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CMO

Monday, March 6th, 2017

!!!Overview

Sub-prime mortgage and the collateralized mortgage obligations (CMOs) that packaged them were singled out for precipitating the financial crisis of 2008.

What is a collateralized mortgage obligation (CMO) that bundles these sub-prime mortgages? It is the product of financial engineering that transforms a group of illiquid financial assets into a security. For instance, there are special bonds backed by financial receivables such as credit card receivables, auto loans, leases and home-equity loans.

These are called asset backed securities (ABS). This special debt market is relatively new but expanding fast. When a pool of residential mortgages are used in the place of these other financial receivables, this particular asset backed security (ABS) is called a mortgage backed security (MBS). Finally, a type of mortgage backed security (MBS) is called a collateralized mortgage obligation when the mortgage backed security (MBS) is divided into portions of the debt based on maturity and/or risks of the pool.

!!!Mechanics of a Collateralized Mortgage Obligation (CMO)

Firstly, an investment bank buys mortgages from retail mortgage banks and brokers, that originated residential mortgage loans to the property owners.Then, different slices of IOUs are sold by the investment bank to satisfy different tastes of risk/return combination of investors. Investors (banks, hedge funds, pension funds, insurance companies, mutual funds, and governmental agencies including central banks) in a collateralized mortgage obligation (CMO) buy these IOUs to receive payments from the income generated by the pool of underlying home mortgages.

!!!Types of CMOs

In accordance to pre-defined and complicated rules, a collateralized mortgage obligation (CMO) pools and re-directs the payments of principal and interest from large pools of home mortgages to different types and maturities of CMOs. These different types of collateralized mortgage obligations (CMOs) are known as ”tranches”. This French word ”tranche” means __a portion of money__. Each type of a collateralized mortgage obligation (CMO) may have different principal balances, coupon rates, maturity dates, and other details of the rights and risks of ownership of any bonds.

The most simple form of CMO is composed of classes that are retired in a strict sequence. In other words, all the outstanding classes of collateralized mortgage obligation (CMO) receive regular interest payments, but principal payments are made to the first class exclusively until it gets paid fully. This is called __Sequential Pay__.

There also are more complicated types such as Planned Amortization Class, Targeted Amortization Class, Companion Tranches, Principal-Only, Interest-Only, Floating-Rate, etc. that are all beyond the scope of this lesson.

!!!__History of CMOs__

A collateralized mortgage obligation (CMO) was first created in 1983 by two investment banks (Salomon Brothers and First Boston) for the U.S. Federal Home Loan Mortgage Corporation whose main function is to provide liquidity for the U.S. home mortgage loans. The value of CMOs peaked in 2007 just before the global financial crisis.

The CMOs were singled out in the mass media for starting the global financial crisis in 2008. Even though the underlying mortgages went bad rapidly, investors for whatever reasons got fixated on the income streams generated by the CMOs instead. Rating agencies and other esoteric financial models failed to pick up increasing foreclosure and payment default rates in the middle of rising housing prices.

!!!__Risks of CMOs__

When Freddie Mac guaranteed the payment of principal and interest on the underlying pool of mortgages in 1983, the collateralized mortgage obligation (CMO) posed essentially no credit risk. This was true since government agencies such as Fannie Mae, Freddie Mac, or Ginnie Mae, at least implicitly, have the full backing of the US Government. Investors took prepayment, interest, market and liquidity risks, however, for which they were compensated with higher yields.

__Private label collateralized mortgage obligations (CMOs)__ were soon issued by investment banks with underlying mortgages that were not guaranteed by Fannie, Freddie or Ginnie. These unconventional collateralized mortgage obligations (CMOs) re-introduced credit risk to the collateralized mortgage obligations (CMOs) market. Credit insurance was mainly used to deal with the credit risk of private label non-conforming collateralized mortgage obligations (CMOs).

With the banks starting to pass more of the credit risk on to investors, collateralized mortgage obligations (CMOs) became absurdly complicated game among three parties of investment banks, mortgage brokers, and credit rating agencies. Soon, therefore, each tranche had to receive its own credit rating from a rating agency.

!!!__Lesson Summary__

Collateralized mortgage obligations (CMOs) provided enormous amount of liquidity into the secondary residential mortgage loan market; thereby enabling various mortgage originators to make more home loans to more property owners. Mortgage banks originated mortgages that the investment banks re-packaged into collateralized mortgage obligations (CMOs) that the investors devoured with the blessings of the rating agencies. The added liquidity quickened the pace of mortgage origination in turn.

