Investments I

Georgia Banking School May 2, 2016

John Hund University of Georgia [email protected] Me

Dr. John Hund is an Assistant Professor in at the University of Georgia, where his research focuses on the estimation of emerging default risk and liquidity, as well as the influence of default on corporate decision making and the credit rating process. Dr. Hund has also taught banking, risk management, and economics in the MBA and executive MBA programs at the University of Texas at Austin, Rice University and Tulane University.

Dr. Hund received his Ph.D. in Finance from the University of Texas at Austin. He has published papers in journals such as the Journal of and the Journal of , served as a fellow of the FDIC, and presented his papers at the NBER and the American Finance Association meetings.

Dr. Hund also co-founded and co-managed the Financial Engineering Group at BankBoston, where he was responsible for developing models to and hedge proprietary interest rate, , and emerging market structured products. He has presented original research at numerous industry conferences and was the highest rated speaker at credit conferences and training courses in New York, London, and Hong Kong. He consults for money center on advanced topics on emerging market and , and also serves as an expert witness in legal cases involving derivatives and corporate appropriateness.

Dr. Hund graduated magna cum laude from Williams College in 1987 with a B.A. in Political Economy and a concentration in Russian, Soviet, and Eastern European Studies. He is a member of Phi Beta Kappa. :

Assets Liabilities

Required reserves Deposits

Excess Reserves -term borrowing

Short-term Investments Long-term borrowing (, Comm. Paper, Repo)

Investments (MBS, Treasury, Municipal, Other)

Loans

Excess Capital

Required Capital Now with some numbers…

https://www.federalreserve.gov/releases/h8/current / Investments by type over time Focus on investments (long-term) . Plan for the next couple of hours: . market structure . US Treasury market . Money Markets (short-term) . Agency MBS (hard to be specific here) . Some very basic valuation ideas . …the valley of the acronyms . RMBS, CMBS, ABS, CMO, CDO, Syn CDO, CDS and …

A Bond is A Bond . Bonds are conceptually simple, but practically extraordinarily complex. . A bond is just a contract…think an IOU. . This simplicity allows for a great deal of customizability between counterparties…and this leads to difficulty. . The simple part (the key 5): . . Counterparty . Face Value . (payment) . Periodicity Key Features of a Bond . Covenants (valuable to buyer) . Events of default . Change of control . Net worth tests . Call provision: refunding operation (valuable to issuer) . Gives issuer the right to call bonds for redemption . Call premium: difference between call price and . Deferred call (call protection), make-whole call . Sinking Fund Provision (valuable to buyer…maybe) . Early Retirement of a bond issue . Call in bonds for redemption or purchase on the open market . Tradeoff: early call versus lower risk But some variations… . Common variations on the theme . Face value amortizing . Face value accreting . Coupon floating . Coupon as some formula (10% - LIBOR) . Embedded options (calls, puts on control, etc.) . Less common…but maybe more fun . Different coupons (formulas) for different dates . Face value depends on difference between . Maturity date extendible . Etc…. Treasury Markets . US Government (Treasury) Market . Primary market is auction, is OTC . Usually issued with maturities of 3M, 6M, 2Y, 5Y, 7Y,10Y, 30Y . Most recently issued bond is termed “on-the-run” . Bonds trade as “when-issued” before auction . Interest paid semi-annually . are quoted as if face value is 100, and in 1/32nd increments . Days are counted as actual/365. . Securities are auctioned to “primary” dealers when the government needs money. . Each bids an amount and a price… . Treasury collects all of the bids until it has “enough” money . Everyone gets the highest fulfilled price.

Latest 10 year auction…

So, in the latest auction for a “10-year” bond, the highest accepted was 1.765%.

That means $20B was bid below 1.765% and that the price everyone receives is 98.739410 per $100 face value.

http://www.treasurydirect.gov/i nstit/annceresult/press/press. htm The Short Money . Money markets are very short term, low risk, funding sources for govts and corporations . Fed Funds rate (only for banks, trade overnight deposits at the Fed) . Other major money markets are: . Treasury bills (US gov’t) . Discount securities issued with maturities less than a year . LIBOR (London InterBank Offer Rate) . Like Fed Funds, but “off-shore” in London . Eurodollar deposits: $ deposits in foreign banks . Overnight, 1M, 3M, 6M, 1Y maturities . Corporate funding sources . . Repurchase (and Reverse Repurchase) Agreements

