We’ve seen a significant increase in shareholder activism in recent years, particularly from large institutional shareholders. One of these areas is that shareholders may now voice opinions on senior management compensation (though not a binding voice). However such activism extends much further to include proposed mergers, acquisitions or spinoffs. Provide some recent examples where shareholder activism has affected a company’s performance or actions, and discuss the consequences of this.
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Module 2 Compiled
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Module 2 Study Guide and Deliverables
Madura: Ch. 9, 10, 11, 12 and HBS#1
Discussions: 2: Shareholder Activism
Initial post due by Wednesday, March 27
at 11:59 PM ET
Reply posts due by Sunday, March 31 at
11:59 PM ET
Homework Exercise 03 – Mortgage
Amortization due by Sunday, March 31 at
11:59 PM ET
Homework Exercise 04 – Equity Pricing
due by Sunday, March 31 at 11:59 PM ET
Short Summary of Term Paper Topic due
by Sunday, March 31 at 11:59 PM ET
Week 2 Introduction
msm_ad712_13_su2_bchambers_w02 is displayed here
What Are Mortgages?
A form of debt used to finance/purchase investment in property
Involves periodic payment > bond-like
Debt secured by the purchased property > collateralized debt
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Value paid for property – Down payment = mortgage
Types of property
single-family: house, apartment, condo
commercial: malls, office buildings
Borrowers: individuals, farmers, corporations
Lenders: commercial banks, savings & loans, mortgage companies
Further sub-classification into Residential, Commercial, Farm
Different government agency assistance / subsidy / support
Different risk characteristics , attracts different investors
Different cash flow
We begin our coverage of mortgages and the mortgage market by going over some basic characteristics of this security.
As with bonds, mortgage securities are considered as a form of debt security since they involve periodic payment of
interest and repayment of the principal amount of the debt. The exception here is that a mortgage security is always
collateralized by the underlying property from the loan. This can be a lien on a residential property, a house or a
condominium, a parcel of land, or a commercial building. The principles are all the same. Residential mortgages
generally refer to single residences (including condos), duplexes, triplexes (like Boston’s infamous triple deckers) and
often small apartment buildings of up to 4 units. Larger apartment complexes are regarded as commercial properties.
Mortgage market securities are typically classified as residential (and in residential mortgage backed securities or
RMBS), commercial (commercial mortgage backed securities or CMBS), or farm properties. As we will see later, these
distinctions are necessary from the viewpoint of governmental housing programs as well as the preferences of investor
participation in a particular class of property. Car loans are not mortgages, since they are not collateralized by property.
The cash flow from a mortgage security is often a type of annuity. This is particularly true if the mortgage is a fixed-rate
mortgage, that is, a fixed amount of mortgage payment per month. Other mortgages have a fixed payment of interest
each month with one single “balloon” payment at the end of the mortgage term to repay the principal.
One encouraging fact about the size of the mortgage market, in particular the North American mortgage market, is its
steady growth over the years. The interruption of this growth in 2007-2009 due to the problems of the sub-prime mortgage
market and the recession constitute a real change from historical patterns and most likely will be seen as a notable
anomaly when more normal conditions return. I analogize the growing mortgage market to that of an expanding universe.
Its rate of growth is driven by certain critical factors. To begin with, the North American demographic is sizeable. New
family units are constantly being created. The desire and need for home ownership (the US, for example, has the highest
rate of home ownership in the world), and hence a mortgage, is also supported by government’s role in making housing
loans widely available to qualified home buyers. One mystery that I will let students chew on for the moment is this:
Where are resources of fund to maintain the growth? An often asked question is, “Where are the deep pockets?” At
times it seems bottomless. We will revisit this mystery in a later topic called securitization. At more than $9 trillion, with
one to four family dwellings as the overwhelming proportion of the total, this is no small mortgage market. It is almost the
size of the North American Gross Domestic Product.