However, there were limited numbers of houses and qualified borrowers to finance; credit standards had to fall to keep up with the profitable business. Many mortgage lenders eventually got involved in falsifying loan applications. Credit rating agencies did not adequately reflected the underlying fraud going on in the front line. With investment banks shopping the bond ratings, the real estate market inevitably ended up in a huge ”bubble”. The market started to lose momentum in 2007; in the following year, it collapsed in the worst financial crisis since the Great Depression of the 1930s.

Sharpe Ratio

Monday, March 6th, 2017

 

!!!Overview

They say that you cannot compare apples to oranges. In the investment world, there are thousands of potential and conflicting investment candidates with different combinations of risk and return characteristics. Such being the case, you cannot compare two different investment opportunities directly (apples and oranges) with different risk profiles without doing something to standardize either risk or return.

In this context, the Sharpe Ratio is the most popular tool to measure the risk-adjusted performance of portfolio or mutual fund managers among other available measuring formulas.

!!!Definition of the Sharpe Ratio

As a measure for calculating risk-adjusted return, the __Sharpe Ratio__ is named after William F. Sharpe of the Stanford University. The way adopted by the Sharpe Ratio to compare apples to oranges in the investment world is to subtract return in excess of the risk-free rate per unit of volatility since volatility is a proxy for the risk in investment world when we assume that average investors are risk averse. Now we can compare apples to oranges with this ratio; the higher the ratio, the better investment opportunity.

[{Image src=’sharpe-ratio.png’ alt=’Sharpe ratio’}]

Here, S stands for Sharpe Ratio. The numerator in the parenthesis is the excess return of a portfolio; that is, R(p) is portfolio return and R(f) risk-free rate. The denominator in the parenthesis is the standard deviation (a proxy unit of risk) of the same portfolio. Standard deviation is the extent of volatility for the portfolio.

!!!Examples of the __Sharpe Ratio__

!!Example 1

A financial asset has an expected return of 8% with the risk-free rate of 2%. When the standard deviation of the asset’s excess return is 10%, the Sharpe Ratio will be:

(0.08 – 0.02)/0.1 = 0.6

!!Example 2

You have a portfolio of investments with an expected return of 15% and a volatility of 10%. The risk-free rate is 2%. The Sharpe Ratio will be:

(0.15 – 0.02)/0.1 = 1.3

You should note, however, that the ex-post Sharpe Ratio uses ”realized” returns while the ex-ante Sharpe Ratio uses ”expected” returns.

!! Applications in Finance

The Sharpe Ratio tells us how well the portfolio’s return compensates for the risk taken. It is also often used to compare the change in a portfolio’s overall risk-return characteristics when a new asset is added to it. The modern ‘Portfolio Theory’ argues that a well-diversified portfolio can decrease portfolio risk without corresponding lower return. In this context, if the addition of a new financial asset increases the __Sharpe Ratio__, it should be added to the portfolio.

On the other hand, even if a portfolio of financial assets can produce higher returns, it is only a good investment if its higher return does not come with an additional risk. In other words, the higher return should be the result of astute investment management, not a consequence of excessive risk-taking.

!!!Lesson Summary

Developed by Nobel Laureate Dr. William F. Sharpe, the Sharpe Ratio quantifies a portfolio’s return in excess of a risk-free investment relative to its risk measure (standard deviation in most cases), since different portfolios have different risk-return profiles. The __Sharpe Ratio__ usually uses the standard deviation as its proxy for the volatility to measure a portfolio’s risk-adjusted returns. In conclusion, the higher a portfolio’s Sharpe Ratio is, the better the relative performance of the portfolio has been in terms of risk.

LBO

Monday, March 6th, 2017

!!!Introduction

Hilton Hotel chains, PetSmart, Inc., Georgia-Pacific LLC, and First Data Corp. are some of target companies of the leveraged buyouts from the 1980s through 2000s. The American private equity firm called Kohlberg Kravis Roberts & Co. pulled off the most famous leveraged buyout (LBO) of all time in 1989, the RJR Nabisco deal. The Blackstone Group picked the worst timing when it bought Hilton in a leveraged buyout in 2007 right before the financial crisis. These deals purport to maximize shareholder values, but are usually considered as hostile takeovers since the current management of the targets do not want the deal in the first place.

!!!Definition of a leveraged buyout

When the management of a company and or a financial buyer, such as a private equity fund wants to buy a company or a part of it but does not want to commit too much of their own equity capital, a financing structure called a __leveraged buyout__ is utilized. The bonds issued in the process are usually ”junk” bonds since the bonds are not backed by much cushion called equity. The cash flow of the company being acquired and/or the assets of the acquiring company are often used as collateral for the loans, given the scant amount of equity investment of the acquiring company.

