required interest revenue = $170.45
This example could be taken one step further to illustrate loan pricing. If securities are $500 and are
earning an average rate of return of 5% and the bank has $1500 in loans, what must be the average loan rate
to generate interest revenue of $170.45?
$170.45 = ($500 × 0.05) + ($1500 × Avg. Loan Rate)
Avg. Loan Rate required = 9.7%
The instructor can now lead the students in a discussion of the factors that would determine whether the
required average loan rate is feasible (the mix, competitive conditions, loan demand and the elasticity of
loan demand with respect to interest rates) and how changing interest rates would affect this number.
Examples of this nature can be found in Gardiner, Mills and Cooperman, Managing Financial Assets: An
Asset/Liability Approach, 4th ed, Dryden Press, 2000.
4. Financial Statement Analysis Using A Return on Equity Framework

Time series and cross sectional ratio analysis can be useful to identify strengths and weaknesses of banks.
The FFIEC or the FDIC websites can be used to generate average data for comparison.
Ratio analysis is very useful for identifying trends over time and for highlighting differences from peer
group competitors. Identifying the proper peer group may be challenging.
a. Return on Equity and Its Components

Chart of ratios illustrating the sources of a bank’s ROE
2007 Full Year Interest Expense

37.46%
Data Operating Income
Profit Margin
Net Income
Operating Income PLL
6.95%
11.89% Operating Income
ROA
Net Income Noninterest expense
38.20%
Total Assets Operating Income
0.93%
ROE Income Taxes
5.21%
Net Income Operating Income
Total Equity Capital
9.13% Asset Utilization Interest Income
5.47%
Operating Income Total Assets
Total Assets
Equity Multiplier 7.15% Noninterest income
1.89%
Total Assets Total Assets
Total Equity
Capital
9.65x
12-7
Numbers are calculated from the FDIC webpage using year end 2007 data for all federally insured
commercial banks. Operating income is interest income plus noninterest income, i.e. this is gross, not net
operating income.44
• ROE measures the profits per dollar of investor’s equity. Generally, higher numbers are better.
• ROA measures the profits per dollar invested in assets. Note the low ROA of banks. Higher numbers
typically indicate better performance.
• The equity multiplier is equal to 1 + Debt/Equity ratio. This implies that the average debt to asset ratio
of banks is 90%. The high percentage of debt is required to offset the low ROA in order to offer a
respectable ROE. Debt magnifies changes in ROE as conditions change and increases insolvency risk.
b. Return on Assets and Its Components

• ROA is the product of the profit margin and asset utilization ratios.
• The profit margin measures how effectively the bank turns a dollar of revenue into a dollar of bottom
line profits. Generally, the higher this ratio the better. If this ratio appears to be too low look for
problems in the following ratios in the chart. The analyst should ascertain whether the PLL is too high.
The PLL to Operating Income ratio fell for banks in 2003 and 2004, improving profitability, but the
ratio increased in 2006 and 2007 due to the mortgage market problems. Salaries are a major
component of noninterest expense and may be the problem if noninterest expense to operating income
is too high. Additional breakdowns for each component of these categories may be desirable.
• The asset utilization ratio measures how effectively the bank converts its assets into gross operating
revenues. Generally, the higher the better. Excessively high ratios may indicate that the bank is
investing in highly risky loans and/or investments. If this ratio appears to be too low look for problems
in the following two ratios in the chart. The bank may also have too many nonearning assets.
Problems here may be indicative of too few loans/excess liquidity, low interest income or a lower
amount of fee based services than peer groups.
c. Other Ratios
• Net interest margin (NIM)
Net Interest Income Interest Income − Interest Expense
NIM = =
Earning Assets Investment Securities + Net Loans and Leases
For 2007 the average NIM = 3.35%. Higher NIM ratios generate a higher bank rate of return on
investments, ceteris paribus. As always, higher returns may come at the expense of higher risk.
• The Spread
Interest Income Interest Expense

Spread = −
Earning Assets Interest Bearing Liabilities
The estimated spread was 2.66% for 2007. The spread measures the average yield on earning assets
less the average cost of interest bearing liabilities.
• Overhead Efficiency
Noninterest Income
Overhead Efficiency =
Non interest Expense
This ratio is seldom greater than 1; the average for 2007 was 67.19%.
You may be more familiar with a similar measure, the net noninterest margin (Noninterest income –
noninterest expense) / earning assets. The net noninterest margin is sometimes called the noninterest
burden because it is usually negative. The Check 21 law should help improve this ratio.
44
This is potentially confusing, most bank income statements have a line titled operating income or net
operating income, the text definition is not the same as in that line.
12-8
Comparison of Webster Financial Services (WFS) and Bank of America (BOA)

Interest Expense WFS = 38.40%
Operating Income BOA = 37.16%
Profit Margin
Net Income
Operating Income PLL WFS = 1.14%
WFS = 14.02% Operating Income BOA = 5.33%
ROA BOA = 18.18%
Net Income Noninterest expense WFS = 38.50%
Total Assets Operating Income BOA = 30.25%
WFS = 0.99%
ROE BOA = 1.43% Income Taxes WFS = 6.94%
Net Income Operating Income BOA = 9.15%
Total Equity Capital
WFS = 8.45% Asset Utilization Interest Income WFS = 5.95%
BOA = 13.36% Operating Income Total Assets BOA = 5.57%
Total Assets
Equity Multiplier WFS = 7.08% Noninterest income WFS = 1.13%
Total Assets BOA = 7.91% Total Assets BOA = 2.34%
Total Equity
Capital
WFS = 8.51
BOA = 9.33
Analysis:
BOA has a substantially higher ROE. This is because

• BOA is more highly leveraged (larger equity multiplier)
• BOA has a higher ROA.
o BOA’s higher ROA is driven by its higher asset utilization (AU) and profit margin (PM)
ratios. BOA has a substantially higher profit margin and its AU ratio is appreciably
higher as well generating a substantially higher ROA for BOA.
The AU ratio is lower at WFS at least partly because of the very low level of
noninterest income to total assets ratio as compared to BOA.
Operating Income – (Interest expense + PLL + Noninterest expense + Income Taxes) = Net Income.
Hence, the top four ratios in the fourth column comprise the cost components of the profit margin. Lower
values for these ratios indicate that the bank translates more dollars of operating income into net income.
As a percent of income, BOA incurs slightly less interest expense than WFS. A further breakdown of this
component reveals that WFS pays a substantially higher percent of operating income than BOA on NOW
accounts, MMDA and retail and wholesale CDs. This is due to the liability mix since BOA’s liability
yields are higher on many liability sources.
BOA has a higher profit margin even though it has a much higher PLL/Operating income ratio and
a higher level of noninterest expense to income. A low PLL indicates high loan quality (or unrealistic
management) and fits with the concentration in real estate loans.
WFS’s is heavily concentrated in mortgages; mortgage loans are 55% of assets.
Salaries and spending on fixed assets are much lower percentages of operating income at BOA. The low
noninterest expense occurs at WFS occurs because WFS does not offer as many fee based services as BOA.
WFS apparently has fewer tax shields than BOA.
Asset Utilization
12-9
BOA generates more operating income per dollar invested in assets. This is in spite of WFS’s
greater percentage investment in loans than BOA.45 BOA has about 56% of assets in loans and leases and
WFS has about 75%. WFS also has a lower percent of nonearning assets than BOA which should lead to
an improved AU.
BOA generates lower interest income per dollar of assets; WFS has higher asset yields on real
estate loans (their largest loan component), and particularly higher yields on municipals and leases. BOA
has higher yields on C&I loans and consumer loans as well as many of their investments.
BOA’s advantage in asset utilization stems in part from the much higher amount of noninterest
income generated per dollar invested in assets. This is because BOA offers many more off balance sheet
and fee related services than WFS.
Other ratios:
The NIM for BOA is 3.04%, substantially lower than WFS’s 3.62%. WFS’s advantage occurs because
their yield advantage in real estate loans and on leases.
WFS has a spread of 3.48%, compared to BOA’s spread of 2.83% indicating again that WFS has a
substantial advantage in net interest yields.
The overhead efficiency ratio is higher for BOA. BOA has an overhead efficiency ratio of 97.77% while
WFS’s ratio is only 40.46%. BOA has lower noninterest expense ratios, and BOA generates much more
noninterest income than WFS, making the efficiency ratio significantly higher for BOA.
Using the average data from the FDIC, WFS is below norm in EM and AU measures.46 WFS’s PM is a bit
higher than the norm. Their PLL / OI measure is quite low, reflecting the low risk nature of their lending.
Noininterest expense to OI is above the industry norm and their average tax rate is higher. WFS earns
lower amounts of noninterest income in relation to total assets than the typical bank.
BOA is above the average for ROE, ROA and PM. BOA is about the same in terms of use of leverage
(EM) and is well above the norm for AU. BOA’s PLL/ OI ratio is slightly lower than the norm, and their
tax rate is well above average. Their interest income to total asset ratio is about the norm. Generally
speaking BOA’s numbers are better than the industry averages.
5. Impact of Market Niche and Bank Size on Financial Statement Analysis

a. Impact of a Bank’s Market Niche
If a bank can find a profitable niche in which to specialize, they can potentially generate higher rates of
return than more diversified institutions at times. Specialization in credit analysis for one loan type for
example builds expertise in credit evaluation and generates time and cost economies. If the specialty
chosen falls on hard times however, a diversified institution may fare better. Webster Financial Services
generated higher profit rates than BOA by specializing in real estate lending funded with core deposits.
Mortgage lending has grown rapidly in recent years and until 2006 and 2007 had enjoyed few default
problems. A different economy may yield quite different results. BOA had a more diversified portfolio and
used more purchased funds and fewer core deposits. This may make them more sensitive to interest rate
changes unless they are well hedged.
b. Impact of Size on Financial Statement Analysis

Some major comparisons
• Large banks have greater access to purchased funds and usually maintain more liquid assets.
• Large banks also typically carry lower amounts of equity. At times the ROA of large banks has been
less than for small banks because the large banks operate in more competitive markets.
• Large banks have higher salary expense (%) and typically have higher % costs for premises.
• Large banks certainly have more noninterest income than smaller banks, but they also have higher
noninterest expense as indicated above.
45
Loans are typically the highest earning asset category.
46
Some of these differences are due to using numbers from different time periods so be careful using
these comparisons.
12-10
Chapter 13 - Regulation of Commercial Banks
Chapter Thirteen
Regulation of Commercial Banks
In this chapter the major aspects of commercial bank regulations are covered. The purpose of this chapter
is to familiarize readers with the types of regulations banks must comply with, and how these regulations
affect profitability. Appendix C provides a list of various DIs and their primary regulators. After reviewing
the primary areas of regulation, the effects of restrictions on lines of business and geographic areas of
operation are presented and the changes in these factors being brought about by the Financial Services
Modernization Act (FSMA) of 1999. The FSMA was a landmark act that repealed many of the Glass-
Steagall restrictions on banking. The history and problems of the FDIC and the FSLIC are covered and the
U.S. system is contrasted with deposit insurance methods overseas. Appendix A shows how to calculate
deposit insurance premium under the new FDIC assessment method. The text provides information on
reserve requirements, risk based capital requirements and off balance sheet regulations. Appendix D
provides numerical examples of calculating reserve requirements and Appendix B contains the new Basel
II risk based capital requirements. Finally, the text compares foreign versus domestic regulations of banks.
II. Notes
1. Specialness and Regulation: Chapter Overview
Banks are entrusted with a large portion of the liquid assets of households. In turn, banks provide essential
services to savers such as maturity and denomination intermediation, risk assessment of investments and
allocating funds to borrowers. Banks also play a major role in the transmission of monetary policy and
operating electronic payment mechanisms. Because of the vital nature of the services provided by banks
and the government’s deposit insurance liability, the government is obligated to regulate this industry.
2. Types of Regulations and the Regulators

a. Safety and Soundness Regulations
Safety and soundness regulations are designed to limit the probability of failure of a DI. Examples
include:
• Lending limits on the amount that can be lent to one or related borrowers. Banks cannot lend an
amount greater than 10% of their own equity capital to one company or borrower (more if the loan is
collateralized by liquid assets).
• Minimum amounts of DI equity capital are required. Greater amounts of equity capital are required if
a bank invests in riskier assets.
• The existence of guaranty funds such as the Deposit Insurance Fund (DIF) operated by the FDIC.
Deposit insurance premiums increase with the riskiness of the bank. Risk based insurance premiums
and capital requirements help limit moral hazard problems (see below).
• Examinations and reporting requirements. DIs must file quarterly call reports and large institutions
must be examined annually. Examiners analyze the bank’s loan policy (credit evaluation procedures)
and internal control processes (among other things) to help ensure the safety and soundness of the
institution. Fraud and embezzlement have also always plagued the banking industry, and regular
examinations are required to prevent illegal activities.
These and other regulations impose a cost called the net regulatory burden upon DIs. The net regulatory
burden is the difference between the private benefit from being regulated, such as the reduction in liability
cost brought about by deposit insurance, less the private cost of adhering to regulations, producing reports,
etc.
b. Monetary Policy Regulation

The central bank directly controls only outside money (money outside the banks such as currency and
coins in circulation) but the majority of the money supply is inside money (bank deposits). Many
governments require banks to back deposits with reserves held at the central bank or other government
13-1
authority. In the U.S. the Fed requires banks to hold reserves at the Fed, and can manipulate both the level
of required reserves and the price of holding excess reserves by manipulating interest rates (see Chapter 4).
c. Credit Allocation Regulation

Credit allocation regulations are designed to channel funds to what are deemed socially deserving areas
such as housing, farming or lending in economically disadvantaged areas. These laws and regulations may
require DIs to lend minimum amounts in one area or to provide loans at subsidized rates. Examples include
the Qualified Thrift Lender Test (for more on the QTL Test see Chapter 14) and the Community
Reinvestment Act (CRA) of 1977. In 1995 CRA regulations were revised to make the objectives more
measurable and to reduce the regulatory burden imposed by the law. Revised rules focus on three
measures:
1. Lending:
a. Geographic and demographic distribution of lending. The object is to prevent redlining
and similar discriminatory practices as well as to encourage lending to disadvantaged
groups.
b. Extent of community development lending. Encourages banks to lend to startups and
engage in loans to micro businesses.
c. Use of innovative or flexible lending practices to assist low or moderate income
individuals.
2. Investment: The institution’s involvement with qualified programs that assist certain people or
areas. An example may include funding for public service organizations that invest in
disadvantaged areas.
3. Service: The extent to which the institution provides banking services to the community and their
willingness to accommodate to area needs.
CRA ratings range from outstanding to substantial noncompliance. Poor ratings can affect regulatory
approval of proposed mergers and other related activities. A bank’s CRA rating must be made publicly
available; most banks of any size put together a brochure outlining their community involvement.
d. Consumer Protection Regulation

The CRA and the Home Mortgage Disclosure Act (1975) are both designed to prevent discrimination in
the granting of credit. Lenders must fill out a standard form for each loan stating why a loan application
was accepted or denied. Bankers have complained that government requirements result in excessive, costly
documentation.
e. Investor Protection Regulation

The Securities Acts of 1933 and 1934 are the two primary pieces of legislation that form the basis of
investor protection. The 1933 act created strict disclosure requirements for primary public offerings. The
1934 act established the SEC and its right to regulate secondary markets.
Ethics Tip: In 2002 Merrill Lynch, Morgan Stanley and many other securities firms were investigated for
allegedly providing customers with biased research reports. The firms settled the allegations by paying
$1.4 billion in fines. After years of industry consolidation and growth, there are very few investment houses
left that just provide research. In order to help promote its underwriting business, research reports
generated by firms that provide underwriting services can sometimes be overly optimistic. Emails at
Merrill Lynch seemed to indicate that Merrill analysts knew that the research reports they were providing
to customers were biased. Ethical points for discussion: 1. Should investment bankers/underwriters be
allowed to sell stock research reports that are promoted as unbiased? Should ‘caveat emptor’ prevail or is
there a role for the government to prevent these conflicts of interest? 2. How private should email be?
(Merrill Lynch and other investment banks now routinely monitor employee’s email).
f. Entry and Chartering Regulation

Market entry is regulated. For instance, national bank charters are granted by the Office of the
Comptroller of the Currency. A given charter also limits the activity of the entity. Controlled entry into
an industry creates a potential competitive barrier that may allow banks to enjoy higher profitability.
g. The Regulators
13-2
The U.S. tends to have more regulatory overlap than other countries. A state chartered insured bank that is
a member of the Federal Reserve System may technically be regulated by the Fed, the FDIC, and a state
banking commission.
In reality due to resource constraints a more rational system is used. The Comptroller of the Currency has
the primary examination responsibility for national banks. The FDIC may defer to the Fed on state
chartered Fed member banks and the FDIC will concentrate more on state banks that are not members of
the Fed.
3. Regulation of Product and Geographic Expansion

The focus of the banking laws from 1933 to 1980 was to limit the number of failures by limiting
• How banks could compete
• Where banks could compete
• What lines of business banks could engage in.
The laws were also designed to protect small banks from being outcompeted and driven out of business by
large banks. The laws worked; about 43% of the existing number of banks failed in the 1923 to 1933 time
period (almost 14,000 banks). From 1941 to 1977 with the tougher regulations fewer than 200 banks
failed.
The environment began to change rapidly in the mid to latter 1970s. The U.S.
experienced inflation and interest rates began rising. In 1979 the Fed stopped targeting
interest rates and allowed rates to rise further. Rates were very high by historical
standards and projected to keep rising due to inflation/energy prices. All DIs faced
disintermediation under Regulation Q (Reg Q limited the ability of banks and thrifts to
offer competitive interest rates on deposits) as money market mutual funds grew rapidly.
There were increasing levels of competition within the banking industry and from non-
bank financial institutions brought about by scale and scope economies generated from
rapid improvements in computer technology. Regulations severely limited growth
opportunities for banks and thrifts. Thus, there were profit opportunities that the banks
could not exploit. Since regulations limited banks from expanding into many related
financial services, banks did what they could and other non-banks attempted to enter new
lines of banking related businesses. For instance, Merrill Lynch created cash
management accounts, insurers granted loans against life insurance policies, money
market mutual funds offered checking features, even Sears, a large retailer, began
offering credit cards. Banks began offering discount brokerage services, and offering
insurance in conjunction with loans. Slow erosion of regulatory firewalls continued but
history shows that Congress never acts until there is a crisis.47 The crisis was provided
by the drop in profitability and the consequent run down in equity values at savings and
loan institutions. Ronald Reagan, a great believer in deregulation, was also elected
President in 1980, the year the first major piece of legislation deregulating financial
services, the DIDMCA, was passed. At this point the setting was ripe for change and the
1980s became a decade of deregulation of financial services.
a. Product Segmentation in the U.S. Commercial Banking Industry
47
The Civil War brought about the National Banking Acts of 1863 and 1864 in order to provide
desperately needed financing for the Federal Government. The severe financial panic of 1907 led to the
creation of the Federal Reserve in 1913. The Crash of 1929 and the ensuing Depression led to the Glass-
Steagall Act and the creation of the FDIC. The failure of the FSLIC brought about the FIRRE Act and the
FDICIA. The merger of Traveler’s and Citicorp forced the FSMA in 1999. You would think that after 150
years Congress would learn to be a little more proactive!
13-3
Germany, Switzerland and the United Kingdom have universal FIs that provide a broader range of
financial services than U.S. banks. The Japanese system is more closely akin to the U.S. because it was
modeled after ours. Nevertheless, overall most foreign banks have long been able to engage in a broader
range of services such as commercial and investment banking, insurance, and other financial activities than
U.S. banks. For regulatory purposes commercial banking is defined as making commercial loans and
taking deposits. Investment banking is underwriting and distributing securities and otherwise engaging in
market making activities.
Separation of financial services was enshrined by regulation during the Depression. The Glass-Steagall Act
came about as a result of the large number of bank failures after the stock market crash of 1929. Prior to
this time banks had been allowed to engage in investment banking activities. Allowing joint investment
banking and commercial banking can create many conflicts of interest (see below). Glass-Steagall
prohibited banks from underwriting most securities (except GOs, Treasuries, private placements and real
estate loans).
Example of the conflicts of interest include implicit or explicit ‘tie in’ arrangements. For example a lender
might pressure a loan customer to purchase a new issue the bank is underwriting as a condition for a
favorable review of a loan application. A lender may also disclose unfavorable information uncovered in
the loan application to the bank’s securities division so that the firm’s stock can be sold before losses occur.
In 1987 the Fed began allowing certain commercial banks to create Section 20 affiliates which could
underwrite corporate debt and equity securities. Since 1997 banks have been allowed to acquire existing
investment banks. This change set off a spate of mergers such as Deutsche Bank’s acquisition of Bankers
Trust. Finally in 1999 the FSMA allowed the creation of full service FIs. In 2005 there were 640
financial service firms in the U.S. with over $7 trillion in assets.
The FSMA also allows bank holding companies to establish insurance underwriting affiliates and allows
insurance companies to operate banks and securities firms. The FSMA is indeed the biggest law change
since the Glass-Steagall Act it repeals.
Prior to the FSMA, banks and bank holding companies (and insurers) were prohibited from owning
nonfinancial entities. The 1956 Bank Holding Company Act required bank holding companies to divest
any amount beyond a 4.9% stake in nonfinancial entities. Until recently, the only way a commercial firm
could enter banking had been to operate a nonbank bank. Nonbank banks either make commercial loans
or take (uninsured) demand deposits but not both.
The FSMA defines a financial services holding company as one which holds at least 85% of its assets in
financial assets. The intent of the law is to ensure that financial services holding companies hold financial
assets, and divestment of commercial enterprises may be required. Commercial banks belonging to a
financial services holding company can now also have a controlling interest in a nonfinancial enterprise as
long as the investment is for a limited time period (the time period is unspecified in the Act) and as long as
the bank does not actively manage the nonfinancial enterprise.
Although the FSMA allows the creation of financial conglomerates that operate in many diverse financial
lines, the act continues functional regulations. For instance, a financial service holding company with a
bank, an insurer and a securities firm will continue to have each activity regulated by the appropriate
agency.
Geographic Expansion in the U.S. Commercial Banking Industry

Throughout the early and mid 1900s many states required banks to be unit banks (banks with no branches)
and the ability to branch has predominantly been regulated at the state level. Most states prohibited or
limited branching because they feared that allowing branch banking would eliminate the small local
independent banks. The McFadden Act of 1927 required nationally chartered banks to adhere to state
branching restrictions. It was actually intended to allow national banks greater freedom to branch, but the
Act contained a provision that left branching restrictions up to the state, and most states quickly prohibited
branch banking and interstate banking. As of 1997 only six states still limited intrastate branch banking.
13-4
b. Regulatory Factors Impacting Geographic Expansion

Banks have always sought ways around the geographic restrictions imposed upon them by regulations.
When they could not acquire or create de novo (build new ones) branches, they began to create multibank
holding companies that led to defacto intrastate and interstate banking. This led to the 1956 Bank
Holding Company Act which limited the ability of multibank holding companies to operate out of state
subsidiaries. Existing multi-state structures were grandfathered and allowed to continue. After this, one
bank holding companies were formed that had nonbank subsidiaries operating across state lines.
Congress closed this loophole in the 1970 Amendments to the Bank Holding Company Act.
Several events led to the eventual demise of many of the restrictions on branching and interstate banking.
First, the regulators allowed DIs from other states to acquire failing institutions during the 1980s, so
defacto interstate banking was occurring. Second, more states began allowing intrastate branching and
interstate banking via reciprocal agreements with neighboring states.
In 1994 Congress passed the Riegle-Neal Act that allowed interstate banking by allowing banks to
consolidate out of state bank subsidiaries into a branch network or by acquiring existing banks across state
lines. The ability to establish de novo branches across state lines is up to the individual states. Some states
prohibit de novo branching to protect the value of small local institutions because in these cases the only
way to gain market access is to buy a local institution. The Riegle-Neal Act has also been a major impetus
for many mergers.
Question: What does this indicate about the lobbying power of smaller banks?
Savings institutions have been allowed to operate across state lines since the 1980s.
4. Bank and Savings Institutions Guarantee Funds

a. The Federal Deposit Insurance Corporation (FDIC)
The FDIC was created during the Depression to restore public confidence in the banking system. The
initial insurance limit was $2,500; this amount has been periodically increased to the current limit of
$100,000.48 The FDIC had little trouble until the 1980s because there were very few failures from the
1930s to the 1980s. There were more bank failures in the 1980s than during the entire previous existence
of the FDIC. Past failures and new potential failures of large banks revealed that the FDIC was
undercapitalized and that additional regulations were needed to improve the safety and stability of the
banking industry. The result was the FDIC Improvement Act (FDICIA) of 1991. The major provisions
of FDICIA include
• Regulators must take prompt corrective action (PCA) and intervene in cases where bank capital falls
below prescribed minimums. See Text Table 13-5 for details.
• The pricing of deposit insurance premiums would be risk based.
• Regulators were very limited in their ability to use government funds to bailout institutions deemed
‘too big to fail.’
• Federal regulations were extended to foreign bank branches and agencies (Foreign Bank Supervision
and Enhancement Act)
The decade of the 1990s saw strong profit growth at banks and very few failures (only three in 2004 with
assets of $151 million total). As of the third quarter of 2004 the FDIC had reserves of $34.5 billion. The
bank fund (or BAIF, see below) reserve ratio was 1.32%, the saving fund (or SAIF) reserve ratio was
essentially the same at 1.33%. The BAIF reserve ratio was higher in 2004 than in 2001-2003. In 2007 the
merged DIF fund equaled $52 billion and was 1.22% of insured deposits. As of the end of 2007 there were
76 problem institutions with $22 billion in assets. Three institutions failed in 2007 with total assets of $2.3
billion. These were the first bank failures since 2004 when four banks failed. (Source: FDIC Quarterly
Banking Profile).
48
There are various ways individuals can increase their insurance coverage beyond $100,000. You
may have an account, your spouse may have a separate account and then you may have a joint account to
get your insurance coverage up to $300,000. Admittedly, most of us don’t have this problem anyway.
13-5
b. The Demise of the Federal Savings and Loan Insurance Corporation (FSLIC) and the FDIC
The FSLIC was the FDIC counterpart to the savings and loan industry. The FSLIC was overseen by the
Federal Home Loan Bank Board (FHLBB). The FHLBB acted as both a regulator and promoter of the
industry. The FSLIC had few problems during the regulated years. The S&L industry was allowed to pay
higher rates on deposits than banks under Regulation Q, creating an advantage for S&Ls. As interest rates
rose in the 1970s and Regulation Q ceilings prevented thrifts from raising rates, disintermediation occurred
and S&L profits plummeted due to their large negative rate sensitivity gap. The Depository Institutions
Deregulation and Monetary Control Act (DIDMCA) of 1980 gave S&Ls greater abilities to diversify
their investment and loan portfolios and offer NOW accounts so that they could be more like banks and
began to phase out Regulation Q. Unfortunately, many S&Ls did not have the expertise to compete in
established banking markets. Moreover regulations did not provide incentives for S&L managers to limit
risk on their own and many, fearing that insolvency was inevitable anyway, undertook greater risks in
unfamiliar areas such as junk bonds and commercial real estate.49 The DIDMCA (and later the followup
Garn-St. Germain Act of 1982 which further broadened S&L powers) did little to stop the profit problems
at S&Ls as short term interest rates soared and the yield curve turned downward sloping. The inverted
yield curve hurt S&Ls because they made long term fixed rate mortgages funded by short term deposits.
Many S&Ls already low capital levels were quickly eroded and record numbers of institutions became
insolvent. At one point the market value of equity for the industry as a whole was negative.
The S&L debacle

Regulators followed a policy of regulatory forbearance, meaning they did not close insolvent S&Ls, or in
many cases even replace management at insolvent institutions. Regulators allowed and even encouraged
'creative accounting methods' to hide problems in the thrift industry. There existed a revolving door in
upper levels of the FHLBB and the industry, and there was a critical lack of funding for the FSLIC. The
typical S&L examiner made little money (about $14,000 a year) and had very little business experience.
Indeed, staff cuts were common throughout the early 1980s. Congressional/Presidential indifference and
even Congressional interference (Keating Five) also exacerbated the problem. Some of the nonstandard
accounting procedures used included:
• Book value accounting for loans: e.g. a 6% mortgage could be carried at book when interest rates were
12%. This hid the inadequacy of that loan's income. At the same time market value accounting was
allowed for physical assets (one time revaluations).
• Net Worth Certificates were given to institutions issued by the regulators which contained promises to
pay, but involved no cash. Thrifts were allowed to count the certificates as capital in order to continue
operating.
• Loan losses were allowed to be deferred over the original life of the loan, but origination fees could be
immediately and fully recognized as income.
(Material for this section is drawn from White, L., The S&L Debacle, Oxford University Press, 1991.)
When the FSLIC was declared insolvent in 1987 Congress was finally forced to act. The result was the
Financial Institutions Reform, Recovery and Enforcement Act (FIRREA). Major provisions of the
FIRE Act as it is sometimes called include: (more detail is provided here than in the text)
• The chartering and supervision of thrifts was taken away from the FHLBB and given to the new Office
of Thrift Supervision (OTS) under the Treasury. The FHLBB was stripped of its powers and
disbanded. The Federal Home Financing Board (FHFB) was created to oversee the 12 Federal Home
Loan Banks. They still exist.
• The Savings Association Insurance Fund (SAIF) was created to replace the bankrupt FSLIC. The
SAIF was administered by the FDIC, although at first the Banking Insurance Fund (BIF), which is
also administered by the FDIC, was kept separate. The two funds have now been merged into the
Deposit Insurance Fund (DIF).
49
This was a rational response from S&L managers who feared failure would occur anyway. Recall
from Chapter 10 that equity can be viewed as a call option on firm value. The value of this call option
increases with increased firm risk. Without incentives to limit risk, the results of deregulating a troubled
industry should have been predictable.
13-6
• The Resolution Trust Corporation (RTC) was created to resolve failed thrifts and dispose of their
assets. The RTC has now fulfilled its commission and has been dissolved.
• Limits on savings bank’s investments in nonresidential real estate, required divestiture of junk bond
holdings by 1994 and strengthened the QTL Test which required a minimum percentage of a thrift’s
assets be in mortgage related assets in order to receive certain tax and funding benefits.
• Equalized the capital requirements of thrifts and banks.
• Required that accounting procedures could be no less conservative than generally accepted accounting
procedures.
c. Reform of Deposit Insurance

Also see the above discussion. It is likely that a combination of poor (unlucky?) environmental factors
combined with management that was inexperienced at competing and inexperienced at interest rate and
credit risk management resulted in the large number of S&L and bank failures in the 1980s. There were
unprecedented swings in interest rates and severe regional recessions, particularly in Texas and the
Southwest in the early to mid 1980s, and later on in the Northeast. As for commercial banks, in 1987 many
large banks had to write off huge amounts of loans to LDCs.50 Throughout much of the 1980s regulators
granted increasing powers to institutions without providing incentives to limit risk. The ensuing moral
hazard problems should have been predictable. Regulators should have either explicitly or implicitly
penalized risk taking. Thrift regulators failed in their duty to preserve the safety and soundness of the
industry, but bank regulators had more success. Congress and the presidential administrations did not
adequately fund the regulatory agencies so that the problem could have been dealt with decisively before
the losses became so large. Outright fraud, some of it outrageous, did occur (for instance, see the student
exercises at the end). Members of Congress did intervene in regulatory matters inappropriately. Still,
hindsight is always a harsh critic. At the time, most people did the best they could with the resources they
had.
In April 2001 the FDIC proposed four major changes to the deposit insurance system. In 2005 there were
two different bills before Congress, but the gist of the bills were as follows:
1. Merge the BIF and SAIF funds in order to achieve cost economies for both DIs and the FDIC. Both
funds offer identical coverage and due to mergers many institutions already have different deposits
insured by both funds. For example, 40% of SAIF insured deposits are now held by commercial banks.
As of March 2005 the two funds were merged.
2. Until recently the FDIC did not charge deposit insurance premiums to well-capitalized highly rated DIs
(as long as fund reserves are at least 1.25% of insured deposits). As a result, because over 90% of all
insured DIs are in this top category, the vast majority of depository institutions have avoided paying
deposit insurance premiums. As of January 2007 the FDIC began more aggressive pricing for risk
regardless of the reserve level of the fund, and plans to disaggregate banks in the top rated category and
charge appropriate risk premiums. The scoring model is presented in Appendix A.
Appendix A: Calculation of Deposit Insurance Premium Assessments

Appendix A contains a summary of the risk adjusted credit score model proposed by the FDIC to price
deposit insurance. Among other things, the model utilizes CAMELS ratings and various ratios.
The FDIC Assessment Rate Schedule for the quarter ending September 30, 2007 was as follows:
Annual Rate in
Risk Category BP # Institutions % Total
I – Minimum 5 2,709 31.6%
I – Middle 5.01-6.00 3,088 36.0%
I – Middle 6.01-6.99 1,422 16.6%
I – Maximum 7 859 10.0%
II 10 422 4.9%
III 28 64 0.7%
IV 43 7 0.1%
50
Citicorp wrote down over $3 billion in LDC loans in one quarter. Many other large banks also
had large write downs of bad loans.
13-7
Source FDIC Quarterly Banking Profile, 3rd Qtr, 2008 Institutions are categorized by supervisory ratings,
debt ratings and financial data as of the report date.
Notice that now even low risk, well capitalized banks (the majority) must pay for deposit insurance, this is
a change from prior years.
d. Non-U.S. Deposit Insurance Systems

European banking systems are largely composed of fewer, larger banks. Traditionally they have not had
explicit deposit insurance, and they have not had bank runs akin to the U.S. experience. This is probably
because depositors believed that their respective governments would either not allow the banks to fail, or
they believed that the government would repay the depositors. Deposit insurance was implicitly provided
and the government probably extracted implicit insurance premiums. In any case, as global competition
provides impetus to standardize regulations we can expect more governments to explicitly offer deposit
insurance and charge fees for the service. For example, Russia is proposing to add deposit insurance to
qualifying banks.
Deposit insurance isn’t really necessary to prevent bank runs if the lender of last resort (central bank
nationally or perhaps someday the IMF internationally) can be counted upon to fund failing banks. Also
why is deposit insurance granted to corporate accounts? Wouldn’t it be better to force corporations to
evaluate the riskiness of their banks and price their required returns on deposits accordingly? Their account
sizes are typically well over the insurance limit in any case and this would seem to help limit the moral
hazard problem induced by deposit insurance. A similar system is used in European banks. All banks
located in the European Union have deposit insurance limited to 20,000 euros and a 10% deductible is
applied in the event of institutional failure to encourage depositors to price the riskiness of their deposits.
5. Balance Sheet Regulations

a. Regulations on Commercial Bank Liquidity
Under Federal Reserve Regulation D banks are currently required to meet minimum liquid asset
requirements to back transactions deposits. Since 1980 all DIs must back their net transactions deposits
with reserves held at the Federal Reserve.51
Appendix D: Calculating Minimum Required Reserves at U.S. Depository Institutions

Text Appendix D contains a detailed example of calculating reserve requirements.
• Transaction accounts are demand deposits, NOW accounts and share drafts (offered by credit
unions).
• The computation period is the length of time over which the level of required reserves is calculated.
In the U.S. the reserve computation period begins on a Tuesday and ends on a Monday 14 days later.
Thus the U.S. uses a two week computation period. The minimum daily average reserve level that a
bank must maintain is computed as a percentage of the daily average net transaction accounts held by
the bank over the two week computation period. Friday’s balances are carried over for Saturday and
Sunday so Friday’s balance counts for three days. Smart bankers can attempt to lower deposits on
Friday by say, sending them to overseas affiliates, and reversing them on Monday. This reduces the
average daily balance by the amount sent times 2/14 and is called the ‘weekend game.’
The first $9.3 million of net transaction accounts carry a 0% reserve requirement, amounts from $9.3
million to $43.9 million carry a 3% reserve requirement and all amounts over $43.9 million require a
10% reserve requirement. Suppose that a bank has average daily gross transaction deposits of $1,650
million, including $150 million in its own deposits elsewhere and in currency in the process of
collection (CIPC) so that net transaction accounts are $1,500 million. The minimum average reserves
the bank must hold is:
Net Transaction Accounts % Reserve Req. Daily Avg. Required

$9.3 million 0% $ 0
$43.9-$9.3 = $35.6 million 3% $ 1.038
51
Very small institutions are exempt. See also footnote 22 in the text.
13-8
$1500 - $43.9 = $1458.7 million 10% $145.610

Minimum required daily average balance $146.648 mill.
• The reserve maintenance period is the 14 day period over which the bank must maintain a daily
average balance of reserves (reserves at the Fed and cash) equal to the calculated amount or more. The
reserve maintenance period begins 30 days after the beginning of the reserve computation period. For
this reason this system is called a lagged reserve accounting system. The U.S. switched from a
contemporaneous reserve accounting system in 1998. Thus the bank manager knows exactly the
value of the minimum reserve target throughout the entire maintenance period. This allows managers
to allow the reserves held to fall below the required minimum on any given day. They can easily
calculate the required levels on the days remaining so that the average daily balance will still meet the
required daily average balance.
b. Regulations on Capital Adequacy (Leverage)

The FDICIA requires banks and thrifts to meet identical risk based capital requirements. FDICIA requires
regulators to mandate prompt corrective actions (PCA) if a bank falls below the well capitalized criteria.
The list of actions is provided in Text Table 13-5.
The 1989 Basle Accord did three things:

1. Defined what banks could count as capital.
2. Increased the amount of capital a bank is required to hold by requiring stricter minimum
capital/asset ratios.
3. Made the required capital levels reflect the risk of the institution.
Many banks had to raise more equity capital. How could they do this?
• Sell new shares
• Reduce dividends
• Reduce amount of risky assets
• Increase profit margin on loans – e.g. credit cards and check fees. This is one reason why credit
card loan rates were so slow to fall in the 1990s as interest rates declined.
An interesting question to pose is to ask how much the Basle Accord affected the U.S. and global economy
in the 1990s. U.S. banks, under pressure to improve capital and under fire for loan quality, were perhaps
less likely to lend. This may have worsened the recession of 1990. Japan’s banking woes were brought to
light by the stricter capital standards required under the Basle agreement. It is at least worth mentioning
that care must be taken when changing regulations for a country’s largest intermediary in order to prevent
unintended consequences.
With no risk adjustment, all banks had the same capital requirement, but not all banks had the same risk.
Because higher risk banks did not have to hold more capital, there was no penalty for additional risk.
Normally, capital markets would discipline banks to limit the amount of financial leverage used by
requiring higher borrowing rates. Two different conditions in the banking industry created a market
failure however: deposit insurance and the ‘Too Big To Fail’ practices of the regulators.
There is a conflict between regulators and managers over capital levels.