Let’s introduce the term “originate”. This is used a lot in mortgage-speak. Although this is not a word unique to this
financial market, it refers to the initial issuance of mortgage contracts by lenders to home buyers. Playing the role of
mortgage originators are mostly commercial banks, savings and loans, and mortgage companies. But there are also
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independent mortgage originators who just act as agents or middlemen, not lending their own money but that of other
lenders, in return for a fee or commission. As an aside, it appears that many of the subprime and so called “Alt-A”
mortgages that have gone into default were initiated by independent mortgage originators who were much more
interested in the volume of mortgages underwritten (enhance their fee income) than in the quality of the underwriting.
From a prior Principles of Finance course, one of the properties of a mortgage’s cash flow is the composition of principle
and interest. The notion of amortization is also associated to mortgage payments since the principal of most residential
mortgages is gradually reduced or amortized over its life, leaving a zero balance at maturity. The chart above illustrates
the ever-changing principal to interest proportion within each payment of a fixed-payment mortgage. Of note is that most
of the payments at the beginning of the loan are made up of interest payments. Mortgages can be a very, very good
business to the lenders. It tends to be very stable with few defaults and generally appreciating collateral should a loan
default (2007 through 2009 excepted). For students who have constructed an actual 30-year amortization table, the sum
of interests over the life of the mortgage is typically a few multiples of the original size of the loan. For example, the 30
year fixed rate mortgage bearing a 6% loan rate will make fixed monthly payments of $599.55 for every $100,000 of
principal, meaning total payments over the 30 year period of $215,838 or total interest payments equal to 116% of the
principal amount. There’s also an FYI section on amortization and its table towards the end of this week’s lecture.
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This is an amortization graph of the same mortgage, but with maturity of 15 years instead of 30 years. Note the drastic
shift away from the sizable proportion of interest at the beginning of the loan. Just a little bit of advice, if you can afford a
15 year mortgage, do it. However, the periodic payments are significantly higher. That is, more pain, but for a much
shorter period of time. Note also that other factors, such as tax considerations and investment opportunities will also
drive your choice of maturity of a mortgage since in the US interest on a first residential mortgage interest is a deductible
expense for income tax purposes. One final word about the principal and interest components of a mortgage’s cash flow.
As we will see later, mortgage securities can be re-packaged and may have the two components of cash flow (the
principal portion and the interest portion) directed to different classes of investors. We will cover in detail this financial
innovation in the mortgage-backed securities segment of this topic.
Residential Mortgages – Characteristics, Data Source, ARMs
Residential Mortgages Characteristics
Conforming – loan amount less than $417,000
Jumbo – above $417,000
FHA – government-backed loan supported by the Federal Housing Authority and
the Department of Housing and Urban Development (HUD)
VA – government-backed loan for enlisted personnel, qualified veterans and
active duty military personnel; Veterans Administration
Less-than-perfect-credit – designed to help borrowers get a mortgage, plus
improve their credit grade for later financing
Mortgage Loan Amortization
monthly payment (pmt) consist of principal and interest
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during early years of mortgage, bulk of payment is interest
over time, interest proportion of pmt decreases, principal portion increases
principal eventually whittled down to zero when mortgage ends
Let’s turn our attention to residential mortgages – the largest proportion of all mortgage debt outstanding. Residential
loans can be categorized by the amount that a home-buyer is borrowing. If the amount is less than $417,000, then its
amount “conforms” to various government housing agencies requirement in the mortgage market. (Note: The ceiling for a
“confirming” mortgage was temporarily raised to $729,750 under the economic stimulus legislation in 2009). Otherwise,
it is called a “jumbo” loan. Loans can also be categorized by the level of assistance from government housing agencies.
Finally, there’s a risky category for home-buyers that have poorer credit profiles. These loans are termed “sub-prime” and
tend to be much riskier than “prime” loans. There is also an in between category termed “Alt-A” mortgages. In some
ways, sub-prime mortgages are analogous to the junk category in the bond market. As is the case, the mortgage rate
will be higher than all other categories.
