Glossary of Industry Terms & Supporting Information

ICON Securities Lending (L – M)

Letter of credit: A standard, commercial letter of credit is a document issued mostly by a financial institution, used primarily in trade finance, which usually provides an irrevocable payment undertaking.

The LC can also be the source of payment for a transaction, meaning that redeeming the letter of credit will pay an exporter. Letters of credit are used primarily in international trade transactions of significant value, for deals between a supplier in one country and a customer in another. They are also used in the land development process to ensure that approved public facilities (streets, sidewalks, stormwater ponds, etc.) will be built. The parties to a letter of credit are usually a beneficiary who is to receive the money, the issuing bank of whom the applicant is a client, and the advising bank of whom the beneficiary is a client. Almost all letters of credit are irrevocable, i.e., cannot be amended or canceled without prior agreement of the beneficiary, the issuing bank and the confirming bank, if any. In executing a transaction, letters of credit incorporate functions common to giros and Traveler’s cheques. Typically, the documents a beneficiary has to present in order to receive payment include a commercial invoice, bill of lading, and documents proving the shipment was insured against loss or damage in transit. However, the list and form of documents is open to imagination and negotiation and might contain requirements to present documents issued by a neutral third party evidencing the quality of the goods shipped, or their place of origin.

Terminology

The English name “letter of credit” derives from the French word “accreditation”, a power to do something, which in turn is derivative of the Latin word “accreditivus”, meaning trust. S.‘The Application any defence relating to the underlying contract of sale. This is as long as the seller performs their duties to an extent that meets the requirements contained in the LC.

How it works

A business called the InCosmetika from time to time imports goods from a business called BLISS, which banks with the ABC Bank. InCosmetika holds an account at the Commonwealth Bank. InCosmetika wants to buy $500,000 worth of merchandise from BLISS, who agrees to sell the goods and give InCosmetika 60 days to pay for them, on the condition that they are provided with a 90-day letter of credit for the full amount. The steps to get the letter of credit would be as follows:

• InCosmetika goes to The Commonwealth Bank and requests a $500,000 letter of credit, with BLISS as the beneficiary.
• The Commonwealth Bank can issue an LC either on approval of a standard loan underwriting process or by InCosmetika funding it directly with a deposit of $500,000 plus fees which are typically between 1% and 8% of the face value of the LC.
• The Commonwealth Bank sends a copy of the LC to the ABC Bank, which notifies BLISS that payment is available and they can ship the merchandise InCosmetika has ordered with the full assurance of payment to them.
• On presentation of the stipulated documents in the letter of credit and compliance with the terms and conditions of the letter of credit, the Commonwealth Bank transfers the $500,000 to the ABC Bank, which then credits the account of BLISS for that amount.
• Note that banks deal only with documents required in the letter of credit and not the underlying transaction.
• Many exporters have mistakenly assumed that the payment is guaranteed after receiving the LC. The issuing bank is obligated to pay under the letter of credit only when the stipulated documents are presented and the terms and conditions of the letter of credit have been met.

Availability

, to the Beneficiary of the Credit provided, stipulated documents strictly complying with the provisions of the LC, UCP 600 and other international standard banking practices, are presented to the issuing bank , then :

• i.if the Credit provides for sight payment – by payment at sight against compliant presentation
• ii.if the Credit provides for deferred payment – by payment on the maturity date(s) determinable in accordance with the stipulations of the Credit; and of course undertaking to pay on due date and confirming maturity date at the time of compliant presentation
• iii.a.if the Credit provides for acceptance by the Issuing Bank – by acceptance of Draft(s) drawn by the Beneficiary on the Issuing Bank and payment at maturity of such tenor draft, or
• iii.b. if the Credit provides for acceptance by another drawee bank – by acceptance and payment at maturity Draft(s)drawn by the Beneficiary on the Issuing Bank in the event the drawee bank stipulated in the Credit does not accept Draft(s) drawn on it,

or by payment of Draft(s) accepted but not paid by such drawee bank at maturity;

• iv. if the Credit provides for negotiation by another bank – by payment without recourse to drawers and/or bona fide holders, Draft(s) drawn by the Beneficiary and/or document(s) presented under the Credit, (and so negotiated by the nominated bank )
• Negotiation means the giving of value for Draft(s) and/or document(s) by the bank authorized to negotiate, viz the nominated bank. Mere examination of the documents and forwarding the same to LC issuing bank for reimbursement, without giving of value / agreed to give, does not constitute a negotiation.
• Financial Documents

Some of the Documents Called for under a LC

Bill of Exchange, Co-accepted Draft

• Commercial Documents

Invoice, Packing list

• Shipping Documents

Transport Document, Insurance Certificate, Commercial, Official or Legal Documents

• Official Documents

License, Embassy legalization, Origin Certificate, Inspection Cert , Phyto-sanitary Certificate

• Transport Documents

Bill of Lading (ocean or multi-modal or Charter party), Airway bill, Lorry/truck receipt, railway receipt, CMC Other than Mate Receipt, Forwarder Cargo Receipt, Deliver Challan…etc

• Insurance documents

Insurance policy, or Certificate but not a cover note.

Legal principles governing documentary credits

One of the primary peculiarities of the documentary credit is that the payment obligation is abstract and independent from the underlying contract of sale or any other contract in the transaction. Thus the bank’s obligation is defined by the terms of the credit alone, and the sale contract is irrelevant. The defenses of the buyer arising out of the sale contract do not concern the bank and in no way affect its liability.  Article 4(a) UCP states this principle clearly. Article 5 the UCP further states that banks deal with documents only, they are not concerned with the goods (facts). Accordingly, if the documents tendered by the beneficiary, or his or her agent, appear to be in order, then in general the bank is obliged to pay without further qualifications.

The policies behind adopting the abstraction principle are purely commercial and reflect a party’s expectations: firstly, if the responsibility for the validity of documents was thrown onto banks, they would be burdened with investigating the underlying facts of each transaction and would thus be less inclined to issue documentary credits as the transaction would involve great risk and inconvenience. Secondly, documents required under the credit could in certain circumstances be different from those required under the sale transaction; banks would then be placed in a dilemma in deciding which terms to follow if required to look behind the credit agreement. Thirdly, the fact that the basic function of the credit is to provide the seller with the certainty of receiving payment, as long as he performs his documentary duties, suggests that banks should honor their obligation notwithstanding allegations of misfeasance by the buyer.  Finally, courts have emphasized that buyers always have a remedy for an action upon the contract of sale, and that it would be a calamity for the business world if, for every breach of contract between the seller and buyer, a bank were required to investigate said breach.

The “principle of strict compliance” also aims to make the bank’s duty of effecting payment against documents easy, efficient and quick. Hence, if the documents tendered under the credit deviate from the language of the credit the bank is entitled to withhold payment even if the deviation is purely terminological.  The general legal maxim de minimis non curat lex has no place in the field of documentary credits.

The price of LCs

All the charges for issuance of Letter of Credit, negotiation of documents, reimbursements and other charges like courier are to the account of applicant or as per the terms and conditions of the Letter of credit. If the LC is silent on charges, then they are to the account of the Applicant. The description of charges and who would be bearing them would be indicated in the field 71B in the Letter of Credit.

Legal Basis for Letters of Credit

Although documentary credits are enforceable once communicated to the beneficiary, it is difficult to show any consideration given by the beneficiary to the banker prior to the tender of documents. In such transactions the undertaking by the beneficiary to deliver the goods to the applicant is not sufficient consideration for the bank’s promise because the contract of sale is made before the issuance of the credit, thus consideration in these circumstances is past. In addition, the performance of an existing duty under a contract cannot be a valid consideration for a new promise made by the bank: the delivery of the goods is consideration for enforcing the underlying contract of sale and cannot be used, as it were, a second time to establish the enforceability of the bank-beneficiary relation.

Legal writers have analyzed every possible theory from every legal angle and failed to satisfactorily reconcile the bank’s undertaking with any contractual analysis. The theories include: the implied promise, assignment theory, the novation theory, reliance theory, agency theories, estoppels and trust theories, anticipatory theory, and the guarantee theory.   Davis, Treitel, Goode, Finkelstein and Ellinger have all accepted the view that documentary credits should be analyzed outside the legal framework of contractual principles, which require the presence of consideration. Accordingly, whether the documentary credit is referred to as a promise, an undertaking, a chose in action, an engagement or a contract, it is acceptable in English jurisprudence to treat it as contractual in nature, despite the fact that it possesses distinctive features, which make it sui generis.

A few countries including the US (see Article 5 of the Uniform Commercial Code) have created statutes in relation to the operation of LCs. These statutes are designed to work with the rules of practice including the UCP and the ISP98. These rules are practice are incorporated into the LC transaction by agreement of the parties. The latest version of the UCP is the UCP600 effective July 1, 2007.  The previous revision was the UCP500 and became effective on 1 January 1994. Since the UCP are not laws, parties have to include them into their arrangements as normal contractual provisions.

International Trade Payment methods

• Advance payment (most secure for seller)

Where the buyer parts with money first and waits for the seller to forward the goods

• Documentary Credit (more secure for seller as well as buyer)

subject to ICC’s UCP 600, where the bank gives an undertaking (on behalf of buyer and at the request of applicant ) to pay the shipper ( beneficiary ) the value of the goods shipped if certain docs are submitted and if the stipulated terms and conditions are strictly complied.

Here the buyer can be confident that the goods he is expecting only will be received since it will be evidenced in the form of certain docs called for meeting the specified terms and conditions while the supplier can be confident that if he meets the stipulations his payment for the shipment is guaranteed by bank, who is independent of the parties to the contract.

• Documentary collection (more secure for buyer and to a certain extent to seller)

subject to ICC’s URC 525, sight and usance, for delivery of shipping documents against payment or acceptances of draft, where shipment happens first, then the title documents are sent to the [collecting bank] buyer’s bank by seller’s bank [remitting bank], for delivering documents against collection of payment/acceptance

• Direct payment (most secure for buyer)

Where the supplier ships the goods and waits for the buyer to remit the bill proceeds, on open account terms

Risk situations in LC transaction

General Risks

• If goods are being offered for sale at a price that is too good to be true, then it probably is too good to be true’

Fraud Risks

• The payment will be obtained for nonexistent or worthless merchandise against presentation by the Beneficiary of forged or falsified documents.
• Credit itself may be forged.

