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Decomposing Underwriting Spreads for GSE's and Frequent Issuer Financial Firms

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Decomposing Underwriting Spreads for GSE's and Frequent Issuer Financial Firms Decomposing Underwriting Spreads for GSEs and Frequent Issuer Financial Firms David M. Harrison Associate Professor Rawls College of Business Administration Texas Tech University Lubbock, TX 79409 [email protected] 806.742.3190 phone 806.742.3197 fax Andrea J. Heuson Professor of Finance University of Miami P.O. Box 248094 5250 University Dr., Jenkins Bldg. Coral Gables, FL 33124 [email protected] 305.284.1866 phone 305.284.4800 fax and Michael J. Seiler Professor and Robert M. Stanton Chair of Real Estate Old Dominion University 2154 Constant Hall Norfolk, VA 23529 [email protected] 757.683.3505 phone 757.683.3258 fax Revise and Resubmit at Journal of Real Estate Finance and Economics December 2010 Decomposing Underwriting Spreads for GSEs and Frequent Issuer Financial Firms Home mortgage debt outstanding grew at a nominal rate of more than 10% per year and a real rate of more than 8% per year during the decade that began in 1997. Much of the increase was funded by investors who purchased mortgage-backed securities through a market supported by Fannie Mae and Freddie Mac – two Government Sponsored Enterprises (GSEs) charged with improving intermediation in the residential mortgage market. Furthermore, both housing and non-housing GSEs and large domestic financial institutions took sizeable investment positions in mortgage-backed securities, funding this increased investment by borrowing in the bond market using callable and non-callable debt agreements. Recent developments make clear that many of these investments carried significant credit risk. This paper investigates the determinants of underwriting fees charged to active GSE and financial industry borrowers on debt issuances, how such fees change over time, and how they vary with the characteristics of the debt, the underwriting mechanism, and the issuer. We pay particular attention to how risk factors generated by the actions of individual mortgage borrowers and the financing strategies put in place by the GSEs, especially those charged with supporting the market for housing finance, impacted the bond underwriting spreads faced by a variety of affected institutions. We find that spreads paid by housing GSEs, non-housing GSEs, and privately held financial firms were all influenced by risk-related developments in the market for housing finance, and that this influence was felt well before the advent of the housing crisis. 2 Decomposing Underwriting Spreads for GSEs and Frequent Issuer Financial Firms Introduction Securities underwriters are investment and commercial bankers who are intermediation experts that help borrowers market their new debt and equity issues to private and institutional investors in return for a fee.1 This fee, known as the spread, is the difference between the face amount issued and the proceeds actually received by the borrower. It compensates the underwriter for the distribution and information costs of publicizing the issue/issuer and for the risk inherent in bringing the issue to market. During the housing boom, the size of the residential mortgage market, the degree to which mortgage-backed debt was integrated into asset portfolios held by large public and private U.S. financial intermediaries, and the intermediaries’ reliance on bond market borrowing to fund investments in mortgage-backed securities all grew precipitously. In this paper, we investigate the extent to which the entities who underwrote the debt issues used (at least partially) to fund this investment in mortgages priced mortgage market risk factors and related financing strategies adopted by the corporate borrowers into their underwriting spreads. We find that multiple housing-related risk factors had small, but sustained, statistically significant effects on the flotation costs paid by both housing and non-housing GSEs and by private financial firms that were active borrowers in the credit markets throughout our January 1 The provisions of the Glass-Steagall Act of 1933 effectively prohibited commercial banks from underwriting corporate debt issues until 1987, when they were allowed to establish subsidiaries to engage in a limited amount of underwriting activities. In 1996, the Federal Reserve raised the limit substantially and commercial bank participation in the market for underwriting corporate debt has increased significantly since that time. 3 1995 to April 2010 sample period. 