Bank managers prefer low levels of capital to increase ROE, and bank regulators prefer higher levels of
capital to reduce insolvency risk. Historically, bank capital/asset ratios had been in the 5-8% range, at
times dropping below 5%. In the early 1980s capital requirements were actually reduced from 4% to 3% at
thrifts! These high debt levels leave little room for error. The regulators knew that the U.S. needed higher
capital requirements and needed capital requirement which accounted for different risk of banks.
Nevertheless, the U.S. was reluctant to require them unless other countries imposed similar requirements,
otherwise U.S. banks would have faced a higher cost of funds than foreign banks. Hence, the international
capital agreement, the Basle Accord was created. Signers include the U.S., Canada, France, Germany,
Italy, Belgium, Japan, Luxembourg, Netherlands, Sweden, Switzerland, and the United Kingdom.
Simply examining a capital to asset ratio is an insufficient measure of the adequacy of capital to protect
against losses for three reasons:
13-9
1. The capital to asset ratio (leverage ratio) is based on book values and the market value of equity may be
substantially negative,52 even though the institution has a positive leverage ratio. This in fact happened
at many S&Ls in the 1980s.
2. A simple leverage ratio fails to consider the different risk levels of different assets.
3. The leverage ratio fails to capture the risk of off balance sheet activities.
As a result of these failings, the Basel Accord developed risk based capital requirements.
Appendix B: Calculating Risk Based Capital Ratios

Text Appendix B contains the details of calculating risk based capital ratios. Note that the new changes
imposed by Basel II were not scheduled to be fully implemented until 2007. Due to complaints from U.S.
banks on certain requirements of Basel II that were applied differently to U.S. and non-U.S. banks, certain
aspects of Basel II will not be implemented in the U.S. until the end of 2008 at the earliest.
Basle Accord I defined two types of capital: Tier 1 or ‘core’ capital and Tier 2 or
‘supplemental capital.’
Tier 1 (Core) capital:"No Contractual Obligated Payments”
» Common Equity, including Retained Earnings (Must be ≥ 4% of Risk Weighted Assets
(RWA) (RWA is defined below)
Subject to regulatory approval:
» Qualifying cumulative and noncumulative perpetual preferred stock (and surplus) {No more
than 25% of the sum of the other Tier 1 elements}
The defining characteristic of Tier 1 capital is that the bank cannot be sued for
nonpayment on any of these accounts, and no principle payments are due on them.
Tier 2 or Supplemental Capital (major components)
• Allowance for loan and lease losses Up to 1.25% of RWA
• Perpetual preferred stock not counted in Tier 1.
• Subordinated debt and finite lived preferred stock maturing no sooner than 5 years. {Maximum
amount that can be counted is 50% of Tier 1}
Limits: The amount of Tier 2 capital in excess of Tier 1 capital does not count as allowable capital.
Total Capital (TC) or Allowable Capital = Tier 1 + Tier 2 (See the limit above)
RWA = Risk Weighted Assets or Risk Adjusted Assets
Minimum capital requirements per category are as follows:

Well Capitalized: (Zone 1)
TC/RWA ≥ 10%, AND Tier 1/RWA ≥ 6%, AND TC/TA ≥ 5%
Adequately Capitalized: (Zone 2)

TC/RWA ≥ 8%, AND Tier 1/RWA ≥ 4%, AND TC/TA ≥ 4%
Undercapitalized: (Zone 3)
TC/RWA < 8%, OR Tier 1/RWA < 4%, OR TC/TA < 4%
Significantly Undercapitalized: (Zone 4)

TC/RWA < 6%, OR Tier 1/RWA < 4%, OR TC/TA < 3%
52
This implies that upon liquidation the deposit insurance agency will be unable to fully recover
payouts to depositors from sale of the assets.
13-10
Critically Undercapitalized: (Zone 5)

TC/RWA ≤ 2% OR Tier 1/RWA ≤ 2%, OR TC/TA ≤ 2%
Risk weighted assets proposed under Basel II

The risk weighting scheme works as follows:
Assets are classified into risk categories and assigned a regulatory determined "weight."
• Low risk items receive a low weight.
• The total amount of Risk Weighted Assets (RWA) is then the sum of (Amount ×
Weight) for each asset category.
• Special conversion factors are applied to off balance sheet items such as letters of credit and swaps.
Summary of the Risk Weights for On Balance Sheet Items:

Risk Weight Asset
Category 1
0% Cash
Securities backed by U.S. and OECD govt.and some U.S. govt. agencies
Reserves at Fed (central banks)
GNMA mortgage backed securities
Loans to sovereigns with an S&P rating of AA- or better
Category 2
20% CIPC
Mortgage backed non-govt. agency sponsored securities such as FNMA and
FHLMC backed securities
Most securities issued by govt. agencies
GO municipals
U.S. and OECD interbank deposits and guaranteed claims
Repos collateralized by U.S.G.S.
Loans to sovereigns with an S&P rating of A+ to A-
Loans to banks and corporates with an S&P rating of AA- or better
Category 3
50% Single or multi-family mortgages (fully secured, first liens)
Revenue bonds
Loans to sovereigns with an S&P rating of BBB+ to BBB-
Loans to banks and corporates with an S&P rating of A+ to A-
Category 4
100% Loans to sovereigns with an S&P rating of BB+ to B-
Loans to banks with an S&P rating of BBB+ to B-
Loans to corporates with an S&P rating of BBB+ to BB-
All other loans to private entities and all consumer loans
Physical assets
Corporate Bonds and other unclassified investments
All other assets, including intangibles
Category 5
150% Loans to sovereigns, banks and securities firms with an S&P rating below B-
Loans to corporates with an S&P rating below BB-
Bold items are new in the Basel II Accord
Conversion factors for off balance sheet contingent or guaranty contracts (Text Table 13-B3)
• Sale and repurchase agreements and assets sold with recourse (& not on the balance sheet) (100%)
• Direct credit substitute (financial) standby letters of credit (100%)
• Performance related standby letters of credit (50%)
13-11
• Unused portion of loan commitments with original maturity of more than one year (50%)
• Commercial letters of credit (20%)
• Bankers acceptances conveyed (20%)
• Other loan commitments (10%)
The risk weights for these categories depend on the riskiness of the creditor under Basel II. Each country
can set different risk weights and different account types may be classified differently within and between
countries
Finding the risk adjusted value of off balance sheet contingent guaranty contracts is a two step process:
1. Multiply the amount outstanding times the appropriate conversion factor listed above. This gives the
credit equivalent amount as if the commitment were on the balance sheet.
2. Multiply the result in step 1 by the appropriate risk weight found in the on balance
sheet risk weight table. For instance, if a bank issues a standby letter of credit guarantee
on a commercial paper issue, the letter of credit commitment is first multiplied by 100%
and then multiplied by 100% again. So that the risk weighted asset amount is equal to the
original amount of the credit. If the bank however issued a standby letter of credit to a
municipal borrower to back G.O. bonds the amount would be multiplied by 100% and
then by 20% since G.O. bonds appear in the 20% risk weight (on balance sheet) category.
Finding the risk adjusted asset value of off balance sheet OTC derivative instruments or market contracts is
more complex. The risk weighting for these contracts is due to counterparty credit risk. Therefore
exchange traded contracts, which do not bear counterparty risk are not included.
The notional value of all nonexchange traded swaps, forwards, OTC options and other
such exposures are first converted into on balance sheet credit equivalents as before, but
this conversion is a two step process that requires estimating the contract’s current and
potential exposure.
The credit equivalent amount is then separated into two components: current exposure and potential
exposure.
• Current exposure is the cost to replace the contract today if the counterparty defaults immediately.
• Current exposure on a forward contract may be calculated by assuming that the counterparty
defaults today and the forward contract has to be replaced using the new forward rate for the time
remaining on the contract. If the bank had bought pounds forward at $1.50 per pound, but now the
forward rate is $1.60 per pound the replacement cost is the discounted value of $0.10 per pound
bought forward. Replacement cost can be positive or negative, but if it is negative the bank must
count it as zero under existing regulations.
• Current exposure on a swap can be calculated as the net present value of the existing swap less the
net present value of a replacement swap.
• Potential exposure measures the expected cost to replace the contract in the future if the counterparty
defaults later on. Exchange rate contracts are more volatile than interest rate contracts so their values
can change more, and regulators require higher conversion factors for them than for interest rate
exposures. The value of longer term contracts is also more volatile than short term contracts, and long
term derivatives also carry higher conversion factors.
Credit conversion factors for interest rate and foreign exchange contracts used in
calculating potential exposure (text Table 13-B4)
Remaining Maturity Interest rate contracts Exchange rate contracts
Less than 1 year 0.0% 1.0%
1-5 years 0.5% 5.0%
> 5 years 1.5% 7.5%
13-12
The notional value times the appropriate factor from the above table yields the potential exposure.
The sum of the potential exposure and the current exposure gives the total on balance sheet equivalent
credit amount. This sum is then multiplied by the appropriate risk weight which was generally 50% under
Basel I, but is 100% under Basel II. (See the following example, its really not that difficult if you do not
have to calculate the current exposure.)
Example calculation:
XYZ Bank (Millions)
Cash & Reserves $ 5 Deposits $113

Investments in Treasuries $ 10 10 year Sub. Debt $ 16
Commercial loans BB+ $ 12 Perpetual Noncum. PS $ 1
Single family mortgages $ 45 Common stock $ 2
Consumer loans $ 35 Retained Earnings $ 5
Commercial loans CCC+ $ 25 Total $137
Allowance for loan losses ($ 10 )
Physical assets $ 15
Total Assets $137
Note:
• Off Balance Sheet: Banker’s Acceptances $20 million to entities with an A+ rating.
• Three year fixed for floating interest rate swap with notional value of $75 million and
a replacement cost of $3 million.
• Three year forward contract to sell euros for $10 million. The contract has a
replacement cost of $1 million.
XYZ Bank (Millions $)

Risk
Weight Capital
Cash & Reserves $ 5 0% Deposits $113 -
Investments in Treasuries $ 10 0% 10 year Sub. Debt $ 16 Tier 2
Commercial Loans BB+ $ 12 100% Perpetual Noncum. PS $ 1 Tier 1
Single family mortgages $ 45 50% Common stock $ 2 Tier 1
Consumer loans $ 35 100% Retained Earnings $ 5 Tier 1
Commercial loans CCC+ $ 25 150% Total $137
Allowance for loan losses ( $ 10 ) N/A
Physical assets $ 15 100%
Total Assets $137
The on balance sheet risk weighted asset total is calculated as the sum of the amount of
each asset times the risk weight. Total on balance sheet risk weighted assets are thus
$122 million. The reserve for loan losses is ignored in this calculation.
The risk weighted equivalent asset amounts for the off balance sheet items are calculated
as follows:
• Off Balance Sheet: Banker’s Acceptance $20 million to entities with an A+ rating.
Banker’s acceptances carry a 20% conversion factor so the credit equivalent amount is
$20 million × 0.20 = $4 million. The counterparty is rated A+ so the risk weight is 50% and the risk
weighted equivalent asset amount is $2 million.
13-13
• Three year fixed for floating interest rate swap with notional value of $75 million and
a replacement cost of $3 million.
Potential exposure:
The potential exposure is calculated as $75 million times the conversion factor of 0.5%
that applies to interest rate contracts with a maturity of 1 to 5 years:
$75 million × 0.005 = $375,000
Current exposure:
The current exposure is the replacement cost of $3 million.
The total credit equivalent amount = current exposure + potential exposure = $3, 375,000
Under Basel II, the risk weight has been increased from 50% to 100% so the equivalent
on balance sheet risk weighted amount is equal to $3,375,000 × 1.00 = $3,375,000.
• Three year forward contract to sell euros for $10 million. The contract has a
replacement cost of $1 million.
Potential exposure:
The potential exposure is calculated as $10 million times the conversion factor of 5%
which applies to exchange rate contracts with a maturity of 1 to 5 years:
$10 million × 0.05 = $500,000
Current exposure:
The current exposure is the replacement cost of $1 million.
The total credit equivalent amount = current exposure + potential exposure = $1,500,000
Under Basel II, the risk weight has been increased from 50% to 100% so the equivalent
on balance sheet risk weighted amount is equal to $1,500,000 × 1.00 = $1,500,000.
Total Risk Weighted Assets (RWA)

On Balance Sheet RWA $122,000,000
Banker’s Acceptances $ 2,000,000
Swap $ 3,375,000
Forward $ 1,500,000
Total RWA $128,875,000
Tier 1 Capital = $8,000,000

Tier 2 Capital = $5,610,937 million = $4 million + $1,610,937
Tier 2 Capital is calculated as follows: Only $4 million in 10 year subordinated
debt can be counted as Tier 2 capital because this category is limited to no more
than 50% of Tier 1 Capital. Only part of the $10 million loan loss reserve can be
counted; recall that a maximum amount of loan loss reserves that can be counted
as capital is 1.25% of risk weighted assets, or $1,610,937 = $128,875,000 *
0.0125 in this case.
Total Capital or Allowable capital = Tier 1 + Tier 2 = $13,567,969
Total Capital/ RWA $13,610,937 / $128,875,000 = 10.56%
13-14
Tier 1 Capital / RWA $8,000,000 / $128,875,000 = 6.21%

Total Capital / Total Assets $13,610,937 / $137,000,000 = 9.94%
This bank is well capitalized:

Well Capitalized: (Zone 1)
Total Capital /RWA ≥ 10%, AND Tier 1 Capital /RWA ≥ 6%, AND Total Capital/TA ≥ 5%
End of Appendix B
As mentioned earlier, the number of Problem Institutions in 2007 was 76, with $22 billion in assets; both
measures are the highest since 2004. In 2007 the leverage ratio for all FDIC insured institutions was
7.98%. The Tier I risk based capital ratio was 10.12%, the total risk-based capital ratio was 12.79%. In
the fourth quarter of 2007 total current exposure to Tier I capital from derivatives was 45.6%, potential
exposure to Tier I capital was 109.8% for a total exposure ratio of 155.4%.
(Source FDIC Quarterly Banking Profile 3rd Qtr, 2008)
Basel II has three main pillars to help ensure the safety and soundness of the financial system:
Pillar 1:
Maintain and update regulatory capital requirements for credit, market and operational risk. The addition
of capital requirements for operational risk is new; the methods of measuring credit and market risk are
updated and expanded, many of which are highlighted above. To measure credit risk Basel II proposes two
methods. The standard approach is the one highlighted above. Alternatively, credit risk may be measured
through the bank’s own internal rating and credit scoring models. If the internal method is used the bank is
expected to be able to prove the validity of its measures. Operational risk measures include the Basic
Indicator, the Standardized, and the Internal Measurement Approaches.
Pillar 2:
Stress the continued importance of the regulatory evaluation process in addition to capital requirements. In
particular ensuring that the bank has valid internal control procedures in place to measure and manage risk
and ensure ongoing capital adequacy.
Pillar 3:
Promote disclosure of the institution’s capital structure, risk exposure and capital adequacy. Much of this
requirement is new.
The new capital regulations in Basel II are currently being implemented in Europe. Uncertainties about
which U.S. banks will use the internal measurement versus the standardized approach have yet to be
decided. The Federal Reserve will only allow U.S. banks to reduce their capital requirement over time,
rather than immediately, if allowed under the internal measurement system. European banks are allowed to
immediately reduce their capital if applicable. This difference could provide profit advantages to non-U.S.
banks. Implementation of the new capital regulations has been delayed until after 2008 while these
problems are resolved.
c. Off Balance Sheet Regulations

In the 1980s banks began increasing off balance sheet (OBS) activity to offset declining profit margins on
traditional bank operations and to escape scrutiny, capital and other requirements imposed on balance sheet
activities. Since 1983 banks have had to report OBS activity on Schedule L of their call reports.
13-15
Chapter 14 - Other Lending Institutions: Savings Institutions, Credit Unions, and Finance Companies
Chapter Fourteen
Other Lending Institutions: Savings Institutions,
Credit Unions and Finance Companies
This chapter covers savings associations, credit unions and finance companies. Savings associations
(traditionally called ‘savings & loans’ or S&Ls) and credit unions have historically been small institutions
serving specialized needs of local groups. Savings banks are a hybrid between savings associations and
banks, larger and better diversified than savings associations, smaller and less diversified than banks.
Today of course the functions of all financial intermediaries (FIs) increasingly overlap. The term savings
institution is used to refer to savings associations and savings banks. The credit union industry has grown
to the point that they are considered a threat to many local banking institutions. Banks have attempted to
persuade Congress to remove credit unions’ nonprofit status. Credit unions are typically small institutions
that do not have the management expertise of other FIs. By themselves, they would be underdiversified
and at risk from failure, so a large cooperative network has been created to assist credit unions. Finance
companies fulfill specific intermediary niches. Some specialize in subprime lending, some finance working
capital needs of companies and some are captive lenders created to channel funds to a specific company or
to finance consumer purchases of the company’s products. They are distinguishable from banks and thrifts
in that they are not funded by deposits and do not offer retail accounts. As a result this industry is much
less regulated than DIs or insurers. This chapter covers the major assets and liabilities of each of these
industries and identifies the key risks and trends each face. The different regulators for each industry are
discussed along with recent performance. The Instructor’s Manual also includes a brief summary of The
Bankruptcy Abuse Prevention and Consumer Protection Act of 2005.
I. Notes
1. Other Lending Institutions: Chapter Overview
Savings associations and savings banks have traditionally specialized in providing mortgage credit to
individuals. Savings banks have always been better diversified than the more specialized savings
associations. Historically, many banks did not make loans to most individuals, particularly uncollateralized
loans. This lack left a nice for credit unions. Credit unions evolved to meet consumer credit needs;
traditionally these were institutions created by employers to meet banking needs of their employees on site.
This had the dual benefit of reducing employee requests for salary advances and other loans from the
company while also reducing employee absenteeism since most banks were only open during normal
working hours. Together, savings associations, savings banks and credit unions are often called thrifts.
The term originates from their traditional primary source of funds, the savings of ‘thrifty’ individuals.
Finance companies are another form of specialized lender. Some specialize in lending to consumers, some
are primarily business lenders, and some have been created to assist financing for specific items their parent
manufacturer supplies. The major differences between finance companies and thrifts are that finance
companies do not accept deposits and finance companies are much less regulated.
2. Savings Institutions
a. Size, Structure and Composition of the Industry
There were 1,257 savings institutions (SIs) with $1.1914 trillion in assets in 2007. In 1989 there were
3,677 savings institutions. Thus, by 2007 there were 65.8% fewer SIs, but in terms of total assets the
industry is now growing again (there were only $905 billion in industry assets in 2001).
SIs traditionally made long term fixed rate mortgages to individuals funded by short term deposits. This
strategy worked reasonably well until the late 1970s. Until then the Federal Reserve closely targeted
interest rates and the yield curve was generally upward sloping. Beginning in 1979 however, the Fed
allowed interest rates to rise to end the inflationary spiral of the 1970s and SI net interest margins (interest
revenue less interest expense divided by earning assets) became sharply negative as short term rates hit
14-1
highs of 15% and 16%, while long term mortgage rates remained much lower. The Federal Reserve’s
Regulation Q limited the rates all DIs could pay on deposits, so SIs were unable to offer attractive interest
rates. Money market mutual fund growth accelerated rapidly as savers withdrew their funds from SIs. This
withdrawal of funds from DIs came to be known as disintermediation. SIs were hurt worse by
disintermediation than banks because SIs did not offer checking accounts at that time, only savings and
CDs. Checking accounts are held for liquidity purposes, savings and CDs are held for emergency liquidity
purposes and to earn a rate of interest. Because of problems in the DI industry, particularly thrifts,
Congress passed the Depository Institutions Deregulation and Monetary Control Act of 1980 and the
Garn-St. Germain Act of 1982. The latter act was euphemistically known as the ‘S&L savior act.’
Neither act was particularly successful at stemming the problems at SIs. The acts authorized NOW
accounts and MMDA accounts respectively and broadened the investment and lending powers of SIs.53
Under the increased powers industry assets grew rapidly, in part because of excessive risk taking. SIs were
largely locally or regionally based institutions, and when oil prices collapsed, taking many western state
economies with them, many western S&Ls became insolvent and should have been closed.54
Political interference (recall the Keating Five) and a lack of resources encouraged regulators to not close
insolvent institutions in the hope they would be able to turn around their losses and return to solvency.
This was termed regulatory forbearance.
The number of failures continued to grow and eventually the FSLIC (the agency that insured SIs) went
bankrupt. Congress passed the Financial Institutions Reform, Recovery and Enforcement Act (the
aptly named FIRRE Act) in 1989 that abolished the Federal Home Loan Bank Board (FHLBB) and the
FSLIC. The twelve Federal Home Loan Banks remain. The act created a new supervisory agency, the
Office of Thrift Supervision (OTS) that was placed under the Treasury. A new insurance fund, the
Savings Association Insurance Fund (SAIF), was created and its management given to the FDIC. The
Act mandated closure of weak institutions, recapitalized the insurance funds, constrained thrift investment
and lending policies to hold more mortgage related loans and investments and stiffened penalties for
fraudulent management actions. Thrifts are granted a tax advantage and the ability to obtain funds from
FHLBs if they maintain 65% or more of their loans and investments in mortgage related activities (called
the qualified thrift lender or QTL test). FIRREA increased the minimum percentage required to pass the
QTL test to discourage SIs from engaging in high risk non-traditional activities such as junk bond
investments. At one time SIs held 20% of outstanding junk bonds.
The FHLBB was the main regulatory authority of SIs and the overseer of the FSLIC. However, the
FHLBB had a dual role of regulating and promoting the industry and preserving its competitiveness
relative to the much larger and more powerful banking industry. Simultaneously promoting and regulating
an industry is a difficult mandate, one that proved to be impossible for the FHLBB. An additional problem
was the so-called ‘revolving door’ between regulators and practitioners where practitioners served on the
FHLBB for several years and then went back into industry positions.
The largest SIs are much smaller than the largest banks and these remain niche institutions.
Industry comparisons
2007 Banks SIs Credit Unions Finance Companies
Number 8,533 ↑ 1,257↓ 8,329↓
Total Assets (Bill $) $10,411↑ $1,862.7 ↑ $748.3↑ $2,159.7 ↑
ROA 0.93% 0.77% 0.97%↑
Equity% of Assets 10.08% 11.8% 9.4% 11%
The up and down arrows indicate the most recent identifiable trend, if any. Typically the credit union ROA
is lower on average than the ROA for banks and savings institutions, but the average ROA for large credit
unions is actually greater than the other DIs. Poor profitability at small credit unions lowers the overall
average substantially.
53
NOW (negotiable order of withdrawal) accounts are interest bearing checking accounts. NOW
accounts were already in use in some states prior to 1980, particularly in the New England area. Money
market deposit accounts (MMDAs) are interest bearing accounts with limited checking features.
54
Texas, Louisiana, and Wyoming were three particularly hard hit states.
14-2
b. Balance Sheet and Recent Trends

Major assets include: (2007)
Cash and securities 10.1%
Mortgages and mortgage backed securities 73.2%
Commercial loans 3.9%
Consumer loans 5.0%
SIs remain nondiversified institutions with a large concentration of assets in mortgages and mortgage
related areas. Indeed the QTL test mandates a lack of diversification. SIs are consequently likely to
experience profit problems when mortgage markets suffer downturns. The commercial and consumer loan
amounts are far under the amounts allowed for SIs under existing regulations and are less than for banks.
SIs have either not been willing or able to compete with banks for the provision of these services.
SI management teams may lack skills necessary to compete with banks, particularly in
commercial lending. They lack business loan analysis and financial statement analysis
expertise. Many SIs lack other aspects of the relationship with corporations, such as a
history of trustworthiness and the ability to provide multiple banking services. Consumer
credit analysis is very important when there is no house for collateral. Consumer loans
will also have a smaller average size than mortgages. This implies that a higher loan
volume is required to generate the same profitability as a mortgage loan. More credit
checks, more loans to service and generally higher collections costs can make consumer
loans less appealing to many small SIs.
Major liabilities include (2007)
♦ Total deposits are 61% of funds sources. Deposits primarily consist of small time and savings
deposits.
♦ Federal Home Loan Bank and other borrowings comprise about 23% of funds sources.
♦ Equity capital is 11.8%, up slightly from 2004.
Most SIs were traditionally mutual associations owned by the depositors as are credit unions. Today
however, the majority have converted to stock ownership in order to raise more capital. The largest SI is
Washington Mutual (WaMu) with total assets of $350 billion in 2007. Recall that the three largest banks
each have more than $1 trillion in assets.
It is not clear to me that these specialized, underdiversified institutions can or should continue. Mortgage
concentration at banks (and to a lesser extent credit unions) has increased due to the shrinking thrift
industry and strong mortgage markets. SIs that are good at managing interest rate risk may survive as niche
institutions that finance mortgages, probably as subsidiaries of larger banking entities. I expect that if
interest rates continue to rise and the home buyer’s market continues to struggle for a long period these
institutions will face significant profit pressures.
3. Regulators of Savings Institutions

• The aforementioned Office of Thrift Supervision (a bureau of the U.S. Treasury) examines and
regulates all federal savings institutions.
• Until recently The FDIC managed the Savings Association Insurance Fund. The SAIF has now been
merged with the Bank Insurance Fund to form the Deposit Insurance Fund (DIF). The FDIC
administers the DIF which backs bank and SI deposits.
• State authorities regulate and supervise state chartered thrifts.
4. Savings Institutions and Savings Bank Recent Performance

Net interest margins, ROA and ROE reached historical highs in the late 1990s, with thrifts enjoying high
ROAs over 1% and ROEs approaching 15%. Profitability fell in 2002, but rose through 2003. ROE fell
somewhat in 2004, but remained high with low interest rates and a strong housing market. In 2004 average
14-3
ROA was 1.19% and average ROE was 11.22%. The flattening and at times inverted yield curve of the
mid 2000s reduced thrift profitability. The subprime mortgage crisis also led to substantial profit problems
at many SIs. Loan loss provisions grew in 2006 and doubled in 2007 dropping ROA from 1.15% to 2005
to 0.77% in 2007. About half of all SIs had a decline in profits between 2006 ad 2007. However, capital
ratios remain healthy and only one SI failed in 2007.
Like banking, industry consolidation is occurring in the thrift industry. Larger institutions have been more
profitable and are increasingly dominating the industry in terms of asset size. Most thrifts have little or no
foreign exposure and they have not suffered from international crises.
5. Credit Unions
Credit unions are nonprofits mutually owned by their depositors. Credit unions cannot serve the general
public as members must have a common bond in order to join. Traditionally most credit unions were
employer based. Even today many credit unions are sponsored by a corporation or government employer.
The sponsor often donates land, money and/or expertise to assist in the formation of the credit union.
Credit unions are not taxed and as they do not compete with one another due to the common bond
requirement, they are exempt from anti-trust prohibitions. Credit unions can and do act cooperatively and
pool funds for their mutual benefit.
a. Size, Structure, and Composition of the Industry

In 2007 there were 8,329 credit unions with assets of $748.3 billion.55 At year end 2003 there were 82.4
million members of credit unions and the industry has a strong trade association and lobby group. From
1988 to 2007 credit union assets grew at 236%. Even though the industry is growing in asset size and they
have a large membership, credit unions are very small compared to banks and other thrifts. The average
size credit union is $89.8million as compared to the $1,416.5 million for banks. The largest credit union is
the Navy Credit Union at $28 billion in assets.
Credit unions were not badly affected by the interest rate volatility of the 1980s because they did not have a
large maturity imbalance, at that time they did not hold many mortgage loans.
Structure of the Industry

• Credit Union National Association (CUNA) – CUNA is a lobby group and trade
association that provides advice and has helped organize some other groups designed
to benefit credit unions. For example, CUNA helps CUs sell mortgages they have
originated, provides mutual fund investments, provides data processing services and
marketing expertise.
• Corporate Central Credit Unions (CCCU) - There are 34 CCCUs organized on a regional basis
cooperatively owned by their member credit unions. CCCUs pool individual credit union’s funds and
invest them in securities markets. This allows small member CUs to enjoy economies of scale in
investing and reduces the level of expertise required at individual CUs. CCCUs also make seasonal
and other short term loans to individual credit unions that may need cash due to layoffs, strikes,
Christmas, etc. The CCCUs provide check clearing services, data processing, accounting and payment
services and informational seminars to aid CU managers.
• The U.S. Central Credit Union: This is a bank in Kansas. It acts as a bank to the corporate central
credit unions. It coordinates credit card services, provides international and large scale investments
and taps international sources of funds which are funneled to the CCCUs and eventually to local credit
unions.
In recent years the most rapidly growing form of credit union has been community
based credit unions. The common bond usually must be a common employer, common
association or common locality. Prior to the 1980s the common bond was interpreted
narrowly and location based credit unions were the least common. Now credit unions
55
It is interesting to note that the credit union industry’s total assets are less than the total assets of even
one of the largest banks.
14-4
can have multiple common bonds, once one is a member of a credit union they can be a
member for life, and some location based credit unions have become large enough to
compete with banks. Because credit unions are not taxed and don’t have a profit goal,
they can offer better loan and/or deposit rates to members than banks can offer. The
banking industry has recently filed lawsuits claiming that credit unions were unfairly
competing with banks. The banks argue that the credit unions’ tax exemption is
equivalent to a $1 billion subsidy per year. CUNA claims that even if that is so, the value
to each credit union member is between $200 and $500 per year. With 90+ million
members, this amounts to $14 billion to $35 billion per year, a good return for the
subsidy. The courts sided with the banks in several lawsuits and attempted to limit access
to credit unions, but Congress effectively removed the restriction imposed by the courts.
This issue will probably be revisited in the future as the credit union industry continues to
grow and credit unions expand their product offerings. Certain employer based credit
unions now offer business loans to employer groups, adding another product line
traditionally held by the banks. The growing level of competition aside however, credit
unions remain a cottage industry compared to banks.
b. Balance Sheet and Recent Trends
Credit union’s major assets include:
Cash 5.7%
Near cash investments 3.5%
Investment securities 14.6%
Consumer loans 31.8%
Home mortgages 40.2%
The investment portfolio is generally of lower default risk and much more liquid than the investment
portfolio of a bank or SI. The loan portfolio is predominantly short term, although credit unions now hold
substantial mortgage loans that could hurt profitability if interest rates rise precipitously. Note that the bulk
of the loans are to members. If an employer or a region has protracted difficulties, the solvency of the
credit union could be imperiled. One of the functions of the cooperative structure is to assist troubled credit
unions in such situations.
Major credit union liabilities include:

Member deposits 86.3%
NOW accounts 9.4%
Small Time & Savings 67.4%
Large Time 9.5%
Other liabilities 4.3%

Reserves and Undivided Earnings 9.4%
Credit unions rely on member deposits for 86.3% of funds, a higher percent than either banks or SIs.
Reserves and undivided earnings are equity. Credit unions have a slightly lower amount of equity than
banks and other thrifts.
Deposits at a credit union are called shares since depositors are the shareholders (owners). Regular shares
are passbook savings, share drafts are NOW accounts and share certificates are CDs. The majority of
small credit unions do not offer share drafts.
c. Regulators
• National Credit Union Administration (NCUA) Board - This is the primary regulatory body of
national credit unions. The NCUA charters, insures, regulates and examines federally chartered and/or
federally insured credit unions. The NCUA is also charged with promoting the growth and welfare of
the industry. The NCUA sets maximum loan rates for CUs and in 1982, the NCUA eliminated all
14-5
deposit rate ceilings and weakened the common bond requirement. The NCUA instituted more formal
risk assessment ratings for CUs in 1987.
• National Credit Union Share Insurance Fund (NCUSIF) - Created in 1970, the NCUSIF insures
member credit union deposits up to $100,000 per account.
Although this is no longer likely to be a problem since 98% of credit union deposits have NCUSIF
insurance, you may wish to warn students never to put their money in an institution that does not have
federal insurance. Since depositors are shareholders they could lose their deposits in the event of failure of
an uninsured institution.
d. Industry performance
ROA at credit unions can (theoretically) be higher than at banks or other thrifts due to the tax advantage
credit unions enjoy. Smaller credit unions have disadvantages due to lack of economies of scale, less
highly trained management, non-business professionals on the board of directors and a lack of loan demand
and thus their profitability (2007 ROA of 0.71%) can be correspondingly low. Larger credit unions tend to
have higher profit ratios (2007 ROA of 1.02%, higher than for banks). Assets of the largest credit unions
have been growing at over 20% per year.
Although efficient utilization of assets is important, profitability should not be the primary goal of a credit
union. When a credit union allows this to become the primary goal, they are abusing their special tax
status. As credit unions seek to grow, a profit goal can defacto emerge as the top priority. In the author’s
experience, some credit unions are banks hiding under a different name. Not all credit unions treat
customers any better than banks (which can be quite bad), and not all offer better loan or deposit rates.
6. Finance Companies
Finance companies provide specialized lending services to various market subsets as described below.
Their primary sources of funding are short and long term debt.
a. Size, Structure and Composition of the Industry

Finance companies were originally created to make unsecured installment loans to consumers. Recall that
historically banks made few unsecured loans to individuals. Because finance companies are not tightly
regulated, they can offer loans to customers that bank regulators might not consider prudent risks. Some
finance companies can even create the financing needed right in the store where the item is purchased in a
matter of minutes because of their affiliation to manufacturers. Of course loan rates reflect the perceived
riskiness of the customer and finance company loan rates are often above comparable rates offered by
banks. Nevertheless, over the last 32 years industry assets have grown at an annualized rate of 10.78% per
year and many finance companies now have highly diversified loan portfolios.56 For instance General
Motors Acceptance Corporation (GMAC) and General Electric Capital Corp (GECC) (the largest with
$432 billion) were originally captive consumer finance lenders. Both now have very large diversified loan
portfolios that include commercial loans of all kinds. Total industry assets as of 2007 were over $2,159.7
billion.
The three major types of finance companies include:
• Sales finance institutions (Ford Motor Credit, GMAC and GECC) that specialize in making loans to
customers of a specific retailer or manufacturer. These are often wholly owned subsidiaries of the
manufacturer or retailer. They are captive finance companies. Their advantage over banks is speed of
granting credit.
• Personal credit institutions (HSBC Finance and Metris) that specialize in installment loans to
consumers including credit card operations and loans for manufactured and mobile homes. One of their
advantages over banks is their willingness and ability to lend to high risk borrowers with low
collateral.
• Business credit institutions (CIT Group, Heller Financial) that provide factoring and leasing services.
Factoring is purchasing a firm’s receivables at a discount. The finance company then has the
56
The industry had $81.6 billion in assets in 1975.
14-6
collections responsibility. Advantages of this group include industry knowledge and expertise with
collections.
Many large finance companies now engage in all three activities. The 20 largest firms account for about
75% of assets. The industry is concentrated at the top. The twenty largest finance companies control 75%
of industry assets. Many of the larger finance companies are now subsidiaries of financial service firms.
For example six of the ten largest finance companies are subsidiaries. Their size and lack of regulation
allow finance companies to be better diversified than many banks and to engage in riskier activities.
b. Balance Sheets and Recent Trends
i) Assets 2007
Major assets include:
Accounts receivables (business, real estate and consumer loans) 80.1%
Business loans 30.4%
Consumer loans 23.6%
Real Estate 26.1%
Loss Reserves and Reserves for Unearned Income (3.5%)
Other assets 23.4%
Note: Securitized business and consumer loans contain motor vehicle loans; securitized real estate contains
single family real estate loans.
Real estate loans are fairly new additions to the finance company’s loan portfolio, business lending and
leasing are currently the fastest growing areas.
• The largest single component of consumer loans is loans for motor vehicles. Some finance companies
have offered lower loan rates on new cars than banks. This reflects attempts by captive finance
companies to stimulate auto sales in the wake of the weak economy. Consumer loans offered by
finance companies typically require higher interest rates than similar bank loans because finance
companies attract subprime (high risk) borrowers. Some loan shark style companies charge
exorbitant interest rates on consumer loans, sometimes as high as 35% and these loans are often
accompanied by high fees.
Many poorer, less educated inner city residents never use banks or other mainline financial intermediaries.
They may cash their paychecks at pawn shops or at payday lenders or other check cashing stores that
charge high interest rates and/or fees. Instruct your students to always inquire about the APR on a loan.
Alternatives to finance company loans such as credit counseling and bill reduction services are available
throughout the country. Many churches can also provide credit counseling services free of charge, or they
may assist persons in paying for such services.
• Another type of subprime lender is the payday lender. Payday lenders provide short term loans
typically due when the borrower receives their next paycheck. Payday loans are now about $40 billion
per year and are generating revenues of about $6 billion per year, a 15% gross margin. There are an
estimated 25,000 payday lenders nationwide. A typical borrower pays about $15 per $100 borrowed
for a two week loan (many workers are paid twice a month). This is a 390% APR or a 3,686% EAR.
Borrowers are typically wage earners that make between $25,000 and $50,000 per year. The growing
demand for these loans in spite of the extremely high rates are probably indicative of both the need for
short term lending programs and a lack of consumer education. Payday lending is coming under
increasing state level scrutiny. As of 2007 thirteen states had banned payday loans. Others place
certain limits on the practice. South Carolina now limits payday loans to $600. Some states also limit
the periodic interest rate, but large APRs are still commonplace.
• Finance companies made few or no real estate loans prior to 1979, but many finance companies are
now willing to grant mortgage loans (26.1% of loans), even to individuals with prior bankruptcies.
Home equity loans are an increasing portion of their business. The average balance of home equity
14-7
loans has risen from $26,627 in 1999 to an astounding $85,472 in 2007. Finance companies are also
originating and selling mortgages, keeping the mortgage servicing contract to generate fee income.
Mortgage securitization facilities this practice. A weaker economy that brings higher default rates on
mortgages may make mortgage lending less attractive in the future.
• The largest single component of finance company loans are business loans (30% of assets). Finance
companies make many wholesale motor vehicle loans, as well as the aforementioned consumer loans.
For instance, GMAC finances a car dealer’s inventory via a procedure called ‘floor planning.’ In
floor planning the retailer has possession of the collateral, but the lender has a specific lien against it.
The retailer pays interest on the amount of the loan but the loan is not due until the car is sold.
Equipment loans are another large category of business receivables. These include the rapidly growing
area of business leasing, particularly to small firms. In leasing the finance company retains title to the
asset. This reduces the costs and efforts involved in collections if the lessee fails to make the
scheduled payments. Many small companies do not have enough taxable income to fully utilize the
tax writeoffs associated with depreciation. The finance company can purchase the equipment, use the
tax writeoff and then lease the equipment to the business user.
• Other areas of lending include financing for dealers of recreational vehicles, manufactured and mobile
homes and other small business needs.
ii) Liabilities and Equity

Major liabilities and equity include: (2007)
Bank Loans 7.1%
Commercial Paper 7.1%
Debt Due to Parent 16.1%
Other Debt 38.3%
Other Liabilities 20.4%
Equity 11.0%
The primary source of funding for finance companies is medium to long term notes and bonds and
commercial paper. In the 1990s finance companies began to rely less on bank sources of funds, bank loans
are now about 7% of total financing (up from 4% in 2004) and are primarily used to meet seasonal funding
needs. Equity capital is at 11%, higher than for banks and SIs.
Without federally insured deposits finance companies must maintain higher margins of safety than banks.
A significant portion of financing is raised from commercial paper (7.1% of assets). Recall from Chapter
5 that commercial paper is unsecured promissory notes issued by borrowers. Finance companies are the
largest issuers of commercial paper. Many larger finance companies maintain sales staffs to market their
paper and are more or less continuously in the market. This implies that finance companies are defacto
using the commercial paper market as a long term source of funding, albeit at short term rates. This
strategy works well when the term structure is upward sloping and short term rates remain low. If rates
rise, the industry could face significantly higher funding costs that would quickly erode profit margins.
The safety of the finance company is very important for funding. Poorly rated issuers either cannot issue at
cost effective rates or must obtain a bank letter of credit backing the issue (adding to the cost). Long term
notes and bonds are another major source of funds for finance companies.
c. Industry Performance
The overall health and future prospects of finance companies are quite good. Finance companies have
several advantages over banks. For instance:
• Banks have extensive product regulations and finance companies (FCs) do not
• Banks have powerful federal regulators with oversight powers and FCs do not
• In many cases FCs have valuable information about products and industry because of their ties to
manufacturers
14-8
•FCs can take riskier customers than banks and if they are good at credit analysis can earn a higher
rate of return on these customers
• FCs have lower overhead than banks because they do not seek retail sources of funds that require
substantial investments in brick and mortar (i.e., branches).
Banks also have some advantages over finance companies. For instance,
• Many banks are larger and have more expertise in providing a wider range of financial services.
These two factors imply that banks can exploit economies of scale and scope and may have higher
profitability than finance companies (FCs).
• Banks obtain a major portion of their funds (deposits) at a subsidized cost because of federal
deposit insurance. This lowers their funds cost and allows them to carry less equity on the balance
sheet, potentially improving the shareholders return on equity.
• Consumer finance companies have the reputation for providing high risk loans and tend to attract
those types of customers. Subprime and consumer FCs are sensitive to the economy because their
customer’s finances are often compromised by economic downturns.
2006 and 2007 were not good years for finance companies involved in the mortgage markets and in
subprime lending in general. Loan defaults increased in 2005 through 2007 with weaker home prices and
higher interest rates. On mortgage loans, some homeowners had borrowed at interest only loans that had to
be refinanced and some had ARMs that had payments adjusting upward. With the weaker economy and
softer home prices payment problems began to emerge. At the end of 2006 14% of subprime mortgages
had payments that were 60 days past due, up from only 6% in 2005. Some estimated that 1 in 5 subprime
originations in 2006 would end in foreclosure. In 2007 originations fell 30% from their $600 billion dollar
2006 level. This reduced profits at many finance companies. As the text indicates, New Century Financial,
which was the second largest subprime originator had a share price drop at one point of 79%. Countrywide
Financial, the largest mortgage lender in the country, saw its share prices cut in half as it announced
subprime losses. Countrywide would have failed but for a $2 billion equity injection by Bank of America,
which eventually acquired the finance company. Countrywide and others, including New Century, are or
have been under investigation for fraud in mortgage origination. With about 2/3s of mortgages being
securitized, the problems in the subprime industry quickly spilled over into the broader mortgage and credit
markets.
Although the overall finance company industry is strong, several industry sectors are at risk from economic
changes. Over the last few years several major subprime lenders have either gone bankrupt or were near
bankruptcy. If economic growth remains slows and interest rates increase, resulting in large numbers of
consumers having difficulty paying off their high rate loans, these types of finance companies could face
severe solvency problems.57
Allegations that many subprime lenders have used misleading and so called ‘predatory’ lending practices
to effectively charge usurious rates have also hurt this industry. Citigroup recently agreed to pay $200
million to settle charges that its acquisition, Associates First Capital Corp engaged in practices such as
encouraging customers to consolidate their debts into home loans with high interest rates (and fees), and
having customers unknowingly buy additional optional insurance on the loans (for more fees) as well as
abusive collections practices. First Plus Financial Group (now bankrupt) just settled similar charges on
second mortgages and home equity loans where they failed to reveal the true APR on such loans and
engaged in false marketing practices.
Firms focused primarily on retail E-lending continue to have difficulties. Apparently, very few people are
willing to apply for a loan on-line, and FCs have not sufficiently simplified the process. In addition, the
FC’s target market is probably not inclined or equipped to use on-line services.
d. Regulation
57
The largest danger now continues to be the home mortgage market. A long term or sharp decline in
housing values would impair household balance sheets considerably and constrain lending and spending
as people would be forced to focus on limiting or reducing their debts
14-9
There is relatively little direct regulation of finance companies although recently efforts have been made to
standardize rules concerning subprime lending practices. Higher loan loss reserves may be imposed on
subprime lenders to offset the higher risk of these loan types. Finance companies are subject to the major
lending laws such as the Fair Credit Trade Act and the Truth in Lending requirements,
antidiscrimination legislation and state usury laws where they exist. Finance companies are subject to
market discipline because their funding costs reflect the riskiness of the institutions. Thus, finance
companies have higher equity to asset ratios than many other regulated financial service providers and
many use letters of credit or other external guarantees to back their debts. The captive finance companies
also have implicit or explicit guarantees from their parent firm.
The American Financial Services Association is a trade organization of consumer and small business
lenders (primarily finance companies). Their website contains some useful personal financial information
that may interest students. The information includes what to do if they become overextended and what
bankruptcy actually entails.
According to the American Financial Services Association’ (see website at end), there were 1.6 million
personal bankruptcy filings in 2004. Consumer lenders have complained for years that certain individuals
were systematically abusing the bankruptcy laws, overborrowing intentionally and then declaring
bankruptcy. In April 2005, President Bush signed the Bankruptcy Abuse Prevention and Consumer
Protection Act. For details see www.senate.gov, Bill S.256. The law has many subparts, but the gist is a
strengthening of the creditor’s ability to recover from the debtor in the event of bankruptcy. The law makes
it more difficult to receive a Chapter 7 bankruptcy (complete relief of all debts). The law changes the
presumption of the need for relief to the presumption of abuse of the bankruptcy provisions for individuals
who have a monthly income above a given calculated amount. In certain situations the burden of proof is
on the debtor to show that abuse has not occurred. The courts now have more discretion to convert the
Chapter 7 filing to a Chapter 11 (reorganizing the debts without complete relief) or Chapter 13
(adjustments of debts of an individual with regular income). The law also requires education for consumers
filing bankruptcy. A second part of the law amends the Truth in Lending Act to include increased
consumer protections from predatory lending practices, greater disclosure on minimum payments,
introductory rates and APRs, late payments and fees, and rules on Internet solicitations. Interestingly, the
law calls for a study of the effect of offering credit to dependent college students.
7. Global Issues
Savings institutions in other countries are usually more focused on channeling small savers’ funds into
commercial projects rather than real estate. Most in Europe remain mutually owned and may have public
service as a goal (sometimes thrust upon them) rather than profitability. Finance companies (FCs) abroad
are generally subsidiaries of banks. These FCs usually obtain a large proportion of their financing from the
parent bank, and FC performance is strongly related to the performance of the parent bank. In 1999 GECC
acquired the healthy assets of Long Term Credit Bank of Japan, an action that would have been unthinkable
just a few years before. The very large U.S. finance companies are making inroads in international
operations. Several finance companies often issue commercial paper in overseas markets.
Nonbank financial institutions are growing in importance overseas. From 1994 to 2007 the percent of
aggregate credit issued by nonblank FIs increased from 22% to 33% in Latin America and from 4% to 16%
in central Europe. Many foreign countries use their postal system as a savings institution. There are about
30 postal savings systems around the world with most of them in Europe. Japan has a very active postal
savings system. A postal savings system has a ready made target audience, particularly for small savers.
The text includes several examples including La Poste, one of the larges credit institutions in France, it has
over 18,000 branches and over 26 million clients! Services offered go beyond basic savings instruments
and include investments in stock markets. The China Postal Savings Bank has a network of 7,780 ATMs
and is the fifth largest FI in China with over 36,000 branches.
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Chapter 19 - Types of Risks Incurred By Financial Institutions
Chapter Nineteen
Types of Risks Incurred By Financial Institutions
In Part V the text provides a more detailed examination of risk management at financial institutions.
Chapter 19 provides an introduction to Chapters 20-24 by discussing why risk management is crucial to
today’s institutions and by categorizing the major risks faced by financial intermediaries. The subsequent
chapters highlight a specific component of risk, or a specific tool to manage risk and provide current
applications. The chapters in Part V ask the reader to apply their knowledge of both markets and
derivatives to risk management problems at intermediaries. Many texts include applications of risk
management with the chapter on derivatives, or with the chapter about the specific intermediary’s line of
business. The text authors have separated the introductory chapters from the risk management chapters so
that the instructor can cover some, all or none of the applications chapters. Chapters 20 through 24 are
more difficult than the prior chapters because of the applications covered, although they are still suitable for
an introductory level course. To help ensure readability, many of the mathematical applications are
relegated to appendices. Chapter 20 covers the management of credit risk that arises from balance sheet
activity. Chapter 21 illustrates the management of liquidity risk. Chapter 22 develops tools to manage
interest rate risk and institutional insolvency risk with the repricing and duration gaps. Chapter 23 presents
the use of derivatives to manage risk and Chapter 24 covers loan sales and securitization.
I. Notes
1. Why Financial Institutions Need to Manage Risk: Chapter Overview
The goal of a FI is the same as any for profit corporation, namely to maximize shareholder wealth. The
major difference between a financial institution and a nonfinancial corporation is in the nature of their
assets and liabilities and the degree of regulation. A majority of financial firms’ assets are pieces of paper.
They are not readily differentiable from assets of competitors; this leads to very low ROAs as discussed in
Chapter 13. In order to offer shareholders a competitive rate of return, FIs must therefore incur substantial
risk. This risk takes the form of using a high amount of leverage, investing in assets riskier than the
liability positions funding them and maintaining minimal liquidity positions. Consequently, small errors in
judgement can have serious negative consequences for the solvency of FIs. Because many institutions
depend upon the public’s perception of their soundness to attract business, events that erode the public’s
confidence in one or several large domestic or foreign FIs can quickly spread and lead to major profit and
solvency problems in many FIs.58 The following sections outline the major risks faced by FIs today.
2. Credit Risk
Credit risk is the possibility that a borrower will not repay principle and interest as promised in a timely
fashion. To limit this risk, FIs engage in credit investigations of potential funds borrowers, or in the case of
investments they may rely on externally generated credit ratings. FIs lend to many different borrowers to
diversify away firm specific (borrower specific) credit risk. Systematic credit risk will remain (credit
risk due to ‘systemic’ or economy wide risks such as inflation and recession) even in a well diversified
portfolio. Many of the S&L problems of the 1980s can be attributed to an underdiversified loan portfolio
overexposed to certain types of lending in certain regions. Chapters 20 and 24 provide methods of
assessing and managing credit risk.
Banks, thrifts, mutual funds and life insurers usually face more credit risk than certain other intermediaries
such as MMMFs and P&C insurers because the former tend to have longer maturity loans and investments.
58
The fear of contagion effects has encouraged regulators to bail out many insolvent or near
insolvent financial institutions around the world including the March 2008 bailout of Bear Stearns
engineered by the Federal Reserve. Bear Stearns was not too big to fail, but it was too intertwined to fail
and had it gone under Lehman and others might have been next.
19-1
What may appear to be relatively small loss rates can quickly bring about the threat of insolvency at
depository institutions (DIs). For instance, unexpected loss rates of 5% to 6% of the total loan portfolio can
easily cause a bank to fail. Most charge off rates on specific types of loans are much lower than this
amount at well managed banks, although credit card loss rates are significantly higher than most other types
of domestic loans. Foreign lending, particularly sovereign lending, has traditionally been the most risky
throughout all of the history of banking (you would think they would learn eventually) and has led to the
loss of many fortunes and caused many failures.
Only the unexpected portion of loan losses generates solvency risk per se because banks set aside an
allowance for loan loss account against to cover expected loan losses.
Net charge offs (NCOs) vary by loan type. Text Figure 19-1 illustrates that credit card NCOs are quite high
(depending on the year between 4% and 7%) followed by charge offs of C&I loans (0.5%-1.5%) and finally
charge offs on real estate loans (close to zero, at least before the subprime crisis.) Although no one yet
knows the extent of the mortgage market problems, early estimates of $400 billion in subprime related
losses are being quoted.
The Bankruptcy Reform Act was passed in October 2005. The Act made it more difficult for higher
income individuals to seek bankruptcy protection. As the text indicates there was a large spate of filings
before the act went into effect followed by a large drop off in filings afterwards.
3. Liquidity Risk
Liquidity risk arises because there is a mismatch in the terms and maturity of a FI’s assets and liabilities.
In many cases liabilities either have an uncertain maturity (they are due upon demand for instance), or they
have a shorter maturity than the assets. Many FI’s assets are also less liquid than the FI’s liabilities. Even
if the existing assets and liabilities were perfectly maturity matched, loan commitments and the
undesirability of turning away potential loan customers would lead to liquidity risk as borrowers increased
their take downs or new loan customers arrived unexpectedly at the FI. FIs maintain precautionary liquid
assets to meet unexpected liquidity needs and may purchase liquidity via brokered deposits, fed funds
borrowed, reverse repos or via other short term financing sources. Chapter 21 covers liquidity risk and
liquidity management at FIs. The Fed lowered interest rates, including the discount rate, during the
subprime crisis to encourage lending during the liquidity problems in the short term markets engendered by
the subprime crisis. The Fed even opened up discount window borrowing to non-bank institutions that are
not extensively regulated such as securities brokers.
4. Interest Rate Risk

Interest rate risk arises from intermediaries’ function as an asset transformer. Recall that many
intermediaries invest in direct claims issued by borrowers (assets) while providing separate claims to
individual savers (liabilities). This process is a form of maturity intermediation. The maturity of a FI’s
assets will normally differ from the maturity of its liabilities. When this is the case changes in interest rates
can lead to changes in profitability and/or equity value. These changes caused by unexpected movements
in interest rates give rise to interest rate risk. Banks and thrifts engage in maturity intermediation to a
greater extent than other institutions such as life insurers. Consequently the former two types of FIs face
more interest rate risk.
In general, if an institution has longer maturity assets funded by shorter maturity liabilities, it is at risk from
rising interest rates. Suppose the FI has two year fixed rate assets funded by one year fixed rate liabilities.
The FI’s liabilities will reprice sooner than its assets. If interest rates rise, the cost of funding on the
liabilities will increase in one year, but the income from the assets will remain the same throughout the
second year, reducing the net interest margin. The institution has refinancing risk because the liabilities
must be rolled over or reborrowed before the assets mature. Refinancing risk is the risk that at rollover
dates the liability cost will rise above the asset earning rate.59
An institution in this situation will however benefit from declining interest rates.
59
Refinancing risk would also encompass increases in rates that reduced the NIM, even if it did not
become negative.
19-2
The converse also holds. Institutions with an asset maturity shorter than the liability maturity will benefit
from rising interest rates, but will be hurt by falling interest rates. If the assets mature more rapidly than
the liabilities then the institution faces reinvestment risk. Reinvestment risk is the risk that the returns on
funds to be reinvested will fall below the cost of those funds.
These ideas are easily illustrated as follows:

A FI has $100 million of fixed earning assets that mature in 2 years. The assets earn an average of 7%.
These are funded by 6 month CD liabilities paying 4%. So in this case the asset maturity is longer than the
liability maturity. The bank’s Net Interest Margin (NIM) = [(7% – 4%)*$100 million] / $100 million =
3%. If in 6 months interest rates increase 100 basis points, the 2 year assets will still be earning 7%, but the
new 6 month CDs will have to pay 5%, reducing the NIM by one-third to 2%. This illustrates refinancing
risk.
Although changes in profitability affect equity value, the effect of a change in interest rates can be more
directly measured by examining how the present value of the existing assets and liabilities will change as
interest rates change.60 The conclusions are similar to above. A FI with longer term (duration) assets
funded by shorter term (duration) liabilities will suffer a decline in the market value of equity if interest
rates rise. This occurs because the market value of the assets will decline more sharply than the market
value of the liabilities.
5. Market Risk
Market risk arises when FIs take unhedged positions in securities, currencies and derivatives. Income
from trading activities has increased in importance during recent years. In general, the volatility of asset
prices and currency values causes market risk.
The failure of Barings bank is an extreme example of market risk (see the Off Balance Sheet section).
Bank assets and liabilities can be separated into ‘banking book’ and ‘trading book’ assets or liabilities
based on the account’s maturity and liquidity. Trading book accounts are on and off balance sheet accounts
that are held for a short time period and are generally speculative in nature. They are held in hopes of
generating price gains or as part of making a market in a given security or contract. Banking book accounts
are those held for longer time periods and generate interest income or provide long term funding. Text
Table 19–3 with examples of both is reproduced below:
Assets Liabilities
Loans Capital
Banking Book
Other illiquid assets Deposits
Bonds (long) Bonds (short)
Commodities (long) Commodities (short)
Trading Book
FX (long) FX (short)
Equities (long) Equities (short)
Off Balance Sheet Derivatives (long) Derivatives (short)
Value at Risk (VAR) is a relatively new method of assessing overall institutional risks.61 VAR attempts to
measure the maximum dollar amount a FI is likely to lose in a given short time period, usually a day, with
some probability.
The VAR is a probabilistic method that estimates the likely loss that could occur at a given confidence
interval (usually 95%). A simple VAR model would attempt to identify and estimate likely values for the
major portfolio risk factors, such as stock price changes, currency changes, interest rate changes, etc.
Based on either the factor’s historical variability or the use of Monte Carlo simulation the VAR model
attempts to estimate the likely changes of each variable over the time interval, incorporating the
correlations between the variables so that the FI can more realistically estimate the maximum loss likely to
occur with 95% confidence. An excellent VAR website can be found at www.contingencyanalysis.com.
60
The text labels this risk “present value uncertainty.” It arises from a difference in the duration of
the FI’s assets and liabilities.
61
The text also uses the term Daily Earnings At Risk or DEAR.
19-3
VAR was originated by J.P. Morgan and information about VAR may also be found at their website under
the title Risk Metrics.
6. Off Balance Sheet Risk

The last twenty years have brought about tremendous growth in off balance sheet activities ranging from
loan commitments to swaps to OTC derivatives. On balance sheet activities are current primary claims
(assets) or current secondary claims (liabilities). Off balance sheet activities are contingent claims that
can affect the balance sheet in the future. A letter of credit is used as an example in the text. A letter of
credit issued by a FI is a contingent promise to pay off a debt if the primary claimant fails to pay.
Profitability is the incentive driving the off balance sheet business. FIs are generating fee income to reduce
the dependence on interest rate spreads and because of the increased competitive pressures on their
traditional lines of business. Off balance sheet assets and liabilities have grown so much that ignoring them
may generate a significantly misleading picture about the value of stockholder’s equity. Net worth is
properly measured as
NW = MVAssetsOn – MVLiabilitiesOn + MVAssetsOff – MVLiabilitiesOff
where MV stands for market value of the given category.
There are many off balance sheet activities including:

• Loan commitments
• Mortgage servicing contracts
• Positions in forwards, futures, swaps and other derivatives (mostly by the largest FIs)
Two aspects of certain types of derivatives lead to additional risks involved with their usage. First,
calculating derivative values and payouts is complicated. This is particularly true for many OTC
derivatives that banks sell. The selling banks typically understand the risks better than the clients. Second,
derivatives typically involve large amounts of leverage. These two attributes imply that misuse of
derivatives is likely to occur, and can result in extreme losses (or extreme gains, but rarely are the winners
upset about those). There have been many cases in recent years where derivatives usage has led to
problems:
1. In February 2008, Societe Generale, a large French bank, indicated that a rogue trader, Jerome
Kerviel had generated $7.2 billion in losses on futures trades. 62 This was the largest market risk
related loss ever. Kerviel used his knowledge of the “back office” order processing systems to hide
trades.
2. In 1995 Barings Bank failed when a so called ‘rogue trader,’ Nick Leeson, bankrupted Barings
after the bank allowed him to run up extremely large losses in futures and option trading on Tokyo
and Singapore derivatives exchanges. Interestingly, Barings did not complain when he
supposedly generated large gains for the bank and allowed Leeson to run back office order
processing as well as trading activity, a clear violation of sound internal control procedures.
3. In 1995, a trader at Sumitomo incurred losses of $2.6 billion from commodity futures trading.
Losses of this size just shouldn’t happen if the bank’s internal controls are functioning properly.
4. Bankers Trust sold several complicated OTC swaps to customers. In one of the swap deals the
customer (Gibson Greeting Cards) had to make variable rate payments based on Libor2. In the
second swap deal with Procter and Gamble, P&G would have to make high variable rate payments
if either short term or long rates rose, and extremely high variable rate payments if both rose,
which is what happened. Both customers sued Bankers Trust claiming they did not understand the
risks they were facing. The fallout helped lead to the Deutsche Bank takeover of BT.
5. Orange County investment advisor Bob Citron, a portfolio manager with very little formal finance
or investment training, purchased structured notes from Credit Suisse First Boston. The notes
were a type of inverse floater that would drop in value if rates increased, which of course they did.
Citron had used an extreme amount of leverage in an attempt to earn higher returns (which he did
for several years). When rates rose, losses mounted quickly and he could not repay the
borrowings and the municipality went bankrupt, losing $1.5 billion. Twenty banks were sued;
CSFB paid $52 million to settle charges.
62
Apparently a ‘rogue’ trader is one who gets into trouble.
19-4
To what extent do these problems imply we should limit derivatives usage? Are we comfortable with the
caveat emptor philosophy currently employed? Note that part of the Paulson reform plan calls for the
Federal Reserve to monitor the complexity of derivatives contracts in use.
7. Foreign Exchange Risk

Foreign exchange risk arises from current and contingent claims in foreign currencies. Net current and
contingent asset exposures are at risk from declining currency values and net liability exposures are at
risk from rising currency values (see Chapter 9).
An Example of an FI’s Exposure to Foreign Exposure Risk

An FI that makes a foreign currency loan (asset) is at risk from a declining foreign currency. For instance,
a U.S. FI lends ¥100 million when the ¥/$ exchange rate is ¥110. The interest rate is fixed at 9% and the
loan is for one year. Suppose that in a year the exchange rate is ¥120 to the dollar,
The original dollar amount lent by the bank is:
¥100,000,000 / ¥110 = $909,090.91
In one year the borrower repays
(¥100,000,000 × 1.09) = ¥109,000,000
In dollar terms this is now worth:
¥109,000,000 / ¥120 = $908,333.33
thus the bank earns a negative rate of return.
Analysis: The dollar depreciated by (¥120/¥110) – 1 = 9.09% and the bank only earned 9% in interest.
The risk of a declining yen could be offset in various ways. The FI could procure yen deposits or other yen
denominated liabilities or the FI could sell the yen forward. Suppose the FI procures a ¥100 million 6
month Euro yen liability to fund the loan. In this case the exchange rate risk is reduced because the change
in $ value of the loan asset should be at least partially offset by a similar change in the $ value of the Euro
yen liability. Some exchange rate risk remains because the 6 month rate may change differently than the 1
year rate. Moreover, the FI faces interest rate risk if we presume that the FI must roll over the CD
borrowings for six more months.
The potential severity of foreign exchange risk is illustrated in the 1997 Asian crisis. Many Asian countries
had short term dollar and yen denominated debts. The debts were serviced by local currency earnings, so
currency devaluations would impair the borrower’s ability to repay the loans. These countries had engaged
in currency stabilization policies that lulled investors to believing that due to the Asian ‘economic miracle’
currency risk was minimal. As growth slowed, currency speculators began betting that the currency values
would have to fall. Once the local currencies began to depreciate, beginning with the Thai baht, contagion
effects quickly spread to other currencies, such as the Indonesian rupiah and eventually the Russian ruble
and Brazilian real. The crisis then fueled itself as local firms could no longer repay their dollar
denominated debts, leading to further currency devaluations. In the ensuing fallout of loan, investment and
currency losses, the earnings of many worldwide FIs were hurt including Chase, which lost $160 million as
a result, J.P. Morgan and many Japanese and South Korean banks.
The foreign exchange markets are the largest markets in the world and banks are major participants. They
engage in currency arbitrage, taking positions in currencies to meet customer’s needs and outright currency
speculation. Participation in the currency markets can actually reduce risk of foreign currency loans and
brick and mortar assets. It is the unhedged positions that add to risk. Moreover, currency movements are
not perfectly correlated so maintaining positions in multiple countries may reduce overall risk given that
some foreign exposure is inevitable.
8. Country or Sovereign Risk