Sovereign and Regulatory Risks

• Performance of the Documentary Credit may be prevented by government action outside the control of the parties.

Legal Risks

• Possibility that performance of a Documentary Credit may be disturbed by legal action relating directly to the parties and their rights and obligations under the Documentary Credit

Force Majeure and Frustration of Contract

• Performance of a contract – including an obligation under a Documentary Credit relationship – is prevented by external factors such as natural disasters or armed conflicts

Risks to the Applicant

• Non-delivery of Goods
• Short Shipment
• Inferior Quality
• Early /Late Shipment
• Damaged in transit
• Foreign exchange
• Failure of Bank viz Issuing bank / Collecting Bank

Risks to the Issuing Bank

• Insolvency of the Applicant
• Fraud Risk, Sovereign and Regulatory Risk and Legal Risks

Risks to the Reimbursing Bank

• no obligation to reimburse the Claiming Bank unless it has issued a reimbursement undertaking.

Risks to the Beneficiary

• Failure to Comply with Credit Conditions
• Failure of, or Delays in Payment from, the Issuing Bank
• Credit Issued by Party other than Bank

Risks to the Advising Bank

• The Advising Bank’s only obligation – if it accepts the Issuing Bank’s instructions – is to check the apparent authenticity of the Credit and advising it to the Beneficiary

Risks to the Nominated Bank

• Nominated Bank has made a payment to the Beneficiary against documents that comply with the terms and conditions of the Credit and is unable to obtain reimbursement from the Issuing Bank

Risks to the Confirming Bank

• If Confirming Bank’s main risk is that, once having paid the Beneficiary, it may not be able to obtain reimbursement from the Issuing Bank because of insolvency of the Issuing Bank or refusal of the Issuing Bank to reimburse because of a dispute as to whether or not payment should have been made under the Credit
• A Credit risk risk from change in the credit of an opposing business.
• An Exchange risk is a risk from a change in the foreign exchange rate.
• A Force majeure risk is 1. a risk in trade incapability caused by a change in a country’s policy, and 2. a risk caused by a natural disaster.
• Other risks are mainly risks caused by a difference in law, language or culture. In these cases, the cargo might be found late because of a dispute in import and export dealings.

Risks in International Trade

Limited partnership: A limited partnership is a form of partnership similar to a general partnership, except that in addition to one or more general partners (GPs), there are one or more limited partners (LPs). It is a partnership in which only one partner is required to be a general partner.^[1]

The GPs are, in all major respects, in the same legal position as partners in a conventional firm, i.e. they have management control, share the right to use partnership property, share the profits of the firm in predefined proportions, and have joint and several liability for the debts of the partnership.

As in a general partnership, the GPs have actual authority as agents of the firm to bind all the other partners in contracts with third parties that are in the ordinary course of the partnership’s business. As with a general partnership, “An act of a general partner which is not apparently for carrying on in the ordinary course the limited partnership’s activities or activities of the kind carried on by the limited partnership binds the limited partnership only if the act was actually authorized by all the other partners.” (United States Uniform Limited Partnership Act § 402(b).)

Like shareholders in a corporation, LPs have limited liability, meaning they are only liable on debts incurred by the firm to the extent of their registered investment and have no management authority. The GPs pay the LPs a return on their investment (similar to a dividend), the nature and extent of which is usually defined in the partnership agreement.

Limited partnerships are distinct from limited liability partnerships, in which all partners have limited liability.

Liquidation: In law, liquidation is the process by which a company (or part of a company) is brought to an end, and the assets and property of the company redistributed. Liquidation can also be referred to as winding-up or dissolution, although dissolution technically refers to the last stage of liquidation. The process of liquidation also arises when customs, an authority or agency in a country responsible for collecting and safeguarding customs duties, determines the final computation or ascertainment of the duties or drawback accruing on an entry.

Liquidation may either be compulsory (sometimes referred to as a creditors’ liquidation) or voluntary (sometimes referred to as a shareholders’ liquidation, although some voluntary liquidations are controlled by the creditors, see below).

Compulsory liquidation

The parties who are entitled by law to petition for the compulsory liquidation of a company vary from jurisdiction to jurisdiction, but generally, a petition may be lodged with the court for the compulsory liquidation of a company by:

1. the company itself
2. any creditor who establishes a prima facie case
3. contributories
4. the Secretary of State (or equivalent)
5. the Official Receiver

Grounds

The grounds upon which one can apply for a compulsory liquidation also vary between jurisdictions, but the normal grounds to enable an application to the court for an order to compulsorily wind-up the company are:

1. the company has so resolved
2. the company was incorporated as a public company, and has not been issued with a trading certificate (or equivalent) within 12 months of registration
3. it is an “old public company” (i.e., one that has not re-registered as a public company or become a private company under more recent companies legislation requiring this)
4. it has not commenced business within the statutorily prescribed time (normally one year) of its incorporation, or has not carried on business for a statutorily prescribed amount of time
5. the number of members has fallen below the minimum prescribed by statute
6. the company is unable to pay its debts as they fall due
7. it is just and equitable to wind up the company

In practice, the vast majority of compulsory winding-up applications are made under one of the last two grounds.

An order will not generally be made if the real purpose of the application is other than for a winding-up, eg. the application is made just to enforce a debt.

A “just and equitable” winding-up enable the ground to subject the strict legal rights of the shareholders to equitable considerations. It can take account of personal relationships of mutual trust and confidence in small parties, particularly, for example, where there is a breach of an understanding that all of the members may participate in the business, or of an implied obligation to participate in management.  An order might be made where the majority shareholders deprive the minority of their right to appoint and remove their own director.

The order

Once liquidation commences (which depends upon applicable law, but will generally be when the petition was originally presented, and not when the court makes the order), dispositions of the company’s property are generally void, and litigation involving the company is generally restrained.

Upon hearing the application, the court may either dismiss the petition, or make the order for winding-up. The court may dismiss the application if the petitioner unreasonably refrains from an alternative course of action.

The court may appoint an official receiver, and one or more liquidators, and has general powers to enable rights and liabilities of claimants and contributories to be settled. Separate meetings of creditors and contributories may decide to nominate a person for the appointment of liquidator and possibly of supervisory liquidation committee.

Voluntary liquidation

Voluntary liquidation occurs when the members of the company resolve to voluntarily wind-up the affairs of the company and dissolve. Voluntary liquidation begins when the company passes the resolution, and the company will generally cease to carry on business at that time (if it has not done so already). If the company is solvent, and the members have made a statutory declaration of solvency, the liquidation will proceed as a members’ voluntary winding-up. In such case, the general meeting will appoint the liquidator(s). If not, the liquidation will proceed as a creditor’s voluntary winding-up, and a meeting of creditors will be called, to which the directors must report on the company’s affairs. Where a voluntary liquidation proceeds by way of creditor’s voluntary liquidation, a liquidation committee may be appointed.

Where a voluntary winding-up of a company has begun, a compulsory liquidation order is still possible, but the petitioning contributory would need to satisfy the court that a voluntary liquidation would prejudice the contributories.

In addition, the term liquidation is sometimes used when a company wishes to divest itself of some of its assets. This is used, for instance, when a retail establishment wishes to close stores. They will sell to a company that specializes in store liquidation instead of attempting to run a store closure sale themselves.

Misconduct

Main articles: Fraudulent trading, Undervalue transaction, Unfair preference and Wrongful trading.

The liquidator will normally have a duty to ascertain whether any misconduct has been conducted by those in control of the company which has caused prejudice to the general body of creditors. In some legal systems, in appropriate cases, the liquidator may be able to bring an action against errant directors or shadow directors for either wrongful trading or fraudulent trading.

The liquidator may also have to determine whether any payments made by the company or transactions entered into may be voidable as a transaction at an undervalue or an unfair preference.

Priority of claims

The main purpose of a liquidation where the company is insolvent is to collect in the company’s assets, determine the outstanding claims against the company, and satisfy those claims in the manner and order prescribed by law.

The liquidator must determine the company’s title to property in its possession. Property which is in the possession of the company, but which was supplied under a valid retention of title clause will generally have to be returned to the supplier. Property which is held by the company on trust for third parties will not form part of the company’s assets available to pay creditors.

Before the claims are met, secured creditors are entitled to enforce their claims against the assets of the company to the extent that they are subject to a valid security interest. In most legal systems, only fixed security takes precedence over all claims; security by way of floating charge may be postponed to the preferential creditors.

Claimants with non-monetary claims against the company may be able to enforce their rights against the company. For example, a party who had a valid contract for the purchase of land against the company may be able to obtain an order for specific performance, and compel the liquidator to transfer title to the land to them, upon tender of the purchase price.

After the removal of all assets which are subject to retention of title arrangements, fixed security, or are otherwise subject to proprietary claims of others, the liquidator will pay the claims against the company’s assets. Generally, the priority of claims on the company’s assets will be determined in the following order:

1. Firstly, the costs of the liquidation are met out of the company’s remaining assets
2. Secondly, the preferential creditors under applicable law are paid
3. Thirdly, in many legal systems, the claims of the holders of a floating charge will be paid; other claims may also fit into this layer
4. Fourthly, if there is anything left, the unsecured creditors are paid out pari passu in accordance with their claims. In many jurisdictions, a portion of the assets which would otherwise be caught by a floating charge are reserved for the unsecured creditors.
5. In the very rare instances where the unsecured creditors are repaid in full, any surplus assets are distributed between the members in accordance with their entitlements.

Unclaimed assets will usually vest in the state as bona vacantia.

See also: Secured creditor, Preferential creditor and Unsecured creditor

Dissolution

Having wound-up the company’s affairs, the liquidator must call a final meeting of the members (if it is a members’ voluntary winding-up), creditors (if it is a compulsory winding-up) or both (if it is a creditors’ voluntary winding-up). The liquidator is then usually required to send final accounts to the Registrar and to notify the court. The company is then dissolved.

However, in most jurisdictions, the court has a discretion for a period of time after dissolution to declare the dissolution void to enable the completion of any unfinished business.