Bond Market Trading and Liquidity is Outstanding

http://www.treasurydirect.gov/govt/reports/pd/pd_debttothepenny.htm

. The relationship between the yields in a particular bond market and their maturities is called either the yield curve or the term structure. . Generally this is derived by plotting the on-the-run or most liquid securities and fitting a “curve” between them . There are yield curves for all markets…UST, A rated, Greek govt debt, US Agency, etc. . The difference between yield curves at any particular point is often called the , or credit spread . There can also be any number of spread measures…be specific! http://www.bloomberg.com/markets/rates-bonds/government-bonds/us https://www.treasury.gov/resource-center/data-chart-center/interest- rates/Pages/Historic-Yield-Data-Visualization.aspx Bond Valuation (just the facts) . Bond prices and yields are inversely related . When yields go up, prices go down. . When yields go down, prices go up. . The relationship between prices & yields is not linear . Low coupon bonds are more sensitive to yield changes . Long maturity bonds are more sensitive to yield changes . To price ANY bond, write down the cashflows and discount them to today. . Be careful using built-in pricing functions… Bond Sensitivity . The players: DV01 and duration . DV01 is the change in price for a 1bp change in yield . Duration is the % change in value for 1bp change in yield . Use DV01 for hedging, duration for investing . In general, use Excel or another computer . If regular cashflows: then PRICE(), YIELD(), and MDURATION() . For non-regular cashflows, you’ll need XNPV and XIRR . And data tables . Portfolio DV01s (unweighted) and durations (weighted) are averages of the individual bonds… Fording the river Hey wait, what’s a non-regular bond? The World Turned Upside Down

. In most credit markets, the relevant question is: . Why don’t you get paid back? . In sovereign markets, the relevant question is: . Why do you ever get paid back? . The concept of sovereignty (not to get too political science on anyone) by definition means that the state can make decisions without interference… . But this means that the corporate frameworks have little meaning (recall that structural models rely on limited liability to generate default triggers) . Even the concept of collateral needs to be re-assessed. "If you owe your bank a hundred pounds, you have a problem. But if you owe your bank a million pounds, it has." Willing or Able? John Maynard Keynes . Sovereign borrowing differs from corporate borrowing in the distinction between willingness to pay vs. ability to pay . This makes the recovery process critical to the pricing of these assets, as well as bringing politics back to the forefront . Leads to creditor conflicts . Public vs. private bailout questions . Collective action and moral hazard

"Countries don't go out of business....The infrastructure doesn't go away, the productivity of the people doesn't go away, the natural resources don’t go away. And so their assets always exceed their liabilities, which is the technical reason for bankruptcy. And that's very different from a company." Walter Wriston Citicorp Chairman Why do you get paid back? . If you can’t take the country to court, why do you ever get your money? . Reputation…that is, a country tries to maintain a good history so it will be able to access markets in the future . But what about political change? . Fact: countries that default are able to borrow again… . Trade sanctions/harassment . But what if bondholders are private…how will this work? . Not clear how credible the threat is . Seizure of collateral . Again, there’s a private/public issue . Countries can move collateral around, in anticipation . Argentina lawsuits We actually don’t really know… Serial Default The (very) long view And then there’s Ecuador… So What Happens In Default?

Since 1997 there have been 24 sovereign defaults… But of these only 14 were on rated bonds, and most have been relatively small Russia, Ecuador, Uruguay, Argentina, and Greece are the only FC defaults over $5B

“Typical” path of sovereign default Missed payment/announced repudiation Wait IMF may or may not continue lending to country Wait Wait Take it or leave it offer from country to creditors (“There will be no other offer to redeem the defaulted securities.”) Creditors accept (usual participation rates are above 80%) Exchange offers are typically exceptionally complex

Old bonds are switched into new bonds, longer maturity and lower coupon Typically a choice of currency, fixed or floating coupon Argentina description is 458 pages…Greece “supplement” is 158 pages

It’s a looking glass world…

I must have been half mad to have dreamed this up. In the beginning…

CDO of CDS CLO RMBS

CDO CDS GSE CMO

CDO of CDS on ABX REMIC

CDO2 ABS

CMBS CDO of ABS Letters gone wild

Mortgage-backed securities . RMBS: Residential Mortgage Backed Securities . CMBS: Commercial Mortgage Backed Securities . Originally began as “pass-through” securities, which pass interest and principal to investors after subtracting servicing fees . Transformed in the early 1980s into complex cashflow instruments . Subject to pre-payment risk and often split interest/principal in complex ways

Prepayment risk Split on prepayment Split on default Split on Interest or Principal Only Mix and match!