Holding assets in a given country creates sovereign risk. Sovereign risk is the risk that a host government
will either refuse to repay its own loans or intervene and prevent some principle from repaying its debts.
Sovereign risk also incorporates the threat of expropriation and repatriation restrictions on assets other than
loans. Argentina’s three defaults on its sovereign debt are a perfect example. Lenders to sovereign
governments usually have little recourse other than to await the outcome of often protracted negotiations
between the country and some international institution such as the IMF. Losses in the 1980s and 1990s due
19-5
to sovereign risk were quite large and would have been even larger except for huge amounts of emergency
funding provided by the IMF to countries experiencing a crisis. In 2001 Argentina defaulted on $130
billion of government issued debt and in September 2003 it defaulted on a $3 billion loan from the IMF. In
2005 Argentina unilaterally announced it would pay only $0.30 per dollar on loans and bonds outstanding
from its 2001 debt restructuring. Apparently happy to get anything, many of the bondholders accepted the
offer. Many other countries have had similar difficulties, for instance, Mexico had two major crises in the
last decades, Russia suddenly and with no explanation defaulted on its foreign loans in 1998. In the past
Indonesia has declared a moratorium on repayments of foreign debt, Malaysia instituted capital controls
after the Asian currency crisis, and Brazil has had difficulty repaying debts several times, etc.
Banks may attempt to assess sovereign risk by examining a country’s trade policy, debt to GDP ratio,
foreign debt to GDP, foreign currency reserves, government control of the economy, extent of property
rights, independence of the monetary authority, history of exchange rate movements, amount of foreign
capital inflows, inflation and structure of the financial system.
9. Technology And Operational Risk

Changing technology is affecting the entire FI industry. At the retail level many banks now offer telephone
deposit and lending services and similar online services. At the wholesale level electronic funds transfers
(EFT) through the Automated Clearing Houses (ACH) and wire transfer payment systems such as the
Clearing House Interbank Payments Systems (CHIPS) are standard methods of funds transfers. The
goals of technological improvements are to generate scale and scope economies and to generate additional
revenue sources. Technology risk arises from the possibility that new technology investments do not
result in profit improvements. Excess capacity and customer reluctance to use online services are two
examples of this type of risk. Online banking is currently facing these problems.
Smart Card tests in certain locations have largely been poorly received. Mondex, a consortium of
companies, developed a new generation of ‘smart card’ several years ago that allowed immediate debiting
of an account for purchases. The account was maintained on the card via a computer chip. The card could
be used at stores and amounts could be transferred from card to card by individuals. The chip could
supposedly even be imbedded under the skin of a user to reduce the possibility of theft. Test runs of smart
cards indicated that the public is not particularly fond of them. However, many people vowed they would
never use ATMs when they first came out. Some technology changes are only accepted after a generation
has passed.
Security seems to be the largest concern with online banking. We certainly already have the technology so
that one could be able to conduct all of their banking through their computer, or better yet, on their
television without ever having to stand in line or deal with ‘banker’s hours.’ Privacy and security concerns
are the major impediments to implementing this type technology. Nevertheless, this may be the last
generation that has the corner bank as the main provider of banking services. The cost savings from online
services will be too great to ignore.
Operational risk arises when technology (or technology users) and other systems fail to perform properly.
Major examples of operational risk include settlement risk, clearing risk, risks associated with custodial
services and outright computer breakdowns. In Wells Fargo’s merger with First Interstate (FI), FI’s
customer account numbers were not properly credited with incoming deposits. Wells Fargo incurred a
$180 million operating loss as a result. In 2002 Citibank’s ATMs went down for several days along with
its online banking. In September 2004 about one third of Wachovia Securities brokers’ assistants could not
access customer records or even log onto their computers. In February 2005, Bank of America announced
it had lost computer backup tapes containing personal information (including social security numbers) of
about 1.2 million federal government employees’ charge cards transactions.
Clearing is verifying the details of the many trades made each day. This activity is critical in ensuring
smooth flow of trading and risk management. Settlement occurs when money and or security title changes
hands. Because banks enter into many transactions with each other throughout the day it is much more cost
effective to calculate and pay only the net amount owed as a result of the day’s transactions. Computer
technology runs these systems and ensure that banks know the net amount to pay and to whom.
19-6
Technology can also be used to make the payments and transfer title to securities electronically. Clearing
and settlement risk, sometimes called ‘Herstatt risk,’ is the risk that these systems fail.
10. Insolvency Risk

Insolvency (bankruptcy) occurs when an institution’s assets are less than its liabilities. Insolvency risk
arises from each of the aforementioned risks. The major safeguards against insolvency are equity capital
and prudent management practices.
A DI’s insolvency usually occurs as a result of problems in the loan portfolio. The problems may show up
elsewhere, as in the case of Continental Illinois (liquidity risk), but the root of the problem is typically poor
lending policies. A good example is the failure of the Bank of New England whose aggressive growth and
weak lending policies resulted in one of the largest bailouts in U.S. history.
11. Other Risks And Interaction Among Risks

The risks described above are interdependent. For example, a bank with problems in its loan portfolio may
face higher funding costs and/or reduced funding availability due to the increased credit risk.63 Liquidity
risk can result in emergency discount window loans and even insolvency. This is roughly what happened
to Continental Illinois in 1984. Credit risk will often rise as interest rates rise, and credit problems can
certainly lead to liquidity problems if the FI was counting on the receipt of loan repayments in its liquidity
planning.
Events can also lead to multiple risk exposures. The most obvious forms of event risk for FIs are
regulatory changes that can affect multiple areas of performance. Terrorist attacks could fit in this category
as well. FI losses due to the September 11, 2001 attacks were quite large. Large stock market moves can
also result in increased credit, liquidity risk, interest rate risk and even foreign exchange risk.
63
Many wholesale sources of funds are well over the insurance limit so these lenders to the bank
will either require a higher rate of return to offset the riskiness of the institution or refuse to provide funds
entirely.
19-7
Chapter 20 - Managing Credit Risk on the Balance Sheet
Chapter Twenty
Managing Credit Risk on the Balance Sheet
This chapter discusses methods of credit analysis and rate of return calculations on loans. Loans are the
main line of business at depository institutions and finance companies. Credit problems in the loan
portfolio are the primary cause of failure at lending institutions so the analysis of credit risk is of primary
importance to many FIs. An understanding of credit risk and credit analysis is useful regardless of whether
one works in the credit department of a lender, or if one is involved in presenting loan applications on
behalf of a corporate borrower, or even for someone who just wishes to increase their chances of success
when seeking a personal loan. Methods of credit evaluation differ for various types of loans and by the size
of the borrower. The primary concerns of credit analysis for four of the major types of loans are presented.
Calculating the rate of return on the assets invested for a loan with fees and compensating balances is
presented as well as the newer risk adjusted return on capital model. The appendix presents an application
of modern portfolio theory to determine the best diversified loan portfolio.
I. Notes
1. Credit Risk Management: Chapter Overview
FIs in the purest form of their function are asset transformers (see Chapter 1). They provide savers with
low risk, liquid claims that savers desire and channel funds to borrowers by granting higher risk, less liquid
loans to funds demanders. To put it succinctly, FIs take peoples money and invest it in risky claims. As
such, the ability to assess, monitor and appropriately price the riskiness of loans is of paramount
importance to many FIs. Loan defaults must be written off against equity; thus, high levels of defaults can
quickly impair an institution’s capital.
: From a macroeconomic perspective a sound private banking system is necessary to appropriately price
risk and allocate capital to its best uses. It is rare for countries to generate substantial sustained economic
growth without private internal capital allocation methods. These methods usually center around the
banking industry. Sound banking systems are also often precursors to strong internal capital markets.
Japan’s protracted economic difficulties have been significantly worsened by the problems and lack of
competitiveness of the Japanese banking system.
U.S. FIs had significant credit problems in the 1980s and into 1990. In the early 1980s problems in
residential and farm mortgages, particularly in certain regions of the economy, led to the failures of many
banks and S&Ls. S&Ls had difficulties with junk bond holdings in the latter part of the 1980s. Problems
in commercial real estate and LDC loans developed and hurt the profitability of both the banking and thrift
industries. In the 1990s there were worries about high credit card debt levels, major defaults in Russia and
moratoriums on debt repayments in Indonesia and Malaysia. The end of the 1990s saw improvements in
the credit quality of most bank loan portfolios however and the level of nonperforming loans (loans 90
days or more past due or not accruing interest) and loss reserves declined. The recession in the early part
of this century reversed these trends, but as the economy improved in the mid 2000s loss rates again fell,
particularly on C&I loans as corporations improved their balance sheet positions dramatically and began to
hold large cash balances. Personal bankruptcy filings have continued to grow, but recent changes in
bankruptcy laws may slow this trend. Overseas, in 2001 Argentina defaulted on $130 billion of
government issued debt and in September 2003 defaulted on a $3 billion loan from the IMF. In 2005
Argentina unilaterally announced it would pay only $0.30 per dollar on loans and bonds outstanding from
its 2001 debt restructuring.
Mortgage delinquency rates increased dramatically beginning in the last quarter of 2006 and remained high
through 2007. Foreclosure filings increased 93% in July 2007 from the same month in the prior year.
Losses from subprime mortgages are expected to reach $400 billion worldwide. Large U.S. institutions
20-1
have written off $130 billion in loans related to the subprime markets. Insured institutions set aside a
record $31.3 billion in provision for loan losses in the fourth quarter of 2007 and one quarter of all
institutions larger than $10 billion reported a net loss for the quarter. Institutions associated with subprime
lending and those with significant trading activity had the largest earnings declines. Net charge offs
(NCOs) rose to 5 year highs in the fourth quarter as well reaching $16.2 billion, up from $8.5 billion in the
fourth quarter of 2006. NCOs on residential mortgages increase 144.2% and NCOs on home equity lines
increased 378.4% while charge offs on credit card loans were up 33% and charge offs on loans to
individuals increased 58.4%.64 This made the annual ROA at 0.86% the lowest since 1991. In the first
quarter of 2008 new loan volume in the riskier parts of the lending market fell dramatically with some parts
of the market dropping upwards of 80%-90%. These areas included collateralized loan obligations, loans
funding LBOs and high yield bonds. Banks were also beginning to restrict higher quality lending. For
instance, as banks focused on capital restoration credit lines less than one year became increasingly popular
as they carry lower capital requirements.65
2. Credit Analysis
: Credit analysis is geared towards one decision, “Does the FI grant the loan?” The purpose of credit
analysis is to generate profitable loans that do not expose the lender to excessive amounts of risk. The
reason for the accept or reject decision should be clearly documented and the decision should be in
accordance with the bank’s stated loan policy. Criteria used must not be discriminatory; thus, the
determinants of the decision cannot be race, gender, location, ethnicity or religious persuasion. If the loan
officer is to err, the errors should be conservative. In the long run it will cost the lender much more to
handle a failed loan than to incorrectly turn down a loan that would not have failed. This is true because
lending has asymmetric outcomes. Distributions of returns on loans exhibit negative skewness. Lowering
credit quality tends to increase the negative skewness, although if the risk is priced this may also increase
the average rate of return on the loan portfolio. Regulators impose quality standards on lenders to help
ensure they do not take on too much risk in attempting to increase the average return on the loan portfolio.
: The bank’s loan policy includes the desired portfolio of loans by category and includes minimum credit
standards such as collateral requirements and minimum ratios. Other provisions include lending limits for
certain loan officer positions, standards for grading loans, requirements for monitoring existing loans,
policies on inside loans and the documentation required to evaluate a loan application. Many banks now
use standard application forms for each type of loan. The loan officer will be trained in the specific form
the bank uses.
Summary of Text Table 20-1: Nonperforming Loans to Total Loans All Banks
Date C&I Real Estate Consumer
2002 2.92 0.89 1.51
2003 2.10 0.86 1.52
2004 1.17 0.65 1.46
2005 0.75 0.70 1.20
2006 0.64 0.81 1.24
2007 0.64 1.62 1.48
Note the large increase in nonperforming rates on Real Estate and Consumer loans in 2007. Banks with
assets greater than $10 billion had uniformly higher rates of nonperforming loans. Because all banks
normally have about 60% of assets in loans and only about 10% in equity even small amounts of loan
losses can quickly deplete equity.
a. Real Estate Lending

Residential mortgage applications are usually very standardized because of the active secondary market for
these claims. The two major factors in making the accept or reject decision for the mortgage loan are 1) the
applicant’s ability and willingness to repay the loan and 2) the value of the borrower’s collateral. In
64
Source: FDIC Quarterly Banking Profile
65
“1Q08 U.S. Loan Market Review: Been Down So Long It Looks Like Up To Me,” Press Release
of the Loan Pricing Corporation, March 28, 2008, www.loanpricing.com.
20-2
assessing the first requirement standard ratios and/or credit scoring models may be used. The character of
the borrower is also very important. Character is assessed by examining the stability of the borrower as
indicated by family status, time in residence, time in job, savings history, payment history and any personal
knowledge the lender may have of the borrower. Assessing character is essentially assessing two factors:
1. Whether the potential borrower is mature enough to manage credit, and
2. Whether the borrower will consider the debt as a moral obligation that he or she will work hard to repay
even if difficulties arise.
The second aspect of the first requirement is the borrower’s ability to repay the loan. To assess sufficiency
of income the lender may calculate the following ratios:
Gross Debt Service

GDS = (Annual mortgage payments + Property taxes) / Annual gross income
The maximum for loan approval is usually 25% to 30%.
Total Debt Service

TDS = Annual total debt payments / Annual gross income
The maximum for loan approval is usually 35% to 40%.
Example:
A mortgage loan applicant has the following data:
Annual
Monthly Mortgage Annual Property Homeowner’s Other Debt
Gross Income P&I Payment Taxes Insurance Payments / year
$175,000 $3,500 $4,500 $950 $29,000
GDS Ratio = (Annual mortgage payments + Property taxes) / Annual gross income
= (($3,500*12) + $4,500) / $175,000 = 26.57%
Conclusion: Pass
TDS Ratio = Annual total debt payments / Annual gross income
= (($3,500*12) + $4,500 + $950 + $29,000) / $175,000 = 43.69%
Conclusion: Fail
Based on these ratios the applicant would not be granted a loan because the TDS ratio is too high.
A credit score may be calculated to provide a broader assessment of the various factors that underlie the
loan evaluation process. A credit score is a mathematical model that uses loan applicant characteristics to
assist the lender in deciding whether or not to grant the loan. Credit scoring models can be developed by
examining the characteristics of both good and bad loans the bank has previously made, and then
attempting to ascertain what characteristics can be used to discriminate between the good and bad loans.
Typical credit scoring attributes include
• annual income,
• a score based on TDS and or the GDS ratios,
• history with the lender,
• age,
• whether the borrower’s residence is owned or not,
• length of time in the current and prior residence and time in the current job,
• credit history, etc.
Based on scores of past good and bad loans, the lender can establish a minimum credit score below which a
loan will not be granted, an intermediate score where additional credit analysis is warranted and another
level beyond which a loan will automatically be granted. Credit scores provide objective, low cost, quick
evaluation methods that are particularly suitable for smaller loan amounts that can utilize standard
evaluation methods. The following has been reproduced the form from Example 20-2 in the text.
20-3
Sample Credit Score

Characteristic Values and Weights
$10,000- $25,000- $50,000- >$100,000
Gross Income <$10,000 $25,000 $50,000 $100,000
75
Score 0 15 35 50
<5%
TDS >50% 35%-50% 15%-35% 5%-15%
50
Score 0 10 20 35
Relation with FI None Checking Savings Both
Score 0 30 30 60
Major credit card None 1 or more
Score 0 20
Age <25 25-60 >60
Score 5 30 35
Residence Live w/ parent Rent Own/Finance Own Outright
Score 0 5 20 50
Length of residence < 1 year 1-5 years > 5 years
Score 0 20 45
Job stability < 1 year 1-5 years > 5 years
Score 0 25 50
Credit history No record Pmt missed in last 5 years Met all pmts
Score 0 -15 50
Automatic rejection level score: 120

Automatic acceptance level score: 190
Scores between 120 and 190 are reviewed by a loan officer or loan committee
An individual with the following characteristics and credit scores would be approved for the mortgage.
(Note that my characteristics and total score are different from the text example.)
Characteristic Value Score

Gross Income $95,000 50
TDS 39% 10
Relation with FI Checking 30
Major credit card 3 20
Age 45 30
Residence Own/Finance 20
Length of residence 3 years 20
Job stability 2 years 25
Credit history Met all payments 50
Total 255
Real Estate loan is automatically approved
20-4
: The decision to approve or reject many mortgage and small consumer loans is made very quickly. Please
don’t leave your students with the impression that this is a long drawn out process entailing meetings with a
loan committee, etc.
The Federal Reserve requires that credit scoring criteria not be discriminatory. Nevertheless age is used in
credit scores. This is presumably acceptable because older potential borrowers are normally assigned
higher credit scores in that category. Some credit scores assign a lower score for age brackets where the
borrower is likely to have college age children.
Verification of the applicant’s information is necessary and the loan application will grant the lender the
right to check relevant sources. Lying on a loan application will normally automatically result in a
rejection.
Lying on loan applications probably contributed to the subprime mortgage crisis. First, originators used so
called “low doc” and/or “no doc” loans where loan applicants did not have to provide verifying
documentation for the loan application and/or the information provided was not verified. Some lenders
allegedly even encouraged applicants to falsify certain information such as income or debts to ensure the
loan would be granted. In most cases the loans were sold and there was no recourse to the loan originators
as long as the first three mortgage payments were made on time. The loans became euphemistically known
as ‘liar’s loans.’
The other major aspect of real estate credit analysis is the assessment of the value of the pledged asset and
its suitability to serve as collateral. The lender must ensure that the house is free and clear of any liens and
all back taxes that could prevent seizure in the event of foreclosure or power of sale.66 This process is
termed perfecting the interest in the collateral. The lender must also ensure that the legal description is
correct, which will normally require a current survey. The value of the collateral will be assessed by an
appraiser.
: Some FIs use their own appraisers, but most hire independent appraisers. Some appraisals are written up
after only driving by the property, others involve more detailed inspections. The appraisal process relies
heavily on the sale price of nearby homes that are supposedly comparable properties. This is one reason
why one should not buy the most expensive house in the neighborhood.
b. Consumer and Small Business Lending

Consumer loans are typically scored similarly to real estate loans. There will be a greater emphasis on
examining whether the individual has the capacity (cash flow) to repay the loan and on the individual’s
character. The credit scoring models are likely to reflect these different weights.
Evaluation of small business loans is more difficult. Many young firms find themselves in financial
difficulty at some point in their history. Some FIs employ minimum time in business requirements to
grant a loan, or may include the time in business in a credit scoring model. Profitability on small business
loans is generally not large considering the extra time and effort needed to evaluate the loan. The ‘life
blood’ of most small businesses is cash flow, and the credit evaluation process is likely to emphasize cash
flow, the soundness of the business plan and the character of the borrower.
c. Mid-Market Commercial and Industrial Lending

Mid-market loans consist of loans to corporations with annual sales of $5 million to $100 million. Loan
maturity ranges from a few weeks to eight years or more and loan amounts range from very small amounts
such as $100,000 to $1 billion or more to major corporations. In mid-market lending on up, the evaluation
66
Foreclosure is seizing the collateral in the event of non-repayment of the loan in exchange for
discharging the debt. The power of sale is the process of seizing collateral and selling it to pay off the loan
when the borrower fails to repay the loan. In this case any excess sale value beyond the loan amount &
costs would be returned to the mortgagor and if the sale value is not sufficient to discharge the debt the
lender would then become an unsecured creditor for the difference.
20-5
process will normally be more detailed and require the lender to both objectively and subjectively evaluate
the loan application. Steps in the process may include:
♦ Meeting the applicant’s customers and suppliers, particularly if there is one or only a few major buyers or
suppliers of the product or service.
♦ Procuring a credit history such as a Dun and Bradstreet report, etc.
♦ Application of the Five C’s of Credit:
• Character (see above)
• Capacity (cash flow to service the loan)
• Collateral: There may be a specified maximum loan to value ratio in the loan policy.
• Conditions: Assessing the impact of changing economic conditions on the borrower’s ability to repay the
loan.
• Capital: Assessing the adequacy of the borrower’s capital to prevent insolvency.
♦ The Five C’s may be assessed by asking the following questions about the given categories:
• Production of marketable output (capacity and conditions):
Are there stable supplies and costs of inputs? For example, for lumber mills dependent on logging of
federal lands, stability of supply has been lacking in recent years. If applicable what are union wage
demands and the probability of costly strikes. What is the firm’s competitive advantage? Is it a
differentiated product with high markup? These firms’ sales can be sensitive to the economy and
technological and taste changes. Firms producing near commodities rely on different advantages.
These may include supply procurement and distribution advantages or customer service, and/or
economies of scale to maintain profitability.
• Management (character and conditions):
Is management trustworthy? Have they been excessively ‘cooking the books?’ Has management
cooperated with the loan officer’s investigation? What is the employee morale and turnover rate?
How credible is the business plan? (Does the firm plan at all!) Is the firm likely to require additional
financing over the loan period? Are they aware of this? Has the firm planned for financing of
additional working capital if needed? To what extent does the business rely on one or only a few key
people who could not be easily replaced?
• Marketing (conditions):
Is the firm in a growing industry or is stealing market share from competitors the only way to generate
sales growth? Has the firm allocated sufficient resources to marketing the firm’s product? Excessive
resources? Is the firm at risk from losing distribution channels to competitors? Is the firm dependent
on sales to one or only a few countries?
• Capital (capital and collateral):
Does the firm have sufficient equity? Do the firm’s managers have significant equity holdings to
ensure they are concerned with firm performance? What is the firm’s debt capacity? How specific are
the assets to the given borrower? Are they useful only to firms in the same industry?
The statement of cash flows is a primary tool in assessing the capacity of a borrower. The cash flow
statement breaks down sources and uses of cash into cash flow from operations, from investment activity
and from financing sources. The lender will wish to assess that cash flow from operations is sufficient to
service the potential loan. A wise lender will ask for a schedule of actual cash disbursements and
receipts. The statement of cash flows does not provide this information. Cash flow from operations are
cash inflows and outflows that result from producing and selling the firm’s product or service including net
income, depreciation and operations related working capital accounts such as changes in inventories,
payables and receivables. Cash flow from investing is cash from purchase and sale of fixed assets as well
as cash from financial investing activities. Cash flows from financing are cash flows that are related to
changes in the financial accounts such as short and long term debt and equity.
The following balance sheet and income statement for a hypothetical loan applicant can be used to illustrate
a simple statement of cash flows and ratio calculations.
20-6
Change Assets 2006 2007 Liabilities & Equity 2006 2007 Change
($60) Cash $170 $110 Accounts payable $135 $120 ($15)
$200 Accounts rec. 500 700 Notes payable 1,200 1,400 $200
Total current
($240) Inventory 1,240 1,000 liabilities 1,335 1520
Total current 1,910 1810 Long-term debt 2,005 2,620 615

$1,500 Fixed assets 2,000 3,500 Common stock 100 200 100
Retained earnings 470 970 500
Total assets $3,910 $5,310 Total liab. & equity $3,910 $5,310
Income Statement 2007

Sales $8,800.00
Costs ($5,600.00)
Depreciation ($900.00)
EBIT $2,300.00
Interest Expense ($350.00)
EBT $1,950.00
Taxes ($760.50)
Net Income $1,189.50
Dividends $689.50
Change RE $500.00
Summary Cash Flow Statement 2007

A: Cash Flow From Operations $ 2,464.50
B. Cash Flow From Investing ($ 2,400.00)
C. Cash Flow From Financing ($ 124.50)
D. Change in Cash ($ 60.00)
Notice that although the firm has positive earnings, cash decreased. Ordinarily the loan applicant should
have positive operating cash flows. Cash from investing may be positive or negative, depending on the
rate of return the firm is earning these investments may generate good growth. In the case above the lender
would wish to verify that the borrower will have sufficient return on investment the fixed asset increases to
ensure that the firm will have adequate cash balances to repay the loan. A trend of declining operating cash
flows financed by cash flow from financing would be a red flag as this is probably not sustainable in the
long run. This would imply the firm is borrowing more (possibly from you) to sustain dropping
profitability.
Various ratios may be analyzed: The numbers are calculated from the data above.
♦ Liquidity ratios
• Current ratio = Current Assets / Current Liabilities = 1.19
• Quick ratio (acid test) = (Cash + Cash equivalents + Receivables) / Current Liabilities = 0.53
These ratios measure the firm’s ability to pay its debts in the short run. If the firm sells big ticket items, or
has a large number of days sales in inventory, the quick ratio may be the better measure.
20-7
♦ Asset management ratios

• Days sales in receivables = (Receivables × 365) / Credit Sales = 29
• Days in inventory = (Inventory × 365) / Cost of Goods Sold = 65
• Sales to fixed assets = Sales / Fixed Assets = 4.40
• Asset turnover = Sales / Total Assets = 1.66
Asset management ratios assess management’s ability to manage a given area of assets such as inventory or
receivables. High ratios may suggest problems in credit management or inventory management or simply
low sales. The turnover ratios measure the number of dollars of revenue generated per dollar invested in
the given asset category. Recall that the asset turnover ratio is a major input into ROE.
♦ Debt (long term solvency) ratios

• Debt to asset or total debt ratio = Total Liabilities / Total Assets = 78%
• Times Interest Earned: EBIT / Interest Expense = 6.57
• Cash flow to debt ratio = (EBIT + Depreciation ) / Debt67 = 77.3%
EBIT is earnings before interest and taxes, EAT is earnings after taxes
These ratios measure the firm’s ability to pay off its debts in the long run. These need to be assessed in
light of the earnings variability of the firm and industry norms. The text includes variations of the fixed
charge coverage ratio. Fixed charges may include interest, lease and sinking fund payments. The
minimum acceptable fixed charge ratio will be higher with greater cash flow variability. At a minimum the
cash flow to debt ratio should also be greater than the interest rate on the debt.
♦ Profitability ratios
• Gross margin = Gross profit / Sales = 36%
• Operating profit margin = Operating profit / Sales = 26%
• Net profit margin = EAT / Sales = 13.5%
• Return on assets = EAT / Average total assets = 22%
• Return on equity = EAT / Total equity = 101.7%
• Dividend payout = Dividends / EAT = 57.9%
These ratios measure the firm’s ability to generate profitability (gross, operating or net) per dollar of
revenue or per dollar of assets or equity. The first three ratios measure management’s ability to control
given expense categories. The ROA and ROE ratios are guides to the firm’s rate of return on invested
dollars. In this case the profitability is very high, but so is the amount of reinvestment and even with the
high profitability the firm had to borrow more money to pay a dividend.
Note that market ratios are often unavailable for this size firm.
Other commonly used tools include common size and indexed statements in order to focus on
comparisons with competitors or over time.
Mid-market loans on up usually require approval from either a senior loan officer and his or her superior or
a loan review committee. These requirements will be in the loan policy.
Followup: The loan evaluation process does not end with loan approval. In particular, before the actual
draw down the lender will ensure that all ‘conditions precedent’ that may prevent the seizure of any
pledged collateral have been cleared. The lender must also monitor the conditions of the borrower and the
collateral and review the credit needs of the borrower. These reviews normally occur at least annually.
Some loans will also be spot checked randomly.
Limits to Ratio Analysis

Ratio analysis has many limitations. First, a ratio by itself tells very little, some benchmark of comparison
is needed. For many smaller loan applicant firms, benchmark data may not be available. On the other
hand, large firm loan applicants are often involved in multiple lines of business, and this can make ratio
67
Only by coincidence will the numerator of this ratio actually equal cash flow because it ignores
changes in balance sheet accruals.
20-8
comparisons difficult as well because there is no one industry to use as a benchmark. Differences in
accounting treatments can lead to substantial differences in ratios, even if the lender’s management is not
purposefully intending to mislead creditors as was the case at Enron, WorldCom, Adelphia and others.
Benchmark data may be found at Value Line Investment Surveys, Robert Morris Associates, Hoovers
Online and MSM Money Web. The FFIEC web site can also be used to generate peer data for comparison
purposes.
d. Large Commercial and Industrial Lending

We normally picture the banker as the tight fisted Scrooge type to whom we have to prove we don’t really
need the money before he or she is willing to lend to us! In reality the market for lending to large
corporations is quite competitive and the bargaining power of the bank lender is very limited.68 Large
corporations have other funding alternatives, including the U.S. and foreign money and capital markets and
other banks, both domestic and foreign. Even though banks cannot often charge large fees to these
borrowers, nor earn large spreads over costs on their loans, the loan amounts are large enough to make
lending profitable. In addition, lending activities may bring other business to the bank that generates
substantial fee income.69
:The growing overlap between commercial and investment banking creates a potential conflict of interest
in credit evaluation. A bank may pressure its own credit officials to grant more questionable loans in order
to generate (or keep) the investment banking business of that loan applicant.
Credit analysis of large commercial borrowers entails the same process as described above in the analysis
of mid-market borrowers, but there are some additional complicating factors:
♦ If the bank lends to a holding company whose assets are its investments in operating subsidiaries, the
bank’s claim is subordinated to the debtors of the operating subsidiaries.
♦ The corporate borrower is likely to be a large, diversified firm that operates in many locations, probably
even in different countries and in various industries. This greatly complicates the task of assessing the
creditworthiness of the borrower.
Banks also have some advantages in lending to large corporate borrowers:

♦ Ratings agencies such as Moody’s and Standard and Poor’s provide information about the credit risk of the
borrower.
♦ Market analysts such as Value Line, Hoovers and a plethora of Wall Street analysts provide current (albeit
biased) forecasts of future earnings and growth prospects.
♦ Sophisticated credit scoring models have been developed for these firms:
• Altman’s Z-Score
Z = 1.2X 1 + 1.4X 2 + 3.3X 3 + 0.6X 4 + 1.0X 5
X1 = Working capital / Total assets
X2 = Retained earnings / Total assets
X3 = EBIT / Total assets
X4 = Market value of equity / Book value of long term debt
X5 = Sales / Total assets
The higher the Z-score, the lower the probability of borrower default. A borrower with a Z-score less than
1.81 is considered to have high default risk, a Z score of 2.99 or more indicates low default risk and a Z–
score between 1.81 and 2.99 indicates that the loan applicant’s default risk is indeterminate (i.e. the
applicant cannot be classified as either high or low risk).
Altman Z example using the balance sheet and income statement data:
68
If you are a fan of old TV shows, picture Milburn Drydesdale instead of Scrooge.
69
Banks may act as a broker and dealer of swaps and foreign exchange, may provide trust services,
finance their foreign trade activities, assist in raising capital overseas, underwrite public security offerings
and provide advice about restructurings and investments, etc.
20-9
Z = 1 . 2 X 1 + 1 . 4 X 2 + 3 . 3 X 3 + 0 . 6 X 4 + 1 .0 X 5
Coefficients Variables
X1 = Working capital / Total assets 1.2 5.46%
X2 = Retained earnings / Total assets 1.4 18.27%
X3 = EBIT / Total assets 3.3 43.31%
X4 = Market value of equity / Book value of long term debt 0.6 44.66%
X5 = Sales / Total assets 1 165.73%
Z-Score 3.6758485
The Z-score indicates the firm is not at risk of bankruptcy, assuming that the methodology is appropriate
for this size firm.
Appropriate uses of a credit score model:

Credit scores are an analytical tool that can determine some of the differences between borrowers that
previously defaulted versus borrowers who did not. They can provide the lender with valuable information
about whether a loan applicant closely resembles the profile of borrowers who have defaulted on prior
loans. This is especially useful in assessing the financial aspects of credit analysis, but it is weaker in
assessing character and management strength.
Credit scores can also assist in risk pricing and the establishment of loss reserves on accepted loans, and
in any case can help provide the lender with quantifiable documentation about why an application was
accepted or rejected. Use of a credit scoring model alone to make a large credit lending decision would be
inappropriate because this would ignore too many other relevant factors.
General limitations of credit scoring models include:

• A credit score model depicts caricatures of reality. In practice, there are many types of ‘default’
ranging from late payments to outright repudiation of debts.
• The weightings on the variables and the variables themselves are only statistical artifacts and are not
theoretically based. Consequently there is little reason to believe that the appropriate weights are
stable through time.
• All models are simplifications of reality. They ignore relevant factors such as the relationship the
lender has with the borrower, the reputation of the borrower and a host of important macro factors. A
good example of this problem occurs if a bank is asked to engage in a highly leveraged transaction or
HLT loan. Credit scores and ratio analysis are likely to suggest rejecting the loan. If the potential
corporate borrower is an otherwise profitable major bank customer the bank may feel it must
participate in the loan. The loan may be syndicated to share the risk. Bank refusals to participate in
HLTs led to the development of the junk bond market. Banks must weigh the loan credit risk against
the risk of permanently losing customers as the borrowers become familiar with raising debt funds
through a growing number of alternative methods.
• Finally there is no agency that collects data on the characteristics of both ‘good’ and ‘bad’ borrowers,
although some FIs are now keeping and sharing this information, hence the development of better
credit scoring models is hindered by a lack of data.
• Lying on applications continues to be a problem. This requires verification of the information
provided.
• KMV credit scoring model:

The KMV model is based on option pricing. The common stock of a corporate borrower can be viewed as
a call option on firm value with an exercise price equal to the book value of the firm’s debt. The ‘option’
feature is represented by the limited liability of common stock. If the value of assets is less than the value
of the debt the equity holders default. This is equivalent to not exercising the option. If the value of the
assets at debt maturity is greater than the value of the debt, the stockholders (owners) exercise the option on
firm value by paying off the debt. Using the value of the stock, it is possible to determine the underlying
implied asset volatility and the market value of the firm’s assets. With this data and the amount of debt, it
is then possible to estimate the probability that the call option winds up in the money (no default) or out of
20-10
the money (default). The probability of default is called the ‘expected default frequency’ or EDF. KMV
provides EDFs for 25,000 companies worldwide. Simulations have shown that the KMV model
outperforms both the Altman Z model and ratings changes by Standard & Poor’s.70 The KMV model will
normally predict changes in default probability ahead of ratings because the EDFs are constructed using
stock market data which is updated frequently whereas ratings evaluations occur only at periodic intervals
such as quarterly or annually. See for instance Text Figure 20-4 for changes in bankruptcy probability for
World Com.
• In September 2006 the Credit Rating Agency Reform Act was passed. The act gives the SEC regulatory
authority over ratings agencies.
:Ratings agencies have an inherent conflict of interest that may prevent them from downgrading a company
as rapidly as firm or market conditions would imply; namely, the ratings agencies receive substantial fees
from the companies they rate. Empirical evidence has generally concluded that market prices of securities
reflect the changing bankruptcy probability substantially sooner than ratings changes. For instance, Enron
was downgraded, but continued to be rated investment grade by Moody’s, S&P and Fitch as late as several
weeks before it declared bankruptcy. At the time, the stock’s price was trading at only $3 per share.71 It is
becoming increasingly obvious that the business model we are using for ratings agencies needs to be fixed.
In hindsight, the ratings agencies have appear to have been unduly influenced by security issuers and
investment bankers and/or have underestimated the riskiness of various firms and complex debt issues.
The government limits the number of ratings agencies which limits competition. The securities issuers pay
for the security rating, which creates an inherent conflict of interest. Negotiations between issuers and
raters on the final ratings are also common. Evidence indicates that security prices move ahead of ratings
changes, so analysts are uncovering the information before the raters. Obtaining and maintaining a rating
appears to be some kind of ‘check off’’ procedure required, not an up to date analysis of the actual default
risk of the security. Historically, investors paid for the ratings rather than the issuers. Perhaps we should
return to that type business model.
3. Calculating The Return On A Loan

a. Return on Assets (ROA) (The traditional approach)
Factors that affect a FI’s return on a loan include:
♦ The base lending rate on the loan (BR)
♦ The credit risk premium (m)
♦ Fees earned as a result of the loan (e.g. origination fee and credit line fees)
♦ Whether the borrower repays in full on time
♦ The value of collateral and ease and cost of collections if the borrower defaults
♦ The nonprice terms and conditions on the loan (other than fees), e.g., compensating balance
requirements
The base lending rate (BR) is the minimum rate required to hit a certain profit target, such as a markup
over the lender’s cost of funds, it may be called the prime rate, although the meaning of the term prime
rate has changed over time. Historically the prime rate was the rate of interest a bank charged its best or
‘prime’ customers on loans of $1 million or more. Subprime lending became common due to the
competitiveness of the lending market and the prime rate term has evolved to mean the base lending rate.
Variable rate business loans are now very common, especially for loans with a maturity greater than one
year. In these cases loan rates may fluctuate with LIBOR or the bank’s prime rate.
Nonprice terms:
♦ Origination fee (f), usually no more than 1% of the loan amount and less for larger loans.
70
For more information, see http://www.kmv.com/.
71
See “Thoughts on Enron: What Happened, Why and How it Can Be Avoided Again,” Testimony of
Frank Partnoy, Financial Engineering News, June/July 2002.
20-11
♦ Compensating balances (b) are non-interest bearing deposits that the borrower is required to hold at
the bank while the loan is outstanding. These may be a percentage of a credit line and/or the
percentage of the drawdown on a credit line.
♦ Reserve requirements (R) on the compensating balances.
If k is the gross return on the loan per dollar lent, or the bank’s gross ROA on that loan then
f + (BR + m)
1+ k = 1+
1 − [b(1 − R )]
Example 1: A bank has a base lending rate of 8% (BR), and charges a certain customer a 110 basis point
risk premium (m). The bank also charges a 1% origination fee (f). The bank requires the borrower to
maintain compensating balances (b) of 7% of the loan amount. The reserve requirement (R) is 10% and the
loan amount is $1 million.
0.01 + (0.08 + 0.011)
1+ k = 1+ or k = 10.78%
1 − [0.07(1 − .10)]
Total income to the bank (ignoring the timing of the receipts) is
$ 80,000 = 0.08 × $1 million (base loan rate)
$ 11,000 = 0.011 × $1 million (credit risk premium)
$ 10,000 = 0.01 × $1 million (loan origination fee)
$ 101,000 = Total income
The amount of funds invested by the bank is:
$1,000,000 (the loan amount)
($ 70,000 ) (the compensating balance)
$ 7,000 (the bank’s reserve requirement on the compensating balance)
$ 937,000 = Net funds invested
The gross ROA on the loan is then $101,000 / $937,000 = 10.78%.
These days the compensating balance requirement may be eliminated or the borrower may be allowed to
meet the requirement with interest bearing time deposits.
: If the fee and compensating balance requirements are more complicated, the above equation will not
work. For instance, banks may charge a fee for the unused portion of a credit line and may charge different
compensating balances for the drawdown amount and the total line. In these cases the concept remains the
same, but the calculation method has to incorporate the different amounts involved and you can’t easily
calculate the cost rate per dollar lent with the above formula. The following example, the idea for which
was drawn from Gardiner, Mills and Cooperman, Managing Financial Institutions: An Asset/Liability
Approach, Dryden Press, 2000 illustrates this concept:
Example 2: A corporate customer obtains a $1 million line of credit from a bank. The customer agrees to
pay a 9% interest rate and agrees to make compensating balances of 6% of the total credit line and 3% of
the amount actually borrowed. These will be held in non-interest bearing transactions deposits at the bank
for one year. The bank charges a 1% loan origination fee on the amount borrowed and a 0.25%
commitment fee on the unused line of credit. The expected draw down (loan amount) is 60% of the line for
one year. Reserve requirements are 10%. What is the expected rate of return to the bank?
$600,000 is the expected drawdown amount, and $400,000 is the unused portion of the line. The numerator
is comprised of the pretax income to the bank and the denominator is the funds lent net of compensating
balances and reserve requirements on those balances.
Income to the bank: [($600,000 × 0.09) + ($600,000 × 0.01) + ($400,000 × 0.0025)] = $61,000
Net funds lent [$600,000 – (0.90 ×((0.06 × 1,000,000) + (0.03 × 600,000))] = $529,800
Gross ROA of loan = Income to the bank / Net funds lent =

$61,000 / $529,800 = 11.51%
20-12
As in the text this example ignores the timing effects of when the fees and interest are earned.
Example 3: The credit risk premium (m) can be set based on historical default rates on loans of this
category and rates of return on defaulted loans. For instance in order to earn the base loan rate of say 9% if
the default history of a given loan category is as follows:
% of loans Default experience Rate of return on given category
98% No default 9% + m
1.5% Limited default 0%72
0.5% Total writeoff -100%
The given credit risk premium required so that the average rate of return earned on this loan category is 9%
can be found as 0.09 = (0.98×(0.09+m)) + (0.015×0) + (0.005×-1) or m = 0.0069, or m = 69 basis points.
Conceptually a bank can calculate the ROE as well as the ROA on a loan. If a bank has 10% equity capital
and lends out $100, only $10 of that loan is funded with equity. If the bank earns 9% on the loan or $9 and
the interest and noninterest cost to provide the loan is $7 then the bank nets $2 and earns an ROA of
$2/$100 or 2% and a ROE of $2 / $10 = 20%. If the bank has established a target ROA that is needed to hit
a given ROE target as is illustrated in the Gardiner, Mills and Cooperman cite above, then it doesn’t really
matter which measure is used. A conceptual problem with both approaches is the lack of an objective risk
adjustment for the loan. For example, these approaches do not use any direct means to increase the
required ROA or ROE for more risky loans. The RAROC measure below attempts to add a risk
adjustment.
b. RAROC Models
The risk adjusted return on capital (RAROC) originated by Banker’s Trust is now widely used instead of
the ROA method of loan pricing presented above.
One year net pretax income on the loan
RAROC =
Amount of funds at risk
The numerator is the gross income on the loans (the numerator of the ROA model) minus the cost of funds.
The denominator is not the actual net funds invested. Instead, the ‘amount of funds at risk’ is measured
as the product of the extreme loss rate times the percentage of loans that are NOT eventually recovered in
the event of default. The amount at risk can be estimated as
Dollar value of the loan * Unexpected default rate * Loss rate given default
Example 4: Continuing with Example 1 from above and adding the additional necessary information will
illustrate how to calculate the RAROC:
The loan had income of $101,000. Suppose the dollar cost rate (including interest and noninterest costs) of
providing the loan is 10.3%. The net loan amount was $937,000 so the dollar cost is thus $96,511
(=$937,000 × 0.103). Suppose that typical default rates on this loan type are 0.3% in a given year.
However, according to historical default rates, the 99th percentile, or the extreme loss rate, for this loan
category is 3%.73 This means that the bank believes that in the worst case scenario (which in this case
should happen only once every hundred years), 3% of the loans will default instead of the typical 0.3%.
Suppose further that based on historical data the bank can expect to eventually recover 25% of the loans
that default. One can now calculate the capital at risk per dollar lent under an extreme loss rate scenario as
0.03 × 0.75 = 0.0225, or for the $1 million loan, the capital at risk is $22,500 = (0.0225 × $1,000,000). The
RAROC is thus ($101,000 - $96,511) / $22,500 = 19.95%. The RAROC is then compared to the lender’s
ROE. If the RAROC is greater than or equal to the lender’s ROE the loan is acceptable with the given
terms.
72
The percent of loans and the rates of return numbers should both be net of recoveries
73
Loan loss rates are not normally distributed. They have limited upside returns and long tail
downside risks. Hence, a bank may wish to calculate the extreme loss rate using a number greater than two
standard deviations below the mean in order to be sure they have the 99th percentile. Bank of America uses
6σ.
20-13
Chapter 21 - Managing Liquidity Risk on the Balance Sheet
Chapter Twenty One

Managing Liquidity Risk on the Balance Sheet
This chapter discusses sources of liquidity risk and how these risks can be managed with both assets and
liabilities. Liquidity risk arises from the need to obtain cash before funds from maturing assets are
available. Sources of funds are decreases in an asset or increases in a liability or equity account. Liquidity
can thus be ‘stored’ by holding cash and near cash assets (sometimes called primary and secondary
reserves) or liquidity can be obtained by borrowing additional funds as needed. Measuring prior period
expected and unexpected liquidity needs can help FI managers plan for future expected and unexpected
liquidity requirements. All DIs operate on a fractional reserve system where they retain only a small
portion of deposits and other borrowings in the form of liquid assets. Each institution is dependent upon
the public’s belief in the soundness and safety of the individual institution and the financial system. A
perceived erosion of the safety of deposits can quickly generate bank runs and liquidity crises although
federal deposit insurance and the Fed’s role as lender of last resort limit the likelihood of banks runs in the
U.S. Deposit insurance in particular has largely eliminated bank runs by the general public, but DI
liquidity crises still occur and are a normal part of market discipline. Insurance companies and mutual
funds normally face lower amounts of liquidity risk than DIs, but liquidity problems can still occur at these
institutions.
II. Notes
1. Liquidity Risk Management: Chapter Overview
All FI managers must deal with liquidity planning and liquidity risk on a daily basis, although DIs have
substantially more liquidity risk than other types of FIs. The main goal of liquidity management is to
maintain ‘just enough’ liquid assets in combination with liability funding sources to be able to meet
expected and unexpected liquidity needs. FIs do not wish to hold excessive amounts of liquid assets
because they earn low rates of return. Banks and DIs generally have more liquidity risk than insurers,
mutual funds and hedge funds. Nevertheless several hedge funds have gone bankrupt recently. Hedge
funds and securities brokers pledge their security holdings for collateral on short term loans used to provide
liquidity. When the subprime problems reduced the value of mortgage backed securities lenders to these
funds and dealers refused to renew loans without better collateral. Two Bear Stearns hedge funds collapsed
as a result, eventually bringing Bear down with them.
2. Causes of Liquidity Risk

♦ Unexpected withdrawals of liabilities
Unexpected withdrawals of deposits or unanticipated policy claims can force FIs to sell assets or
borrow more funds. If the FI does not have enough liquid assets to sell, or cannot borrow enough
additional funds at short notice they may have to liquidate longer term investments, perhaps at prices
below market value (at so called ‘fire-sale’ prices). If the liquidated assets must be marked down to
market, balance sheet losses occur and equity write downs would result.
For example, a bank faces net deposit withdrawals of $30 million of uninsured deposits as word
hits the street that the bank faces large loan losses from a regional collapse in real estate values. 74
The bank liquidates $15 million in liquid assets at fair market value, borrows an additional $10
million in short term debt markets, and liquidates longer term investments at below book value,
and even below fair market value because it needs the money now. The book value of the long
term investments is $7 million but the bank obtains only $5 million net of transaction costs. The
bank must bear a $2 million loss due to its illiquidity.
♦ Unexpected increases in assets
74
Amounts over the $100,000 insurance limit are uninsured.
21-1
Unexpected drawdowns on credit lines and unanticipated loan demand are two sources of asset side
liquidity risk. Unanticipated defaults on loans can also generate additional cash needs, as can
unexpected payments on contingent items such as bankers’ acceptances and financial standby letters of
credit.
3. Liquidity Risk and Depository Institutions

a. Liability Side Liquidity Risk
DIs have large amounts of transaction and savings deposits that customers can make due immediately if
they choose. These accounts give depositors a put option with the exercise price equal to the amount of
their deposit. Banks estimate the amount of core deposits that are usually relatively stable on a day to day
basis and estimate expected growth in deposits. Core deposits are low turnover accounts that are at the
bank for reasons other than the interest rate earned.75 They may be placed at the bank for convenience
needs, or because the customer has some other relationships with the institution. Net deposit withdrawals
are called net deposit drains. Although net deposit drains usually have a seasonal component, increasing
at Christmas and vacation time for example, they are usually quite predictable on a daily basis, particularly
if a FI has a substantial core deposit component.
Purchased liquidity
Banks can obtain funds by borrowing additional cash in the money markets. This practice is termed
‘purchasing liquidity’ or sometimes ‘liability management.’
: The practice of purchasing liquidity is fairly recent. It began in the 1960s with the advent of a secondary
market for negotiable CDs and it has been spurred on by the growth in the fed funds market. Purchasing
liquidity can be expensive and can increase the interest rate sensitivity of a bank’s liabilities because the
bank adds interest rate sensitive funds to meet liquidity needs, thus reducing the proportion of funding from
core deposits. The tradeoff is that if a bank is willing to rely on purchased liquidity sources, it need not
hold as many low earning liquid assets. More funds can then be placed in riskier investments and loans
that promise higher rates of return. Purchased liquidity allows a bank to maintain a given size and
distribution asset portfolio while still allowing the institution to obtain the cash needed to fund withdrawals
or additional loan demand.
Stored Liquidity
Liquidity can be stored by investing in cash and/or liquid securities that earn a rate of return. Primary
reserves are vault cash, CIPC, correspondent balances and deposits at the Federal Reserve. Recall that the
Fed imposes minimum liquidity requirements on DIs (basically 10% on transaction deposits), but banks
generally hold substantial excess reserves (reserves beyond the Fed requirements) that can be used for
liquidity purposes.
Banks normally both purchase and store liquidity. The costs of each can be easily illustrated via an
example:
NorthView Bank (NVB)
Assets Liabilities and Equity
Amount Rate of Amount
(mill$) Return (mill$) Cost Rate
Cash $ 20 0% Deposits $ 560 4%
Securities 230 7% Borrowings 160 6%
Loans 550 10% Equity 80
Total $800 Total $800
NVB is expecting a $35 million deposit drain and only $5 million in cash is available for liquidation since
required reserves are $15 million. NVB faces the choice of purchasing liquidity by borrowing or by
liquidating cash and securities. Let’s examine the costs of each alternative:76
75
Core deposits typically include all consumer accounts, some business accounts and retail CDs.
76
All examples ignore changes in required reserves resulting from the change in deposits.
21-2
1. Borrow $35 million to replace lost deposits: Deposit cost is 4% and borrowing cost is assumed to remain
at 6% so the pre–tax change in net income from the deposit drain is 2% * $35,000,000 = –$700,000.
The advantage of borrowing is that no part of the asset portfolio has to be liquidated.
2. a) Pay off depositors with $5 million in cash excess reserves and liquidate $30 million in securities on
which the bank is earning 7%. The change in pre–tax net income in this case is ($35,000,000 * 0.04) –
($30,000,000 * 0.07) = –$700,000. In this case the costs of alternatives 1 and 2 are identical, but
alternative 2 decreases the bank size by $35 million and decreases the amount of leverage. The drop in
size may be a concern if the bank loses economies of scale.
2. b) Pay off depositors with $5 million in cash excess reserves and liquidate $30 million in securities on
which the bank is earning 7%. This alternative is the same as 2. a), but in this case suppose the
securities liquidity index is 97% (the liquidity index is described below). This implies that the bank
can only receive 97 cents per dollar of fair market value on the securities liquidated because they must
be liquidated rapidly. The bank has to liquidate $30 million / 0.97 = $30,927,835 in securities to raise
$30 million. This results in an additional loss of $927,835. The change in pre–tax net income in this
case is ($35,000,000 * 0.04) – ($30,927,835 * 0.07) – $927,835 =
–$1,692,783. The loss represented by the sale below fair market value reduces equity as well.
b. Asset Side Liquidity Risk

Exercise of loan commitments by borrowers can also generate liquidity needs. In 2001 regulators found
that unused loan commitment were 11 times greater than liquid assets at some banks. This can be
dangerous because if the bank has not planned properly because net unexpected asset increases lead to
immediate funding requirements. As before the FI can choose to meet the need by purchasing liquidity
(and allowing the bank’s assets to grow) or by using stored liquidity (maintaining the same amount of
assets).
c. Measuring a Bank’s Liquidity Exposure

Tools to measure liquidity exposure include
♦ Net liquidity statement
A net liquidity statement is a report of net available liquid sources of funds:
Net Liquidity Position (mill $)

Sources
1. Total near cash assets $ 5,000
2. Excess cash reserves $ 2,000
3. Maximum new borrowings $ 9,000
Total $16,000
Uses
1. Funds already borrowed $ 8,000
2. Discount Window loans that must
be repaid quickly $ 1,000
Total $ 9,000
Total Net Liquidity $7,000
The FI can handle unanticipated liquidity needs of $7,000 million.
: The FI management must decide if the amount of liquidity coverage ($7,000 mill.) is reasonable in light
of the likely amount of net deposit drains. Examining the historical distribution of drains adjusted for any
seasonality can help the FI ascertain the likely amount of drains. The FI does not want to hold excessive
amounts of liquid assets because their low return is a drag on profitability and competitiveness.
♦ Peer group ratios

Banks will often monitor key liquidity ratios such as March 200877
♦ Loans to deposits 81.33%
♦ Loans to core deposits 102.84%
77
Source: FFIEC; all banks in the nation, Peer Group Data Report, Report Date 3/31/08.
21-3
♦ Short Term Non Core Funding to Assets 17.08%

♦ Core deposits to total liabilities & equity 65.24%
♦ Commitments to lend to total assets 11.14%
♦ Liquidity Index
The liquidity index is the ratio of the fire sale price required to liquidate assets in an emergency
situation divided by the fair market value of the assets liquidated. The lower the index the greater the
liquidity risk. For instance, suppose a securities portfolio contains two securities with the following
data:
Value if liquidated % invested in each
Securities immediately Fair market value (at FMV)
Treasury Bills $ 9,700,000 $ 9,850,000 38.58%
Bonds $15,000,000 $15,675,000 61.42%
The liquidity index is calculated as:

[38.58% * ($9.7 mill / $9.85 mill)] + [61.42%*($15 mill / $15.675 mill)] = 96.76%
Discount instruments increase in price as they approach maturity but non-discount instruments receive
interest income. The liquidity index should measure not only any loss in fair market value, but also any
loss in income due to a required change in FI behavior. For example, a T-bill may be priced at fair market
value at 99% of par prior to maturity. Nevertheless, if the FI planned to hold the bill until maturity but had
to sell it to meet liquidity needs, the required sale at the fair market value of $99 per $100 of par still
represents a loss due to liquidity risk. Thus, the index should account for lost interest as well as losses in
current fair market value.
The index is a better measure of the cost of liquidity risk than the likelihood of occurrence of liquidity
problems.
♦ Financing Gap and the Financing Requirement

(Uses) (Sources)
Financing Gap = Average loans – Average (core) deposits
If the financing gap is positive, (as it is for the typical bank) the DI must obtain additional financing
either by borrowing or liquidating assets. The Financing Requirement is the amount of funds that must
be borrowed and it is found as:
Financing Requirement = Financing Gap + Required liquid asset holdings78
An increasing financing requirement may indicate future liquidity problems for a bank since this
indicates greater borrowing requirements for the DI.
♦ Maturity Ladder/Bank of International Settlements (BIS) scenarios

The BIS recommends banks follow a maturity ladder approach to managing liquidity. The ladder
method measures cash inflows and outflows over short (daily) and longer time periods such as out to 6
months, calculating cumulative funding needs over the different time periods. The purpose is to help
DI managers understand their upcoming liquidity needs and to plan for upcoming cash shortfalls and
excesses. The BIS also recommends banks construct liquidity analyses under various scenarios and to
have a contingency plan to obtain liquidity in the event the worst case scenario occurs.
♦ Liquidity Plan
A liquidity plan should include the following key components:
78
The textbook does not indicate that the assets must be required although this is implied in a
footnote. Logically the bank could liquidate its liquid assets and reduce its financing requirement. Note
that in this formulation these numbers are not flows, they are balance sheet levels. Because these are
levels, there is also an implicit assumption that the level of non-earning assets equals the amount of equity.
21-4
o Managerial guidelines and assignment of responsibilities

o List of fund providers ranked by likelihood of withdrawal (Institutional and corporate
investors are more likely to withdraw funds quickly.)
o Estimation of seasonal components of liquidity (Christmas, planting time, harvest time,
vacation season, etc.)
o Estimation of amounts of withdrawals over specified time intervals.
o Internal limits on subsidiary and branch borrowings from parents and maximum borrowing
rates.
o Planned order of disposition of assets in the event liquidations become necessary.
An example liquidity plan may look like the following:

Potential Deposit Withdrawals and Associated Required Asset Liquidations (Mill $)
Potential Deposit From most likely to withdraw to least likely

Withdrawals
Mutual Funds $ 70
Pension Funds $ 40
Correspondent banks $ 50
Large corporations $ 45
Small businesses $ 25
Consumers $ 75
Total $305
Expected total withdrawals per period Average Maximum Likely

One week $ 60 $100
One month $ 70 $150
Three months $130 $220
Total $260 $470
Sequence of funding
options as needed One Week One month Three month
New deposits $ 15 $ 35 $ 75
Sale liquid assets $ 15 $ 25 $ 55
Sale investment portfolio $ 30 $ 40 $ 50
Borrowings from other FIs $ 30 $ 40 $ 35
Borrowings from Fed $ 10 $ 10 $ 5
Total $100 $150 $220
In the event the maximum likely withdrawals actually occur, the bank has already determined how the
withdrawals will be funded in the bottom panel. The numbers in the bottom panel are developed in
conjunction with the necessary strategies that can be used if needed to bring about the increases shown.
For instance, in the one week period, deposit rates may have to be increased 15 basis points to attract $15
million in new deposits.
d. Liquidity Risk, Unexpected Deposit Drains and Bank Runs

Abnormal deposit drains can threaten a FI’s solvency. These usually arise due to problems in the
management of some other area of risk such as credit or interest rate risk.
Demand and other deposits are first-come, first-served contracts that are full pay or no pay contracts.
They are not pro-rata claims that are apportioned based on a fair distribution of the liquidation value of the
DI’s assets. Hence, there is always a possibility of a bank run when banks maintain only partial reserves to
back deposits because only the first depositors to demand their money receive anything. A bank run
occurs when the fundamental assumption underlying fractional reserve banking is violated; namely, that all
depositors do not wish to obtain their money at the same time. Since all deposits in all institutions are this
way, failure, or fear of failure, at one or more institutions can quickly spread (the dreaded contagion effect)
21-5
potentially causing widespread bank panics or system wide runs on banks. Contagion effects are
particularly serious in countries or situations where there is no credible deposit insurance.
e. Bank Runs, the Discount Window and Deposit Insurance

The two major stabilizing factors that limit bank runs are the discount window and deposit insurance.
♦ Deposit Insurance
In the U.S. deposits are currently insured up to $100,000 per account.79 When deposit insurance was
established in 1933, bank runs were virtually eliminated at federally insured institutions. State
insurance is not sufficient to prevent widespread bank runs because the insurance funds do not have
enough reserves to maintain public confidence in a crisis. The FDIC now assesses risk based deposit
insurance premiums. Capital adequacy and supervisory judgment are used to assign DIs to risk
categories. Low risk institutions pay 5 cents per $100 of insurance and the highest risk institutions pay
43 cents. DIs now have to pay more to maintain deposit liquidity when they take on more risk.
♦ The Discount Window

The Fed provides short term emergency lending to qualifying DIs. The Fed has shown a willingness to
open the discount window during risky events such as the 2001 terrorist attacks, during several stock
market crashes and most recently the subprime crisis. In the 2001 attacks on the World Trade Center
phone and computer outages, grounding of plans that carried checks and building evacuations led to
many disruptions of payment systems. These problems led to unexpected shortages at other
institutions expecting to be paid by New York banks. On September 11th, the Fed announced the
window was open and encouraged all FIs to borrow as needed to cover unexpected shortfalls. It was
particularly important that the Fed offered discount window services to banks and securities dealers
who finance their substantial securities inventory with short term call loans. If banks had called in
large numbers of these loans some of the major investment banks could have been in danger of severe
liquidity crises forcing them to liquidate their securities inventories and causing sharp declines in asset
prices.
♦ Typically DIs must pledge short term, high quality assets as collateral that are ‘discounted,’ hence the
term discount window loans. The discount rate used to be kept below open market rates and at that
time the Fed actively discouraged use of the discount window except as an emergency source of short
term borrowing. The Fed has now changed the discount window policy. See Chapter 4 for details but
basically the Fed operates three types of loan programs. The first is termed primary credit. Primary
credit is available to sound institutions on a short term basis at a rate 100 basis points above the FOMC
target fed funds rate. Primary credit loans may be used for any purpose and loan terms can be as long
as several weeks. Secondary credit is available for overnight loans to sound institutions that are
having temporary funding problems at a rate 150 basis points above the FOMC target fed funds rate.
Secondary credit may not be used to finance institutional growth. Finally, seasonal credit is available
on a longer term basis at a rate below the target FOMC fed funds rate. The borrower must demonstrate
seasonality.
♦ In response to the liquidity problems caused by the credit crunch in 2007 and 2008 the Fed announced
in March 2008 that it would lend up to $200 billion to both commercial and investment banks. The
borrowers could swap mortgage backed securities for Treasuries. The borrower could swap some
securities that the Fed would not ordinarily have accepted. The Fed took is extraordinary step because
many institutions were unable to borrow against mortgage securities, creating a liquidity crunch. Not
all agree that this was a sound move by the Fed. Some analysts believe the bailout of Bear Stearns and
the intervention into the markets will create or exacerbate the moral hazard problem and encourage
other institutions to take on excessive risks, believing that the Fed will come to their rescue if needed.
One of the original functions of the Fed was to serve as a lender of last resort to DIs. If the Fed was
willing to supply unlimited amounts of loans to a DI facing insolvency, there would theoretically be no
need for deposit insurance to prevent bank runs. The Fed could create whatever money was needed to
prevent a DI from becoming insolvent and the public would have no reason to withdraw their deposits.
The conditions the Fed imposes on discount window loans limit its effectiveness as a deterrent to bank
79
The FDIC Act of 2005 increased deposit insurance coverage for retirement accounts (e.g., IRA
and Keogh accounts) from $100,000 to $250,000.
21-6
runs. Indeed the Fed was around during the Crash of 1929 and it was either unable or unwilling to
prevent the widespread bank runs that led to the failure of thousands of banks at that time. Several
aspects of Fed policy limit the usefulness of the ‘lender of last resort’ in preventing bank runs. These
include:
a) The requirement to pledge high quality assets to back the loan eliminates the ability of most failing
institutions to obtain a sufficient amount of discount window loans.
b) The Fed does not automatically grant discount window loans for extended periods, so depositors
cannot count on this method as a sufficient means of financing to ensure that the value of all
deposits will be preserved even with the Fed’s new policies.
c) The purpose of the discount window is to provide short term financing to solvent institutions not to
keep afloat failing institutions. Indeed, loans to troubled, undercapitalized institutions are
specifically limited to no more than 60 days in any 120 day period unless the FDIC and any other
primary regulator certify that the bank is viable. The discount window is designed to limit bank’s
need to liquidate assets at fire sale prices in order to fund required liquidity needs, not to protect
depositors.
4. Liquidity Risk And Insurance Companies

a. Life Insurance Companies
Life insurers face liquidity risk due to unexpected policy cancellations and working capital needs. If an
insurer cancels (surrenders) a policy with a cash value, the insurer must pay the surrender value of the
policy to the insured. Some policies also allow the insured to borrow against the value of the policy. Both
situations can cause funds needs. Insurers typically rely on new premiums to help meet liquidity needs.
They also hold liquid assets and can sell portions of their long term investment portfolio if necessary
although the latter sales may occur at disadvantaged prices. A run occurred on First Capital Insurer in 1991
due to junk bond losses when new premiums were not forthcoming and surrenders increased dramatically.
b. Property-Casualty Insurance Companies
PC insurers have more liquidity risk than life insurers because the payouts on their liabilities are more
unpredictable and the maturity of their claims is shorter than life insurance claims. Consequently, PC
insurers hold more liquid assets than life insurers, and they tend to reprice their claims more frequently to
help limit risk. Large unexpected claims and unexpected policy terminations are major sources of liquidity
risk for PC firms. Catastrophic events such as the 2001 terrorist attacks, the slides in California and the
Florida hurricanes indicate how unpredictable and large liquidity needs can be at this type insurer.
c. Guarantee Programs for Life and Property-Casualty Insurance Companies
Although insurers cannot offer policyholders federal insurance, many states either sponsor or require the
insurance firms in their state to operate insurance guarantee funds. Most states do not have permanent
funds, and the policy claims are not a liability of the state. Rather when a failure of an insurer occurs, the
remaining insurance firms are assessed a premium to help pay off the failed insurer’s claims to
policyholders. The payments are often capped per year and there can be long delays before the
policyholders of the failed insurer receive all their promised value if they ever do.
5. Liquidity Risk And Mutual Funds

Open end mutual funds face liquidity risk because they must redeem shares from shareholders upon
demand. In 2007 mutual funds maintained cash reserves of 3.34% of total assets. Runs on mutual funds
can occur but for different reasons than bank runs. Mutual fund shares are pro-rata claims, not full pay or
no pay, so mutual fund investors lack the incentive to try to be first in line to receive their cash. It is the
pay in full or no pay characteristic of deposits that encourages banks runs. If investors fear that the value of
the mutual fund shares will drop, large numbers of investors may attempt to redeem their shares all at once,
using up the fund’s cash reserve and forcing the fund to liquidate some of its holdings.80 This provides a
similar effect as a run and could be termed as such. Heavy mutual fund redemptions may further depress
the prices of the fund’s asset holdings, leading to additional redemptions and a repeat of the cycle. This is
essentially what happened in the stock market crash of October 1987.
80
Closed end mutual funds do not face this risk. For them liquidity is needed only to be able to
purchase investments quickly without having to liquidate some other part of the investment portfolio.
21-7
Chapter 22 - Managing Interest Rate Risk and Insolvency Risk on the Balance Sheet
Chapter Twenty Two

Managing Interest Rate Risk and Insolvency Risk
Providing maturity intermediation is a major function of FIs. Recall from Part I of the text that institutions
are intermediaries between ultimate borrowers and lenders. They serve as asset transformers by providing
claims designed to better meet the specific needs of borrowers and lenders. The asset transformation
function often leaves the FI with longer term assets than liabilities. Thus as interest rates change over
time the spread between a FI’s asset earnings and liability costs may increase or decrease, leading to major
changes in a FI’s profitability. Likewise, changes in the market value of the FI’s assets and liabilities will
not be the same when interest rates change. Changes in interest rates can cause the value of assets to
change more or less than the value of liabilities. The FI’s equity value can thus fluctuate sharply as interest
rates change because the market value of equity is equal to the market value of assets minus the market
value of liabilities. This chapter discusses the measurement of profitability and present value risk and
discusses methods of manipulating the balance sheets to manage these risks. The chapter concludes by
reemphasizing the role of equity capital in limiting insolvency risk and discussing the benefits of market
value accounting.
II. Notes
1. Interest Rate And Insolvency Risk Management: Chapter Overview
The large interest rate movements of the 1980s illustrated the interest rate risk exposure of many FIs as
large numbers of lenders were bankrupted by the swings in interest rates in the early 1980s coupled with
regional problems in real estate loans.81 Changes in interest rates can impair a FI’s profitability and affect
the market value of a FI’s equity. The repricing model measures the effect of interest rate changes on
profitability; the duration model measures the predicted change in the market value of equity. Once the
exposures have been determined, it is possible to mitigate the effects of interest rate changes by
manipulating the balance sheet, or by using the off balance sheet tools discussed in Chapter 23.
Insolvency occurs if the value of liabilities exceeds the value of assets resulting in negative equity.
Insolvency normally occurs because of liquidity risk, credit risk and/or interest rate risk. Maintaining
sufficient equity capital and prudently managing the risks a FI faces provides the surest protection against
insolvency.
Fed policy strongly affects interest rates. In the summer of 2004 the Fed began a series of interest rate
increases to curb inflationary pressures in the economy. The Fed increased interest rates 17 consecutive
times, each time by 25 basis points. In 2007 and 2008 the Fed reversed the increases rapidly bringing rates
down as the subprime crisis worsened.
2. Interest Rate Risk Measurement And Management

The repricing model (sometimes called the funding gap model) has historically been the accepted method
of measuring a FI’s interest rate risk. With the recent advances in computer technology and the ability to
easily generate more complex calculations, the duration gap model is now becoming the standard measure
of interest rate risk.
81
Chapter 19 points out that interest rate risk and credit risk are interrelated. If rates begin to rise
precipitously once again, default rates will also rise, and an unhedged mortgage lender funding the loans
with short term liabilities will likely face some of the same problems that S&Ls faced in the 1980s.
Securitization allows DIs to largely avoid interest rate risk. Nonndiversified DIs engaging in mortgage
lending that do not securitize or otherwise hedge face potentially severe insolvency risk from rising interest
rates.
22-1
Both are still used. The repricing gap model is easier for bankers (and students) to understand
conceptually. Understanding the duration gap model presented here requires an understanding of Chapter
3, understanding the repricing model does not. Institutions that concentrate on long term lending funded by
short term deposits face greater interest rate risk. All DIs are now required to measure and report interest
rate risk. In addition the BIS has recently proposed that all DIs report the level of capital at risk from
interest rate changes. Although this chapter presents these models as means for DIs to limit risk, banks and
others can (and do) choose to take positions on interest rates in order to bolster profitability. A high level
committee usually called the “Asset and Liability Committee” or something similar manages the
institution’s interest rate risk. Members of the committee will normally include the bank president and
senior VPs.
a. The Repricing Model