P.S. I just can’t help but put this stretch limo pig on this slide. Some of you might have seen this pop up on some
websites. It points to the competitive environment of the mortgage market. It didn’t take long after the shock of the
mortgage crisis for these ads to start reappearing. It is extremely easy and convenient to apply online for a mortgage.
Note the various range of mortgage rates being offered. They correspond to a wide choice in terms of loan size, maturity,
as well as risk categories.
A few more characteristics about residential mortgages. “Points” is a mortgage practice that is unique to the American
mortgage market. It refers to up-front money that the borrower can pay in order to acquire a mortgage that has a slightly
lower stated interest rate and is analogous to issuing bonds at a discount. Part of this buy-down incentive benefits the
lenders as well. They manage to generate up-front cash upon origination, and could use these funds to originate
proportionally more mortgages. Another recent trend that highlights the competitiveness among mortgage originators, is
the practice of offering mortgage rates with 0% down payment on the purchase price of the property. Again this would
make the loan “non-conforming” as the maximum loan-to-value (LTV) rate for conforming loans is 90%. (which some
would say is already pretty high). This practice, by the way, places more risk on the lender in the event the borrower
defaults. We will discuss FICO scores in detail later. It is standardized way of measuring a borrower’s credit strength,
based on the borrower’s credit history.
The most common original maturities for mortgages are a 15-, 20-, or 30-year mortgage. One recent trend is the
introduction of 10-year mortgages. The shorter maturity gained some popularity during the early 2000s when the general
level of mortgage rates was at a multi-decade low. If you do the calculation, when mortgage rates rise above 6%, the
monthly payment of $300,000 to $500,000 mortgage practically makes it unaffordable for most average-income families.
Balloon payment mortgages are like time bombs. During the early years payments, which are interest only, are much
lower and affordable. However, once this honeymoon period is over, borrowers of this form of mortgage will have to face
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Although mortgages are always collaterized with the loan’s property, there’s still a chance that the borrower might
default, something that has been all too evident in recent years. This situation is made worse when the seized property
no longer retains its mortgage value during depressed property market conditions. The chances of this are, of course,
exacerbated when the original LTV ratio was quite high and/or when a high general level of defaults or recessionary
conditions put a lot more properties on the market, further reducing the property’s market value. Therefore, an insurance
scheme to insure against such event can add a lot of additional protection to lenders. One form of insurance is those
that are backed by various government housing agencies, like the Federal Housing Administration (FHA). Its mission is
to make housing loans affordable to low- and mid-income families, as well as first-time home-buyers. Conventional
mortgages on the other hand, are arrangements with private insurance companies. One implication of these two
schemes of mortgage insurance is that investors of federally insured mortgages require a lower rate of return than those
of conventionals. Recall during last week’s topic on bond markets, no entity has a better credit quality than the full faith
and trustworthiness of the United States government. And therefore, by extension, its governmental agencies. Private
insurers, in contrast, have a very small but not zero chance of default, hence the larger margin.
Fixed-rate mortgages and adjustable-rate mortgages are the two common forms of mortgage rates. Fixed rate payments
throughout the life of the loan certainly has its appeal to some borrowers. If the general level of future interest rates is
expected to increase, then a fixed-rate mortgage should be higher than the adjustable-rate mortgage. We will discuss
more about interest rate expectations and their theories during the third week of the course. Adjustable rate mortgages
(ARMs), also called variable rate, however, set the loan rate at a margin over some index, like LIBOR or the Treasury
rate. The actual mortgage rate is then re-set periodically (annually is common) to reflect increases or decreases in the
index rate. When general interest rates are low, ARMs can look very attractive. The pinch comes when the index rate
increases and the homeowner gets surprised by a sometimes huge increase in the interest rate and the required
monthly payment. The popularity of ARMs from the mid 1990s onwards and the increase in interest rates from 2004
through 2006 certainly contributed to the increased rate of defaults in the following years.