As we saw in the MM Proposition I & II, the use of debt, which has a lower cost of capital than equity, serves to reduce the overall cost of financing the acquisition, thus the name of ”leveraged” buyout.

!!!Types of leveraged buyouts

There are variants of leveraged buyouts such as __highly leveraged transactions (HLTs), __management buyout__ (MBO) by the current management, __management buy-in__ (MBI) of outside management, __secondary leveraged buyouts__ of a company that was acquired through an original leveraged buyout, etc. But, they are typically categorized for the following three purposes:

*Converting a public company into a private one
*Leveraged buyouts in spin-offs
*Financing private property sell-off

!!Public-to-Private

When a financing buyer purchases all of the outstanding stock of a public company and turns the company into a privately one, this particular leveraged buyout is called a __public-to-private deal__. Depending on the management’s point-of-view, these deals could be either friendly or hostile. In a friendly deal, the current management buys the company out for itself with plans to run it. On the other hand, when an outside financing group buys to reorganize and to resell the company, it is called a hostile deal.

!!Spin-Offs

Companies sometimes need to sell off a segment of their business to pay the investors back. In some cases, the seller may itself have been bought in a leveraged buyout. In these situations, the management of the spun-off segment may initiate the management buyout or may be passive in the transaction. Regardless, the fundamental financial logic of such leveraged buyouts, however, are the same.

!!Private Deals

__Private deals__ are the case where a privately held operation is bought by an investor group. This oftentimes happens when a small company owner wants to retire. The owner resorts to this private deal leveraged buyout when he wants to sell the company and cannot find an outside buyer. The eventual buying group tends to be the company’s employees or managers who are familiar with the operation already.

!!!Summary

A __leveraged buyout__ is usually structured to form a new company for the purpose of acquiring the target company. The financial buyers or management of the target company, depending on the case, invest a small amount of capital with the majority of debt provided by investment banks.

Subsequently, the target company either becomes a subsidiary of a new company or they merge with each other later on. As financial buyers increase their returns by employing a very high leverage, they have an incentive to employ as much debt as possible to finance an acquisition. This has in many cases; however, led to situations in which companies were ‘~’over-leveraged’~’. They did not generate sufficient cash flows to service their debt, which in turn led to the equity owners losing control of the company to the investment banks.

Interest Rates

Monday, March 6th, 2017

 

What is a common thread going through the whole macroeconomic system, linking all the separate players such as the government, businesses, and consumers? It is the interest rate. It acts as a signal in moving funds among these players. This is true in the international arena, too, through foreign exchange rates. In a perfect market, the interest rates over different maturity should be the same given the same risk since these interest rates are affected by the risk only. In reality, however, this is not true.

In economics, the relationship between different terms or maturities (for instance, 1 month, 1 year, or 10 years), and the interest rates for risk-free debt is called the __Term Structure of Interest Rates__. In real life, the term structure of interest rate is rarely horizontal over the time. As you can see, the benchmark interest rates either rise or decline as the maturity of debt increases. In other words, the flat yield curve (b) is a theoretical behavior of the interest rate in the perfect capital market and this rarely happens.

[{Image src=’fd17598d-4952-48ca-9b6e-fd5a7d815b54_rising-yield-curve1.jpg’ alt=’Term Structure’}]

Now, we need to come up with some explanations to account for the difference between the theoretical flat term structure and real (either increasing or decreasing) term structures.

!!!Theories

In general terms, the following observations of interest rates over time are made in reality.

1. Interest rates for different terms move together.

2. Interest rates on short-term debts fluctuate more than those on long-term debts.

3. The term structure of interest rates usually slopes upward in most cases.

To account for these facts, we will introduce three existing theories of the Term Structure of Interest Rates: Expectations Theory, Segmented Market Theory, and Liquidity Premium Theory.

!!Expectations Theory

The underlying premise of this theory is that investors are indifferent to the maturity of bonds. So, they can switch bonds if their interest rates are not competitive with other maturities. In economics, these bonds are called perfect substitutes. According to this theory, therefore, all the long-term rates are simply the averages of expected future short-term rates.

!!Segmented Markets Theory

The underlying assumption of this theory is that markets for different maturity bonds have their own set of supply and demand, thus completely insulated from each other. The interest rate for each bond with a different maturity is determined by their own supply and demand set of the segmented market.