A pool isn’t just for swimming . Mortgage Backed Securities (MBS) . RMBS: Residential Mortgage Backed Securities . CMBS: Commercial Mortgage Backed Securities

. Originally began as “pass-through” securities, which pass interest and principal to investors after subtracting servicing fees . Transformed in the early 1980s into complex cashflow instruments . Subject to pre-payment risk and often split interest/principal in complex ways

Private pools can be risky . Agency vs. Non-Agency . GSE (government sponsored entity) such as Freddie Mac and Fannie Mae which guarantee against homeowner default in the pool . But not default of the GSE! . Almost all of the mortgages in the pools are conforming . Mostly rated AAA (because of implied gov’t sponsor) . But how can other folks get in on the fun? . Problem: don’t have a handy AAA rating to use . Answer: SECURITIZATION! Mash around the risk so that some folks get high risk and others get low risk The Air Mattress of Risk Letters gone wilder

Cashflow Structured Finance Securities . ABS: Asset Backed . CMO: Collateralized Mortgage Obligation . CDO: Collateralized Mortgage Obligation . CLO: Collateralized Loan Obligation . Come in an infinite variety, but refer to tranched securities, or pools of underlying assets that are divided by the order in which they absorb either losses or prepayments . Mostly issued from SPVs (special purpose vehicles) . Can be overcollateralized or insured to enhance credit Synthetic Structured Finance Securities . Synthetic CDO: CDO that holds CDS (Credit Default Swaps) instead of actual cash market securities in the pool . CDO/CMO-squared: CDO/CMO that holds the of other CMO/CDO securities in the underlying pool

Mortgage-backed Issuance CDO of RMBS . Note, that there were a LOT of these securities being created. If you want to add, you need an ABACUS Simpler… Let’s look at the most basic example… . Assume that we have 10,000 mortgage loans, all with a 5% coupon and a loan balance of $200,000. . 2 billion dollars total in aggregate . Each year generates 100 million dollars in interest (right now, assume no amortization which is unrealistic) . These loans are originated but not held by the originator…they are sold into the secondary market. Assume that I need to raise capital to buy them: . 1.6 billion dollars at 4% coupon called AAA . 300 million dollars at 6% coupon called Tranche BB . 100 million dollars of “equity” . Losses are absorbed by the “equity” first, than by Tranche BB and eventually by Tranche AAA . Importantly, when principal is being repaid, the AAA is even safer! . Note that 20% of all mortgages would have to default with zero recovery in order for Tranche AAA to suffer any losses at all! . Note that the “equity” tranche is high risk, high reward… . Usually, these are constructed with 6 or 7 tranches. CMO unrealistically simple Nice, but not realistic . In reality, securitization of this type works very well . Agency RMBS distribute the risk of prepayments . They increase the total pool of funds available for mortgage purchases to AAA security buyers like insurance and money market funds . But when we begin to securitize assets with relatively high rates of default . Or more accurately, with high degrees of correlated defaults… . They also unsurprisingly generate high fees and higher rates on “AAA” securities . Moody’s probability of loss less than .01% . But what happens when we get a little excited about securitizing things… Not just mortgages…anything! That was fun…let’s do it again! . Now, suppose that I can find 10 of those Tranche BBB securities . Each one is 300 million, with a coupon of 6% . Total face value is 3 billion . Yearly interest (again, not worrying about prepayment) is 180 million . Now I raise the 3 billion dollars to buy them by issuing securities . 1.95 billion of AAA securities with a coupon of 5% . 600 million of BBB securities with a coupon of 7% . 300 million of BB securities with a coupon of 8% . 150 million of “equity” . What has to happen in order to see losses? . Ummmm…let’s just say it’s “difficult”. . How much of this went on? . 64 billion of BBB subprime bonds “magically” became $140 billion of CDO assets But oh, no, we’re not done yet! . First, we have to meet another player…our friend the credit default . . Essentially a credit default swap is less a swap and more an … . Basically, the buyer (of protection) is paying a fee (periodically) for compensation from the seller if the underlying credit defaults . Problem: What is default? On what? . What are the incentives of the buyer or seller? . Very much like buying insurance that makes the underlying asset “risk-free” . Except for what? . Usually quoted as a spread to LIBOR . For example, Ford senior at 515/555 for 5 years . Walmart senior at 37/39 for 5 years

First, are there any lawyers in the house…

. In a CDS the buyer of protection ("Buyer") pays a periodic fee in exchange for the seller of protection ("Seller") contracting to make a payment should a corporate or sovereign borrower ("Reference Credit") suffer some credit crisis ("Credit Event"). . Different Credit Events can be included in the contract: . Bankruptcy by the Reference Credit . Restructuring or Failure to Pay by a asset or assets ("Reference Obligation") issued by the Reference Credit. . Following a Credit Event there are two main ways of settling the contract: Cash Settlement and Physical Delivery. . Cash Settlement is a formulaic payment equal to the par value of the Reference Obligation minus its post-default trading value as determined by a pre-agreed dealer poll mechanism. . Physical Delivery involves the transfer of a pre-agreed asset or assets ("Deliverable Obligation") to the Seller in exchange for a payment equal to the notional of the contract. Based on Credittrade language Blah, blah, blah, blah… . What does this look like in boxes?