See also: Dissolution (law)

Striking off the Register

In some jurisdictions, the company may elect to simply be struck off the Register as a cheaper alternative to a formal winding-up and dissolution. In such cases an application is made to the Registrar, and they may strike off the company if there is reasonable cause to believe that the company is not carrying on business or has been wound-up and, after enquiry, no case is shown why the company should not be struck off.

However, in such cases the company may be restored to the Register if it is just and equitable so to do (for example, if the rights of any creditors or members have been prejudiced).

Fresh Start Options for Limited Companies (Ltd)

In the UK, many companies in debt decide it’s more beneficial to “start again”. This is often called in the UK a “Phoenix”. To enact a phoenix effectively means to die and then come alive again. In business terms this will mean liquidating a company as the only option and then resuming under a different name with the same customers, clients and suppliers. In some circumstances it can be ideal for the company.

Liquidity risk: In finance, liquidity risk is the risk that a given security or asset cannot be traded quickly enough in the market to prevent a loss (or make the required profit).

Types of Liquidity Risk

1. Asset Liquidity – An asset cannot be sold due to lack of liquidity in the market – essentially a sub-set of market risk. This can be accounted for by:
   1. Widening bid/offer spread
   2. Making explicit liquidity reserves
   3. Lengthening holding period for VaR calculations
   4. Funding liquidity – Risk that liabilities:
      1. Cannot be met when they fall due
      2. Can only be met at an uneconomic price
      3. Can be name-specific or systemic

Causes of Liquidity Risk

Liquidity risk’ arises from situations in which a party interested in trading an asset cannot do it because nobody in the market wants to trade that asset. Liquidity risk becomes particularly important to parties who are about to hold or currently hold an asset, since it affects their ability to trade.

Manifestation of liquidity risk is very different from a drop of price to zero. In case of a drop of an asset’s price to zero, the market is saying that the asset is worthless. However, if one party cannot find another party interested in trading the asset, this can potentially be only a problem of the market participants with finding each other. This is why liquidity risk is usually found higher in emerging markets or low-volume markets.

Liquidity risk is financial risk due to uncertain liquidity. An institution might lose liquidity if its credit rating falls, it experiences sudden unexpected cash outflows, or some other event causes counterparties to avoid trading with or lending to the institution. A firm is also exposed to liquidity risk if markets on which it depends are subject to loss of liquidity.

Liquidity risk tends to compound other risks. If a trading organization has a position in an illiquid asset, its limited ability to liquidate that position at short notice will compound its market risk. Suppose a firm has offsetting cash flows with two different counterparties on a given day. If the counterparty that owes it a payment defaults, the firm will have to raise cash from other sources to make its payment. Should it be unable to do so, it too will default. Here, liquidity risk is compounding credit risk.

A position can be hedged against market risk but still entail liquidity risk. This is true in the above credit risk example—the two payments are offsetting, so they entail credit risk but not market risk. Another example is the 1993 Metallgesellschaft debacle. Futures contract Futures were used to hedge an Over-the-counter finance OTC obligation. It is debatable whether the hedge was effective from a market risk standpoint, but it was the liquidity crisis caused by staggering margin calls on the futures that forced Metallgesellschaft to unwind the positions.

Accordingly, liquidity risk has to be managed in addition to market, credit and other risks. Because of its tendency to compound other risks, it is difficult or impossible to isolate liquidity risk. In all but the most simple of circumstances, comprehensive metrics of liquidity risk do not exist. Certain techniques of asset liability management asset-liability management can be applied to assessing liquidity risk. A simple test for liquidity risk is to look at future net cash flows on a day-by-day basis. Any day that has a sizeable negative net cash flow is of concern. Such an analysis can be supplemented with stress testing. Look at net cash flows on a day-to-day basis assuming that an important counterparty defaults.

Analyses such as these cannot easily take into account contingent cash flows, such as cash flows from derivatives or Mortgage-backed security/mortgage-backed securities. If an organization’s cash flows are largely contingent, liquidity risk may be assessed using some form of scenario analysis. A general approach using scenario analysis might entail the following high-level steps:

• Construct multiple scenarios for market movements and defaults over a given period of time
• Assess day-to-day cash flows under each scenario.

Because balance sheets differ so significantly from one organization to the next, there is little standardization in how such analyses are implemented.

Regulators are primarily concerned about systemic implications of liquidity risk.

Measures of Liquidity Risk

Liquidity Gap

Culp defines the liquidity gap as the net liquid assets of a firm. The excess value of the firm’s liquid assets over its volatile liabilities. A company with a negative liquidity gap should focus on their cash balances and possible unexpected changes in their values.

As a static measure of liquidity risk it gives no indication of how the gap would change with an increase in the firm’s marginal funding cost.

Liquidity Risk Elasticity

Culp denotes the change of net of assets over funded liabilities that occurs when the liquidity premium on the bank’s marginal funding cost rises by a small amount as the liquidity risk elasticity. For banks this would be measured as a spread over Libor, for nonfinancials the LRE would be measured as a spread over commercial paper rates.

Problems with the use of liquidity risk elasticity are that it assumes parallel changes in funding spread across all maturities and that it is only accurate for small changes in funding spreads.

Measures of Asset Liquidity

Bid-Offer Spread

The bid-offer spread is used by market participants as an asset liquidity measure. To compare different products the ratio of the spread to the product’s mid price can be used. The smaller the ratio the more liquid the asset is.

This spread is comprised of operational costs, administrative and processing costs as well as the compensation required for the possibility of trading with a more informed trader.

Market Depth

Hachmeister refers to market depth as the amount of an asset that can be bought and sold at various bid-ask spreads. Slippage is related to the concept of market depth. Knight and Satchell mention a flow trader needs to consider the effect of executing a large order on the market and to adjust the bid-ask spread accordingly. They calculate the liquidity cost as the difference of the execution price and the initial execution price.

Immediacy

Immediacy refers to the time needed to successfully trade a certain amount of an asset at a prescribed cost.

Resilience

Hachmeister identifies the fourth dimension of liquidity as the speed with which prices return to former levels after a large transaction. Unlike the other measures resilience can only be determined over a period of time.

Managing Liquidity Risk

Liquidity-adjusted Value At Risk

Liquidity-adjusted VAR incorporates exogenous liquidity risk into Value at Risk. It can be defined at VAR + ELC (Exogenous Liquidity Cost). The ELC is the worst expected half-spread at a particular confidence level.

Another adjustment is to consider VAR over the period of time needed to liquidate the portfolio. VAR can be calculated over this time period. The BIS mentions “… a number of institutions are exploring the use of liquidity adjusted-VAR, in which the holding periods in the risk assessment are adjusted by the length of time required to unwind positions.”

Liquidity at Risk

Greenspan (1999) discusses management of foreign exchange reserves. The Liquidity at risk measure is suggested. A country’s liquidity position under a range of possible outcomes for relevant financial variables (exchange rates, commodity prices, credit spreads, etc.) is considered. It might be possible to express a standard in terms of the probabilities of different outcomes. For example, an acceptable debt structure could have an average maturity–averaged over estimated distributions for relevant financial variables–in excess of a certain limit. In addition, countries could be expected to hold sufficient liquid reserves to ensure that they could avoid new borrowing for one year with a certain ex ante probability, such as 95 percent of the time.

Scenario analysis-based contingency plans

The FDIC discuss liquidity risk management and write “Contingency funding plans should incorporate events that could rapidly affect an institution’s liquidity, including a sudden inability to securitize assets, tightening of collateral requirements or other restrictive terms associated with secured borrowings, or the loss of a large depositor or counterparty.”  Greenspan’s liquidity at risk concept is an example of scenario based liquidity risk management.

Diversification of liquidity providers

If several liquidity providers are on call then if any of those providers increases its costs of supplying liquidity, the impact of this is reduced. The American Academy of Actuaries wrote “While a company is in good financial shape, it may wish to establish durable, ever-green (i.e., always available) liquidity lines of credit. The credit issuer should have an appropriately high credit rating to increase the chances that the resources will be there when needed.”

Derivatives

Bhaduri, Meissner and Youn discuss five derivatives created specifically for hedging liquidity risk.:

• Withdrawal option: A put of the illiquid underlying at the market price.
• Bermudan-style return put option: Right to put the option at a specified strike.
• Return swap: Swap the underlying’s return for LIBOR paid periodicially.
• Return swaption: Option to enter into the return swap.
• Liquidity option: “Knock-in” barrier option, where the barrier is a liquidity metric.

Case Studies

Amaranth Advisors LLC – 2006

Amaranth Advisors lost roughly $6bn in the natural gas futures market back in September 2006. Amaranth had a concentrated, undiversified position in its natural gas strategy. The trader had used leverage to build a very large position. Amaranth’s positions were staggeringly large, representing around 10% of the global market in natural gas futures.  Chincarini notes that firms need to manage liquidity risk explicitly. The inability to sell a futures contract at or near the latest quoted price is related to one’s concentration in the security. In Amaranth’s case, the concentration was far too high and there were no natural counterparties when they needed to unwind the positions.  Chincarini (2006) argues that part of the loss Amaranth incurred was due to asset illiquidity. Regression analysis on the 3 week return on natural gas future contracts from August 31st 2006 to September 21 2006 against the excess open interest suggested that contracts whose open interest was much higher on August 31, 2006 than the historical normalized value, experienced larger negative returns.

Northern Rock – 2007

Main article: Nationalisation of Northern Rock

Northern Rock suffered from funding liquidity risk back in September 2007 following the subprime crisis. The firm suffered from liquidity issues despite being solvent at the time, because maturing loans and deposits could not be renewed in the short-term money markets . In response, the FSA now places greater supervisory focus on liquidity risk especially with regard to “high-impact retail firms”.

LTCM – 1998

Long-Term Capital Management (LTCM) was bailed out by a consortium of 14 banks in 1998 after being caught in a cash-flow crisis when economic shocks resulted in excessive mark-to-market losses and margin calls. The fund suffered from a combination of funding and asset liquidity. Asset liquidity arose from LTCM failure to account for liquidity becoming more valuable (as it did following the crisis) . Since much of its balance sheet was exposed to liquidity risk premium its short positions would increase in price relative to its long positions. This was essentially a massive, unhedged exposure to a single risk factor.  LTCM had been aware of funding liquidity risk. Indeed, they estimated that in times of severe stress, haircuts on AAA-rated commercial mortgages would increase from 2% to 10%, and similarly for other securities. In response to this, LTCM had negotiated long-term financing with margins fixed for several weeks on many of their collateralized loans. Due to an escalating liquidity spiral, LTCM could ultimately not fund its positions in spite of its numerous measures to control funding risk.