!!Liquidity Premium Theory

Throughout our discussion of the term structure of interest rate theories, we have assumed that average investors are risk averse and demand a premium for longer maturity bonds because of inflation and interest rate risk. The longer the term of the bond, the greater the bond market price changes due to a given change in interest rates. The buyer of long-term bonds, therefore, require higher premiums for the higher risks (inflation & interest rate risks) of long-term bonds.

!!!Lesson Summary

Interest rates are the only common thread linking all the different players in the macro economy. The relationship between different terms and the interest rates for risk-free debt is called the __Term Structure of Interest Rates__. The behavior of this fundamental benchmark of interest rates is very carefully followed by all the economic agents to use the rate as their basis for decision making and to predict what is in store in the future in terms of economic activity. The term structure and the direction of interest rates are also often used to judge the overall credit market condition.

Tax Lien

Monday, March 6th, 2017

When people cannot pay the back taxes for whatever reason, they tend to bury their heads in the sand or panic not to respond to payment demand letters from the IRS. Your best bet, however, is to contact them as promptly as possible and/or cooperate with them to the fullest extent since the Internal Revenue Service has the discretion to extend the payment period up to 120 days. But, they always have the right to file the __Notice of Federal Tax Lien__ with a proper local authority to claim their interests in your properties once your tax payments become delinquent.

!!! What is a Federal Tax Lien and What is a Levy?

Due to unforeseen financial circumstances, you can either fail to pay your tax fully on time or can be assessed after the tax audit. In either case, you are supposed to pay in full within 10 business days unless you qualify for up to 120 days of additional time to pay. If you cannot make payments to settle your delinquent taxes after the notice and demand letter, the Internal Revenue Service (IRS) of the United States Treasury has the right to rectify the situation by filing a federal tax lien. This __lien__ is the legal claim against non-compliant taxpayer’s current and future properties. On the other hand, a __levy__ directly freezes the assets of a tax debtor to secure more immediate payment.

!!! How to Remove a Federal Tax Lien

If you pay off the delinquent federal debt in full, the Internal Revenue Service (IRS) will remove the lien within 30 days of full payment, which includes penalty and interest. When you cannot pay in full, however, you had better pay as much as you can at the moment and explore other payment options with either tax attorney or a qualified accountant. Other payment arrangements include the monthly payment plan and an Offer in Compromise.

!! Payment Plan (Monthly Installment Agreements)

__ Form 9465 (Installment Agreement Request)__ allows monthly installments to be made if you find paying the amount owing all at once is too burdensome but installments must be on time. Otherwise, you will be in default on the taxes. In that case, you might have to pay a reinstatement charge. If you satisfy all the prerequisites of the IRS payment plan, you may even be able to use an online payment arrangement, depending upon the delinquent tax amount.

!! Offer in Compromise

Like the monthly payment plan with the IRS, you must be current with the IRS by filing all the required taxes before you apply for an offer in compromise. An __Offer in Compromise__ allows you to settle your tax debt for less than the full amount you owe by filing Form 433-A (Collection Information Statement for Wage Earners and Self-Employed Individuals) or Form 433-B ( Collection Information Statement for Businesses) with the proof of your financial status.

The Internal Revenue Service will consider your unique personal and financial situations and facts such as the current assets, ability to pay, current and prospective income, current age, living expenses, family problems, etc. An __Offer in Compromise Pre-Qualifier__ in the IRS web site can give you a preliminary proposal amount. If the accepted amount is paid, the taxpayer should initiate to request the release of the lien. The IRS often do not follow through with the removal of the lien voluntarily.

!!! The Statute of Limitations and Federal Tax Liens

For taxes assessed after November 5, 1990, the IRS has ten years from the date of a tax assessment to collect tax debt from the taxpayer. When this date passes, the IRS is barred from attempting to collect your debt unless you waive the enforcement of the statute by a written consent. You should initiate to obtain a Certificate of Release of Federal Tax Lien to expunge the record of the lien from the local and/or state office of records since the IRS is well known to be tardy in removing the lien.

There are, however, many exceptions that extend the collection time period such as a signing of a waiver, bankruptcy proceedings, Offer in Compromise, and the filing of a Collection Due Process. Innocent Spouse Relief and any other forms of relief extend the statute of limitations. It is imperative for you to consult with either a tax attorney or a qualified CPA when you are asked to sign a form after your offer has been accepted.

!!! Lesson Summary

When people cannot pay the back taxes, they tend to ignore payment demand letters from the IRS. Your best policy, however, is to contact them as promptly as possible and cooperate with them to the full extent since the Internal Revenue Service has the right to file the __Notice of Federal Tax Lien__ with a proper authority to claim their interests with your current and/or future properties once your tax payments become delinquent. If you cannot make one lump sum payment, you can opt for either an installment plan or offer in compromise. The statute of limitations on the collection of the federal tax lien is usually ten years from the date of assessment.