The repricing model attempts to measure how a FI’s interest income will change relative to interest
expense over a given time period if interest rates change. The time periods (called maturity buckets)
typically include one day, 3 months, 6 months, 1 year, 5 years, and greater than 5 years.82 The model
classifies assets and liabilities as “fixed rate” or “rate sensitive” based on whether the earnings or costs
will change on these accounts during the planning period if interest rates change. Rate sensitive accounts
are those where the cash inflows on an asset or outflows on a liability will change at some point within the
planning period if interest rates change. Accounts are classified as fixed rate if the cash inflows on an asset
or outflows on a liability will not change within the planning period even if interest rates change.
Conceptually one can then compare the rate sensitivities of the two sides of the balance sheet and estimate
how Net Interest Income (NII) is likely to change if interest rates change.
For example, a simple balance sheet has been classified for a 6 month maturity bucket below:
Assets Liabilities
Rate Sensitive Assets (RSAs) $100 Rate Sensitive Liabilities (RSLs) $ 50
Fixed Rate Assets (FRAs) $206 Fixed Rate Liabilities (FRLs) $256
Nonearning Assets (NEAs) $ 34 Equity $ 34
Because we can think of every asset as financed by a liability or equity account we can think of the
individual asset categories as financed by a given liability or equity account. Students can readily grasp
that there is very little profit risk from an interest rate change on the $34 of NEA financed by equity.
Likewise there is little profit risk from the $206 FRAs financed by FRLs because the cash inflows and
outflows on these accounts do not change over the given maturity bucket. Notice that this pairing leaves
$50 in FRLs not yet accounted for. There should not be an excessive amount of risk for the amount of
RSAs financed by RSLs, because both are rates sensitive. For instance, if interest rates rise, the earnings
on RSAs and the costs on RSLs should both rise and the spread should be roughly unchanged. If the spread
changes this is termed a ‘spread effect’ (as described below). There are $50 (out of the total $100) RSAs
financed by RSLs. This leaves a final category, the remaining $50 in RSAs that are financed by the
remaining $50 in FRA. This category is a major source of interest rate risk because one side (the assets) is
rate sensitive and the other side is not. This category is called the repricing gap. The repricing model
measures this ‘GAP’ or the difference in sensitivity of interest income and interest expense in the given
maturity bucket
If R = the general level of interest rates then we can predict the ∆NII resulting from a given ∆R as follows:
∆NII = GAP × ∆R = (RSA − RSL) × ∆R where RSA and RSL are equal to the balance sheet
quantity of rate sensitive assets and liabilities respectively. The change in NII over a given time period is a
function of the size and sign of the gap and the size and sign of the interest rate change.
When comparing the interest sensitivities of two or more institutions of different size, or when comparing
one institution to peer averages the percentage gap (= dollar gap / Assets) is more useful than the dollar
gap. Sometimes one also calculates the Gap Ratio (= RSA / RSL) (see the text). This measure can lead to
incorrect comparisons about interest sensitivity if used to compare the interest sensitivity of a bank with a
82
Cumulative repricing gaps are then calculated across the maturity buckets. The text calls these
CGAP.
22-2
positive dollar gap to a bank with a negative dollar gap. The bank with the ratio furthest from 1 may not be
the most interest sensitive. For this reason the percentage gap is a better comparison tool than the gap ratio.
The following paradigm can be used to measure the repricing gap for a particular maturity bucket and
simultaneously analyze the profitability of the two sensitivity classes:83
1. Classify each asset on the balance sheet as either:
RSA FRA NEA
2. Classify each liability/equity account:

RSL FRL Equity
3. Group assets and liabilities into the following groups:

RSAs financed by RSLs
FRAs financed by FRLs
NEA financed by Equity
Gap: Positive dollar RS Gap: Indicates that excess RSAs financed by remaining FRLs
Negative dollar RS Gap: Excess FRAs financed by remaining RSLs
The leftovers:
Whatever is leftover financed by equity OR Equity financing whatever is leftover
This analysis highlights the idea that the quantity of interest rate risk depends upon the size of the gap.
4. Calculate the average annual % rate of return on each asset category and the average annual % cost
rate on each liability category and then calculate the spreads. Spreads are the difference between the
income rate and the cost rate per dollar invested in the category.
5. Calculate the dollar contribution to profit from each category as the product of the amount times the
spread.
6. Add up the profits. The banker is now in a position to both understand the major
sources of profitability and compare pricing with other institutions. One can also
easily forecast changes in profitability for various projected changes in interest rates.
This method is illustrated in the example that follows.
The dollar gap for each maturity bucket is measured as the dollar quantity of rate sensitive assets (RSAs)
minus the dollar quantity of rate sensitive liabilities (RSLs). The cumulative gap (CGAP) is calculated by
adding the gaps for subsequent time periods.
♦ For a positive CGAP, rising interest rates over the maturity period will normally
increase profitability, all else equal, and falling interest rates will decrease
profitability. In other words, interest rates and profitability move in the same
direction if CGAP is positive.
♦ For a negative CGAP, rising interest rates will decrease profitability, all else equal,
and falling interest rates will increase profitability. Interest rates and profitability
move in opposite directions if the CGAP is negative.
♦ These effects are termed CGAP effects.
Unequal changes in rates on RSAs and RSLs
The repricing gap analysis is more complicated than previously indicated because although the rates of
return on RSAs and RSLs will generally move in the same direction as interest rates change, they will only
rarely move identically. Thus, the spread between the interest income earned on the RSAs and the interest
83
See Gardiner, Mills and Cooperman, Managing Financial Institutions: An Asset/Liability
Approach, Dryden Press, 2000.
22-3
cost on the RSLs will normally change as interest rates change.84 The change in income from this category
as interest rates change is called the Spread Effect.
♦ If the Spread Effect is positive, when interest rates either rise or fall the spread of interest income
earned on RSAs less the interest cost on RSLs tends to increase, thereby contributing to higher NII.
♦ If the Spread Effect is negative, when interest rates rise or fall, the spread of interest income earned on
RSAs less the interest cost on RSLs tends to fall, thereby contributing to lower NII.
Conclusions about CGAP and Spread Effects:

Dollar GAP Spread Effect ∆R Direction of ∆NII
Positive Positive Increase Increase
Negative Increase Ambiguous
Positive Decrease Ambiguous
Negative Decrease Decrease
Negative Positive Increase Ambiguous

Negative Increase Decrease
Positive Decrease Increase
Negative Decrease Ambiguous
The following tables contain a more detailed example of a calculation of the repricing model for a 1 year
maturity bucket.85
Assets ($ Mill) Liabilities & Equity

Investments under 1 year @ 5% $ 100 Deposits < 1 year @ 4% $ 900
Loans < 1 year @ 7% $ 350 All Long Term Liabilities @ 7% $ 500
Variable rate loans
(rate reset in 6 months) @ 6.5% $ 300 Equity $ 200
Fixed Rate Assets > 1 year maturity @ Total $1,600
8% $ 850
Total $1,600
The percentages are the average interest rate earned or paid on the given account. All assets and liabilities
that mature in less than one year or have an interest rate reset within one year are potentially rate sensitive
because their income could change if interest rates change. Rearranging the assets and liabilities into the
appropriate sensitivity categories based on maturity and payment pattern results gives the following results:
84
Their correlation is less than +1 for reasons indicated below.
85
Detailed examples of this type (from which this example is drawn) can be found in the
aforementioned Gardiner, Mills and Cooperman, Managing Financial Institutions: An Asset Liability
Approach, Dryden Press. 2000. More realistic applications of both the repricing and duration gap models
can be found in Saunders, Financial Institutions Management: A Modern Perspective, Irwin, 1994.
22-4
Rate Sensitive Assets Rate Sensitive Liabilities

Amnt Income Amnt Cost
Investments under 1 year @ 5% $ 100 $ 5.00 Deposits < 1 year @
4% $ 900 $ 36.00
Loans < 1 year @ 7% $ 350 $24.50
Variable rate loans
(rate reset in 6 months) @ 6.5% $ 300 $19.50
Total RSAs $ 750 Total $ 900
Total Income $49.00 Total Cost $ 36.00
NII from this category $13.00
Average rate of return 6.533% Average cost rate 4.000%
Spread on RSAs financed by RSLs 2.533% (6.533% - 4%)
The spread indicates the contribution to profit from this category per dollar invested (ignoring noninterest income
and costs.) Note that some RSLs are used to finance something other than RSAs since there are only $750 RSAs
but $900 RSLs.
Dollar Gap = RSAs – RSLs = -$ 150 The negative dollar gap indicates that some fixed rate
assets are financed by rate sensitive liabilities.
Percentage Gap = -$150 / $1,600 = -9.375%
The ‘gap’ indicates the imbalance in sensitivities of the
Gap ratio = $750 / $900 = 0.833 liabilities that are funding the assets.
Fixed rate assets and liabilities

Fixed Rate Assets Fixed Rate Liabilities
Amnt Income Amnt Cost
Fixed Rate Assets > 1 year maturity @ All Long Term
8% $ 850 $68.00 Liabilities @ 7% $ 500 $ 35.00
Total FRAs $ 850 Total $ 500
Total Income $68.00 Total Cost $ 35.00
NII from this category $33.00
Average rate of return 8.000% Average cost rate 7.000%
Spread on FRAs financed by FRLs = 1.000% (8% - 7%)
The spread indicates the contribution to profit from this category per dollar invested (ignoring noninterest income
and costs.) Note that only $500 of FRAs are actually financed by FRLs. $200 FRAs are financed by equity and
the remaining $150 FRAs are financed by RSLs.
Notice the GAP ≠ FRAs – FRLs
The profit calculations per category can be found as the product of the amount and the spread:
Category Amount Spread $ Profit
RSAs financed by RSLs $ 750 2.533% $19.00
FRAs financed by FRLs $ 500 1.000% $ 5.00
FRAs financed by equity86 $ 200 8.000% $16.00
The Gap: FRAs financed by RSLs $ 150 4.000% $ 6.00
NII $46.00
Average rate of return per dollar invested 2.875%
The two categories that are subject to interest rate risk are the categories in bold type: RSAs financed by
RSLs and the Gap, which in this case is FRAs financed by RSLs.87 In each case the spreads are calculated
as the average rate of return for the given asset category less the average cost rate for the liability category
used to finance those assets. Note that equity has a contractual cost rate of zero so the spread on that
86
FRAs financed by equity are not a part of the gap since the assets and liabilities in this category
are both fixed rate. Instructors please be aware that the profit table has to be constructed based on the size
of the given categories. For instance, one will not always include a line where FRA is financed by equity.
If the gap had been positive the third row would have been RSA financed by equity.
87
Had the gap been positive the gap would have been represented by RSAs financed by FRLs.
22-5
category is simply the given asset rate of return. The spread on the gap is the rate of return on the FRAs
minus the cost rate on the RSLs. If the gap had been positive this spread would be calculated differently
(the rate of return on the RSAs less the cost of the FRLs). The return on equity can be calculated by
dividing NII by equity (ignoring noninterest income and expenses).
Using the calculations: Suppose interest rates increase 100 basis points and the spread effect is a negative
30 basis points:
Category Amount Spread $ Profit
RSAs financed by RSLs $ 750 2.233% $16.75
FRAs financed by FRLs $ 500 1.000% $ 5.00
FRAs financed by equity88 $ 200 8.000% $16.00
The Gap: FRAs financed by RSLs $ 150 3.000% $ 4.50
NII $42.25
Average rate of return per dollar invested 2.641%
The change in ROA is 2.641% - 2.875% = - 23 basis points.
If the spread effect had been positive the profit drop would have been smaller.
The bank could reduce the amount of RSLs and increase the amount of FRLs to minimize the effect of the
rising interest rates. The bank may also wish to focus on RSL accounts that are not as interest sensitive and
attempt to increase the interest sensitivity of the RSAs to minimize the negative spread effect. A problem
with balance sheet manipulations of this type is that the customer will normally desire the opposite of what
the bank wishes to offer them. That is, in a period of rising rates customers will desire long term, fixed rate
loans (bank FRAs) and short term or variable rate deposits (bank RSLs) while the bank will desire to offer
them short term, floating rate loans (bank RSAs) and long term, fixed rate deposits (bank FRLs) to
maximize the bank’s Net Interest Margin (NIM) or equivalently, NII.
Problems with the repricing model include:

♦ The repricing model (RPM) measures only short term profit changes, not shareholder wealth changes.
As such it suffers from the same problems as the goal of maximizing profits. In particular the RPM
ignores cash flows changes that occur outside the maturity bucket and ignores the change in current
value of future cash flows as interest rates change.
♦ The maturity buckets are arbitrarily chosen and can be difficult to manage. It is possible to have a
positive 3 month RS gap, a negative 6 month RS gap and a positive 1 year RS gap. Managing this
requires detailed forecasts of interest rate changes over the various arbitrarily chosen time periods.
♦ All assets and liabilities that mature within the maturity bucket are considered equally rate sensitive.
This is defacto not true if a spread effect exists.
♦ The RPM ignores runoffs. Runoffs are receipts of cash on FRA or payments due on FRLs that occur
during the maturity bucket period.89 This cash must be reinvested by the intermediary and it is rate
sensitive. Runoffs are not calculated in the basic version of the RPM presented here.
♦ The RPM ignores prepayments. Prepayment patterns are affected by changing interest rates and are
difficult to predict. Prepayments increase with declining rates so assets that were considered fixed rate
may become rate sensitive by being prepaid within the maturity bucket.
♦ The RPM ignores cash flows generated from off balance sheet activities. These cash flows are also
often sensitive to the level of interest rates, so the RPM underestimates the interest rate sensitivity of
the institution.
88
FRAs financed by equity are not a part of the gap because the assets and liabilities in this category
are both fixed rate. Instructors please be aware that the profit table has to be constructed based on the size
of the given categories, for instance, it will not always include a line where FRA is financed by equity. If
the gap had been positive the third row would have been RSA financed by equity.
89
Payments on FRLs that require additional borrowing would result in a change in interest expense
on a given account, making it rate sensitive. Similarly, if the bank had to liquidate part of a fixed rate asset
to pay the liability, this would change the income on fixed rate assets.
22-6
Many accounts do not have fixed maturities and the classification of RS or FR must be based on historical
turnover patterns and management’s subjective evaluation. Investors’ desire for liquidity may change as
interest rates change, and accounts that were previously fixed rate may become rate sensitive or vice versa.
b. The Duration Model

Even if a bank could set the repricing gap for all maturity buckets to zero (and the model had no
deficiencies) so that the bank could ensure that a given level of profits would occur no matter how interest
rates changed, the bank could not ensure that the present value of the given profits would be the same if
interest rates changed. If rates rose the present value of the given hedged future profit stream would
decline. Equity value is theoretically equal to the present value of future profits so in this case the market
value of equity would decline if rates rose and rise if interest rates fell. The market value of equity is also
equal to the market value of assets minus the market value of liabilities. Banks can thus do a better job of
managing stockholder risk and rate of return by estimating how much the value of assets will change
relative to how much the value of liabilities will change when interest rates move. These values can be
estimated by measuring and comparing the duration of the asset portfolio (DA) and the duration of the
liability portfolio (DL). DA is the weighted average of the durations of each asset: D A = ∑ (X i × D i )
where Xi is the percentage of total assets invested in asset i and Di is the duration of the ith asset. DL is
calculated similarly.
The accounting identity states that A = L + E or ∆E = ∆A - ∆L where E = Equity, A = total assets and L =
total liabilities.
The percentage change in A and L for a given change in rates is given by (from Chapter 3):
∆A ∆R ∆L ∆R
= −D A = −D L respectively.
A (1 + R ) L (1 + R )
Dollar changes in A and L are given by:

∆R ∆R
∆A = A × − D A ∆L = L × − D L
(1 + R ) (1 + R )
so that
 ∆R   ∆R 
∆E = A × − D A  − L × −D L 
 (1 + R )   (1 + R ) 
If ∆R and (1+R) are the same for assets and liabilities then ∆E can be simplified as:
∆R
∆E = {[A × −D A ] − [L × −D L ]} and by multiplying by A / A:
(1 + R )
∆R
∆E = −{D A − kD L }× A × where k = L / A or the total debt ratio.
(1 + R )
{DA – kDL} is termed the duration gap.
Example calculation: Suppose a bank with $500 million in assets has an average asset duration of 3 years,
and an average liability duration of 1 year. The bank also has a total debt ratio of 90%. R may be thought
of as the required return on equity (see Gardner and Mills) or perhaps as the average interest rate level. If
R is 12% and the bank is expecting a 50 basis point increase in interest rates, by how much will the equity
value change?
Equity Value Change

∆E = – [3 – (0.90×1)]× $500 million × (0.0050 / 1.12) = –$4,687,500.
To find the percentage change in equity, divide both sides of the equation by E:
E = $500 million ×(1-0.90) or E = $50 million so that:
22-7
∆E/E = – [3 – (0.90×1)]× ($500 million/$50 million) × (0.0050 / 1.12) = – 9.375% or ∆E/E may be more
simply found as -$4,687,500 / $50,000,000 = -9.375%.
Changes in the value of equity for different duration gaps

Recall that duration measures the value change of the assets or liabilities for a given interest rate change. If
we assume similar rate changes for assets and liabilities then the following generalizations can be made:
Interest Rate Biggest Value Equity

Duration Gap Change Change Value
Assets Decreases
Positive
Decrease Assets Increases
Increase Liabilities Increases

Negative
Decrease Liabilities Decreases
Both asset and liability values for fixed income contracts increase when rates fall and decrease when rates
rise. However, for a positive duration gap the absolute value of the change in value of the assets is greater
than the change in value of the liabilities when interest rates change. With a negative duration gap the
change in value of the liabilities will be larger in absolute terms than the change in value of the assets.
The duration of a variable rate contract may be thought of as the time until the rate reset. This will
typically be much shorter than the maturity. Thus, a 30 year mortgage with a rate adjustment due in 6
months has a 6 month duration. Contracts with a maturity of 3 months or less may be thought of as having
a duration equal to their maturity without substantively affecting the analysis. This simplifies the duration
calculations for many accounts.
If the bank has a positive duration gap and is forecasting rising rates, they may wish to switch to shorter
term assets and/or variable rate assets and try to lengthen the duration of the liability portfolio.
Alternatively, the off balance sheet tools discussed in Chapter 23 could be used. If the leverage adjusted
duration gap is zero, the equity value will be approximately unchanged for small changes in interest rates.
Problems with the duration model include:

♦ Duration matching can be time consuming and costly. Although this is still true, with today’s
computing power this criticism is less valid than in the past.
♦ Immunization (setting and keeping the duration gap at zero) is a dynamic process. The durations of
the assets and liabilities will change every time interest rates change and will change at uneven rates
over time (the duration formula is not linear with respect to time). This implies that maintaining a
given duration gap requires frequent on or off balance sheet adjustments, and implies that trading costs
have to be weighed against the benefits of duration management.
♦ Immunization does not provide protection for large interest rate changes due to convexity because
duration predicts a linear price change with respect to interest rates. In actuality the capital loss
associated with a given percentage interest rate increase is less than the capital gain associated with a
given interest rate decrease. Duration thus overpredicts capital losses and underpredicts capital gains
because of convexity.
22-8
The duration model can cause bankers to become complacent about the interest rate risk they face. Aside
from convexity, which can be a significant problem in an abnormal market, the duration model suffers from
many of the same problems as the RPM. For instance, the effects of defaults, prepayments, and call
features of securities are difficult to include in the duration calculations. This can lead to the belief that the
bank precisely knows its risk level when in fact a large interest rate move that changes investor behavior is
not incorporated into the model.90
3. Insolvency Risk Management

a. Capital and Insolvency Risk
Equity is the FI’s main cushion against insolvency. It also serves as a source of funds and as a requirement
for growth given the minimum capital to asset requirements in force for DIs. Equity can be thought of as
either the book value of assets minus the book value of liabilities, with some adjustments allowed by
regulators, or as the market value of assets minus the market value of liabilities. Book values are only
rarely accurate representations of market values.
Book values are not necessarily good representations of liquidation values either. It is not clear to this
author exactly what book value of equity actually measures. It is roughly the sum of past decisions on asset
acquisitions less the face amount borrowed. As such it appears to be roughly a measure of net sunk costs
by managers. It has the advantage of being calculated according to a set of rules that limit management’s
ability to manipulate equity value, and it provides a fairly predicable number on a day to day basis. For
those who remember their economics training, this very stability implies that the book value of equity
cannot be a fair representation of the ongoing day to day value of the firm in a dynamic marketplace.
Capital and credit risk:

Loan losses are written off against capital. As loans are marked to market, capital is reduced. When
enough loan losses eliminate all the existing equity, the institution is insolvent.
Capital and interest rate risk:

Realized losses in value of securities and loans are also written off against capital. If losses due to rising
interest rates (net of the reduced value of liabilities) are large enough to wipe out the FI’s capital, the
institution becomes insolvent.
Market value accounting and insolvency

If regulators closed an institution as soon as its market value of capital became zero, theoretically no
liability holders or taxpayers would suffer any losses and the FDIC’s DIF would never be required. This is
not the case if regulators wait until the book value of equity is zero to close the institution. Book value of
equity is composed of par value + surplus + retained earnings + loan and lease loss reserves. It is not
automatically adjusted downward as credit or interest rate losses occur. For instance, under GAAP, FI
managers do not have to recognize loans as ‘bad’ and write them off in the year that payment problems
develop. Managers may also sell other assets that have gains in value (these are marked to market when
sold) and inflate the book value of capital even though losses on other loans and securities have not been
recognized. This practice is called ‘gains trading’ and can be used to postpone insolvency (while
generating larger losses).91 The use of book value does not recognize losses due to interest rate risk either.
As interest rates rise, an institution with a positive duration gap suffers losses to the market value of equity.
The book value of equity is unchanged until the assets and liabilities are marked to market. This explains
why over half of all S&Ls were insolvent in the early 1980s under market value accounting but were
allowed to continue to operate. The insolvent S&Ls went on to generate even larger losses that eventually
bankrupted the industry’s insurer, the FSLIC. Examinations help limit the difference between book value
and market value of capital by forcing FIs to recognize its true losses. Loan and security sales also reduce
the difference. However, in times of high credit losses and high interest rate volatility, the difference
between the book and market value of equity can become quite large. One can attempt to measure this
difference by examining an institution’s market to book ratio. The market to book ratio is the market
90
This is a false precision problem. VAR suffers from similar criticisms, as the failure of Long
Term Capital Management showed.
91
New market value accounting rules should help minimize gains trading.
22-9
value of equity divided by the book value of equity. In 2008 for a small sample of large banks, the market
to book ratios ranged from a low of 0.7 for Wachovia to as high as 2.6 for U.S. Bancorp.92
In summary, using book value accounting increases the government’s potential liability to depositors
and other claimants.
Predictably, the industry is against implementing market value accounting. The reasons usually cited are:
1. Banks and thrifts maintain that implementing market value accounting is difficult and burdensome,
particularly for smaller institutions that have many nontraded assets for which it would be difficult to
obtain a market value. However, it seems fairly easy to impute a market value for financial assets and
liabilities, so this argument does not seem particularly relevant except perhaps for very small
institutions.
2. Managers do not want unrealized (paper) gains and losses to be reflected in income, claiming this
would excessively destabilize earnings and equity. Accounting theory tells us that the purpose of
income as it is measured is to smooth out fluctuations in cash flows through time to provide a better
picture of value than short term, highly variable cash flows. Accruals adjustments supposedly give a
truer picture of the cash flow potential of the firm over the long term. Stock prices appear to more
closely follow income than short term cash flows or EVA adjusted cash flow measures. Managers
claim they hold many of their assets and liabilities to maturity and marking them to market would
simply distort the value of the bank to shareholders. Moreover, the FDIC claims that marking to
market could cause them to have to close an institution that might otherwise survive simply because of
a short term interest rate movement. Both arguments have some validity but are incorrect
theoretically. The managers’ claim that we should not update values as market conditions change
implies that equity should measure something other than present value of expected future cash flows.93
An economic variable that measures future prospects must be unstable if those prospects are changing.
Bankers and accountants don’t think this way though. They want a measure of value that is stable and
encourages accountability. The FDIC’s argument forgets that during the 1980s the FSLIC went
bankrupt (and the FDIC came close) because book value accounting allowed institutions to build large
losses which the insurer eventually had to pay. There is also an implicit assumption in their argument
that an interest rate change will be reversed in time to restore profitability to the institution. I doubt the
validity of that argument, but more importantly, I would counter that if a short term interest rate move
can put an institution under then the regulators need to bring about a change in management at that
institution anyway.
3. FIs also maintain that they would be less likely to engage in long term lending and investing if these
accounts were regularly marked to market. This statement itself is very revealing as it indicates that FI
managers recognize that the current accounting rules allow managers to take on more risk than
they could otherwise. There might be disruptions in the short run, but in a free capital system, other
new lenders would emerge if banks refused to make these loans. They may not make as many, or they
may increase the price of the loans, or they may simply hedge more. This appears to be a disingenuous
argument.
92
The text data includes thrifts.
93
Alternatively managers may be implicitly implying that the maturity of their investments is the proper
time horizon over which value should be measured, but equity does not mature when their investments do
so they are ignoring reinvestment risk over the longer time horizon, the value of which is better captured by
current market values.
22-10
Chapter 23 - Managing Risk with Derivatives
Chapter Twenty Three

Managing Risk off the Balance Sheet with
Derivative Securities
FIs are increasingly managing their risks with derivative securities. These provide off balance sheet
methods to tailor or reduce the risk exposure that an FI faces. Derivatives usage remains concentrated
among the larger and more sophisticated FIs, but because derivatives can be used to cheaply and effectively
reduce risk, their usage will continue to grow as product familiarity increases. Some of the largest FIs also
act as dealers, creating derivative contracts that other customers purchase. This chapter discusses the use of
hedging with futures, forwards, options and swaps. The main features of these securities and their
valuation can be found in Chapter 10. This chapter illustrates in conceptual terms how a FI may use
derivatives to manage the risks discussed in Chapters 19 through 22. The appendices and the supplement
provide numerical examples of hedging, including calculating the hedge ratio where appropriate. This
chapter is more difficult than prior chapters and the ancillary materials in particular are technical. By
relegating the more detailed applications to the appendices and the supplement the instructor can choose to
provide the students with the concept of hedging without requiring students to understand the more difficult
quantitative aspects. If the instructor prefers, one or more of the example applications in the additional
material can be used to illustrate the mechanics of hedging.94
II. Notes
1. Derivative Securities Used to Manage Risk: Chapter Overview
Derivative securities can be used to create new payoff patterns for FIs. They can be used to reduce a
repricing or duration gap much more quickly than attempting to change balance sheet accounts. For
instance if a FI wished to increase its rate sensitive loan amounts relative to its fixed rate loans in order to
profit from a projected rate increase, it would probably need to alter the loan pricing patterns on the two
accounts to overcome customer resistance.95 Balance sheet manipulations take time to effect, and the
required changes in pricing needed to affect customer behavior may more than offset any gain from the
interest rate increase.96 Using derivatives to hedge is best thought of as purchasing insurance to limit
certain risks that arise from currency or interest rate movements. Growth in derivatives usage has been
tremendous in recent years (see Chapter 10) and is likely to continue. Banks generated fees and revenue
from derivatives of $20.7 billion in 2007. This chapter covers hedging with forwards and futures, option
contracts and swap contracts. Some of the features of these contracts are reiterated in this chapter, but
readers should be familiar with Chapter 10 before studying the hedging applications. The advantages and
disadvantages of the types of hedging instruments are also covered.
Total derivatives usage at commercial banks in 2004 was $181,594,996 million (notional principal).
Seventy-eight percent of the total was in interest rate contracts, the bulk of which were swaps, another
10.87% were foreign exchange contracts and credit derivatives comprised 9.05%. Notice the 600% growth
in credit derivatives since 2004. Banks were guarantors on credit derivatives about as many times as they
were beneficiaries. Derivatives usage is heavily concentrated among the largest banks. As of 2007 about
94
There are several test bank questions keyed to the appendices and supplement and they are clearly
marked as such on the “Response” line in the test bank.
95 Sophisticated loan customers also have rate forecasts.
96 Indeed in
a perfect, efficient market the required change in pricing would exactly offset the profit
change from the expected rate change. Admittedly, derivative markets are probably highly efficient as
well.
23-1
940 banks actively used derivatives, about 92% of which were provided by only three large bank dealers,
J.P. Morgan Chase, Bank of America and Citigroup.97
% of % of Growth from
Derivatives Usage at Commercial Banks (Millions $) Total Category 2004
March 31, 2008
Notional Amount of Credit Derivatives 16,441,414 9.05% 600%
Bank is the guarantor 8,058,557 49%
Bank is the beneficiary 8,382,857 51%
Interest Rate Contracts 141,864,796 78.13% 88%

Notional value of interest rate swaps 108,551,080 77%
Futures and forward contracts 11,722,244 8%
Written option contracts 10,965,766 8%
Purchased option contracts 10,625,706 7%
Foreign Exchange Contracts 19,738,174 10.87% 119%

Notional value of exchange swaps 3,354,053 17%
Commitments to purchase FX 11,592,855 59%
Spot FX contracts 1,240,739
Written options contracts 2,428,432 12%
Purchased options contracts 2,362,834 12%
Other Contracts 3,540,612 1.95% 151%

Notional value of other swaps 648,209 18%
Futures and forward contracts 286,459 8%
Written option contracts 1,309,518 37%
Purchased option contracts 1,296,426 37%
Total $181,584,996 100%
Source FDIC, SDI Report on Derivatives, All banks

Notes: FX = Foreign Exchange; Spot FX contracts are a part of Commitments to purchase FX
2. Forwards and Futures Contracts

A spot contract is a contract for immediate payment and delivery. Settlement is usually within two to
three business days. A forward contract is a contract for future payment and delivery beyond two or three
days, but the terms of the transaction are determined when the contract is initiated. Futures contracts are
standardized, exchange traded forward contracts except that futures have daily marking to market, virtually
no default risk and are typically highly liquid.
a. Hedging With Forward Contracts

Naïve hedge: A naïve hedge is one where the spot (or ‘cash’) instrument is fully hedged with a forward or
futures contract as opposed to a partial hedge. The “naivete” implied is the hedger’s unwillingness to bear
any risk by taking a position on a rate or price change.
When faced with a hedging situation a simple paradigm can help identify the appropriate derivatives
position:
1. Identify the rate or price change that hurts the existing or anticipated position.
97
See the text section titled “Risks Associated With Futures, Forwards and Option.”
23-2
2. Choose a derivatives position that makes money if the bad event (unfavorable rate or price change)
happens.
3. Calculate the number of contracts required if appropriate.
4. Secure sources of interim funding if needed (futures or written option positions).
Example 1:
A pension fund manager is anticipating buying 10 year duration, 9% yield corporate bonds in six months.
They are currently priced at par. She is afraid that rates may fall, raising the purchase price of the bonds.
How can she use a forward contract to fully hedge the position?
Answer: Enter into a forward contract to buy the bonds in six months at a 9% yield.
In an efficient market she should NOT be able to buy the bonds forward at a 9% yield when rates are
forecasted to fall. This is a serious drawback to a naïve or full hedge, and it is one of the reasons why the
German oil firm, MAG, did not fully hedge its risk and eventually went bankrupt from derivatives. A FI
does not hedge to earn a better rate of return, but rather to reduce undesired risk. It is one thing to partially
hedge to limit risk, it is quite another to attempt to use a hedging program to bolster returns. Two reasons
make the latter a risky practice; first, because of the high amount of leverage involved mistakes can quickly
generate larges losses, and second, because hedging is supposed to reduce risk and these activities are very
technical, the internal control procedures on this activity may not accurately assess the risk exposure if
hedgers go beyond limiting risk.
b. Hedging With Futures Contracts

♦ Microhedging
A microhedge is a hedge of a particular current or anticipated account or transaction. To limit basis risk
the hedger will normally select a futures contract on an underlying instrument that is as similar as possible
to the account to be hedged. Perfect matches are rare however. The risk that remains in a hedged position
is called basis risk. The basis is the difference between the spot and futures price at a given point in time.
The risk of a hedged position is the risk that spot and futures prices will not move together over time, thus,
the more similar the spot and futures instruments, the less the basis risk.
♦ Macrohedging
A macrohedge is a hedge of an entire balance sheet’s value. This is usually accomplished by devising a
hedge to change the effective duration of the hedged balance sheet to zero. Rather than construct a
macrohedge, the bank could construct a series of microhedges. The positions and results of micro- and
macrohedges can be quite different and macrohedges are probably a more efficient means of hedging.98
♦ Choosing between macro and microhedges
• Risk and return: Macrohedges may be used to reduce the FI’s overall risk exposure to interest
rates. If interest rate risk is eliminated, the FI is said to be immunized. This would also reduce
the FI’s expected rate of return. If FIs perfectly hedged all risks, including credit risks, over time
their shareholders could expect to earn the T-bill rate (the risk free rate), and they would probably
fire the board of directors. Managers may instead choose to reduce some risks by applying
selective microhedges to more price volatile instruments. Partial macrohedges could achieve the
same result.
• Accounting rules and hedging strategies: FASB rulings favor microhedges. Under current FASB
rules, gains and losses on futures used in microhedges and the instrument being hedged are
marked to market and thus go through the income statement. Since these should be offsetting
that is not a particular problem. Macrohedges may generate futures gains or losses that are
recognized in earnings but are not offset because many accounts are carried at book value. This
can be upsetting to management.
• Policies of bank regulators: Regulations generally encourage hedging instead of speculating and
require disclosure of significant risk positions. It may be that banks have a more difficult time
98
As applied to a hedge, the term ‘efficiency’ (an overused word) refers to the hedge’s effectiveness at
reducing variability of outcomes at the lowest possible cost.
23-3
proving to regulators that macrohedges are valid hedges since they are not tied to individual
accounts. Forward contracts are subject to risk capital requirements and futures contracts are
not.
♦ Microhedging with Futures