London Interbank Offered Rate (LIBOR): The London Interbank Offered Rate (or LIBOR, pronounced /?la?b?r/) is a daily reference rate based on the interest rates at which banks borrow unsecured funds from other banks in the London wholesale money market (or interbank market).

Introduction

During 1984 it became apparent that an increasing number of banks were trading actively in a variety of relatively new market instruments, notably interest rate swaps, foreign currency options and forward rate agreements. Whilst recognizing that such instruments brought more business and greater depth to the London Interbank market, it was felt that future growth could be inhibited unless a measure of uniformity was introduced. In October 1984 the British Bankers’ Association working with other parties such as the Bank of England established various working parties, which eventually culminated in the production of the BBAIRS terms – the BBA standard for interest swap rates. Part of this standard included the fixing of BBA interest settlement rates, the predecessor of BBA LIBOR. From 2 September 1985 the BBAIRS terms became standard market practice.

BBA LIBOR fixings did not commence officially before 1 January 1986, although before that some rates were fixed for a trial period commencing in December 1984.

It should be noted that member banks are international in scope, with more than sixty nations represented among its 223 members and 37 associated professional firms (as of 2008).

Scope

LIBOR rates are widely used as a reference rate for financial instruments such as:

• forward rate agreements
• short-term interest rate futures contracts
• interest rate swaps
• inflation swaps
• floating rate notes
• syndicated loans
• variable rate mortgages
• currencies, especially the US dollar (see also Eurodollar).

They thus provide the basis for some of the world’s most liquid and active interest rate markets.

For the Euro, however, the usual reference rates are the Euribor rates compiled by the European Banking Federation, from a larger bank panel. A Euro LIBOR does exist, but mainly for continuity purposes in swap contracts dating back to pre-EMU times. LIBOR is just an estimate and not interred in the legally binding contracts of an LLC

Technical features

LIBOR is calculated by Thomson Reuters and published by the British Bankers’ Association (BBA) after 11:00 am (and generally around 11:45 am) each day (London time). It is a trimmed average of inter-bank deposit rates offered by designated contributor banks, for maturities ranging from overnight to one year. LIBOR is calculated for 10 currencies. There are either eight, twelve or sixteen contributor banks on each currency panel and the reported interest is the mean of the middle values (the interquartile mean). The rates are a benchmark rather than a tradable rate, the actual rate at which banks will lend to one another continues to vary throughout the day.

GBP LIBOR is often used as a rate of reference for Pound Sterling and other currencies, including US dollar, Euro, Japanese Yen, Swiss Franc, Canadian dollar, Australian Dollar, Swedish Krona, Danish Krone and New Zealand dollar.^[2]

In the 1990s, Yen LIBOR rates were influenced by credit problems affecting some of the contributor banks.

For a precise definition of BBA LIBOR, see: The BBA LIBOR fixing & definition.

Six-month USD LIBOR is used as an index for some US mortgages. In the UK, the three-month GBP LIBOR is used for some mortgages—especially for those with adverse credit history.

Definition of LIBOR

LIBOR is defined as:

“The rate at which an individual Contributor Panel bank could borrow funds, were it to do so by asking for and then accepting inter-bank offers in reasonable market size, just prior to 11.00 London time.”

This definition is amplified as follows:-

• The rate at which each bank submits must be formed from that bank’s perception of its cost of funds in the interbank market.
• Contributions must represent rates formed in London and not elsewhere.
• Contributions must be for the currency concerned, not the cost of producing one currency by borrowing in another currency and accessing the required currency via the foreign exchange markets.
• The rates must be submitted by members of staff at a bank with primary responsibility for management of a bank’s cash, rather than a bank’s derivative book.

• The definition of “funds” is: unsecured interbank cash or cash raised through primary issuance of interbank Certificates of Deposit.

LIBOR-based derivatives

Eurodollar contracts

The Chicago Mercantile Exchange‘s Eurodollar contracts are based on three-month US dollar LIBOR rates. They are the world’s most heavily traded short term interest rate futures contracts and extend up to ten years. Shorter maturities trade on the Singapore Exchange in Asian time.

Interest rate swaps

Interest rate swaps based on short LIBOR rates currently trade on the interbank market for maturities up to 50 years. A “five year LIBOR” rate refers to the 5 year swap rate vs 3 or 6 month LIBOR. “LIBOR + x basis points“, when talking about a bond, means that the bond’s cash flows have to be discounted on the swaps’ zero-coupon yield curve shifted by x basis points in order to equal the bond’s actual market price. The day count convention for LIBOR rates in interest rate swaps is Actual/360.

Reliability

On Thursday, 29 May 2008 the Wall Street Journal released a controversial study suggesting that banks may have understated borrowing costs they reported for LIBOR during the 2008 credit crunch.^[3] Such underreporting could have created an impression that banks could borrow from other banks more cheaply than they could in reality. It could also have made the banking system appear healthier than it was during the 2008 credit crunch.

For example, the study found that rates at which one major bank “said it could borrow dollars for three months were about 0.87 percentage point lower than the rate calculated using default-insurance data.”

In response to the study released by the WSJ, the British Bankers’ Association announced that LIBOR continues to be reliable even in times of financial crisis. According to the British Bankers’ Association, other proxies for financial health such as the default credit insurance market, are not necessarily more sound than LIBOR at times of financial crisis, though more widely used in Latin America, especially the Ecuadorian and Bolivian markets.

Additionally, other authorities have contradicted the Wall Street Journal article. In their March 2008 Quarterly Review The Bank for International Settlements have stated that “available data do not support the hypothesis that contributor banks manipulated their quotes to profit from positions based on fixings”. Further, In October 2008 the International Monetary Fund published their regular Global Financial Stability Review which also found that “Although the integrity of the U.S. dollar LIBOR fixing process has been questioned by some market participants and the financial press, it appears that U.S. dollar LIBOR remains an accurate measure of a typical creditworthy bank’s marginal cost of unsecured U.S. dollar term funding”

Market participants of course understand that there exist substantial incentives for banks to under-report LIBOR values, as many floating-rate debt instruments are based on the LIBOR value plus some additional number of basis-points. Faking up a low LIBOR number by false reporting will lower funding costs for market participants whose interest costs are pegged to LIBOR values. And as LIBOR is not an actual bid or offer – this means that it is not possible to legally require the person or agency posting the number to actually make a loan at that price – then it is almost certain to be different from the actual price that would prevail for any entity attempting to obtain funds in a marketplace. This virtually ensures that the LIBOR rate will understate any true market-negotiated interest rate. The LIBOR numbers are not worthless, nor are they explicitly fraudulent. But as they are simply posted values created by an association of co-operating bankers, and not the result of any true open-outcry fair-market process – they are almost certain to understate the true cost of borrowing money, regardless of counterparty creditworthiness. The LIBOR value is a rate at which a loan *may* happen, not a rate at which a loan *shall* happen. This subtle difference rendered the LIBOR rate an almost worthless indicator during the recent credit crisis, as it reflected what might occur, rather than what was actually occurring.
Margin: In finance, a margin is collateral that the holder of a position in securities, options, or futures contracts has to deposit to cover the credit risk of his counterparty (most often his broker). This risk can arise if the holder has done any of the following:

• borrowed cash from the counterparty to buy securities or options,
• sold securities or options short, or
• entered into a futures contract.

The collateral can be in the form of cash or securities, and it is deposited in a margin account. On U.S. futures exchanges, “margin” was formally called performance bond.

Margin buying: Margin buying is buying securities with cash borrowed from a broker, using other securities as collateral. This has the effect of magnifying any profit or loss made on the securities. The securities serve as collateral for the loan. The net value, i.e. the difference between the value of the securities and the loan, is initially equal to the amount of one’s own cash used. This difference has to stay above a minimum margin requirement. This is to protect the broker against a fall in the value of the securities to the point that they no longer cover the loan.

In the 1920s, margin requirements were loose. In other words, brokers required investors to put in very little of their own money. Whereas today, the Federal Reserve’s margin requirement limits debt to 50 percent, during the 1920s leverage rates of up to 90 percent debt were not uncommon.

When the stock market started to contract, many individuals received margin calls. They had to deliver more money to their brokers or their shares would be sold. Since many individuals did not have the equity to cover their margin positions, their shares were sold, causing further market declines and further margin calls.

This was one of the major contributing factors which led to the Stock Market Crash of 1929, which in turn contributed to the Great Depression, a troubling financial time in the 1930′s. However, as reported in Peter Rappoport and Eugene N. White’s 1994 paper Was the Crash of 1929 Expected, all sources indicate that beginning in either late 1928 or early 1929, “margin requirements began to rise to historic new levels. The typical peak rates on brokers’ loans were 40-50 percent. Brokerage houses followed suit and demanded higher margin from investors.”
Margin call: When the margin posted in the margin account is below the minimum margin requirement, the broker or exchange issues a margin call. The investor now either has to increase the margin that they have deposited, or they can close out their position. They can do this by selling the securities, options or futures if they are long and by buying them back if they are short. If they don’t do any of this the broker can sell his securities to meet the margin call.

Price of Stock for Margin Calls

The minimum margin requirement, sometimes called the maintenance margin requirement, is the ratio set for:

• (Stock Equity – Leveraged Dollars) to Stock Equity
• Stock Equity being the stock price * no. of stocks bought and Leveraged Dollars being the amount borrowed in the margin account.
• E.g. An investor bought 1000 shares of ABC company each priced at $50. If the initial margin requirement were 60%:
• Stock Equity: $50 * 1000 = $50,000
• Leveraged Dollars or amount borrowed: ($50 * 1000)* (1-60%) = $20,000

So the maintenance margin requirement uses the above variables to form a ratio that investors have to abide by in order to keep the account active.

The point is, let’s say the maintenance margin requirement is reduced from 60% to 25% – At what price would the investor be getting a margin call? Let P be the price, so 1000P in our case is the Stock Equity.