Share-Based Compensation

Monday, March 6th, 2017

With the dot-com boom since 1995, financial newspapers have been replete with terms such as employee call options, stock purchase plans, restricted stocks, and stock appreciation rights. What are these arrangements for? Why were they so popular? The common thread of these arrangements is that they’re all based on the price of the company’s shares. With stock market going up so rapidly, these derivative arrangements based on stock price were ever more popular among startups and more established companies.

!!!What is Share-Based Compensation?

__Share-based compensation__ is now very common among companies as a part of compensation scheme. Many startups and mature companies supplement their cash payroll with the shares of their own companies or the options to buy shares. These companies also pay for the services and sometimes for the goods they receive in the form of stock options, restricted stocks, and/or stock appreciation rights.

Share-based compensation, therefore, allows management and employees to share in the growth of the company’s stock price without depleting the company’s cash reserves. If all the players in the companies have a stake in the value of the company’s shares, they will usually try to achieve the maximization of share price or be willing to stay with the company longer than otherwise.

Tech startups, however, use options more frequently. Larger and more established companies tend to use restricted stocks and other share-based methods compared with equity call options. Upstart tech companies use these compensation methods to recruit young talent and/or reward superior financial performance of existing emplyees. Share-based compensation schemes, however, must take into account applicable accounting disclosure and securities laws, such as securities registrations and regulatory disclosure requirements and fair value measurement.

Stock options usually have very little downside risk for the recipients. However, many studies have shown that options and other share-based compensation may encourage the current management to be reckless in undertaking new projects, which could have adverse long-term consequences for shareholders in the long run.

!!!Types of Compensation

The three common types of share-based compensation are stock call options, restricted stocks and stock appreciation rights.

!!Stock Call Option

A stock call option is a right, but not an obligation, to buy shares at a predetermined strike (exercise) price. American options can be exercised any time between the date of purchase and the expiration date of the option. European options, on the other hand, are slightly less common and can only be redeemed at the expiration date. When used as part of compensation, these options have a vesting period, however, which usually specifies when employees may exercise their options.

Startups usually are in need of cash reserves. They use stock options to save cash and to attract key employees. These key employees are usually the seasoned executives who are willing to sacrifice at first for the stock price increases later on.

Stock options usually have very little downside risk for the recipients. However, options and other share-based compensation may encourage moral hazard of managers by making them plunge into risky investments to influence share prices. This could have adverse long-term consequences for shareholders, though.

!!Restricted Stock

Companies issue restricted stock to employees, who may sell the stock only after meeting certain criteria, such as a vesting period or certain performance criteria. Usually, restricted stocks are those purchased in unregistered, private sales from the issuing company. Rule 144 identifies more specifically what kind of sales generate restricted stocks. Restricted stock is nontransferable and must be traded in compliance with Rule 144.

SEC Rule 144 is about resale of control and restricted stocks. They typically become available for sale under a graded vesting schedule. From the perspective of existing shareholders, these restricted stocks are less diluting than options.

!!Stock Appreciation Rights (SARs)

Similar to stock call options, Stock Appreciation Rights (SARs) give the participating employees a bonus in cash or shares if the company’s set of shares performs better than expected over a specified period. Sometimes called a ‘plan’, SARs resemble stock call options because the employees benefit if the company’s stock price increases above set price in the award. Depending on the company’s plan, however, SARs differ from call options in that the participating employees are not required to pay the exercise price, but just receive the amount of any increase in stock price either in cash or stocks upon exercising.

!!!Lesson Summary

__Share-based compensation__ serves many purposes. To cash-restrained startups, it could be a supplemental compensation in addition to its being incentive to stay longer with the risky venture. To more mature and established companies, share-based compensation could align the interests of all the players. The popular types are stock call options and restricted stocks.

Considerations of the Investment in Bonds

Monday, March 6th, 2017

!!!Considerations of the Investment in Bonds

In an introductory corporate finance course, you may learn that the relationship between the interest rate and price of a bond is inverse (convex). But, this relationship does not tell us the ”degree” of bond price change with respect to the ”given” interest rate change.

For the standard type of coupon bonds, the cash flows spread out until the maturity date. For this reason, we need to know the effective maturity of the bond on top of the price sensitivity in relation to the interest rate to effectively manage our portfolio.