2 First, underwriters reacted to decisions by individual borrowers that increased the uncertainty of payments on mortgage-backed debt (e.g., refinancing a primary loan or choosing adjustable instead of fixed-rate debt) by raising spreads. Second, financing and investment strategies adopted by the primary housing GSEs (Fannie Mae and Freddie Mac), as well as by the non-housing GSEs (the Federal Home Loan Banks, the Farm Credit System, and Sallie Mae), had far-reaching effects in that underwriting spreads rose as the GSEs consumed a larger and larger percentage of the overall funds raised in the U.S. credit market. Third, increased required returns in the marketplace, as measured by higher treasury rates, higher credit risk spreads (the average yield on Baa rated securities minus the average yield on Aaa rated securities), and increased inflation expectations (measured by consumer surveys) all led to increased underwriting fees. Taken together, these results suggest the institutions that acted as underwriters of both GSE debt and issues floated by financial firms active in the credit market have a real-time, in-depth awareness of the characteristics of the debt and the financing/investment strategies of the issuer. The remainder of this paper is organized as follows. The next section contains a brief review of the existing literature analyzing the pricing behavior of bond underwriters and identifies the various determinants of underwriting spreads. Then, our empirical model is developed and formalized. Estimation results, conclusions, and suggested extensions appear in the final section. Determinants of Underwriting Spreads 2 Government Sponsored Enterprises (GSEs) are federally chartered agencies whose mission is to support a specific area of the economy by providing liquidity and/or default risk mitigation services. 4 A. Issue and Issuer Characteristics Ederington (1975) develops and tests a simple model of the relationship between the risks involved in moving a bond issue through the primary market and the spread an underwriting syndicate charges for that service. Specifically, spreads increase with the riskiness of the issuer and decrease with issue size and the inclusion of a call feature. This last result is somewhat surprising given later work by Kish and Livingston (1992), who explore the issuer’s decision to float callable debt in greater detail. They find that the call feature is more likely to be associated with longer maturity debt, higher market interest rates, a greater reliance on debt in the firm’s capital structure, and weaker credit strength, all of which are factors that typically increase the risk of the issue. The relationship between an issue’s size and the underwriting fee is further explored by Altinkilic and Hansen (2000), who show that initial economies of scale in amount borrowed are eventually outweighed by risk considerations, so that spreads fall and then rise with issue size. Gande, Puri, and Saunders (1999), Roten and Mullineaux (2002), and Drucker and Puri (2005) reiterate the importance of borrower risk factors, documenting a positive relationship between underwriting spreads, issue maturity, and the credit rating of the issuer. These three papers all identify and analyze a secular decline in underwriting spreads on debt issues as commercial banks entered the market in force in the mid 1990s, and a general decline over time as technological developments lowered information costs. B. GSE Debt and Developments in the Single Family Mortgage Market The data used in the studies reviewed in the previous section excludes the borrowing of GSEs and ends before an important shift in the allocation of funds took place in U.S. capital 5 markets. There are seven major GSEs charged with improving efficiency and liquidity in different areas of the overall economy. Five of the seven were active borrowers (defined as entities that floated more than 100 bond issues) during our 1995 – 2010 sample period.3 The five active-borrower GSEs we study are: 1) Freddie Mac – conventional residential mortgage pass through guarantor, 2) Fannie Mae – conventional residential mortgage pass through guarantor, 3) Federal Home Loan Banks – advances to commercial banks, 4) Sallie Mae (Student Loan Marketing Association) – student loans for college education, and 5) Farmer Mac (Farm Credit Banks) – agricultural lending support. The debt of these GSEs was not formally guaranteed by the full faith and credit of the U.S. government for most of the sample period, so we expect associated underwriting fees to directly reflect firm characteristics, issue characteristics, and market risk factors.4 Furthermore, we focus our attention on an important shift in financing and investment strategies that occurred during the middle of our sample period. Specifically, we take account of when Fannie Mae and Freddie Mac (and to a lesser extent the other GSEs) expanded their investments in mortgage- backed securities by dramatically increasing the amount of their indebtedness, and altered the type of borrowing they undertook. Table 1 presents a snapshot of borrowing volume at the five active GSEs and a sample of
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