• (Stock Equity – Leveraged Dollars) divided by Stock Equity = 25%
• (1000P – $20,000)/1000P = 0.25
• (1000P – $20,000) = 250P
• P = $26.67

So if the stock price drops from $50 to $26.67, investors will be called to add additional funds to the account to make up for the loss in stock equity.

Margin loan: A margin loan is when the owner of a stock or security borrows against these assets through the brokerage firm housing the securities used as collateral.

Margin loans are normally granted with the following general terms –

• Full Recourse Loan with additional liability, fees and penalties upon default.
• Personal Guarantee given by borrower, in addition to pledging securities as collateral .
• · Maximum loan-to-value (LTV) of 50%, depending upon securities’ trading volume and liquidity.
• · Not all NASDAQ, AMEX, NYSE stocks are “marginable”.
• Stock value must be at less $10.00 per share.
• If the share price drops below 75 percent to 80 percent of original total stock value, a margin call is initiated and may you normally have only one day to cure the default, which may result in the unwanted sale of your securities.

Market maker: A market maker is a company, or an individual, that quotes both a buy and a sell price in a financial instrument or commodity held in inventory, hoping to make a profit on thebid/offer spread, or turn.^[1]

In foreign exchange trading, where most deals are conducted over-the-counter and are, therefore, completely virtual, the market maker sells to and buys from its clients. Hence, the client’s loss and the spread is the market-maker firm’s profit, which gets thus compensated for the effort of providing liquidity in a competitive market. This extra liquidity reduces transaction costs and therefore facilitates trades for the clients, who would otherwise have to accept a worse price or even not be able to trade at all. Most foreign exchange trading firms are market makers and so are many banks, although not in all currency markets.

Recent developments in the over-the-counter FX market have permitted even buy-side (non bank participants) in becoming virtual market-makers through the advent of high speed/frequency software applications. These algorithmic engines submit bids and offers outside of prices that are available on other networks or ECN (electronic communication networks) where FX is traded.

Most stock exchanges operate on a matched bargain or order driven basis. In such a system there are no designated or official market makers, but market makers nevertheless exist. When a buyer’s bid meets a seller’s offer or vice versa, the stock exchange’s matching system will decide that a deal has been executed.

In the United States, the New York Stock Exchange (NYSE) and American Stock Exchange (AMEX), among others, have a single exchange member, formerly known as specialists, and now as Designated Market Makers, who acts as the official market maker for a given security. In return for a) providing a required amount of liquidity to the security’s market, b) taking the other side of trades when there are short-term buy-and-sell-side imbalances in customer orders, and c) attempting to prevent excess volatility, the specialist is granted various informational and trade execution advantages.

Other U.S. exchanges, most prominently the NASDAQ Stock Exchange, employ several competing official market makers in a security. These market makers are required to maintain two-sided markets during exchange hours and are obligated to buy and sell at their displayed bids and offers. They typically do not receive the trading advantages a specialist does, but they do get some, such as the ability to naked short a stock, i.e., selling it without borrowing it. In most situations, only official market makers are permitted to engage in naked shorting.

There are over two thousand market makers in the USA^[2] and over a hundred in Canada.^[3]

On the London Stock Exchange (LSE) there are official market makers for many securities (but not for shares in the largest and most heavily traded companies, which instead use an automated system called TradElect. Some of the LSE’s member firms take on the obligation of always making a two-way price in each of the stocks in which they make markets. It is their prices which are displayed on the Stock Exchange Automated Quotation system, and it is with them that ordinary stockbrokers generally have to deal when buying or selling stock on behalf of their clients.

Proponents of the official market making system claim market makers add to the liquidity and depth of the market by taking a short or long position for a time, thus assuming some risk, in return for hopefully making a small profit. On the LSE one can always buy and sell stock: each stock always has at least two market makers and they are obliged to deal.

This contrasts with some of the smaller order driven markets. On the JSE Securities Exchange, for example, it can be very difficult to determine at what price one would be able to buy or sell even a small block of any of the many illiquid stocks because there are often no buyers or sellers on the order board. However, there is no doubting the liquidity of the big order driven markets in the U.S.

Unofficial market makers are free to operate on order driven markets or, indeed, on the LSE. They do not have the obligation to always be making a two way price but they do not have the advantage that everyone must deal with them either.

Merchant bank: In banking, a merchant bank is a financial institution primarily engaged in offering financial services and advice to corporations and to wealthy individuals. The term can also be used to describe the private equity activities of banking.  The chief distinction between an investment bank and a merchant bank is that a merchant bank invests its own capital in a client company whereas an investment bank purely distributes (and trades) the securities of that company in its capital raising role. Both merchant banks and investment banks provide fee based corporate advisory services including in relation to mergers and acquisitions.

History

Merchant banks, now so called, are in fact the original “banks”. These were invented in the Middle Ages by Italian grain merchants. As the Lombardy merchants and bankers grew in stature based on the strength of the Lombard plains cereal crops, many displaced Jews fleeing Spanish persecution were attracted to the trade. They brought with them ancient practices from the middle and far east silk routes. Originally intended for the finance of long trading journeys, these methods were now utilized to finance the production of grain.

The Jews could not hold land in Italy, so they entered the great trading piazzas and halls of Lombardy, alongside the local traders, and set up their benches to trade in crops. They had one great advantage over the locals. Christians were strictly forbidden the sin of usury. The Jewish newcomers, on the other hand, could lend to farmers against crops in the field, a high-risk loan at what would have been considered usurious rates by the Church, but did not bind the Jews. In this way they could secure the grain sale rights against the eventual harvest. They then began to advance against the delivery of grain shipped to distant ports. In both cases they made their profit from the present discount against the future price. This two-handed trade was time consuming and soon there arose a class of merchants, who were trading grain debt instead of grain.

The Jewish trader performed both finance (credit) and an underwriting (insurance) functions. He would derive an income from lending the farmer money to develop and manufacture (through seeding, growing, weeding and harvesting) his annual crop (the crop loan at the beginning of the growing season). He would underwrite (insure) the delivery of the crop (through crop or commodity insurance) to the merchant wholesaler who was the ultimate purchaser of the farmer’s harvest. And he would make arrangements to supply this buyer through alternative sources (the merchant function) of supply (such as grain stores or alternate producer markets), should any particular farming district suffer a seasonal crop failure. He could also keep the farmer (or other commodity producer) in business during a drought or other crop failure, through the issuance of a crop (or commodity) insurance against the hazard of failure of his crop.

Thus in his underlying financial function the merchant banker (trader) would ensure the continuous smooth flowing of the commodity (crop, wool, salt; salt-cod, etc.) markets by providing both credit and insurance.

It was a short step from financing trade on their own behalf to settling trades for others, and then to holding deposits for settlement of “billete” or notes written by the people who were still brokering the actual grain. And so the merchant’s “benches” (bank is a corruption of the Italian for bench, banca, as in a counter) in the great grain markets became centers for holding money against a bill (billette, a note, a letter of formal exchange, later a bill of exchange, later still, a cheque).

These deposited funds were intended to be held for the settlement of grain trades, but often were used for the bench’s own trades in the meantime. The term bankrupt is a corruption of the Italian banca rotta, or broken bench, which is what happened when someone lost his traders’ deposits. Being “broke” has the same connotation.

A sensible manner of discounting interest to the depositors against what could be earned by employing their money in the trade of the bench soon developed; in short, selling an “interest” to them in a specific trade, thus overcoming the usury objection. Once again this merely developed what was an ancient method of financing long distance transport of goods.

Islam makes similar condemnations of usury as Christianity.

The medieval Italian markets were disrupted by wars and in any case were limited by the fractured nature of the Italian states. And so the next generation of bankers arose from migrant Jewish merchants in the great wheat growing areas of Germany and Poland. Many of these merchants were from the same families who had been part of the development of the banking process in Italy. They also had links with family members who had, centuries before, fled Spain for both Italy and England.

This course of events set the stage for the rise of banking names which still resonate today: Schroders, Warburgs, Rothschilds, even the ill-fated Barings, were all the product of the continental grain trade, and indirectly, the early Iberian persecution of Jews. These and other great merchant banking families dealt in everything from underwriting bonds to originating foreign loans. Bullion trading and bond issuing were some of the specialties of the Rothschild family.

Modern practices

Known as “accepting and issuing houses” in the U.K. and “investment banks” in the U.S., modern merchant banks offer a wide range of activities, including portfolio management, credit syndication, acceptance credit, counsel on mergers and acquisitions, insurance, etc.

Of these two classes of merchant banks, the U.S. variant initiates loans and then sells them to investors.  Even though these companies call themselves “merchant banks,” they have few, if any, of the characteristics of former merchant banks.

Goldman Sachs, Morgan Stanley, The Weston Group, maintain an active merchant banking presence.

Money market: In finance, the money market is the global financial market for short-term borrowing and lending. It provides short-term liquidity funding for the global financial system. The money market is where short-term obligations such as Treasury bills, commercial paper and bankers’ acceptances are bought and sold.

Overview

The money market consists of financial institutions and dealers in money or credit who wish to either borrow or lend. Participants borrow and lend for short periods of time, typically up to thirteen months. Money market trades in short-term financial instruments commonly called “paper.” This contrasts with the capital market for longer-term funding, which is supplied by bonds and equity.

The core of the money market consists of banks borrowing and lending to each other, using commercial paper, repurchase agreements and similar instruments. These instruments are often benchmarked to (i.e. priced by reference to) the London Interbank Offered Rate (LIBOR) for the appropriate term and currency.

Finance companies, such as GMAC, typically fund themselves by issuing large amounts of asset-backed commercial paper (ABCP) which is secured by the pledge of eligible assets into an ABCP conduit. Examples of eligible assets include auto loans, credit card receivables, residential/commercial mortgage loans, mortgage-backed securities and similar financial assets. Certain large corporations with strong credit ratings, such as General Electric, issue commercial paper on their own credit. Other large corporations arrange for banks to issue commercial paper on their behalf via commercial paper lines.

In the United States, federal, state and local governments all issue paper to meet funding needs. States and local governments issue municipal paper, while the US Treasury issues Treasury bills to fund the US public debt.