Premium (i.e. 3%) Protection Protection Buyer Seller Settlement in default Coupon (i.e. 6%)

Bond Now for the magic… . But do you really need the bond? . Not really…can just sell insurance on a “reference asset” . Or an index of bonds . Or a basket of bonds . Or on N out of M bonds . Or… . What does the premium on the CDS reflect? . Really (to an approximation) the spread over riskfree assets . Some issues with fixed coupons and floating rates, but essentially, it’s compensation for default risk . What happens if I just grab a CDS off the shelf and mix it with a riskfree bond? . I get something that has the same cashflows as the risky bond… . But I don’t have to own anything? It’s just contracts? . Can I securitize these? You bet I can! So finally we’re ready for the ABACUS Basic Bond Sensitivity

Inputs Outputs Portfolio Values Ford Motor Bond Ford Motor Bond Settlement Date 5/1/2016 YTM 5.8559% Credit Spread 409.141 Face Value 10,000,000 Price @ Shift 158.294 Credit Spread @ Shock 509.141 Coupon 9.980% DV01 0.2060 Price @ Shock 139.831 Maturity 2/15/2047 Mduration 12.8424 Price 158.5 Old Mkt Value 15,850,000 Shift bp 1 Shock Mkt Value 13,983,051 Credit Spread Shock 100 Hedging Amounts Change in Value (1,866,949) Hedge Ratio 2.317 Short Amt 23,171,837 Value at Shift of Ford 15,829,399 Change in Val @ Shift (20,601) OTR 10 Year OTR 10 Year Settlement Date 5/1/2016 YTM 1.764% Value of 10YR 22,882,189 Face Value 100 Price @ Shift 98.661 Value of 10YR at Shift 22,861,588 Coupon 1.625% DV01 0.089 Change in Value of 10YR (20,601) Maturity 2/15/2026 Mduration 8.9768 Price 98.75 Net Portfolio Change (0.00) Shift bp 1 Change in Ford Bond Value (1,866,949) 100 (1,866,949) 50 (980,321) 1 (20,601) - 0 (1) 20,643 (50) 1,086,250 (100) 2,292,452 Super Simple Securitization

Total Mortgages 10,000 Mortgage Size 200,000 Interest Rate 5% Total Asset Size 2,000,000,000 Total Interest Pool 100,000,000

Coupon Tranche AAA 1,600,000,000 80% 4% 64,000,000 Tranche BB 300,000,000 15% 6% 18,000,000 Equity 100,000,000 5% 18.00% 18,000,000

Loss rate 0.50% 1.00% 1.00% 1.00% 1.00% Principal loss 10,000,000 19,900,000 19,701,000 19,503,990 19,308,950

Year 1 Prin Tranche AAA 1,600,000,000 1,600,000,000 1,600,000,000 1,600,000,000 1,600,000,000 Tranche BB 300,000,000 300,000,000 300,000,000 300,000,000 300,000,000 Equity 90,000,000 70,100,000 50,399,000 30,895,010 11,586,060

Year 1 Interest Tranche AAA 64,000,000 64,000,000 64,000,000 64,000,000 64,000,000 Tranche BB 18,000,000 18,000,000 18,000,000 18,000,000 18,000,000 Equity 16,200,000 12,618,000 9,071,820 5,561,102 2,085,491

5 year cashflows (1,600,000,000) 64,000,000 64,000,000 64,000,000 64,000,000 1,664,000,000 (300,000,000) 18,000,000 18,000,000 18,000,000 18,000,000 318,000,000 (100,000,000) 16,200,000 12,618,000 9,071,820 5,561,102 13,671,551 1.00% 1.00% 1.00% 1.00% 1.00% 1.00% 19,115,861 18,924,702 18,735,455 18,548,100 18,362,619 18,178,993

1,600,000,000 1,600,000,000 1,600,000,000 1,600,000,000 1,600,000,000 1,600,000,000 292,470,199 273,545,497 254,810,042 236,261,942 217,899,322 199,720,329 ------

64,000,000 64,000,000 64,000,000 64,000,000 64,000,000 64,000,000 17,548,212 16,412,730 15,288,603 14,175,717 13,073,959 11,983,220 ------

4.00% 6.00% -16.97%