J. K. Dietrich - FBE 524 - Fall, 2005 Fixed Income Market (1) Week 13 – November 9, 2005

J. K. Dietrich - FBE 524 - Fall, 2005

Fixed Income Market (1)

Week 13 – November 9, 2005


Fixed Income MarketsIssuer 2004

U. S. Treasury 4,307.7$ Agencies 2,679.7 Agency Mortgage Pools 3,542.5 State and Local Governments 1,569.6 Corporations 2,947.4 Mortgage-Backed Securities 1,511.4 Consumer Credit 592.9

Total Shown 17,151.2$

Source: Flow of Funds 1995-2004


Fixed Income Markets Government Debt

– U.S. Treasury Sponsored agencies State and local government debt Sovereign debt


Overview of Financial SystemFinancial Sector

Assets Liabilities Assets Liabilities Assets Liabilities Assets LiabilitiesCurrency CurrencyDeposits Reserves Reserves DepositsU.S. Treasuries U.S. Treasuries U.S. Treasuries U.S. TreasuriesMunicipal Debt Municipal Debt Municipal DebtMortgages Mortgages MortgagesAuto Loans Auto Loans Auto LoansCredit Cards Credit Cards Credit CardsBonds Bonds Bonds

Non-Financial Sectors Governmental Sector Monetary Authority

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U. S. Treasury Debt Treasury debt outstanding in June 2005

– Total outstanding $ 7.860 trillion– Held by government* 3.309 “– Held by public** 4.551 “

Publicly held – Marketable 4.013 “– Non-marketable .515 “

Savings bonds .204 “

* Largely social security trust fund **Including Federal ReserveSource: Treasury Bulletin, Tables FD-1 to FD-4


Marketable U.S. Debt June 2005

Of the total $3.519 trillion– T-Bills are $920 billion– Notes are $2.272 trillion– Bonds are $530 billion– TIPS are $ 291 billion

Treasury will begin seeling 30-year Treasury bond again

Source: Treasury Bulletin, Tables FD-1 to FD-4


Issues in Government Debt

Does government borrowing cause inflation?– Depends on central bank policy (monetizing the

debt or printing money)– One-time deficit produces one-time price

increase, inflation requires sustained debt monetization

Is total government liability reflected in debt? Unfunded pension liability and government guarantees are also liabilities


Ricardian Equivalence

Is government debt wealth?– Private claim on public sector: does it cancel out when

sectors are aggregated (see previous slide)?

– What is the source of the value of government debt: future taxes

Ricardian Equivalence (named after David Ricardo) argues that public recognizes that future taxes will increase if government debt increases and hence government debt is not wealth and does not influence the level of interest rates


Agency Bonds

Budget agencies, e.g. Tennessee Valley Authority (TVA)

Government-sponsored enterprises (Federal National Mortgage Association, FNMA, and Federal Home Loan Bank, FHLB)

Mortgage-backed securities issued by FNMA, FHLB, and Federal Home Loan Mortgage Corporation (FHLMC), and Farmers Home Administration


History of FNMA and FHLMC

Federal Housing Administration (1934) and Veteran’s Administration (1944) provided government-guaranteed mortgages following certain standards (called FHA-VA or guaranteed or conforming loans)

FNMA and guarantor General National Mortgage Association (GNMA or Ginnie Mae) functions were separated in 1968 and FNMA became private firm


Agencies

FNMA = Fannie Mae is a stockholder owned corporation trading on the NYSE

FHLB system is member-owned, before 1989 predominantly lent to savings and loans in the form of advances, and now open to all financial institutions

FHLMC = Freddie Mac established (1970) as a non-guaranteed (conventional) mortgage counterpart to FNMA


Agency Issues

Direct borrowings from capital markets, like FHLB issues used for advances to members

Government guaranteed pools of mortgages like GNMA and FNMA issues

The extent of the U.S. government commitment to make payments of agencies is not backed by the full faith and credit of the Treasury, hence there is default risk


Agency Market since 1968

Agencies 1968 1970 1980 1990 2004Budget Agencies 11.3 8.1 4.4 32.4 24.3

Sponsored Agencies 21.6 38.9 159.9 393.7 2,679.7 Mortgage Pools 2.5 4.8 114.0 1,019.9 3,542.5

70-80 80-90 90-0415.2% 9.4% 13.6%37.3% 24.5% 8.4%

Sponsored AgenciesAnnualized Growth Rates

Mortgage Pools

Source: Flow of Funds 1995-2004


Sponsored Agency Controversy

FNMA, FHLBB and FHLMC borrow at the agency rate which is only slightly higher than the Treasury rate

Agencies compete with private firms in financing home mortgages

Agencies are not subjected to same regulatory and capital review as private financial institutions


Agency Controversy (continued) Balance sheets of FNMA, FHLMC, and

FHLB reflect agency debt used to invest in loans and mortgages, implying a valuable government guarantee on borrowings

Agencies and GNMA also guarantee loans The implicit government liability is

estimated in the trillions of dollars Agencies accused of accounting

irregularities (associate with hedging activities) and with having too little capital


Role of Agencies

Huge organizations have been able to establish standards and possibly realize economies of scale

Agencies have been very innovative Trade mortgages and form pools Make loan commitments Would private sector have been as

innovative?