• Trading companies often purchase bankers’ acceptances to be tendered for payment to overseas suppliers.
• Retail and institutional money market funds
• Banks
• Central banks
• Cash management programs
• Arbitrage ABCP conduits, which seek to buy higher yielding paper, while themselves selling cheaper paper.
• Merchant Banks
• Certificate of deposit – A deposit that you can deposit to deposit goods withing a safe deposit box and then you must read the enclosed instruction book for instructions on how to find the enclosed instruction book. Only then can you deposit your cheque of deposit to open the enclosed instruction book. If you have any questions or concerns, please refer to the enclosed instruction book.* Repurchase agreements – Short-term loans—normally for less than two weeks and frequently for one day—arranged by selling securities to an investor with an agreement to repurchase them at a fixed price on a fixed date.
• Commercial paper – Unsecured promissory notes with a fixed maturity of one to 270 days; usually sold at a discount from face value.
• Eurodollar deposit – Deposits made in U.S. dollars at a bank or bank branch located outside the United States.
• Federal Agency Short-Term Securities – (in the U.S.). Short-term securities issued by government sponsored enterprises such as the Farm Credit System, the Federal Home Loan Banks and the Federal National Mortgage Association.
• Federal funds – (in the U.S.). Interest-bearing deposits held by banks and other depository institutions at the Federal Reserve; these are immediately available funds that institutions borrow or lend, usually on an overnight basis. They are lent for the federal funds rate.
• Municipal notes – (in the U.S.). Short-term notes issued by municipalities in anticipation of tax receipts or other revenues.
• Treasury bills – Short-term debt obligations of a national government that are issued to mature in three to twelve months. For the U.S., see Treasury bills.
• Money funds – Pooled short maturity, high quality investments which buy money market securities on behalf of retail or institutional investors.
• Foreign Exchange Swaps – Exchanging a set of currencies in spot date and the reversal of the exchange of currencies at a predetermined time in the future.

History

Development of the Money Market

Common money market instruments

Mortgage: A mortgage is the transfer of an interest in property (or the equivalent in law – a charge) to a lender as a security for a debt – usually a loan of money. While a mortgage in itself is not a debt, it is the lender’s security for a debt. It is a transfer of an interest in land (or the equivalent) from the owner to the mortgage lender, on the condition that this interest will be returned to the owner when the terms of the mortgage have been satisfied or performed. In other words, the mortgage is a security for the loan that the lender makes to the borrower.

This comes from the Old French “dead pledge,” apparently meaning that the pledge ends (dies) either when the obligation is fulfilled or the property is taken through foreclosure.

In most jurisdictions mortgages are strongly associated with loans secured on real estate rather than on other property (such as ships) and in some jurisdictions only land may be mortgaged. A mortgage is the standard method by which individuals and businesses can purchase real estate without the need to pay the full value immediately from their own resources. See mortgage loan for residential mortgage lending, and commercial mortgage for lending against commercial property.

Participants and variant terminology

Legal systems in different countries, while having some concepts in common, employ different terminology. However, in general, a mortgage of property involves the following parties.

Mortgage lender

A mortgage lender is an investor that lends money secured by a mortgage on real estate. Typically, the purpose of the loan is for the borrower to purchase that same real estate. The borrower, known as the mortgagor, gives the mortgage to the lender, known as the mortgagee. As the mortgagee, the lender has the right to sell the property to pay off the loan if the borrower fails to pay.

The mortgage runs with the land, so even if the borrower transfers the property to someone else, the mortgagee still has the right to sell it if the borrower fails to pay off the loan.

So that a buyer cannot unwittingly buy property subject to a mortgage, mortgages are registered or recorded against the title with a government office, as a public record. The borrower has the right to have the mortgage discharged from the title once the debt is paid.

Borrower

A mortgagor is the borrower in a mortgage—they owe the obligation secured by the mortgage. Generally, the debtor must meet the conditions of the underlying loan or other obligation and the conditions of the mortgage. Otherwise, the debtor usually runs the risk of foreclosure of the mortgage by the creditor to recover the debt. Typically the debtors will be the individual home-owners, landlords or businesses who are purchasing their property by way of a loan.

Other participants

Because of the complicated legal exchange, or conveyance, of the property, one or both of the main participants are likely to require legal representation. The terminology varies with legal jurisdiction; see lawyer, solicitor and conveyancer.

Because of the complex nature of many markets the debtor may approach a mortgage broker or financial adviser to help them source an appropriate creditor, typically by finding the most competitive loan.

The debt is, in civil law jurisdictions, referred to as hypothecation, which may make use of the services of a hypothecary to assist in the hypothecation.

Default on divided property

When a tract of land is purchased with a mortgage and then split up and sold, the “inverse order of alienation rule” applies to decide parties liable for the unpaid debt.

When a mortgaged tract of land is split up and sold, upon default, the mortgagee first forecloses on lands still owned by the mortgagor and proceeds against other owners in an ‘inverse order’ in which they were sold. For example, A acquires a 3-acre (12,000 m²) lot by mortgage then splits up the lot into three 1-acre (4,000 m²) lots (A, B, and C), and sells lot B to X, and then lot C to Y, retaining lot A for himself. Upon default, the mortgagee proceeds against lot A first, the mortgagor. If foreclosure or repossession of lot A does not fully satisfy the debt, the mortgagee proceeds against lot B, then lot C. The rationale is that the first purchaser should have more equity and subsequent purchasers receive a diluted share.

Legal aspects

Mortgages may be legal or equitable. Furthermore, a mortgage may take one of a number of different legal structures, the availability of which will depend on the jurisdiction under which the mortgage is made. Common law jurisdictions have evolved two main forms of mortgage: the mortgage by demise and the mortgage by legal charge.

Mortgage by demise

In a mortgage by demise, the mortgagee (the lender) becomes the owner of the mortgaged property until the loan is repaid or other mortgage obligation fulfilled in full, a process known as “redemption”. This kind of mortgage takes the form of a conveyance of the property to the creditor, with a condition that the property will be returned on redemption.

Mortgages by demise were the original form of mortgage, and continue to be used in many jurisdictions, and in a small minority of states in the United States. Many other common law jurisdictions have either abolished or minimized the use of the mortgage by demise. For example, in England and Wales this type of mortgage is no longer available, by virtue of the Land Registration Act 2002.

Mortgage by legal charge

In a mortgage by legal charge or technically “a charge by deed expressed to be by way of legal mortgage”, the debtor remains the legal owner of the property, but the creditor gains sufficient rights over it to enable them to enforce their security, such as a right to take possession of the property or sell it.

To protect the lender, a mortgage by legal charge is usually recorded in a public register. Since mortgage debt is often the largest debt owed by the debtor, banks and other mortgage lenders run title searches of the real estate property to make certain that there are no mortgages already registered on the debtor’s property which might have higher priority. Tax liens, in some cases, will come ahead of mortgages. For this reason, if a borrower has delinquent property taxes, the bank will often pay them to prevent the lien holder from foreclosing and wiping out the mortgage.

This type of mortgage is most common in the United States and, since the Law of Property Act 1925, it has been the usual form of mortgage in England and Wales (it is now the only form – see above).

In Scotland, the mortgage by legal charge is also known as Standard Security.

In Pakistan, the mortgage by legal charge is most common way used by banks to secure the financing.  It is also known as registered mortgage. After registration of legal charge, the bank’s lien is recorded in the land register stating that the property is under mortgage and cannot be sold without obtaining an NOC (No Objection Certificate) from the bank.

Equitable mortgage

Equitable mortgages don’t fit the criteria for a legal mortgage, but are considered mortgages under equity (in the interests of justice) because money was lent and security was promised. This could arise because of procedural or paperwork issues. Based on this definition, there are numerous situations which could lead to an equitable mortgage.  As of 1961, English law required the consent of the court before the equitable mortgagee was allowed to sell.  When the borrower deposits a title deed with the lender, it has historically created an equitable mortgage in England, but the creation of an equitable mortgage by such a process has been less certain in the United States.

In an equitable mortgage the lender is secured by taking possession of all the original title documents of the property and by borrower’s signing a Memorandum of Deposit of Title Deed (MODTD). This document is an undertaking by the borrower that he/she has deposited the title documents with the bank with his own wish and will, in order to secure the financing obtained from the bank.

History

At common law, a mortgage was a conveyance of land that on its face was absolute and conveyed a fee simple estate, but which was in fact conditional, and would be of no effect if certain conditions were met – usually, but not necessarily, the repayment of a debt to the original landowner. Hence the word “mortgage” (a legal term in French meaning “dead pledge”). The debt was absolute in form, and unlike a “live pledge” was not conditionally dependent on its repayment solely from raising and selling crops or livestock or simply giving the crops and livestock raised on the mortgaged land. The mortgage debt remained in effect whether or not the land could successfully produce enough income to repay the debt. In theory, a mortgage required no further steps to be taken by the creditor, such as acceptance of crops and livestock in repayment.

The difficulty with this arrangement was that the lender was absolute owner of the property and could sell it or refuse to reconvey it to the borrower, who was in a weak position. Increasingly the courts of equity began to protect the borrower’s interests, so that a borrower came to have an absolute right to insist on reconveyance on redemption. This right of the borrower is known as the “equity of redemption“.

This arrangement, whereby the lender was in theory the absolute owner, but in practice had few of the practical rights of ownership, was seen in many jurisdictions as being awkwardly artificial. By statute the common law’s position was altered so that the mortgagor would retain ownership, but the mortgagee’s rights, such as foreclosure, the power of sale, and the right to take possession, would be protected.

In the United States, those states that have reformed the nature of mortgages in this way are known as lien states. A similar effect was achieved in England and Wales by the Law of Property Act 1925, which abolished mortgages by the conveyance of a fee simple.

Foreclosure and non-recourse lending

See also: Strategic default

In most jurisdictions, a lender may foreclose on the mortgaged property if certain conditions – principally, non-payment of the mortgage loan – apply. Subject to local legal requirements, the property may then be sold. Any amounts received from the sale (net of costs) are applied to the original debt.

In some jurisdictions, mortgage loans are non-recourse loans: if the funds recouped from sale of the mortgaged property are insufficient to cover the outstanding debt, the lender may not have recourse to the borrower after foreclosure. In other jurisdictions, the borrower remains responsible for any remaining debt, through a deficiency judgment. In some jurisdictions, first mortgages are non-recourse loans, but second and subsequent ones are recourse loans.