The metric that helps bond portfolio managers gauge uncertainty in these two areas is the concept of duration. There are two popular duration metrics: Macaulay Duration and Modified Duration. The term ”duration” has a special meaning in the context of bonds. It is extensively used as a measure of how long it takes for the coupon payments and principal to pay the market price of the bond. It is also an important estimate of price sensitivity of bonds to the interest rate. Bonds with a higher duration are riskier than bonds with lower duration.

Frederick Macaulay, in 1938, came up with the effective maturity concept on the duration of a bond. Graphically, Macaulay Duration is the fulcrum point of a group of present values of cash flows generated by a bond. It is also interpreted as the weighted average number of years for the cash flow from the bonds to equal the market price of the bond. Therefore, as a bond’s maturity increases, duration increases. Call provisions, on the other hand, decreases the duration of bonds.

Modified duration is slightly different from the Macaulay Duration in that it expresses the change in the value of a bond in response to a change in interest rates. This formula is used to determine the effect that a percentage change in interest rates will have on the bond price.

!!!What is Convexity?

Now let’s move on to the concept of convexity. A bond’s convexity is the rate of change of its duration. Since the concept of duration applies to the point measurement of price sensitivity with respect to interest rate, the convexity is, in calculus terms, the second derivative of the bond’s price with respect to its yield.

Negative convexity exists when the shape of a bond’s yield curve is concave instead of convex. Mortgage-backed bonds and callable corporate bonds show this characteristic.

!!!Examples of Negative Convexity

The relationship between interest rates and price of bonds is inverse in most cases. We call this the convexity of bonds. If a bond has a __negative convexity__ the price will decrease as interest rates fall. For example, callable corporate bonds’ price fall as interest rates fall and the incentive for the issuer to call the bond at par increases. This is why we say that a callable bond has negative convexity with respect to interest rates.

Mortgage-backed securities (MBS) are another example of negative convexity since those MBS typically lose value when interest rates fall. As in the case of a bond with a call option, with MBS, a decrease in interest rates increases the number of borrowers that will repay their loans and refinance at the lower rate. The property of __negative convexity__ brings down the value of the bonds when interest rates head south.

!!!Lesson Summary

Despite the common inverse relationship of the interest rate and price of bonds, some bonds’ prices go down when the interest rates fall. This is called the __negative convexity__ of bonds. Mortgage-backed securities and corporate bonds with call options are common examples.

What is an Activist Investor?

Monday, March 6th, 2017

!!!What is an Activist Investor?

T. Boone Pickens, Jr., Kirk Kerkorian, Carl Icahn, Nelson Peltz, Bill Ackman, David Einhorn, Dan Loeb… Financial newspapers regularly report on these people. But, who are they? What do they do to earn their living? ”Are they really corporate raiders or agitators for the shareholders?”

These people have been called __activist investors__ or corporate raiders, depending on the perspective of the commentator. What kind of change do they want to bring about and for whom?

Activist investors are individuals or institutional investors (such as hedge funds and private equity funds) that purchase a significant amount stocks in a public company. They do so to instigate changes within that company. The goal of an activist investor may ultimately be to gain a seat on the board of the target company.

Typically, a company can become the target for activist investors if the company has excessive cash reserves or wasteful operating costs that could be distributed as dividends to shareholders, or the company could be run more efficiently as a private company. Activist investors do not usually manage the corporations in which they invest. Instead, they rely on the support of external institutional investors to exert friendly pressure as they exercise shareholder rights.

Activist investor tactics can be anything from collaborative to contentious. They can include negotiating with management, public campaigns, shareholder resolutions, proxy contests, and even litigation. Proxy fights and litigations can be costly and time consuming so few activist investor campaigns proceed to that level.

A good indicator of a company becoming a target for activist investors is the filing of SEC Schedule 13D (beneficial ownership report). When an activist investor or institutional investor purchases beneficial ownership of more than 5 percent of a voting class of the target company’s stocks registered under Section 12 of the Securities Exchange Act of 1934, they are required to file a Schedule 13D or 13G. Once a company becomes a target, they may also want an amicable settlement in an effort to avoid a costly battle due to the changing attitudes of institutional investors.

!!!Examples of Activist Investors

!Carl Icahn

Carl Icahn started as a stockbroker in 1961 on Wall Street. In 1978, he began to act as an activist investor by taking controlling positions in individual firms. Companies such as Trans World Airlines, U.S. Steel, Yahoo Inc., Netflix Inc., Xerox, and the Clorox Company became the targets. One of Icahn’s more notable investments was in Apple Inc. and Xerox Corporation.