Creative Mortgage Financing – too many choices!
FRMs: Fixed-Rate Mortgages
ARMs: Adjustable-Rate Mortgages
GPMs: Graduated-Payment Mortgages
initial payments start low, rises, then levels off
tailored to borrower’s income: expected to rise and keep pace with rising
SAMs: Shared-Appreciation Mortgages
“discounted” mortgage, i.e. below market rate
lender shares in future appreciation of property
Equity Participation Mortgages
like SAMs but outside investor participant instead of lender
secured by the same real estate, but junior to 1st mortgage in case of
often has a shorter maturity than first mortgage
has higher interest rate than the first mortgage due to increased default
RAMs: Reverse Annuity Mortgages < owner/retiree of property gets paid https://learn.bu.edu/bbcswebdav/pid-6629015-dt-content-rid-25348983_1/courses/19sprgmetad712_o2/course/module_02/ad712_W02_Print… 6/77 2019/3/26 Module 2 Compiled Beyond fixed- and adjustable-rate mortgages, we also have a wide range of new mortgage products developed during the housing boom in 2002-2006. Such a wide variety of choices to a borrower attests to the depth and competitiveness of the mortgage market. For sure, it was a borrower's market. This market power, from the borrower's perspective, is unavailable in other countries. Try asking for a GPM (Graduated-Payment Mortgage) in Singapore, and the originators will
give you a puzzled look. The market saw some questionable mortgage practices like zero down payments, artificially low
“teaser” interest rates for the first year or two of a mortgage (which huge escalation of the interest rate and payment
once the teaser rate had expired), negative amortization loans or loans where the size of the monthly payment was
optional (and anything less than the normally scheduled payment was simply added on to the principal of the loan), and
“no documentation” loans where the lender never even checked whether the borrower had the income needed to make
the monthly payment or even had a job. With such “great” innovations was there any question that a mortgage crisis
would occur at some point?
Let me also point out reverse annuity mortgages, or RAMs. This has received some attention in the media and promoted
by individual financial planners for retirees. In this mortgage, the roles of the borrower and the lender for a particular
property are reversed. A retiree home-owner while still occupying the property, receives periodic payments from a bank.
To the retiree, cash flows from the RAM are thus used to supplement those from retirement funds. The loan is then
repaid when the retiree dies and the house is sold.
The “lock” feature in a mortgage is useful to potential borrowers. Because mortgage rates fluctuate based on market and
economic conditions, as well as actions from the Fed, a lock is a lender’s guarantee of a particular rate to potential
borrowers over a certain period of time. Locks serve the borrowers in two ways. First, the legal paperwork may take more
than a few days to process. Second, even if a potential homebuyer has already identified his dream home, it may take
weeks and even months for the transaction to actually close. Even a slight change in mortgage rate during this period
could derail a home-buyer’s affordability on that property. Again, locks exist as a result of competition among mortgage
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Let’s talk about ARMs. Each different colored segment in the table below represents variance of adjustable-rate
mortgages. For example, N-year arms refer to how frequently mortgage rates get adjusted. The N here refers to the
number of years. The N-1 ARMs – those highlighted in blue – refers to an initial period of fixed mortgage rate. It is then
followed by annual interest rate adjustments for the rest of the loan. Students are not required to memorize all these
variants, as well as those in the blue box below, but having the basic principles and the direction of influences set in your
mind will be useful.
This box below describes the mechanism used by ARMs in adjusting the mortgage rate. That is, how often is it being
adjusted, by how much per adjustment, and what is the total maximum amount of adjustment during the life of the
loan. The basic principle is that adjustments are typically linked to some benchmark rate, such as a T-bill, the 10-year Tnote, or LIBOR. If the interest ra …
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