Specific procedures for foreclosure and sale of the mortgaged property almost always apply, and may be tightly regulated by the relevant government. In some jurisdictions, foreclosure and sale can occur quite rapidly, while in others, foreclosure may take many months or even years. In many countries, the ability of lenders to foreclose is extremely limited, and mortgage market development has been notably slower.

Mortgages in the United States

Types of mortgage instruments

Two types of mortgage instruments are commonly used in the United States: the mortgage (sometimes called a mortgage deed) and the deed of trust.

The mortgage

In all but a few states, a mortgage creates a lien on the title to the mortgaged property. Foreclosure of that lien almost always requires a judicial proceeding declaring the debt to be due and in default and ordering a sale of the property to pay the debt.

Security deed

The deed to secure debt is a mortgage instrument used in the state of Georgia. Unlike a mortgage, a security deed is an actual conveyance of real property in security of a debt. Upon the execution of such a deed, title passes to the grantee or beneficiary (usually lender), however the grantor (debtor) maintains equitable title to use and enjoy the conveyed land subject to compliance with debt obligations.

Security deeds must be recorded in the county where the land is located. Although there is no specific time within which such deeds must be filed, the failure to timely record the deed to secure debt may affect priority and therefore the ability to enforce the debt against the subject property.

The deed of trust

The deed of trust is a deed by the borrower to a trustee for the purposes of securing a debt. In most states, it also merely creates a lien on the title and not a title transfer, regardless of its terms. It differs from a mortgage in that, in many states, it can be foreclosed by a non-judicial sale held by the trustee.  It is also possible to foreclose them through a judicial proceeding.

Most “mortgages” in California are actually deeds of trust.  The effective difference is that the foreclosure process can be much faster for a deed of trust than for a mortgage, on the order of 3 months rather than a year. Because the foreclosure does not require actions by the court the transaction costs can be quite a bit less.

Deeds of trust to secure repayments of debts should not be confused with trust instruments that are sometimes called deeds of trust but that are used to create trusts for other purposes, such as estate planning. Though there are superficial similarities in the form, many states hold deeds of trust to secure repayment of debts do not create true trust arrangements.

Mortgage lien priority: “title theory” and “lien theory”

Except in those few states in the United States that adhere to the title theory of mortgages, either a mortgage or a deed of trust will create a mortgage lien upon the title to the real property being mortgaged. The lien is said to “attach” to the title when the mortgage is signed by the mortgagor and delivered to the mortgagee and the mortgagor receives the funds whose repayment the mortgage secures. Subject to the requirements of the recording laws of the state in which the land is located, this attachment establishes the priority of the mortgage lien with respect to most other liens on the property’s title.  Liens that have attached to the title before the mortgage lien are said to be senior to, or prior to, the mortgage lien. Those attaching afterward are said to be junior or subordinate.  The purpose of this priority is to establish the order in which lien holders are entitled to foreclose their liens in an attempt to recover their debts. If there are multiple mortgage liens on the title to a property and the loan secured by a first mortgage is paid off, the second mortgage lien will move up in priority and become the new first mortgage lien on the title. Documenting this new priority arrangement will require the release of the mortgage securing the paid off loan.

Mortgage-backed security: A mortgage-backed security (MBS) is an asset-backed security or debt obligation that represents a claim on the cash flows from mortgage loans, most commonly on residential property.

First, mortgage loans are purchased from banks, mortgage companies, and other originators. Then, these loans are assembled into pools. This is done by government agencies, government-sponsored enterprises, and private entities. Mortgage-backed securities represent claims on the principal and payments on the loans in the pool, through a process known as Securitization. These securities are usually sold as bonds, but financial innovation has created a variety of securities that derive their ultimate value from mortgage pools.

Most MBSs are issued by the Government National Mortgage Association (Ginnie Mae), a U.S. government agency, or the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac), U.S. government-sponsored enterprises. Ginnie Mae, backed by the full faith and credit of the U.S. government, guarantees that investors receive timely payments. Fannie Mae and Freddie Mac also provide certain guarantees and, while not backed by the full faith and credit of the U.S. government, have special authority to borrow from the U.S. Treasury. Some private institutions, such as brokerage firms, banks, and homebuilders, also securitize mortgages, known as “private-label” mortgage securities.

Residential mortgages in the United States have the option to pay more than the required monthly payment (curtailment) or to pay off the loan in its entirety (prepayment). Because curtailment and prepayment affect the remaining loan principal, the monthly cash flow of an MBS is not known in advance, and therefore presents an additional risk to MBS investors.

Commercial mortgage-backed securities (CMBS) are secured by commercial and multifamily properties (such as apartment buildings, retail or office properties, hotels, schools, industrial properties and other commercial sites). The properties of these loans vary, with longer-term loans (5 years or longer) often being at fixed interest rates and having restrictions on prepayment, while shorter-term loans (1–3 years) are usually at variable rates and freely pre-payable.

History

The Federal National Mortgage Association (FNMA) was formed by the US Federal Government in 1938. Its purpose was to promote home ownership in the United States. It did so by purchasing mortgages from originators. This freed up the originators’ capital so they could originate more mortgages. Market participants dubbed the firm “Fannie Mae.” The Government National Mortgage Association and the Federal Home Loan Mortgage Corporation were formed in 1968 and 1970, respectively. They play a similar role to Fannie Mae, but target different segments of the mortgage market. Today, they are called Ginnie Mae and Freddie Mac.

Ginnie Mae issued the first mortgage pass-through in 1970. Today, all three organizations actively repackage and sell mortgages as pass-throughs. Ginnie Mae guarantees timely payment of principal and interest on its pass-throughs. Fannie Mae and Freddie Mac guarantee payment of principal and interest. 

Market size and liquidity

There is about $14.6 trillion in total U.S. mortgage debt outstanding.

There are about $8.9 trillion in total U.S. mortgage-related securities.

The volume of pooled mortgages stands at about $7.5 trillion. About $5 trillion of that is securitized or guaranteed by GSEs or government agencies, the remaining $2.5 trillion pooled by private mortgage conduits.

Mortgage backed securities can be considered to have been in the tens of trillions, if Credit Default Swaps are taken into account.

According to The Bond Market Association, gross U.S. issuance of agency MBS was:

• 2005: USD 967 billion
• 2004: USD 1.019 trillion
• 2003: USD 2.131 trillion
• 2002: USD 1.444 trillion
• 2001: USD 1.093 trillion

The high liquidity of most mortgage-backed securities means that an investor wishing to take a position need not deal with the difficulties of theoretical pricing described below; the price of any bond is essentially quoted at fair value, with a very narrow bid/offer spread.

Reasons (other than investment or speculation) for entering the market include the desire to hedge against a drop in prepayment rates (a critical business risk for any company specializing in refinancing).

Structure and features

Weighted-average maturity

The weighted-average maturity (WAM) of an MBS is the average of the maturities of the mortgages in the pool, weighted by their balances at the issue of the MBS. Note that this is an average across mortgages, as distinct from concepts such as weighted-average life and duration, which are averages across payments of a single loan.

To illustrate the concept of WAM, let’s consider a mortgage pool with just three mortgage loans that have the below mentioned outstanding mortgage balances, mortgage rates, and months remaining to maturity.

Loan	Outstanding Mortgage Balance	Mortgage Rate	Remaining Months to Maturity	Each Loan’s Weighting
Loan 1	$200,000	6.00%	300	22.22%
Loan 2	$400,000	6.25%	260	44.44%
Loan 3	$300,000	6.50%	280	33.33%

The weightings are computed by dividing each outstanding loan amount by total amount outstanding in the mortgage pool (i.e., $900,000). These amounts are the outstanding amounts at the issuance/initiation of the MBS. Now, the WAM for the above mortgage pool that consists of three loans is computed as follows:

   WAM = 22.22% (300) + 44.44% (260) + 33.33% (280)

       = 66.67 + 115.56 + 93.33

       = 275.56 Months or 276 months after rounding

Weighted-average coupon

The weighted average coupon (WAC) of an MBS is the average of the coupons of the mortgages in the pool, weighted by their original balances at the issuance of the MBS. For the above example this is:

   WAC = 22.22% (6.00) + 44.44% (6.25) + 33.33% (6.50)

       = 1.333 + 2.778 + 2.167

       = 6.28%  after rounding

Why and where we use WAM and WAC

WAM and WAC are used for describing a mortgage passthrough security, and they form the basis for the computation of cash flows from that mortgage passthrough. Just as we describe a bond by saying 30 year bond with 6% coupon, we describe a mortgage passthrough by saying, for example, “this is a $3 billion passthrough with 6% passthrough rate, 6.5% WAC, and 340 month WAM.”

Note here, the passthrough rate is different from WAC. The passthrough rate is the rate that the investor would receive if he/she holds this mortgage passthrough security (or simply mortgage passthrough). Almost always, the passthrough rate is less than the WAC. The difference goes to servicing (i.e., costs incurred in collecting the loan payments and transferring the payments to the investors) the mortgage loans in the pool.

Types

Most bonds backed by mortgages are classified as an MBS. This can be confusing, because some securities derived from MBS are also called MBS(s). To distinguish the basic MBS bond from other mortgage-backed instruments the qualifier pass-through is used, in the same way that ‘vanilla’ designates an option with no special features.

Mortgage-backed security sub-types include:

• Pass-through mortgage-backed security is the simplest MBS, as described in the sections above. Essentially, a securitization of the mortgage payments to the mortgage originators. These can be subdivided into:
  • Residential mortgage-backed security (RMBS) – a pass-through MBS backed by mortgages on residential property
  • Commercial mortgage-backed security (CMBS) – a pass-through MBS backed by mortgages on commercial property
• Collateralized mortgage obligation (CMO) – a more complex MBS in which the mortgages are ordered into tranches by some quality (such as repayment time), with each tranche sold as a separate security.
• Stripped mortgage-backed securities (SMBS): Each mortgage payment is partly used to pay down the loan’s principal and partly used to pay the interest on it. These two components can be separated to create SMBS’s, of which there are two subtypes:
  • Interest-only stripped mortgage-backed securities (IO) – a bond with cash flows backed by the interest component of property owner’s mortgage payments.
  • Principal-only stripped mortgage-backed securities (PO) – a bond with cash flows backed by the principal repayment component of property owner’s mortgage payments.