!Bill Ackman

Bill Ackman is the founder and chief executive officer (CEO) of the Pershing Square Capital Management, a hedge fund management company. Pershing has taken positions in Target Corporation, Wendy’s Company, Valeant Pharmaceuticals, and Chipotle Mexican Grill. Ackman’s notable investments and positions include Valeant Pharmaceuticals International Inc. and a short position in Herbalife Ltd.

!Dan Loeb

Dan Loeb is the founder of the $10.8 billion hedge fund Third Point Partners, a hedge fund based in New York. Third Point has sizable positions in Baxter International Inc. and Ligand Pharmaceuticals Inc. He also gained a seat on the Yahoo board of directors in 2012. Loeb’s strategy is to purchase companies that are in trouble, replace the management, and attempt to restore profitability.

!Activist Investment Funds

Examples of activist investment funds include the California Public Employees’ Retirement System (CalPERS) and the State Board of Administration of Florida.

!!!Lesson Summary

Whenever the management of public companies lacks appropriate incentives to maximize shareholder value, __activist investors__ jump in to make the company more valuable. Without activist investors, the complacent managers incur agency costs, maintaining their position regardless of performance while receiving excessive executive compensation and fringe benefits.

Term Structure of Interest Rates

Friday, March 3rd, 2017

!!!Interest Rates

What is a common thread going through the whole macroeconomic system, linking all the separate players such as the government, businesses, and consumers? It is the interest rate. It acts as a signal in moving funds among these players. This is true in the international arena, too, through foreign exchange rates. In a perfect market, the interest rates over different maturity should be the same given the same risk since these interest rates are affected by the risk only. In reality, however, this is not true.

In economics, the relationship between different terms or maturities (for instance, 1 month, 1 year, or 10 years), and the interest rates for risk-free debt is called the __Term Structure of Interest Rates__. In real life, the term structure of interest rate is rarely horizontal over the time. As you can see, the benchmark interest rates either rise or decline as the maturity of debt increases. In other words, the flat yield curve (b) is a theoretical behavior of the interest rate in the perfect capital market and this rarely happens.

[{Image src=’fd17598d-4952-48ca-9b6e-fd5a7d815b54_rising-yield-curve1.jpg’ alt=’Term Structure’}]

Now, we need to come up with some explanations to account for the difference between the theoretical flat term structure and real (either increasing or decreasing) term structures.

!!!Theories

In general terms, the following observations of interest rates over time are made in reality.

1. Interest rates for different terms move together.

2. Interest rates on short-term debts fluctuate more than those on long-term debts.

3. The term structure of interest rates usually slopes upward in most cases.

To account for these facts, we will introduce three existing theories of the Term Structure of Interest Rates: Expectations Theory, Segmented Market Theory, and Liquidity Premium Theory.

!!Expectations Theory

The underlying premise of this theory is that investors are indifferent to the maturity of bonds. So, they can switch bonds if their interest rates are not competitive with other maturities. In economics, these bonds are called perfect substitutes. According to this theory, therefore, all the long-term rates are simply the averages of expected future short-term rates.

!!Segmented Markets Theory

The underlying assumption of this theory is that markets for different maturity bonds have their own set of supply and demand, thus completely insulated from each other. The interest rate for each bond with a different maturity is determined by their own supply and demand set of the segmented market.

!!Liquidity Premium Theory

Throughout our discussion of the term structure of interest rate theories, we have assumed that average investors are risk averse and demand a premium for longer maturity bonds because of inflation and interest rate risk. The longer the term of the bond, the greater the bond market price changes due to a given change in interest rates. The buyer of long-term bonds, therefore, require higher premiums for the higher risks (inflation & interest rate risks) of long-term bonds.

!!!Lesson Summary

Interest rates are the only common thread linking all the different players in the macro economy. The relationship between different terms and the interest rates for risk-free debt is called the __Term Structure of Interest Rates__. The behavior of this fundamental benchmark of interest rates is very carefully followed by all the economic agents to use the rate as their basis for decision making and to predict what is in store in the future in terms of economic activity. The term structure and the direction of interest rates are also often used to judge the overall credit market condition.

CMOs

Friday, March 3rd, 2017

!!!Overview

Sub-prime mortgage and the collateralized mortgage obligations (CMOs) that packaged them were singled out for precipitating the financial crisis of 2008.

What is a collateralized mortgage obligation (CMO) that bundles these sub-prime mortgages? It is the product of financial engineering that transforms a group of illiquid financial assets into a security. For instance, there are special bonds backed by financial receivables such as credit card receivables, auto loans, leases and home-equity loans.