One needs to know a good deal about the contract terms including size, delivery dates, liquidity, etc to
establish a specific hedging strategy. In general terms however, if the FI’s risk is from falling interest rates
(or rising prices), a long hedge (buying futures) should be used.99 If the FI’s risk is from rising interest
rates (or falling prices) then a short hedge (selling futures) should be used.
The number of contracts needed to hedge a position is calculated based on two factors: 1) the size of the
cash position relative to the futures contract size and 2) the price volatility of the spot relative to the price
volatility of the futures contract. The larger the cash position relative to the quantity specified for delivery
in the futures contract, the greater the number of contracts required to hedge. The greater the price
volatility of the spot relative to the price volatility of the underlying futures commodity with respect to
interest rates, the larger the number of contracts needed to hedge.
3. Options
a. Basic Features of Options (See Chapter 10 for details)
Buying options: A call option on a bond gives the holder gains if interest rates fall. Thus buying bond
calls is a useful hedge against falling rates. A put option on a bond gives the put holder gains if interest
rates rise and prices fall. Thus buying bond puts can hedge rising interest rates. Recall that options differ
from forwards and futures in that the holder has the right, but not the obligation, to buy or sell the
commodity at a set price. This
right causes the asymmetric Profit
nature of option hedge outcomes. Call
At expiration profit diagram of a
long bond call and put option
respectively:
The maximum loss is the call or B

put premium respectively. The
call makes money when bond
prices rise (interest rates fall).
The put makes money when
bond prices fall (interest rates
rise).
Writing options: When you write a call (put) option you receive the premium up front but you have
granted someone else the right to make you sell (buy) the underlying commodity at the exercise price if it is
advantageous for the Profit
counterparty to do so. The
maximum gain is the premium
that the writer receives and it Long Put
occurs if bond prices move such
that the option winds up out of
the money. The maximum loss
is generally unlimited and losses BT
increase with rising (falling)
bond prices on a written call
(put) option. Writing naked or
uncovered options is thus riskier
than buying options, and these
99
Futures hedges are normally named according to the position taken in the futures market.
23-4
are appropriate strategies only in low volatility environments.100
At expiration profit diagram of a written bond call and put option respectively:
The maximum loss is unlimited with the call and is quite large, but finite for the put. The written call
provides a limited gain equal to the call premium Profit
when bond prices fall (interest rates rise). The
put earns the put premium when bond prices rise
above the exercise (interest rates fall).
b. Actual Interest Rate Options

See Chapter 10 for a discussion of actual
contracts available. BT
Written
c. Hedging With Options Call
If the FI’s spot position is exposed to falling
interest rates, a call option may be purchased (or
a put option may be written) to limit the FI’s net
exposure.
Profit
Example 2:
Suppose a FI has sold bonds short. It is at risk
Writing a Put
from falling interest rates (rising bond prices). In
order to hedge this risk the FI may purchase call
options on the bonds. This would entail a small
capital investment relative to the size of the cash BT
position and would limit the risk from rising bond
prices (see the graph below).
Profit
S0 - C0
ST = S0 - C0
E
$0 St
S0 - C0 - E
Figure 1
100
For instance, the call option writer does not gain from large price drops (high downside price
volatility) and incurs large losses if prices rise (high upside price volatility). This strategy is a bet that
prices will not move much in either direction, i.e. low volatility. The same conclusion is true for writing
puts although the direction of the price effects is reversed.
23-5
HEDGE A SHORT BOND POSITION WITH BOND CALLS

Profit Table ST < E ST > E
S0 - ST S0 - ST S0 - ST
-C0 -C0 -C0
+CT 0 ST - E
= Profit S0 - ST - C0 S0 - ST - C0 + ST - E
Breakeven ST = S0 - C0
S = Spot value at given time, C = Call value at time t where the time subscripts are 0 = hedge initiation
time, and T = expiration of the hedge and option contract. E = option exercise or strike price.
The hedged position has a small maximum loss. The loss is limited to the initial call premium if the call
was originally at the money and the position has a potentially large gain. Note that the combination of the
short bond position and the call creates a synthetic put. If an investor were long in bonds, an appropriate
option hedge may be obtained by purchasing puts to limit the risk of falling bond prices. This situation is
depicted below in Figure 2:
Profit
ST = S0 + P0
E
$0 St
E - S0 -
Figure 2
HEDGE A LONG BOND POSITION WITH BOND PUTS
Profit Table ST < E ST > E
ST - S0 ST - S0 ST - S0
-P0 -P0 -P0
+PT E - ST 0
= Profit ST - S0 - P0 + E - ST ST - S0 - P0
Breakeven ST = S0 +P0
S = Spot value at given time, C = Call value at time t where the time subscripts are 0 = hedge initiation
time, and T = expiration of the hedge and option contract. E = option exercise or strike price.
The hedged position again has a small maximum loss. The loss is limited to the initial put premium if the
put was originally at the money and the position has a potentially large gain. Note that the combination of
the long bond position and the put creates a synthetic call.
23-6
d. Caps, Floors and Collars

As an alternative to buying a put or call on a bond, a FI can hedge interest rate risk by buying caps and
floors. A cap is conceptually a type of European call option on interest rates with multiple exercise dates.
If an interest rate or rate index is above the cap rate (equivalent to the exercise price on a standard call on a
security) at one or more specified dates in the future the seller of the cap pays the buyer the difference
between the interest rate and the cap rate times the notional principal amount. The seller of the cap
receives a premium (sale price) at the time of sale. These are OTC options and the terms are negotiated.
Counterparty credit risk can be substantial.
A floor is similar to a put option on interest rates. If an interest rate or rate index is below the floor rate
(equivalent to the exercise price on a standard call on a security) at one or more specified dates in the future
the seller of the floor pays the buyer the difference between the interest rate and the floor rate times the
notional principal amount.
The floor is equivalent to a call option on bond prices while the cap is equivalent to a put option.
A collar is a simultaneous position in a cap and a floor. These may be of two kinds. The FI may
simultaneously buy (sell) both a cap and a floor. This would limit the effect of rising and falling interest
rate movements on the FI’s profitability or market value. Alternatively, the FI could buy (sell) the cap and
sell (buy) the floor with different exercise rates. Suppose a bank constructs a collar by buying a cap and
selling a floor. When used this way the cap hedges increases in interest rates (the FI receives money if
interest rates rise above the cap rate) and the sale of the floor helps finance the cost of purchasing the cap.
This position is illustrated in the appendix.
4. Risks Associated with Futures, Forwards and Options

The risks associated with derivatives vary with exchange traded and OTC deriviatives. Both carry
substantial trading risk if used improperly because of the high amount of leverage employed in these
contracts. OTC contracts also carry an additional risk that the text terms ‘contingent risk.’ Contingent
risk results from the possibility that the counterparty will default. Contingent risk would include the costs
of replacing the contract and the losses that arise from the spot position that is no longer hedged. Exchange
traded options and futures contracts have a very small chance of default, thus they have only limited
contingent risk. With exchange traded contracts the exchange backs the performance of the counterparty.
Daily marking to market, margin requirements, position limits and daily price limit change rules employed
by exchanges all help limit the exchange’s risks so that their performance guarantee is credible and sound.
Default and contingent risk can be substantial on OTC contracts and if participants are concerned about
counterparty default, collateral may be required on the contract.
5. Swaps (See Chapter 10 also)

There are five types of swaps: Interest rate swaps, currency swaps, credit risk swaps, commodity swaps and
equity swaps.
a. Hedging with Interest Rate Swaps

Interest rate swaps are by far the largest component of the swap market. An interest rate swap is akin to a
series of forward rate agreements although the payments are not known with certainty at contract initiation.
The major advantages of swaps over other hedge types are related to their flexibility. These are custom
contracts that can be tailored to meet the specific needs of hedgers. They can be for much longer time
periods than typical futures or option contracts (see table below). In a plain vanilla swap one party makes
a variable rate payment and the counterparty makes a fixed rate payment on a given notional principal
amount. The dollars due are calculated by multiplying the appropriate interest rate times the agreed upon
notional principal. Only the net amount due is exchanged on an enactment date. Swaps may enact
quarterly, semiannually or annually.
Average swap maturity
Percent of swaps Swap Maturity
40% 1 year or less
35% >1 to 5 years
25% > 5 years
Source: Bank International Settlements Latest Tri-annual Survey, June 2007
23-7
Example 3:
A U.S. insurer has a positive repricing gap of $50 million and believes that interest rates may fall, reducing
their profitability. A bank with a considerable amount of mortgage loans has a negative repricing gap of
$50 million. The bank is concerned that rates may rise, hurting their profitability (See Chapter 22 for
explanations of the repricing and duration gaps). The insurer does not have enough rate sensitive (variable
rate or short maturity) liabilities, the bank has too many. The risk of both can be reduced by setting up a
swap with a $50 million notional principal where the insurer pays a variable rate of interest to the bank, and
the bank pays a fixed rate to the insurer. This swap will effectively reduce the repricing gaps of both
institutions to zero. The insurer effectively ‘transforms’ $50 million of fixed rate liabilities to rate sensitive
liabilities, the bank ‘transforms’ $50 million in fixed rate liabilities to rate sensitive liabilities. It is very
likely that the deal will be arranged through a third party FI, probably a large commercial or investment
bank. The swap broker takes a fee for arranging the deal. The swap broker may also guarantee the
payments of each participant in the swap (for an additional fee) so that counterparty default risk may not be
an issue. Also note that basis risk still exists to the extent that the variable rate index specified in the swap
(often LIBOR) is not perfectly correlated with the institution’s own cost of funds or asset earning rate.101
b. Currency Swaps
Fixed-fixed currency swaps
Example 4:
Ohio Bank has all of its assets in dollars but is financing some of them with an issue of the equivalent of
$75 million of 5 year fixed rate notes denominated in British pounds. Bulldog Bank, a British FI, has a net
$75 million dollar fixed rate liability. Ohio Bank is at risk from a depreciating dollar (or an appreciating
pound) because this would increase the cost to pay off the pound notes. Bulldog Bank is at risk from a
rising U.S. dollar (depreciating pound) because it must use some of its pounds to pay off the dollar debt.
Both FIs can reduce their currency risk by engaging in a swap, this time of both interest and principal.
Ohio bank agrees to pay the dollar interest and principal on $75 million of principal for 5 years. In return,
Bulldog agrees to pay the pound interest and principal on a similar amount. Both have eliminated their
exchange rate risk. This may be less expensive than refinancing at current market rates.
Fixed-floating currency swaps can also be arranged. If Ohio had borrowed at a fixed rate of interest as
before, but Bulldog had incurred a floating rate liability and if Ohio had rate sensitive assets it wished to
match, then a fixed-floating swap might be possible to arrange (See the Supplement).
Large FIs may act as swap dealers (act as the counterparty) even if no other customer with opposing needs
can currently be found because the FI knows that eventually it will be able to engage in other swaps that
offset the risk involved in the current swap deal. FIs keep a ‘book’ of their swap deals and manage their
net risk exposures.
c. Credit Risk Concerns With Swaps

There is now a risk based capital requirement imposed on banks who engage in swaps. Credit risk on
swaps is generally much lower than on loans of equivalent principal amounts because:
1. Only the net payment is due on the swap payment dates, and this amount will be less
than the typical interest payment on a equivalent principal loan.
2. Swap payments are often interest only and not principal, so the notional principal is not at risk.
3. If a swap partner is concerned about the counterparty’s creditworthiness they may require the
counterparty to obtain a standby letter of credit or to post collateral.
6. Comparison of Hedging Methods
101
Recall that basis risk is the risk that the spot price (or rate) and the price (or rate) on the hedging
instrument do not move together or as predicted.
23-8
Table of Exposures and Methods of Hedging

Futures/ Call/Put Caps &
Exposure Risk Forwards Options Floors Swaps
Macrohedges Side to Pay:
+ Repricing gap or
– Duration Gap Falling rates Long Call Floor Variable
- Repricing gap or
+ Duration Gap Rising rates Short Put Cap Fixed
Microhedges
Long security or future
commitment to sell Falling prices Short Put na na
Short security or future
commitment to buy Rising prices Long Call na na
a. Writing Versus Buying Options

Writing options is riskier than buying options because hedges with written option positions generally offer
limited gains and unlimited losses, whereas hedges involving purchased options offer limited losses and
unlimited gains.
b. Futures Versus Options Hedging
Futures hedges typically place an absolute ceiling on both gains and losses, whereas options hedges can
limit downside loss while allowing the hedger to enjoy large gains if prices move favorably. As you might
expect, hedging with options will normally involve more outright or out of pocket costs than hedging
with futures because the option buyer is purchasing a right which can be used if it is profitable, rather than
committing to a future purchase or sale.
The tradeoffs are largely due to differences in out of pocket costs and opportunity costs plus the effects of
marking to market on futures. With options there are greater up front out of pocket costs. Options are less
frequently used for hedging because many managers feel they are too costly. Futures have less up front out
of pocket costs, but may require bridge financing to cover marking to market and because futures are a
commitment they have larger opportunity costs. Managers overcome these by partially hedging and
actively trading. It is believed that futures trading costs for institutions are also less than for trading
options. Both can have similar high leverage ratios. Leverage reduces the cost of hedging because the
hedger has lower costs to hedge with a higher leverage ratio.
c. Swaps Versus Forwards, Futures, and Options

Swaps and forwards are OTC custom contracts with fully flexible terms. Futures and listed options are
highly standardized and have only limited maturities available. One of the big advantages of swaps is their
potentially long maturity. Some last 20 years or more, thus swaps allow longer term hedging than is
available with any other contract. OTC options are available that are more flexible and may have longer
maturities than listed options and futures.102 Futures are marked to market daily and may require a hedger
to put up more cash before realizing offsetting gains in the cash market. This can distort near term earnings
and may cause concern to upper level FI managers (particularly to those that do not fully understand the
hedging program). Futures and listed options have little or no default risk. Forwards and swaps may
involve significant counterparty risk unless a third party guarantees performance. Finally, futures and
options contracts are more liquid than forwards and swaps.
7. Derivative Trading Policies of Regulators

Derivatives are subject to three levels of regulation.
102
Exchanges are concerned about trading volume because that is how they profit from a contract and long
term contracts almost always have significantly lower trading volume, limiting their desirability for
exchanges.
23-9
Level 1: The SEC and the Commodity Futures Trading Commission (CFTC) are the ‘functional’
regulators of derivatives. They regulate trading activities and reporting requirements for derivative
contracts, although swaps are less regulated. The CFTC specifically regulates all futures contracts and
options on futures. The CFTC regulations include minimum capital requirements for traders, clearinghouse
rules, and the typical antifraud and manipulation rules. The SEC regulates options and other exchange
traded derivatives.
Level 2: Bank regulators, particularly the Federal Reserve, the FDIC and the Comptroller of the Currency
have established guidelines for bank users of derivatives. These include requirements that banks must
1) establish internal guidelines for hedging activity,
2) establish trading limits, and
3) disclose large positions that may materially affect shareholders and outside investors.
Generally, the regulations are designed to encourage hedging rather than speculation.
Level 3: General accounting rules provide another layer or level of regulation. The Federal Accounting
Standards Board (FASB) requires all FIs to reflect the current market value of derivatives positions in
financial statements. FIs also must discloser whether the derivatives positions are hedges or speculative.
Appendix 23A: Hedging With Futures Contracts

(all text appendices are available only on the web at www.mhhe.com/sc4e)
The reader should be comfortable with the material presented in Chapter 3, Chapter 10, and both Chapters
22 and 23 before attempting the appendices and supplement.
♦ Microhedging with Futures

The number of futures contracts (NF)
From Chapter 3: (D = Duration)

∆F/F = -DF × (∆RF/(1+RF)) or
∆F = -DF × F × (∆RF/(1+RF)) F = Total futures value ∆F = dollar change in F
∆P = -DP × P × (∆R/(1+R)) P = Market value of the instrument to be hedged
If P is fully hedged then ∆F = ∆P, the dollar change in F offsets any dollar change in P, or substituting from
above:
-DF × F × (∆RF / (1+RF)) = -DP × P × (∆R/(1+R))
Assuming that ∆RF / (1+RF) ≈ ∆R / (1+R)
-DF × F = -DP × P
F = NF × P F Where PF = the price per contract
Substituting this in:
-DF × NF × PF = -DP × P or
NF = (-DP / -DF) × (P / PF)
The concept of NF is easy to understand as mentioned above in Section 2b. The number of contracts
needed to hedge a position is calculated as a function of two factors: 1) the size of the cash position relative
to the futures contract size (P / PF) and 2) the price volatility of the spot relative to the price volatility of the
futures contract (-DP / -DF). The larger the cash position relative to the quantity specified for delivery in
the futures contract, the greater the number of contracts required to hedge. The greater the price volatility
of the spot relative to the price volatility of the underlying futures commodity with respect to interest rates,
the larger the number of contracts needed to hedge.
Example 5:
A bank has a long position in $500,000 face value 11.03% yield Treasury Bonds that have a duration of 11
years. The bank is concerned about rising interest rates between now and August. The bonds have a price
quote of 91 1/32 or $455,156. T-Bond futures contracts call for the delivery of $100,000 face value of
Treasury Bonds. The September contract (the nearest to August) has a price quote of 89 (or $89,000) and
23-10
the underlying T-bonds to be delivered have a 7 year duration and a 9.397% yield.103 How many futures
contracts are needed to fully hedge the position?104
NF = (-11 / -7) × ($455,156 / $89,000) = 8.036 or 8 contracts should be sold. Always round the number of
contracts down, because hedging efficiency is improved if one slightly underhedges rather than overhedges.
If prices move according to the duration predictions (convexity notwithstanding) then the hedge should
prevent large gains or losses from occurring for normal interest rate movements. For instance if rates rise
50 basis points:
∆F = ∆PF × NF = - 7 × (0.0050 / 1.09397) × $89,000 = $2,847.43 gain per contract × 8 contracts =
$22,779.42.
The price of the futures contract drops, but a drop in price makes money for a short position in futures.
The predicted change in the spot value is

∆P = - 11 × (0.0050 / 1.1103) × $455,156 = -$22,546.68
The predicted net gain or loss is the difference or $232.74.
♦ Macrohedging With Futures

A macrohedge is normally designed to immunize the equity value with respect to interest rate changes. I.E.
we desire ∆E = 0. From Chapter 22,
∆E = – [DA – kDL] × A × (∆R / (1+R))
∆F = – DF × NF × PF × (∆RF / (1+RF)) Setting ∆E = ∆F and if the interest rates and rate changes are the
same:
– [DA – kDL] × A = -DF × NF × PF Solving for NF yields:
[D A − kD L ]× A
NF =
D F × PF
Example 6:
Suppose a $500 million bank has an average asset duration of 3 years and an average liability duration of 1
year (See Chapter 23 of the IM for this example). The bank also has a total debt ratio of 90%. If R is 12%
and the bank is expecting a 50 basis point increase in interest rates, how many T-bond futures contracts are
required to fully hedge the equity value if the Treasury bond futures terms are the same as in Example 5?
Expected ∆E from the rate change is – [3 – (0.90×1)]× $500 million × (0.0050 / 1.12) =
–$4,687,500.
NF =
[3 − (0.90 ×1)]× $500Million = 1,685.39 Or the FI should sell 1,685 contracts.
7 × $89,000
If interest rates increase 50 basis points and prices move according to duration predictions then the gain on
the futures position will be:
∆F = ∆PF × NF = - 7 × (0.0050 / 1.09397) × $89,000 = $2,847.43 gain per contract × 1,685 contracts =
$4,797,920
As before the price of the futures contract drops, but a drop in price makes money for a short position in
futures. The net gain (loss) is $4,797,920 - $4,687,500 = $110,420.
103
T-bond futures contracts are priced according to the cheapest to deliver bond. The deliverable
bond must have at least a 15 year time to first possible call or maturity, and is priced as if it were an 8%
coupon bond. I used these terms to arrive at the yield price combination on the futures contract.
104
In this case RF does not equal R but ∆R = ∆RF. Omitting the (1+R) and (1+RF) terms usually does
not materially affect the hedge. If the change in rates is not likely to be similar between the cash and
futures instrument (as in a cross hedge), then one should include the different rate changes. For instance,
∆RF may be characterized as an expected percentage of ∆R based on regression analysis of historical
changes of the two rates.
23-11
Appendix 23B: Hedging With Options

This supplement examines hedges with purchased options, not written options for the reasons discussed in
the chapter.
Let ∆O = the total dollar change in the value of an option position and then ∆O = (NO × ∆o) where NO = the
number of option contracts and ∆o equals the dollar value change per contract. For a Treasury bond
contract let B = market value of the underlying T-bonds ($100,000 face value).
∆o ∆B
∆o = × × ∆RB Appendix Equation 2
∆B ∆RB
∆o / ∆B = the option’s delta (see Chapter 10). It is in the range 0 to +1 for a call option and 0 to –1 for a
put option. It is literally N(d1) from the Black-Scholes model and measures the change in option value per
dollar change in the underlying bond price. Write the delta as δ. Rather than differentiate between the
hedging equations for puts and calls, it is simpler to remember that the delta is positive for a call and
negative for a put.
∆B / ∆RB = the change in the underlying bond price per 1 basis point change in interest rates. This is equal
to [-DurB / (1+RB)] × B. (Note that DurB / (1+RB) is sometimes called the ‘modified duration’ or MD for
short so ∆B / ∆RB = -MD × B.)
In words, the first component measures the change in option value per dollar change in the underlying
bond’s price, the second term measures the underlying bond’s price response to an interest rate change, and
the third term measures the size of the interest rate change.
Rewriting Equation 2
DurB ∆RB
∆o = − δ × − × B × ∆RB = δ × DurB xB × Appendix Equation 6
1 + RB 1 + RB
Recall that N0 = total number of option contracts purchased and then the total dollar change in option value
∆O = NO x ∆o.
To hedge ∆O must equal ∆Spot.

∆RSpot
∆Spot = −DurSpot × × Spot Equation A
1 + RSpot
∆RB
(1 + RB )
Setting ∆Spot = ∆O, letting br = and solving for NO:105
∆RSpot
(1 + RSpot )
DurSpot × Spot
NO = Appendix Equation 13
δ × DurB × B × br
Example 7: (Continuation of Example 5)

A bank has a long spot position in $500,000 face value 11.03% yield Treasury Bonds that have a duration
of 11 years. The bank’s managers are concerned about rising interest rates between now and August. The
bonds have a price quote of 91 1/32 or $455,156. September put options on T-bond futures are available
with an exercise price of $90 per $100 of face value. The September options (the nearest to August) have a
premium of $1.625 per $100 of face value and the put option delta is –0.52. The contracts are for $100,000
105
For a macro hedge the numerator to Equation 13 will be (DurA – k DurL) x A. See Appendix Equation
8.
23-12
face value T-bonds. The underlying T-bonds to be delivered have a 7 year duration and a 9.397% yield for
an $89,000 price. How many put option contracts are needed to fully hedge the position?
11× $455,156
NO = = 15.22 contracts or 15 put contracts should be purchased. The
0.52 × 7 × $89,000 × 1.01493
total cost of the contracts is 15 × $1.625 × $100,000 / $100 = $24,375 or 5.35% of the market value of the
bonds.
If prices move according to the duration and delta predictions, then the hedge should prevent large gains or
losses from occurring for normal interest rate movements. For instance if rates increase 50 basis points:
∆O = ∆o × No = 0.52 × - 7 × (0.0050 / 1.09397) × $89,000 = $1,480.66 gain per contract × 15 contracts =
$22,210.
As before ∆Spot = - 11 × (0.0050 / 1.1103) × $455,156 = -$22,547.
The net difference in this case, is -$337 excluding the put premiums. The net loss including the premiums
is -$24,375 + -$337 = -$24,712. Recall that option outcomes are not symmetric, if the bond price increases
the puts will expire worthless but the gain in bond prices may outweigh the put premiums. You may wish
to have the students calculate the breakeven point as an exercise. The breakeven would occur when prices
have risen $24,375 if the puts had been exactly at the money.
Basis risk: On a direct hedge basis risk can probably be safely ignored. The correction for basis risk is the
term br and it may be omitted for a direct hedge.
Appendix 23C: Hedging with Caps, Floors and Collars
An FI has the following balance sheet categorized over a 2 year planning period:
Amount Liabilities Amount
Assets (Mill $) & Equity (Mill $)
RSAs @ 5% $ 50 RSLs @ 4% $100
FRAs @ 6% $350 FRLs @ 5% $300
NEA $ 60 Equity $ 60
Current Profitability Amount Spread Profitability

RSAs financed by RSLs $ 50 1% $0.5
FRAs financed by FRLS $300 1% $ 3
FRAs financed by RSLs $ 50 2% $ 1
$400 Total $4.5
Since the category NEA financed by equity has a zero spread
and does not contribute to profitability it can be omitted.
Profitability after rate
increase Amount Spread Profitability
FRAs financed by RSLs $ 50 1% $0.5
$400 Total $4.0
The FI has a 1% spread on rate sensitive and fixed rate assets, but the FI has a negative repricing gap of $50
million and is thus at risk from rising interest rates.106 This FI could purchase a 2 year cap with a cap rate
of 4.5% with a notional principal that matches the bank’s gap of $50 million with payments made annually.
The cap may cost the FI $5,000. Let interest rates increase such that that all RS rates increase 100 basis
106
Recall that in this case the FI has $50 million in FRAs financed by RSLs.
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points. The FI would then receive the difference between 5.5% and the cap rate of 4.5%. In other words
the FI would receive 1% * $50 million = $500,000.
Profitability after rate

increase with Cap Amount Spread Profitability
FRAs financed by RSLs $ 50 1% $0.5
$400 Total $4.0
Cap $50 1% $0.5
Total w/ Cap* $4.5
* Ignoring the cost of the cap
The cap protects the FI’s profits from an increase in interest rates for two years with payments made each
year. Note that the hedge is not perfect, particularly if the rate sensitive accounts reprice more frequently
than once a year. A floor would work similarly for an institution at risk from falling interest rates. The FI
may wish to sell a floor to defer some of the costs of purchasing the cap.
Collars:
The above FI may wish to hedge with a cap, but feels that the cost of the cap is too high. The FI could then
also sell a floor with a lower interest rate of say 4%. To simplify, assume that the cap and floor are for one
year and have only a payment at maturity. In this case the FI’s profit diagram, including the on balance
sheet changes, would be as follows:
Profit
El
F -C =
$ S
E
Profit Table at Time T when

the options expire in one year IT < EFloor EFloor < IT < ECap IT > ECap
NP*(FRA – RSLT) NP*(FRA – RSLT) NP*(FRA – RSLT) NP*(FRA – RSLT)
-NP*(FRA – RSL0) -NP*(FRA – RSL0) -NP*(FRA – RSL0) -NP*(FRA – RSL0)
-C0 -C0 -C0 -C0
+F0 +F0 +F0 +F0
+CT 0 0 NP*(RSLT – Cap)
-FT -NP*(Floor -RSLT) 0 0
-C0+F0 + -C0+F0 + -C0+F0 +
= Profit NP*(RSL0 – Floor) NP*(RSL0 - RSLT) NP*(RSL0 – Cap)
F0 - C0 =NP*(RSL0-
Breakeven RSLT)
23-14
NP = Notional principal, assumed the same for the gap and the options, Ct and Ft represent the value of the cap
and floor at time t respectively. T = 1 year, 0 = today. E = exercise rate
Supplement: Hedging With Swaps

♦ Macrohedging With Swaps
To protect the value of equity the swap should be designed to yield a gain equal to ∆E (the change in equity
value) if interest rates change. The swap is a negotiated contract so that the duration of the fixed and
variable sides of the contract can be constructed as needed. Likewise the notional principal is negotiable.
The swap designer is limited only by the ability to attract a counterparty willing to enter into the deal. It is
also only necessary to manage the net duration of the swap. The swap duration to a fixed rate payer is
equal to the duration of the variable payments minus the duration of the fixed payments. The converse is
true for the variable rate payer. Nevertheless it is convenient to solve for the optimal notional principal for
a given duration of the fixed and variable sides of the swap. Note that the duration of the variable
payments (or floating payments) is simply the time until the payments are reset.
The optimal notional principal of the swap NS can be found as:
NS = [(DA – kDL)×A] / [Dfixed – Dfloating] where Dfixed is equal to the duration of the fixed payments and
Dfloating is equal to the duration of the floating or variable payments.
Example 8: Continuation of Example 6

Suppose a $500 million bank has an average asset duration of 3 years and an average liability duration of 1
year. The bank also has a total debt ratio of 90%. R is 12% and the bank is expecting a 50 basis point
increase in interest rates.107 The FI can enter into a swap where the duration of the fixed rate payments is 6
years and the duration of the variable rate payments is 1 year. What is the optimal notional principal of the
swap that immunizes the equity value? Does the FI make or receive the fixed rate payments?
NS = [(3 – (0.9×1))×$500 million] / [6 – 1] = $210 million. The FI has a positive leverage weighted
duration gap so it has longer duration assets than liabilities. To reduce the duration gap the FI would pay
fixed (effectively extending the liability duration) and receive variable (effectively shortening the asset
duration).
♦ Fixed Floating Currency Swaps

Example 9:
♦ A Japanese FI has made variable rate dollar denominated loans to Taiwanese borrowers. The loans
are funded by fixed rate yen deposits. The Japanese FI is at risk from dropping Eurodollar interest
rates and from a depreciating dollar.
♦ A U.S. bank has made fixed rate yen loans to multinationals operating in the Far East, but these
loans are funded by variable rate dollar deposits. The U.S. bank is at risk from rising U.S. interest
rates and from a depreciating yen (appreciating dollar).
♦ The two institutions can design a swap that limits the risk of both parties. Separate the risks and
handle them individually when faced with more complex swap arrangements.108
The Japanese FI faces interest rate risk from falling interest rates. They have too many variable rate assets
so the Japanese FI will pay a variable rate of interest in exchange for receiving a fixed rate of interest.
The U.S. FI faces interest rate risk from rising interest rates. They have too many fixed rate assets so the
U.S. FI will pay a fixed rate of interest in exchange for receiving a variable rate of interest.
107
R may be thought of as either the average rate or return on assets and liabilities or as the return on
equity.
108
This assumes the risks are not hedged elsewhere. There is also an implicit assumption that the
swap deal is the cheapest source of hedging the risk. On balance sheet hedges (called money market
hedges) could also be used. The Japanese FI could borrow dollars at a variable rate and directly hedge the
risk. The size and popularity of the swap market indicates that swaps are often the cheapest method of
reducing the risk.
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The Japanese FI faces currency risk from a depreciating dollar as this will reduce the yen value of
repayments made by the Taiwanese borrowers. The Japanese FI will thus pay dollars in exchange for
receiving yen. The yen received will be used to pay off its fixed rate yen depositors.
The U.S. FI faces currency risk from an appreciating dollar (depreciating yen) as this will reduce the dollar
value of the yen repayments made by the multinational borrowers. The U.S. FI will thus pay yen in
exchange for receiving dollars.
Putting it together is now simple in concept:

♦ The Japanese FI will pay dollars at a variable rate of interest in exchange for receiving yen at a
fixed rate of interest.
♦ The U.S. FI will pay yen at a fixed rate of interest in exchange for receiving dollars at a variable
rate of interest.
23-16
Chapter 24 - Managing Risk Off the Balance Sheet with Loan Sales and Securitization
Chapter Twenty Four

Managing Risk Off the Balance Sheet with
Loan Sales and Securitization
Rather than engaging in hedging activities to limit risk as discussed in the prior chapters, FIs can also
manage their risks via loan sales and asset securitization. Loan sales may involve selling whole loans or
parts of loans, while loan securitization involves transforming portfolios or pools of loans into marketable
securities. In selling or securitizing loans, FIs are passing on the risk of asset transformation to others and
choosing to act as asset brokers instead. Because the broker function is generally less risky than the asset
transformation (or financing) function, sales and securitization may reduce the rate of return to the
selling FI unless a sufficient additional volume of transactions can be generated. Nevertheless, sales and
securitization allow the FI more alternatives to tailor the risk return combination they choose to bear.
Increasing the emphasis on the loan brokerage function reduces the sensitivity of profits to the net interest
margin (NIM), and may help stabilize profitability because the NIM can fluctuate dramatically as interest
rates change (see Chapter 22). Related benefits may include reduced capital and reserve requirements
and better balance sheet liquidity.109 In theory loan sales and securitization may also reduce the
government’s deposit insurance liability. Indeed there is no particular theoretical reason why depository
institutions should be the primary providers of loan financing. With the passage of the FSMA we can
expect loan originating institutions to increasingly act as asset brokers as markets for loan sales and
securitization mature.
I. Notes
1. Why Financial Institutions Sell and Securitize Loans: Chapter Overview
Loan sales are the sales of individual loans in whole or in part; these sales may be with or without recourse.
A sale without recourse means the loan seller has no contingent obligation to repay the loan to the loan
buyer in the event of borrower default. Loan securitization is the conversion of loans into marketable
securities. This is usually accomplished by placing the loans in a trust (or selling them to an FI who will do
this) and issuing (selling) marketable securities using the loans as collateral. The basics of securitization
are covered in Chapter 7 and readers should be familiar with that material, although some of the same
concepts are repeated in this chapter for clarity. Loan sales and securitization can improve the FI’s risk
return tradeoff by:
• reducing the credit risk the FI faces,
• improving the liquidity of the balance sheet and by
• reducing the regulatory burden imposed on traditional lending and deposit taking activities.
2. Loan Sales
Loan sales have been a traditional activity of correspondent banking for over 100 years in the U.S.110
Small banks often sell all or part of loans they have originated that are too large for them to finance on their
own and large banks sell loan participations to smaller banks. The market for buying and selling loans after
origination is called the syndicated loan market. This market has three type participants:
1. Market makers who commit capital to create liquidity and take outright positions in the markets.
These are primarily the large money center banks and investment banks.
2. Institutions that actively participate in the market. These would include some commercial and
investment banks, insurers and specialized investment funds (see below).
3. Occasional participants who either sell or buy loans as opportunities arise. Examples would
include smaller banks involved in correspondent relationships purchasing pieces of large loans
109
With fewer loans on the balance sheet there may be less need for deposit funding.
110
Correspondent banking is the term used to characterize the relationship and the services large
banks offer to smaller banks.
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originated by bigger institutions or the reverse with the small banks selling shares in a loan to
larger institutions.
Loan sales grew rapidly in the 1980s due to the growth of levered buy outs (LBOs). Banks provided
financing for many of these LBOs via lending for so called highly leveraged transactions or HLTs. HLTs
are primarily loans to finance takeovers and mergers where the resulting borrower has a high leverage ratio
after the takeover. Technically a HLT is a transaction that meets the following two criteria: 1) the loan is
for a buyout, acquisition or recapitalization and 2) one of the following: either the company’s liabilities are
doubled as a result and the leverage ratio is at least 50%, or the resulting leverage ratio is at least 75%. In
some of the HLTs, large banks divested parts of the loans to smaller banks in order to spread the high risk
of these transactions. The quantity of loan sales tends to rise and fall through time with M&A and HLT
activity.
Loan Sales Through Time
Year Billions $
1980 < $ 20
1989 $285
1999 $ 79
Early to mid2000s $120
2007 ≈$300
Source: Text
The HLT market grew rapidly in the 1980s, tapered off in the early 1990s, grew again in the boom years of
the latter part of the decade, dropped in the early 2000s and began growing again with the economy by the
mid 2000s.
A bank loan sale occurs when the originating institution sells the loan to another party. If the loan is sold
without recourse the loan is removed from the balance sheet and the bank has no further liability in the
event of borrower default. The bank may or may not retain the workout responsibility (collections and
resolution of problem loans). Most loan sales are without recourse. If the sale is with recourse, the loan
seller removes the loan from the balance sheet, but the seller records a contingent liability that must be
disclosed in the footnotes. There may be reserve and capital requirements for loans sold with resource.
Types of Loan Sales Contracts