Varieties of underlying mortgages in the pool:

• Prime: conforming mortgages: prime borrowers, full documentation (such as verification of income and assets), strong credit scores, etc.
• Alt-A: an ill-defined category, generally prime borrowers but non-conforming in some way, often lower documentation (or in some other way: vacation home, etc.) (Article on Alt-A)
• Subprime: weaker credit scores, no verification of income or assets, etc.

There are also jumbo mortgages, when the size is bigger than the “conforming loan amount” as set by FannieMae.

These types are not limited to Mortgage Backed Securities. Bonds backed by mortgages, but are not MBS can also have these subtypes.

Covered bonds

In Europe there exists a type of asset-backed bond called a “covered bond” (commonly known by the German term Pfandbriefe).  Pfandbriefe were first created in 19th century Germany when Frankfurter Hypo began issuing mortgage covered bonds. The market has been regulated since the creation of a law governing the securities in Germany in 1900. The key difference between Pfandbriefe and mortgage-backed or asset-backed securities is that banks that make loans and package them into Pfandbriefe keep those loans on their books. This means that when a company with mortgage assets on its books issue the covered bond its balance sheet grows, which it wouldn’t do if it issued an MBS, although it may still guarantee the securities payments.

Uses

There are many reasons for mortgage originators to finance their activities by issuing mortgage-backed securities. Mortgage-backed securities

1. transform relatively illiquid, individual financial assets into liquid and tradable capital market instruments.
2. allow mortgage originators to replenish their funds, which can then be used for additional origination activities.
3. can be used by Wall Street banks to monetize the credit spread between the origination of an underlying mortgage (private market transaction) and the yield demanded by bond investors through bond issuance (typically, a public market transaction).
4. are frequently a more efficient and lower cost source of financing in comparison with other bank and capital markets financing alternatives.
5. allow issuers to diversify their financing sources, by offering alternatives to more traditional forms of debt and equity financing.
6. allow issuers to remove assets from their balance sheet, which can help to improve various financial ratios, utilize capital more efficiently and achieve compliance with risk-based capital standards.

Pricing

Theoretical pricing

Pricing a vanilla corporate bond is based on two sources of uncertainty: default risk (credit risk) and interest rate (IR) exposure. The MBS adds a third risk: early redemption (prepayment). The number of homeowners in residential MBS securitizations who prepay goes up when interest rates go down. One reason for this phenomenon is that homeowners can refinance at a lower fixed interest rate. Commercial MBS often mitigate this risk using call protection.

Since these two sources of risk (IR and prepayment) are linked, solving mathematical models of MBS value is a difficult problem in finance. The level of difficulty rises with the complexity of the IR model, and the sophistication of the prepayment IR dependence, to the point that no closed form solution (i.e. one you could write it down) is widely known. In models of this type numerical methods provide approximate theoretical prices. These are also required in most models which specify the credit risk as a stochastic function with an IR correlation. Practitioners typically use Monte Carlo method or Binomial Tree numerical solutions.

Interest rate risk and prepayment risk

Theoretical pricing models must take into account the link between interest rates and loan prepayment speed. Mortgage prepayments are most often made because a home is sold or because the homeowner is refinancing to a new mortgage, presumably with a lower rate or shorter term. Prepayment is classified as a risk for the MBS investor despite the fact that they receive the money, because it tends to occur when floating rates drop and the fixed income of the bond would be more valuable (negative convexity). Hence the term: prepayment risk

To compensate investors for the prepayment risk associated with these bonds, they trade at a spread to government bonds.

There are other drivers of the prepayment function (or prepayment risk), independent of the interest rate, for instance:

• Economic growth, which is correlated with increased turnover in the housing market
• Home prices inflation
• Unemployment
• Regulatory risk; if borrowing requirements or tax laws in a country change this can change the market profoundly.
• Demographic trends, and a shifting risk aversion profile, which can make fixed rate mortgages relatively more or less attractive.

Credit risk

Main article: Credit risk

The credit risk of mortgage-backed securities depends on the likelihood of the borrower paying the promised cash flows (principal and interest) on time. The credit rating of MBS is fairly high because:

1. Most mortgage originations include research on the mortgage borrower’s ability to repay, and will try to lend only to the credit-worthy. An important exception to this would be “no-doc” or “low-doc” loans.
2. Some MBS issuers, such as Fannie Mae, Freddie Mac, and Ginnie Mae, guarantee against homeowner default risk. In the case of Ginnie Mae, this guarantee is backed with the full faith and credit of the US Federal government. This is not the case with Fannie Mae or Freddie Mac, but these two entities have lines of credit with the US Federal government; however, these lines of credit are extremely small when compared with the average amount of money circulated through Fannie Mae or Freddie Mac in one day’s business. Additionally, Fannie Mae and Freddie Mac generally require private mortgage insurance on loans in which the borrower provides a down payment that is less than 20% of the property value.
3. Pooling many mortgages with uncorrelated default probabilities creates a bond with a much lower probability of total default, in which no homeowners are able to make their payments (see Copula). Although the risk neutral credit spread is theoretically identical between a mortgage ensemble and the average mortgage within it, the chance of catastrophic loss is reduced.
4. If the property owner should default, the property remains as collateral. Although real estate prices can move below the value of the original loan, this increases the solidity of the payment guarantees and deters borrower default.

If the MBS was not underwritten by the original real estate & the issuer’s guarantee the rating of the bonds would be very much lower. Part of the reason is the expected adverse selection against borrowers with improving credit (from MBSs pooled by initial credit quality) who would have an incentive to refinance (ultimately joining an MBS pool with a higher credit rating).

Real-world pricing

Most traders and money managers use Bloomberg and Intex to analyze MBS pools. Intex is also used to analyze more esoteric products. Some institutions have also developed their own proprietary software. TradeWeb is used by the largest bond dealers (“primaries”) to transact round lots ($1 million+).

For “vanilla” or “generic” 30-year pools (FN/FG/GN) with coupons of 3.5% – 7%, one can see the prices posted on a TradeWeb screen by the primaries called To Be Announced (TBA). This is due to the actual pools not being shown. These are forward prices for the next 3 delivery months since pools haven’t been cut — only the issuing agency, coupon and dollar amount are revealed. A specific pool whose characteristics are known would usually trade “TBA plus {x} ticks” or a “pay-up” depending on characteristics. These are called “specified pools” since the buyer specifies the pool characteristic he/she is willing to “pay up” for.

The price of an MBS pool is influenced by prepayment speed, usually measured in units of CPR or PSA. When a mortgage refinances or the borrower prepays during the month, the prepayment measurement increases.

If the buyer acquired a pool at a premium (>100), as is common for higher coupons then they are at risk for prepayment. If the purchase price was 105, the investor loses 5 cents for every dollar that’s prepaid, possibly significantly decreasing the yield. This is likely to happen as holders of higher-coupon MBS have good incentive to refinance.

Conversely, it may be advantageous to the bondholder for the borrower to prepay if the low-coupon MBS pool was bought at a discount. This is due to the fact that when the borrower pays back the mortgage he does so at “par”. So if the investor bought a bond at 95 cents on the dollar, as the borrower prepays he gets the full dollar back and his yield increases. This is unlikely to happen as holders of low-coupon MBS have very little incentive to refinance.

The price of an MBS pool is also influenced by the loan balance. Common specifications for MBS pools are loan amount ranges that each mortgage in the pool must pass. Typically, high premium (high coupon) MBS backed by mortgages no larger than 85k in original loan balance command the largest pay-ups. Even though the borrower is paying an above market yield, they are dissuaded to refinance a small loan balance due to the high fixed cost involved.

Low Loan Balance: < 85k
Mid Loan Balance: Between 85k – 110k
High Loan Balance: Between 110k – 150k
Super High Loan Balance: Between 150k – 175k
TBA: > 175k

The large number of factors needed, makes it difficult to calculate the value of an MBS security. Quite often, market participants do not concur resulting in large differences in quoted prices for the same instrument. Practitioners constantly try to improve prepayment models and hope to measure values for input variables implied by the market. Varying liquidity premiums for related instruments as well as changing liquidity over time, makes this a devilishly difficult task.

Mortgage modification: Mortgage modification is a process where the terms of a mortgage are modified outside the original terms of the contract agreed to by the lender and borrower (i.e mortgagor and mortgagee). In general, any loan can be modified.

Background

In the normal progression of a mortgage, payments of interest and principal are made until the mortgage is paid in full (or paid-off). Typically, until the mortgage is paid, the lender holds a lien on the property and if the borrower sells the property before the mortgage is paid-off, the unpaid balance of the mortgage is remitted to the lender to release the lien. Generally speaking, any change to the mortgage terms is a modification, but as the term is used it refers to a change in terms based upon either the specific inability of the borrower to remain current on payments as stated in the mortgage, or more generally government mandate to lenders.

Types of modification

Mortgages are modified to the benefit of the borrower in one or more of the following ways:

• Reduction in interest rate, or a change from a floating to a fixed rate, or in how the floating rate is computed
• Reduction in principal
• Reduction in late fees or other penalties
• Lengthening of the loan term
• Capping the monthly payment to a percentage of household income

The borrower can be current, late, in default, in bankruptcy, or in foreclosure at the time the application for modification is made. The programs available will vary accordingly.

There may be modifications made at the discretion of the lender. The lender is motivated to offer better terms to the borrower because of the expectation that the borrower might be able to afford a lower payment, and that a performing loan (i.e. one in which payments are current) will be more valuable ultimately than the proceeds obtained from a foreclosure sale.

The state and federal government may structure a mortgage modification program as voluntary on the part of the lender, but may provide incentives for the lender to participate. A mandatory mortgage modification program requires the lender to modify mortgages meeting the criteria with respect to the borrower, the property, and the loan payment history.

Scams

After the beginning of the mortgage crisis, unscrupulous mortgage professionals began setting up “Foreclosure rescue” companies promising for a large fee to persuade lenders to modify desperate homeowners’ mortgages. Nonprofit housing counselors approved by the Department of Housing and Urban Development will help borrowers for free; companies charging a fee are usually invariably scams operating illegally.