These are called asset backed securities (ABS). This special debt market is relatively new but expanding fast. When a pool of residential mortgages are used in the place of these other financial receivables, this particular asset backed security (ABS) is called a mortgage backed security (MBS). Finally, a type of mortgage backed security (MBS) is called a collateralized mortgage obligation when the mortgage backed security (MBS) is divided into portions of the debt based on maturity and/or risks of the pool.

!!!Mechanics of a Collateralized Mortgage Obligation (CMO)

Firstly, an investment bank buys mortgages from retail mortgage banks and brokers, that originated residential mortgage loans to the property owners.Then, different slices of IOUs are sold by the investment bank to satisfy different tastes of risk/return combination of investors. Investors (banks, hedge funds, pension funds, insurance companies, mutual funds, and governmental agencies including central banks) in a collateralized mortgage obligation (CMO) buy these IOUs to receive payments from the income generated by the pool of underlying home mortgages.

!!!Types of CMOs

In accordance to pre-defined and complicated rules, a collateralized mortgage obligation (CMO) pools and re-directs the payments of principal and interest from large pools of home mortgages to different types and maturities of CMOs. These different types of collateralized mortgage obligations (CMOs) are known as ”tranches”. This French word ”tranche” means __a portion of money__. Each type of a collateralized mortgage obligation (CMO) may have different principal balances, coupon rates, maturity dates, and other details of the rights and risks of ownership of any bonds.

The most simple form of CMO is composed of classes that are retired in a strict sequence. In other words, all the outstanding classes of collateralized mortgage obligation (CMO) receive regular interest payments, but principal payments are made to the first class exclusively until it gets paid fully. This is called __Sequential Pay__.

There also are more complicated types such as Planned Amortization Class, Targeted Amortization Class, Companion Tranches, Principal-Only, Interest-Only, Floating-Rate, etc. that are all beyond the scope of this lesson.

!!!__History of CMOs__

A collateralized mortgage obligation (CMO) was first created in 1983 by two investment banks (Salomon Brothers and First Boston) for the U.S. Federal Home Loan Mortgage Corporation whose main function is to provide liquidity for the U.S. home mortgage loans. The value of CMOs peaked in 2007 just before the global financial crisis.

The CMOs were singled out in the mass media for starting the global financial crisis in 2008. Even though the underlying mortgages went bad rapidly, investors for whatever reasons got fixated on the income streams generated by the CMOs instead. Rating agencies and other esoteric financial models failed to pick up increasing foreclosure and payment default rates in the middle of rising housing prices.

!!!__Risks of CMOs__

When Freddie Mac guaranteed the payment of principal and interest on the underlying pool of mortgages in 1983, the collateralized mortgage obligation (CMO) posed essentially no credit risk. This was true since government agencies such as Fannie Mae, Freddie Mac, or Ginnie Mae, at least implicitly, have the full backing of the US Government. Investors took prepayment, interest, market and liquidity risks, however, for which they were compensated with higher yields.

__Private label collateralized mortgage obligations (CMOs)__ were soon issued by investment banks with underlying mortgages that were not guaranteed by Fannie, Freddie or Ginnie. These unconventional collateralized mortgage obligations (CMOs) re-introduced credit risk to the collateralized mortgage obligations (CMOs) market. Credit insurance was mainly used to deal with the credit risk of private label non-conforming collateralized mortgage obligations (CMOs).

With the banks starting to pass more of the credit risk on to investors, collateralized mortgage obligations (CMOs) became absurdly complicated game among three parties of investment banks, mortgage brokers, and credit rating agencies. Soon, therefore, each tranche had to receive its own credit rating from a rating agency.

!!!__Lesson Summary__

Collateralized mortgage obligations (CMOs) provided enormous amount of liquidity into the secondary residential mortgage loan market; thereby enabling various mortgage originators to make more home loans to more property owners. Mortgage banks originated mortgages that the investment banks re-packaged into collateralized mortgage obligations (CMOs) that the investors devoured with the blessings of the rating agencies. The added liquidity quickened the pace of mortgage origination in turn.

However, there were limited numbers of houses and qualified borrowers to finance; credit standards had to fall to keep up with the profitable business. Many mortgage lenders eventually got involved in falsifying loan applications. Credit rating agencies did not adequately reflected the underlying fraud going on in the front line. With investment banks shopping the bond ratings, the real estate market inevitably ended up in a huge ”bubble”. The market started to lose momentum in 2007; in the following year, it collapsed in the worst financial crisis since the Great Depression of the 1930s.

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