Taxation

U.S. debt is taxed at both state and federal level

Debt of state and local governments is not taxed at the federal level and may not be taxed at the state level (depends on state)

Qualifying debt of state and local governments (municipalities) are therefore called tax-exempt issues or municipal bonds


Tax-Exempts After-Tax Yield

Two ways to look at the impact of municipal debt tax treatment:

Example, 39% tax rate tax-exempt yield of 4.93% (26-year CA Infr&EconDevBayAr quoted November 6, 2003):

)RateTax1(

YieldExemptTaxEquivalentYieldTaxable

%08.8)39.1(

%93.4EquivalentYieldTaxable


Implicit Tax Rate Compare the before-tax yield equivalent of

8.08% in the previous example to the 26-year Treasury on the same date, 5.36%

The tax rate which makes taxable Treasury yields equal to the tax-exempt rate is called the implicit tax rate, calculated:

Investors with tax rates higher than the implicit rate earn higher after-tax returns

%8.8088.912.1%36.5

%93.41RateTaxImplicit


Types of Municipals Short-maturity municipals

– Tax anticipation notes and bond anticipation notes are short term and will be repaid out of the next tax collection cycle or financing

– Municipal bonds can have legal restrictions like not being used to finance long-term deficits

Long-maturity municipals– General obligation (GO’s) are secured by the overall

taxing authority of the issuer– Revenue bonds are paid out of specific revenues

streams, like toll roads, dormitories, etc.


Banks and Municipals

Even prior to GLB Act of 1999, banks could underwrite and make markets in general obligations bonds (GO’s) and banks were major players

Until the Tax Reform Act of 1986, banks also could deduct all interest on deposits and borrowed funds even though some funds were invested in tax-exempts, a tax arbitrage, and other corporations could not


Municipal Market before 1986

Tax arbitrage by municipalities borrowing and investing proceeds in U.S. Treasuries (for “construction accounts”, etc.)

Tax arbitrage by municipalities financing “industrial development” using industrial development bonds

Federal subsidies through allowance of pollution control bond financing of investments in pollution control equipment


Tax Reform Act of 1986

Motivation: simplify tax code and reduce hidden subsidies and tax breaks

Removed many advantages of investment in municipal bonds for banks (allocate interest expense to tax-exempt investments)

Strictly limited opportunities for tax arbitrage

Effects of tax changes on municipal market


Municipal Market 1982-2004Municipal Bonds 1982 1986 1990 2004

Short-Term 22.7 20.4 26.2 95.4 Long-Term 381.2 704.5 956.4 1,569.6

Total 404.0 724.9 982.7 1,665.0

Of which:Households 170.6 355.4 575.0 665.6

Commercial Banks 158.3 203.4 117.4 140.8 Casualty Insurance 87.0 101.9 136.9 251.9

Mutual Funds 21.3 131.1 196.6 613.0

Share of Holdings*Households 42.2% 49.0% 58.5% 40.0%

Commercial Banks 39.2% 28.1% 11.9% 8.5%Casualty Insurance 21.5% 14.1% 13.9% 15.1%

Mutual Funds 5.3% 18.1% 20.0% 36.8%Source: Flow of Funds * Includes loans


Sovereign (Foreign) Debt

Foreign government debt– Most countries issue more debt as percent of

GDP than United States– Markets for major countries are well developed

(e.g. Japan, Germany, United Kingdom)– Emerging markets may be less well developed

» Latin America and monetization of debt» Low deficits and undeveloped debt markets in Asia

Domestic policies and regulations Currency denomination


International Organizations

International Bank for Reconstruction and Development (IBRD or World Bank) borrows billions, innovates in debt markets – $17 billion in 2001 (232 deals in 9 currencies,

with maturities of 1 to 30 years and average of 6.5 years)

– $65 billion in 1998 to 2000 in total borrowings Backed by IBRD’s 183 sovereign

shareholders Other regional development banks


Next Week – Nov. 16, 2005

Read Chapter 21 and 22 for next week Remember due date on group project is

November 30 Final is scheduled on December 7, 2005

7:00 to 9:00pm Review text readings, but also my

objectives, vocabulary, and slides, they reflect my emphasis in course materials

Documents

J. K. Dietrich - FBE 524 - Fall, 2005 Fixed Income Market (1) Week 13 – November 9, 2005