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Archive for the ‘Investment’ Category

What is ABS?

Posted by Kelly Chung on January 7, 2009

Securitization is the transformation of an illiquid asset into a security.
Like, consumer loans(credit card debts) can be transformed into a publicly issued debt security (like corporate bonds). With credit enhancement in place, asset-backed securities (ABS) have became safe, liquid and high-yielding investments. For industrial, financial and other service sector companies capable of originating and servicing securitizable assets, ABS became a corporate finance alternative as equities, bonds and bank loans.
A lender originates loans, like homeowner or corporation. The bank or firm sells certain assets to the investors. Credit Agency (like Moody’s) reviews the company’s rating and credit enhancement.The credit agencies will update the rating based on the company inherent risks. Here are the factors agencies examine: – credit risk – liquidity risk – counterparty risk – legal risk – interest risk and currency risk – prepayment risk – cash flow structure

A financial guarantee (bond insurance) is used in ABS to enhance a security to the triple A level, based on the financial guarantee company’s triple-A rating. The guarantee is designed to ensure that investors will receive timely payments of principal and interest, regardless of whether the underlying collateral assets are able to support such payments.

Note: Credit enhancement means excess cash flow, third-party guarantees, Letters of credit, cash collateral accounts

AAA = High quality debt instruments, like US Treasury;   A = Strong to adequate ability to pay principal and interest;   B = Principal speculative;   D = Default

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Mortgage Securities

Posted by Kelly Chung on January 7, 2009

A mortgage loan is a loan which is secured by the collateral of a specified real estate property. The real estate pledged with a mortgage can be dived into two categories: residential and non-residential. Mortgage securities represent an ownership interest in mortgage loans made by financial institutions, for example, commercial banks or mortgage companies to finance the borrower’s purchase of a home or real estate. As the underlying mortgage loans are paid off by the homeowners, the investors receive payments of interest and principal. Residential properties include houses, condominiums, cooperatives, and apartments.  Non-residential properties include commercial and farm properties. The majority of mortgage securities are issued by an agency of the U.S. government i.e. Ginnie Mae, or by government-sponsored enterprises i.e. Fannie Mae and Freddie Mac.
Mortgage securities are often priced at a higher yield than US Treasury and corporate bonds. These securities may be sold at par, or at a premium or a discount to their face value. Their prices fluctuate in response to changing interest rates: when interest rates fall, prices rise, and vice verse.

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ARM

Posted by Kelly Chung on January 7, 2009

Adjustable Rate Mortgage (ARM) is a variable rate loan.  ARMs usually offer a lower initial rate than fixed-rate loans.  The interest rate can change at specified time periods based on changes in an interest rate index that based on current finance conditions, i.e. LIBOR index or the Treasure index. Common indices include the cost of funds for savings and loan institutions, the national average mortgage rate, and the most popular one-year rate for the government’s sale of treasury bills. The ARM promissory note states maximum and minimum rates.  When the interest rate on an ARM increases, the monthly payments will increase.  When the interest rate on an ARM decreases, the monthly payments will be lower.

For an ARM, the lender designates an index and then add a margin above this index. For examle, the T-bill (Treasury bill) index were 7 and the lender’s margin were 2.5 (= 250 basis points), the ARM would call for an interest rate of 9.5. A big problem in an ARM is the possibility of negative amortization.  When the index rises while the payment is fixed, it may cause the payments to fall below the amount necessary to pay the interest required by the index. The shortfall is added back into the principal, causing the principal to grow larger after the payment.
As of  Feb 3 2000, the ARM Indexes: Prime rate was 8.75%
As of Jan 22 2008, the ARM Indexes: Prime rate was 6.5%
As of Dec 16 2008, the ARM Indexes: Prime rate was 3.25%

Before choosing an ARM over a fixed-rate mortgage, compare the current index value plus margin (i.e. 3.54% one-year Treasury Index + 2.75% margin = 6.21%) to the current fixed-rate (8.25%).  The difference (2.04%) is the interest rate savings that you would get by choosing an ARM if interest rates were to remain the same.

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A Shock with a Bigger Shock

Posted by Kelly Chung on January 7, 2009

Today’s crisis differs in complexity, speed and scale. We live in a complicated financial system. Almost every financial instruments connect to fixed income, especially, sub-prime loans. They are very complicated and not transparency. It is very hard to calculate the risks. The complexity of these financial instruments are not easy to comprehend.  I came from fixed income groups when I used to work for wall street firms.  The credit crisis and the downturn in world economies may offer a useful lesson: diversify your portfolios. You should have Treasury bonds, money market fund, corporate bonds, cash equivalents, currencies and gold in your portfolios. I got a call from my friend four months ago. He is an oncologist (cancer doctor). He wanted my opinion about his investments. His portfolio has some pharmaceutical stocks and REITS. Since he still receive income from his clinic, I suggested him to hold xyz (I can’t reveal it here!). Plus, he could sell his practice in one day. All his need is capital preservation. I suggested him that a good portion of his portfolio should be in stable, income-producing investments. Last year another friend of mine is an anesthesiologist. He told me he invested all his money in commodities. Looking back I thought it was a smart move. Now, I have a different opinion…As you know all commodities got crushed this summer due to slow growth in the global economy.

With a diversified stock portfolio, risk is reduced because different stocks rise and fall independently of each other. On a broader scale, combinations of different investment assets may well cancel out each other’s fluctuations in price, reducing the overall risk.

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