There are two types of loan sale contracts: participations and assignments. There are technical differences
in the two.
♦ Loan participations: A loan participation is buying a share in a loan, but the buyer has only limited
control and rights over the borrower. In particular, in a participation the original loan agreement
between the originating lender and the borrower remains intact after the sale. The loan buyer is thus
not a direct claimant of the borrower, but of the loan seller. The loan buyer has only limited control
over any changes in the loan contract. The loan buyer(s) can only vote on changes in the interest rate
or collateral backing, but other contractual changes that the buyer does not approve can occur. Thus,
the loan buyers are clearly in a subordinate position to the original lender. For example if a borrower
fails to repay the original loan, the loan seller, who normally retains a part of the loan, may agree to
renegotiated terms that the loan buyers do not want. Moreover if the loan seller fails, the original
borrower’s debt may be netted against any claims (such as deposits at the failed FI) the borrower has
against the selling FI. This would reduce the amount the loan buyers could collect. The loan buyer
must thus monitor the creditworthiness of the borrower (or trust the loan seller to do so) and monitor
the creditworthiness of the loan seller. Direct loan participations occur in less than 10% of U.S. loan
sales.
♦ Loan assignments: An assignment of a loan is the purchase of a share in a loan where the loan buyer
is assigned or granted contractual control and rights over the borrower. Assignments are used in over
90% of U.S. loan sales instead of participations. In an assignment the loan buyer holds a direct claim
on the borrower, that is, the loan buyer obtains all rights upon purchase of the loan. In some cases the
original loan agreement will prevent assignment to certain parties or in certain conditions. Loan
24-2
buyers must be sure that the loan agreement does not contain specific exclusions that limit their rights.
Because of the complexity involved a loan sale is not a quick, easy process. It may take several
months to complete the sale of a loan although most are completed within about two weeks.
a. The Loan Sale Market

There are three segments of the market, two are discussed in this section and the third is discussed in part
c):
♦ The short term segment is comprised of sales of one to three month loans. The loans are normally
secured by tangible collateral of the borrower and are of investment grade. These loans are typically
sold in units of $1 million and up and are the traditional segment of the loan sale market. The rates on
these loan sales are closely tied to the commercial paper market, a competing source of short term
funds for well secured borrowers.
These characteristics keep the risk down. Many bankers, particularly at smaller conservative institutions,
are reluctant to invest in loans when they did not conduct the credit evaluation. As a result, sales of well
secured loans by creditworthy corporations have been the traditional mainstay of the loan sale market.
♦ HLT loan sales: Loan sales grow with the volume of HLTs. This segment of the market was
insignificant before 1985 but grew with the increased interest in LBOs and takeovers in the latter
1980s. HLT and other loans can be either ‘distressed’ (the borrower is having difficulty making the
scheduled loan payments) or ‘nondistressed.’ A distressed HLT loan is valued at less than 80¢ on the
dollar (the text mentions 90¢ rather than 80¢). HLT loans are usually long term, secured with
collateral, floating rate and have strong covenant protections. As of 2004 distressed loan sales
comprised about 28% of the total, down from 36% and 42% from 2001 and 2002 respectively. The
stronger economy of the mid-2000s reduced the distressed component and even as the economy
weakened in 2006 and 2007 the distressed loans were only 9% of loan sales.
The junk bond market grew rapidly in the 1980s as takeovers of larger and larger firms occurred. Banks
were unable or unwilling to provide the necessary financing to fund the large takeovers. Michael Milken
and his firm Drexel Burnham saw an opportunity and successfully created a secondary market for junk
bonds (below investment grade bonds). Junk bond financing allowed the takeovers of firms previously
considered too large to acquire.
Loan buyers:
Vulture funds: These are specialized funds that invest in distressed loans and bonds. These funds are
often operated by investment banks. They can be actively managed; loan purchasers of distressed funds are
often able to dictate favorable terms that can result in high rates of return. Other funds passively diversify
their holdings instead, being content with the higher promised yield on distressed loans. The active funds
sometimes pressure borrowers to restructure debts and/or sell off assets. These investors are looking for a
quick return on their capital and unlike a bank lender are usually not interested in building long term
relationships with the borrowers.
Investment banks: Investment banks invest in HLT loans because of their expertise in analyzing M&A
activity and their role in junk bond financing (a related product, see the Teaching Tip above).
Commercial banks: Banks have traditionally been interested in buying loans to circumvent interstate
banking prohibitions (perhaps due to the desire to remain fully invested in loans in periods of weak local
loan demand), generate better geographic diversification of their loan investments and develop
correspondent banking relationships. Small banks have often had to sell large loans to avoid loan
concentration limits. This market has been shrinking with the demise of interstate banking prohibitions
and the large number of bank mergers. Correspondent banking relationships are also less important today.
Finally there are increasing concerns about the moral hazard involved in loan sales. Originating
24-3
institutions may sell problem loans and keep the good ones.111 The moral hazard problem was evident in
the securitization of subprime mortgages.
Foreign banks: Foreign banks are the dominant buyer of U.S. domestic loans. Loan sales allow them to
participate in U.S. loans without incurring the cost of branching. Nevertheless, many foreign banks,
particularly Japanese banks that have a large U.S. presence, have recently been downsizing and
experiencing profit problems of their own.
Closed End Bank Loan Mutual Funds: (Such as Merrill Lynch Prime Fund) Some mutual funds both
purchase and originate loans.
Insurance Companies, Pension Funds & Nonfinancial Corporations: Large insurers and pensions buy a
significant amount of loans and a few corporations purchase loans.
The loan sellers include: Money center banks: These are the primary loan sellers; Small banks; Foreign
banks; Investment banks, generally limited to HLTs.
b. The Secondary Market For Lesser Developed Country (LDC) Debt

A third segment of the loan sale market is the sale of LDC loans (see Chapter 19). The major players in
this market are large U.S. and foreign commercial and investment banks. LDC loans are the highest risk
component of the loan portfolio and only the largest banks have LDC loans. Many of the problem LDC
loans made throughout the 1980s and 1990s have been restructured as Brady bonds. A Brady bond is a
bond that was created via a swap for a distressed LDC loan (see Chapter 6). The bonds were fixed rate,
whereas most LDC loans are variable rate. The bonds are more liquid than the loans, but they were of
lower value than the original loan amount. The swap allowed the lender to eliminate any further losses by
selling the bonds. Many bonds of emerging countries had good performance in the early 2000s. Brazil’s
economic growth, Mexico’s credit rating upgrade and Russia’s debt restructuring have encouraged
investors and generated growing interest in these markets. Low U.S. yields undoubtedly helped as well.
The experience of Argentina’s creditors has not been as promising and growing unrest in other South and
Central American countries will continue to contribute to the riskiness of this region.
c. Factors Encouraging Future Loan Sales Growth

♦ Sales without recourse eliminate the credit risk faced by the originating institution.
♦ Sales may still generate fee income for the loan seller. The bank can retain the servicing contract
(processing term payments) for which it receives a fee, and the lender normally charges a loan
origination fee. By creating and selling more loans, the FI can report higher current earnings than by
financing the loans and reporting interest income through time.
♦ The ability to sell the loans improves the liquidity of the bank’s loan portfolio. This may allow the
bank to hold fewer liquid assets and invest more in higher earning assets.
♦ Most loans carry a substantial risk weight in calculating the required amount of capital. If the loans are
sold without recourse the amount of capital a FI must hold can be reduced and additional growth in
total assets may be possible for a given level of capital.
♦ Loans sold without recourse do not have any reserve requirements. If loans are routinely sold, the FI
does not need as large a deposit base to fund its activities. With the smaller deposit base, its required
reserves will be reduced.
d. Factors Deterring Future Loan Sales Growth

♦ Corporations are increasingly using the commercial paper market to fund short term financing needs.
This reduces the quantity of high grade loans available for sale. The commercial paper market is now
becoming more accessible to midsize firms, further reducing the availability of short term loans.
111
This problem can be partially resolved by requiring the selling institution to keep a significant
portion of the loan, as is usually the case.
24-4
♦ Some high profile fraudulent conveyance proceedings may limit the popularity of loan sales.
Fraudulent conveyance means that a loan sale was conducted improperly or illegally according to the
terms of the original loan agreement. In particular, fraudulent conveyance is the transfer of assets at
less than fair value made while a firm is insolvent. This activity is prohibited to protect the interests of
creditors.
Suppose a bank is technically insolvent but is still operating. Bank managers have an incentive to sell
loans at fire sale prices in order to raise cash to keep the institution afloat as long as possible.
Alternatively, suppose a corporation is insolvent. Its banker may attempt to sell any loans the bank has
with the corporation at discounted prices to limit its losses. The loan buyer may be unaware of the
corporation’s insolvency and would be purchasing a claim that is different than represented by the
selling bank. Notice that both these problems stem from information asymmetry between the parties.
3. Loan Securitization (See Chapter 7)

In 2007 there were $7,210.3 billion in mortgage related securities outstanding. According to the text,
GNMA mortgage pools totaled $427.5 billion, FNMA, $2,168.0 billion and FHLMC, $1,660.6 billion.
Agency mortgage backed securities (MBS) totaled $4,545.9 billion or 63% of the total. Agency CMOs
were $1,343.5 or about 19% of the total and Non-Agency MBS were $1320.9 or about 18%. Issuance of
Non-Agency MBS in January and February 2008 had declined 94% year to date from the same time period
in 2007, although agency related issuance was up 19% in the same time period.112 The Non-Agency MBS
market includes issuers involved in the bulk of the subprime market.
According to Thomson Financial, international securitization volume dropped by about 92% in the first
quarter of 2008 as compared to the same time period in 2007. This was the smallest volume since 1996.113
Although at first securitization was largely limited to mortgage loans, other loan types are now being
securitized and many new institutions had entered the securitization business before the subprime crisis.
The subprime mortgage crisis

Mortgage delinquencies increased dramatically in the last quarter of 2006 and remained high throughout
2007. Foreclosure filings increased 93% in July 2007 over July 2006. The delinquencies caused severe
problems in the mortgage backed securities markets. Losses from the decline in value of subprime
mortgages and the securities that have these loans as collateral are estimated at $400 billion. Financial
institutions and government agencies that invested in MBS saw the value of their holdings plummet. The
largest commercial and investment banks wrote off about $130 billion in loans. Citigroup, Merrill Lynch
and Morgan Stanley wrote off about $40 billion combined. Bank of America and Wachovia wrote off $3
billion and $1.2 billion respectively while UBS took looses of $10 billion. Two Bear Stearns hedge funds
failed due to mortgage related losses, eventually bringing the parent firm down with them. In February
2008 MBIA, a bond and mortgage insurer reported a $2.3 billion loss related to mortgages it insured.
a. Pass-Through Security
With a mortgage pass-through security, after origination mortgages may be placed in a pool held by a
trustee and then mortgage pass-through securities may be sold to the public. The pool organizer passes
through all mortgage payments (less a servicing fee) made by the homeowners, including prepayments, to
the holders of the pass-through securities on a pro-rata basis. Payments are thus monthly and are variable
based on how many homeowners pay off their mortgages early. The pool organizer and/or the government
usually provides insurance for the mortgages in the pool. Default risk is not generally a worry for a
government backed pass-through security holder (such as a GNMA pass-through). These securities carry
substantial prepayment risk.
Privately Issued Pass-Throughs or PIPs are pass-throughs created without government or quasi government
involvement. Before the subprime crisis there were a growing number of private mortgage pass-through
issuers. They typically securitize nonconforming mortgages that do not qualify for government insurance
nor have appropriate loan to value ratios.
112
All data are from the Securities Industry and Financial Markets Association (SIFMA) website.
113
See http://banker.thomsonib.com Debt Capital Markets
24-5
The advantages of securitization:

A DI has just originated 1000 thirty year single family FHA mortgages at a 9% rate with an average loan
amount of $100,000. The DI charges a 1% origination fee to offset processing costs. If processing costs
are 0.5% then net fee income is $500,000. After securitization the DI may retain about 35 basis points in
fee income for processing the mortgage payments. If the cost of such processing is 10 basis points, the DI
nets 25 basis points of the payment amount or (0.0025 × $804.62 / month × 12 months × 1000 mortgages)
= $24,138.60 per year. The discounted present value of the annual net fee income using a 9% interest rate
over 30 years for simplicity is $247,991.114 Total originating and servicing fee income is thus estimated at
$747,991 = ($500,000 + $247,991).
The FI can avoid the following costs and investments by securitizing the mortgages:
♦ Capital requirement (See Chapter 14) = $100,000 × 1000 × 0.50 × 0.08 = $4,000,000.115 If having to
raise equity capital increases the weighted average cost of capital by 50 basis points, then the cost of
the additional equity investment can be estimated as 0.0050 × $4 million = $20,000 per year. The total
present value of this annual cost for the 30 years using the 9% rate for simplicity is $205,473.
♦ If the remaining funding is in the form of transactions deposits with a 10% reserve requirement then
the reserve requirement on these accounts that can be avoided is found as $96,000,000 / (1 – 0.1) =
$106.67 million or $10.67 million dollars of noninterest earning reserves at the Fed must be held to
back the deposits. The present value of lost interest income on this amount over 30 years if these funds
would have been invested in liquid assets earning 5% comes to $10,165,476.89.116
♦ Annual deposit insurance premiums (assuming a cost of 27 basis points) of $106.67 million × 0.0027 =
$288,009. In recent years this considerably overestimates the cost of actual insurance premiums levied
for most institutions. The present value of this cost at 9% is $2,958,904.
♦ Total costs avoided are $205,473 + $10,165,477 + $2,958,904 = $13,329,854
Adding up the costs avoided and the fee income allows one to see why securitization has grown in
popularity.
Securitization can reduce repricing and funding gap problems (interest rate risk) because a long term
fixed rate asset is removed from the balance sheet. The process can also be used to reduce liquidity risk.
The reduction in liquidity risk occurs because the loans are now saleable and if the FI wishes to invest in
the real estate markets mortgage backed securities that are also liquid can replace the loan investments.
Prepayment Risk
Most mortgages are set up as fully amortized loans where there will be no remaining balance at the end of
the 30 year or 15 year maturity. However, most mortgages are also prepaid (paid off in full prior to
maturity). GNMA and other pass-throughs have little or no default risk, but they have substantial
prepayment risk (see Chapter 7). Prepayments increase in falling interest rate environments and leave the
pass-through holder with a shorter maturity instrument than expected. The duration is reduced by
prepayments so the price gains anticipated from falling rates are not as large as predicted, but the lost
reinvestment income from having to reinvest at lower rates does occur. This can substantially reduce the
investor’s realized rate of return over time. The dollars of interest earned each month can decline fairly
rapidly as interest rates drop and prepayments increase. The reduction in total expected cash flows over the
life of the pass-through dampens the increase in price associated with the interest rate drop, but the future
value of the reinvestment income declines due to the lower reinvestment rate and the lower amount of
interest that will be received.
114
In reality the mortgages will be prepaid long before the maturity and the fee income will be less
than this.
115
SF mortgages have a 50% risk weight and I assumed an 8% minimum capital ratio requirement
similar to the text.
116
The amount invested in required reserves declines each year as the mortgages are amortized, the
capital required declines also. I used a spreadsheet to calculate the lost interest on the required reserves
using the declining reserve requirements each year. I did not account for prepayments. I ignored the
declining capital requirement in the capital cost calculation because the cost was relatively small to begin
with.
24-6
b. Collateralized Mortgage Obligation (CMO)

The CMO was created in 1983 by FHLMC and what was then the investment bank First Boston as a means
of repackaging prepayment risk. CMOs are created by repackaging mortgage payment streams, or more
typically, by repackaging payments on pass-throughs. The innovation of the CMO is to offer different
classes or ‘tranches’ that offer different degrees of prepayment protection.117 The simplest form of CMO is
a sequential pay CMO (see below). This is a profitable activity for CMO backers because the CMO
investor has a better idea of the prepayment risk they face; consequently, they are willing to pay more for a
CMO than a pass-through, ceteris paribus.
CMOs are a hybrid between a pass-through and a bond. With a sequential pay CMO, separate classes are
created with different levels of prepayment protection. Suppose a sequential pay CMO with a total pool
value of $150 million has three classes, A, B and C with principal amounts of $50 million per class. The
Class A CMO holder would receive all the initial principal payments (on the entire pool), including all
prepayments on the entire pool. These payments would reduce the Class A holders principal. Initially,
Class B and C holders would receive no principal payments until all of the principal of Class A holders
have been paid. Likewise, Class C is not affected by any prepayments until Class B holders have been
paid. The multiple classes allow investors to better choose the level of prepayment risk desired.
Example of payments on a Sequential Pay CMO:

Suppose the mortgages in the pool have a 9% interest rate and further suppose the CMO makes monthly
payments. It could make quarterly or semiannual payments as well. The mortgage holders make their
scheduled monthly payments; if there are defaults the pool organizer will make the scheduled payment:
Month 1 Amount paid into pool in Month 1: $2 million
Beginning Interest Due
Class Balance & Paid Actual Principal reduction End Balance
A $50,000,000 $375,000 $2 mill - $1,125,000 =$875,000 $49,125,000
B $50,000,000 $375,000 $50,000,000
C $50,000,000 $375,000 $50,000,000
Total $1,125,000
Month 2 Amount paid into pool in Month 2: $3 million

Beginning Interest Due
Class Balance & Paid Actual Principal reduction End Balance
A $49,125,000 $368,437 $3 mill - $1,118,437 =$1,881,563 $47,243,437
B $50,000,000 $375,000 $50,000,000
C $50,000,000 $375,000 $50,000,000
Total $1,118,437
Only Class A holders are initially affected by prepayments or any principal payments. Once Class A
principal is totally retired, Class B holders will begin to receive all principal payments, including
prepayments. CMOs sometimes have six to nine classes. Class A may have an expected maturity of 2 to 3
years, Class B may have an expected maturity of 5 to 7 years, and Class C may have a typical expected
maturity of 8 to 10 years or more. Buyers of Class A bonds are seeking short duration mortgage
investments and are typically purchased by FIs with shorter time horizons, including thrifts, banks and
P&C insurers. Class B bonds have some prepayment protection; these appeal to longer term investors such
as banks, pension funds and life insurance companies. Class C securities are generally desirable
investments for institutions seeking long term investments and are primarily held by pension funds and life
insurers. Each class is usually quoted at a markup over the appropriate maturity Treasury rate. Thus
mortgage investments offer a higher promised rate than comparable maturity Treasuries with little or no
additional default risk. Actual promised rates depend upon expected prepayment patterns. Higher
prepayments result in shorter maturities. Pool organizers often can sell CMO claims for more total value
than similar pass-throughs because some investors are usually willing to pay more for the additional
prepayment protection.
117
CMO tranches can also be set up for credit enhancement.
24-7
The Z class
CMOs usually have a Z class which is different from the other classes. The Z class is a residual claim on
the mortgage pool. Initially the Z class receives no payments, but its face value increases at a stated
coupon rate. Once the principal on all other classes have been fully paid, Z class investors begin to receive
both interest and principal payments. Z class investments are long duration and are thus risky. Faster
prepayments will start payments to the Z class investor sooner. An investor faces uncertainty when
payments will begin and how many payments will be received. Typical investors are institutions such as
hedge funds that are seeking long duration investments with higher risk and return.
REMICs
The IRS normally rules that issuers that securitize and issue securities with multiple debt classes are
engaging in a taxable activity. If the IRS taxes the interest payments on the mortgage backed securities
CMOs could not be as competitive for many potential buyers. To circumvent this problem Congress
created the Real Estate Mortgage Investment Conduit (or REMIC) trust that was specifically exempt
from IRS taxation. Most CMOs are placed in REMICs and the industry often uses the terms
interchangeably.
Other Types of CMOs:
1. Interest Only and Principal Only securities

Mortgage pools can be used to create mortgage pass-through strips such as interest only and principal
only securities. The interest only (IO) and principal only (PO) strips are special types of CMOs. The IO
provides the holder a pro-rata claim to all interest payments made on the pool of mortgages. The PO
provides the holder a pro-rata claim on all principal payments made on the pool. An IO can exhibit
negative convexity because as interest rates fall, prepayments rise and the total amount of interest accruing
to these securities falls. Lower rates raise the present value of the cash flows, but the lower overall cash
flows can result in a decline in the value of the IO when rates fall. The converse also holds. If the
prepayment effect dominates the IO will exhibit negative convexity, if the present value effect dominates
it will not, so the net result depends on changes in prepayment behavior as interest rates move. The text
indicates that when interest rates are above the coupon rate on the mortgages the IO will act more like a
standard security. This is not strictly true as IOs and POs are priced according to an expected level of
prepayments, as one would expect in an efficient market. Nonstandard price changes can still occur
because a change in rates would change the probability of prepayments. The prepayment effect however is
more likely to dominate when rates are below the coupon rate. IOs that are expected to exhibit negative
convexity can be used by FI’s desiring to hedge against rising interest rates. Since IOs are investments
that provide cash flows, these may be more acceptable to managers than caps or futures positions.
POs exhibit greater volatility than an equivalent maturity bond. As interest rates fall and prepayments
increase, the present value of the cash flows will rise, increasing the value of the PO and cash payments to
the PO holder are accelerated, further increasing the value of the PO. The converse is also true. In this
case, the present value and prepayment effects both work in the same direction to increase the PO’s
volatility relative to a standard bond. POs may appeal to investors who want a potentially higher rate of
return than a standard bond offers without facing additional default risk. POs may also be useful for FIs
who wish to increase the interest rate sensitivity of their assets. For instance, POs may be useful hedging
investments for institutions with a negative duration gap or positive repricing gaps.
Both IOs and POs can be used to hedge balance sheet interest rate exposures. These are examples of
financial engineering.
2. Planned Amortization Class CMO

An alternative to a sequential pay CMO is the planned amortization class (PAC) CMO. The basic PAC
CMO has two classes:
• The PAC or Planned Amortization Class:
For a range of Prepayment Speeds, for example, 80% of standard to 250% of standard, the
maturity of the PAC and the principal and interest payments received will not change. That is,
24-8
payments will be according the original planned amortization schedule. PAC investors have a
higher degree of certainty of the cash flows they will receive and the maturity of their investments
than investors in pass-throughs.
• The “Companion Class.” (The text uses the term “Support Class” instead)
The Companion Class receives all prepayments as long as prepayment speed stays within the
given range. If the prepay speed moves outside the standard range, prepayments are shared
between the PAC and Companion Class.
Other types of CMOs exist. The websites of FHLMC and FNMA can provide more examples.
c. Mortgage Backed Bond (MBB) (See Chapter 7)

The MBB is different from a pass-through and a CMO in that the MBB does not remove the mortgages
from the balance sheet. MBBs are also standard bonds that have mortgages as collateral. There is no
‘passing through’ of mortgage payments (transformed or not) with MBBs. Thus MBBs do not offer the FI
the main advantages of securitization discussed above that resulted from removing the mortgages from the
balance sheet. They also leave the issuing FI with substantial prepayment risk because the bonds require
fixed coupon payments to be paid regardless of the level of prepayments. The FI will receive the promised
principal, but they must reinvest the principal at lower interest rates while still paying the higher promised
bond interest rate. As a result, most MBBs have to be overcollateralized in order to receive a high quality
credit rating. MBBs are advantageous to investors in that the bondholders have no prepayment risk (unless
the bonds are callable). MBBs may be advantageous to the FI because the bond issue can be used to fund
the mortgages and the bond issue will have a similar maturity to the mortgages’ expected maturity, thus
reducing the repricing and duration gap problems. The text indicates that this advantage to the FI comes at
increased risk to the FDIC because the pledged assets backing the mortgage bonds may not be available
to insured depositors in the event of FI failure. The MBB may also actually reduce the FI’s liquidity
because now the pledged mortgages cannot be sold; moreover the FI must pledge more mortgages than
bonds issued so overall liquidity can be reduced. Due to these disadvantages, MBBs are the least used
form of securitization.
Teaching Tip: With a pass-through security, the investor bears all of the prepayment risk. With a non-
callable mortgage backed bond the issuer bears all of the prepayment risk. With a CMO the prepayment
risk is shared between the issuer and the investors and the investors can choose their desired level of
prepayment protection by choosing between the different CMO classes.
4. Securitization of Other Assets

Other assets are now being securitized (2007 data): 118
♦ Automobile loans ($198.5 billion)
♦ Credit card receivables (called CARDs) ($347.8 billion)
♦ SBA guaranteed loans
♦ C&I loans
♦ Student loans ($243.9 billion)
♦ Mobile home loans ($26.9 billion)
♦ Junk bonds
♦ Equipment leases ($46.2 billion)
♦ Time share loans
♦ Adjustable rate mortgages
In total, $2,472.4 billion of non-mortgage related asset backed securities were outstanding according to the
SIFMA.
5. Can All Assets Be Securitized?
118
Data are from The Securities Industry and Financial Markets Association (SIFMA) website.
24-9
There are three reasons that securitization occurred first for mortgage loans. First, they are highly
standardized. Second, government mortgage insurance has limited the need for buyers of mortgage
backed securities to engage in individual credit risk investigations. Before 2007 homes also generally
maintained their collateral value. Third, mortgages are long term so the costs of securitization can be
efficiently spread through time. Lack of these characteristics would seem to be the major limiting factors
in securitization of other loan types. Standardization can be achieved at the origination level to some extent
and pooling can lead to additional standardization. Third party participants may be willing to insure against
default risk, or securities buyers may be willing to bear the default risk. In some cases such as for credit
card loans, the pooling of large numbers of borrowers and the ability to charge sufficiently high interest
rates to offset higher loss rates can overcome the default risk problem. As familiarity grows and the costs
to securitize fall, shorter term loans may be able to be securitized if sufficient economies of scale can be
achieved, perhaps by high volume. Nevertheless the terms and risks of many loans are unique. Ultimately
it is the ability to accurately assess and measure the level of risk of the pool that may limit securitization.
The more heterogeneous the loans of a given type and the more uncertain the collateral values are absent
insurance, the more difficult it will be to successfully securitize a given loan type.
Collateralized Debt Obligations (CDOs) and Collateralized Loan Obligations

(CLOs)119
CDOs are a type of securitization that can take many forms.120 In its simplest form the pool organizer
purchases a pool of assets and using the pool as collateral issues different claims or ‘tranches’ to CDO
investors. The tranches have different levels of security. The senior tranche has a prior claim on principal
and interest earned by the asset and is usually setup so that it is overcollateralized and will have a AAA
rating. A basic CDO strategy is similar to the bond investment strategy, ‘riding the yield curve.’ The assets
are typically longer term than the liabilities. When the term structure is upward sloping this will provide
part of the profit margin to the CDO organizer who usually is an equity investor in the CDO. See the
simple example below of a Cash Flow CDO but be aware that many variations exist.
Example CDO
Assets Liabilities & Equity
Medium & Long Term Debt Senior Tranche
Bank Subordinated Debt Asset Backed Commercial Paper
Mortgage Backed Securities Junior Tranche
Medium Term Notes
Equity Tranche
Residual cash flows
As the yield curve flattened in the mid-2000s profit margins were squeezed and more CDOs began to add
riskier securities to the asset pool; some added subprime mortgages. When subprime defaults and past dues
began to increase, the security of senior tranche holders quickly evaporated and CDO organizers had
difficulty persuading investors to refinance in the asset backed commercial paper tranche.
Some CDOs are used to remove assets from the balance sheet as discussed under securitization benefits
above. Some are formed because the organizer hopes to earn the difference between the interest earned on
the assets and the interest paid to tranche holders. This type is termed an arbitrage CDO. If the underlying
asset portfolio is predominantly loans it is termed a Collateralized Loan Obligation or CLO. If the
collateral is asset backed securities or mortgage backed securities it is called a ‘structured finance’ CDO. A
special type of CDOs called synthetic CDOs sell credit default swaps (CDS) rather than invest in securities.
Finally CDO2 are CDOs that invest in other synthetic or cash CDOs rather than securities.
119
Information is drawn from Securities Industry and Financial Markets Association website and
from “CDOs in Plain English: A Summer Intern’s Letter Home,” Nomura Fixed Income Research,
September 13, 2004, Nomura Securities International.
120
You may also hear the term SIV. A Structured Investment Vehicle (SIV) is a type of CDO that is
more actively managed and does not have a maturity date.
24-10
CDOs are yet another form of securitization that contributed to the credit crunch when problems developed
in the subprime mortgage markets. These instruments are complicated and difficult to value, especially the
more exotic forms. It is doubtful that all investors understood the risks they faced. CDOs are structured
based on correlation analysis of security prices in normal markets and even small changes in the underlying
security values can result in declines in credit quality of even senior tranches. In the credit crunch asset
correlations all increased toward +1. Under most CDO contracts, collateral declines from dropping asset
values can force CDO managers to change investment policies to restore collateralization levels. This in
turn can force asset sales and in the markets managers faced in 2007 these sales led to additional declines in
asset values.
Using CDOs allows banks to create more mortgages which are then placed into a CDO structure. As we
found out in 2007 and 2008, the banks still had responsibility for these mortgages even though they were
not required to hold capital to back them since they had been shifted off the balance sheet. Should these
complex investment vehicles be banned? Innovations such as these that allow risk sharing probably
provide net benefits to society, but regulators must move more quickly to understand the risks involved
from financial engineering before a crisis occurs.
24-11

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Management of Financial Institutions

Anthony Saunders and Marcia Cornett

1. Why Study Financial Markets and Institutions?

With the pace of globalization and increasing deregulation of financial institutions,

intermediaries in increasingly complex and competitive businesses will grow in

2. Overview of Financial Markets

Selected Money Market Instruments, billions of dollars, amounts outstanding

Selected Capital Market Instruments, billions of dollars, amounts outstanding

c. Foreign Exchange Markets

Historically, when a nation’s current account deficit surpasses 5% of GDP a correction

d. Derivative Security Markets

e. Financial Market Regulation

3. Overview of Financial Institutions

Deposit-Type Institutions -- Offer liquid, government insured claims to savers, such as

Other Types of Financial Intermediaries:

a. Unique Economic Functions Performed by Financial Institutions (FIs)

monitoring is needed or when special additional financing requirements may be

The federal government insures deposits of certain intermediaries. Because of deposit

b. Additional Benefits FIs Provide to Suppliers of Funds

c. Economic Functions FIs Provide to The Financial System as a Whole

d. Risks Incurred by Financial Institutions

Some FIs face:

e. Regulation of Financial Institutions

4. Globalization of Financial Markets and Institutions

1. Interest Rate Fundamentals: Chapter Overview

2. Time Value of Money and Interest Rates

FV = PMT × ((1 + (i/M))N×M – 1) / i

N = number of years M = number of compounding periods per year

d. Effective Annual Rate

3. Determinants of Interest Rates For Individual Securities

The Fisher Effect relates nominal and real interest rates.

c. Default or Credit Risk

e. Special Provisions of Covenants

4. Term Structure of Interest Rates

b. Liquidity Premium Theory

c. Market Segmentation Theory

5. Forecasting Interest Rates

1. Interest Rates as a Determinant of Financial Security Values: Chapter Overview

2. Various Interest Rate Measures

e. Realized Rate of Return

The normal annual discount or premium amortization due to approaching maturity is

b. Formula Used to Calculate Yield to Maturity

c. Equity Valuation Models

4. Impact of Interest Rate Changes on Security Value

5. Impact of Maturity on Security Values

b. Maturity and Security Price Sensitivity to Changes in Interest Rates

6. Impact of Coupon Rates on Security Values

b. Coupon Rate and Security Price Sensitivity to Changes in Interest Rates

Coupon Varies Maturity

b. A General Formula for Duration

Closed form duration equation:

Terms for calculating duration

Terms for calculating duration

Students should be aware that although duration is a modified measure of maturity, it is

d. Economic Meaning of Duration

e. Large Interest Rate Changes and Duration

Appendix 3A: Duration and Immunization (web only: See www.mhhe.com/sc4e)

Duration: [80/1.08 + (80*2)/1.082 + (80*3)/1.08 3 + (80*4)/1.08 4 +(80*5)/1.085 +

Case 1: Rates stay same:

Duration: [80/1.08 + (802)/1.082 + (803)/1.08 3 + (804)/1.08 4 +(805)/1.085 +