CRE 19 - Mortgage Economics and Investment

Question 1

Describe the expectations hypothesis for explaining the shape of the yield curve

Answer 1

Expectations about the level of future short-term rates account for some of the difference between short-term and long-term yields

• if yields of short-term bonds will higher in future, investors will demand higher hields on long-term bonds (than short-term bonds)
• Otherwise, employ a roll-over strategy of investing only short-term bonds

Question 2

How does inflation impact short-term rates

Answer 2

It’s normally close to the level of short-term rates, since investors in short-term bonds want to at least preserve their purchasing power

• When inflation is abnormally high, investors expect inflation to be lower in the long run, which will drive down the short-term rates
• If investors are worried about future inflation, this will lead to an expectation of higher short-term rates, and thereby higher long-term rates

Question 3

How does the Fed influence short-term rates?

Answer 3

• Tight monetary policy to control inflation can drive up short-term interest rates
• Expansionary policy (in recessions), fed can stimulate the economy by driving down short-term rates

Question 4

Describe the liquidity preference theory for explaining the shape of the yield curve

Answer 4

Preferences of bond investors drive the yield curve shape

• If bond investors prefer to own short-term bonds, then long-term bonds need to offer higher yields to attract more demand

Question 5

Provide two reasons why investors prefer trading short-term bonds

Answer 5

1. Short-term bonds offer greater liquidity
2. Roll-over strategy in short-term bonds has less interest rate risk then investing in long-term bonds and selling them prior to maturity

Question 6

Maturity Gap of fixed income portfolios

Answer 6

When a firm’s assets have greater weighted average duration than its liabilities

Question 7

Ways banks can mitigate their duration mismatch between assets and
liabilities

Answer 7

1. Make more short-term (i.e. construction) and fewer long-term (permanent mortgages) loans
2. Issue floating rate or adjustable rate loans
   
   • Not as sensitive to interest rates due to lower duration
3. Sell existing long-term loan assets into the secondary market
   
   • To life insurance companies and pension funds to match their long-term liabilities

Question 8

Describe the interest rate risks that banks face

Answer 8

• Typically face risk from interest rate increasing due to liabilities (short-term deposits) have shorter duration than assets (loans)

Question 9

List two types of fixed income portfolio investment strategies

Answer 9

1. Trading-oriented strategies
2. Immunization-oriented strategies

Question 10

Describe trading-oriented strategies and how can leverage be employed in this strategy?

Answer 10

Involves regulary buying and selling bonds prior to maturity

• Includes active and passive strategies

Depending on risk aversion, leverage might be employed to exploit yield spreads

• Borrow at lower short-term and invest at higher long-term rates

Question 11

Describe immunization-oriented strategies

Answer 11

Hold bonds until maturity to avoid interest rate risk

• More conservative and results in lower average return
• Applied by matching weighted average duration of assets and liabilities

Question 12

List six components of ex-ante returns of a commercial mortgage

Answer 12

1. Real risk-free rate
2. Inflation premium
3. Yield curve component
4. Default risk
5. Yield degradation
6. Illiquidty premium

Question 13

Describe the real risk-free rate component of the ex-ante return

Answer 13

• Pure time-value of money component of required return
• Calculated as: T-bill yield - current inflation rate

Question 14

Describe the inflation premium component of the ex-ante return

Answer 14

• Premium due to the expected rate of inflation in the short term
• Reflects the need of the investor to obtain the short-term real return measured in constant purchasing power

Question 15

How to calculate inflation premium in the Ex Ante returns of mortgage yield

Answer 15

Question 16

Describe the yield curve component of the ex-ante return

Answer 16

Term premium associated with longer-term bonds

• Reflects expectations about future short-term interest rates, as well as liquidity prefrences and interest rate risk

Question 17

Describe the default risk component of the ex-ante return

Answer 17

Risk premium due to the RISK (not expectation) of default

• Investors demand a risk premium in ex ante due to risk aversion

Question 18

Describe the yield degradation component of the ex-ante return

Answer 18

Difference b/w:

1. Contractual yield of the mortgage under the assumption of no default
2. Expected return that includes the possibility of default

Question 19

Components of total default-based spread b/w ex ante returns of commerical mortgages and similar-duration Treasury Bonds

Answer 19

• Default risk-based yield
• Ex ante yield degradation

Question 20

Driver of default spreads in Commercial Mortgages

Answer 20

Loan-to-Value (LTV) ratios

Question 21

Describe the illiquidity premium component of the ex-ante return

Answer 21

Premium due to relative illiquidity

Question 22

Reason that contractual yields on CMBS that are securitized may not be much lower than those on loans held whole by portfolio lenders

Answer 22

Despite their relative liquidity, securitization adds another layer of admin costs

Question 23

Sum of Real risk-free rate, Inflation premium, Yield curve component in ex ante commerical mortgages

Answer 23

Yield of a treasury bond with similar maturity

Question 24

Describe the ex-post yield of a commercial mortgage

Question 25

Sum of Default risk premium, expected default yield degradation, illiquidity premium in ex ante commerical mortgages returns

Answer 25

Spread of the mortgage-stated yield over the yield of a Treasury bond with the same maturity

Question 26

Describe the ex-post yield of a commercial mortgage

Answer 26

• The realized ex post returns of investors who sell mortgages prior to maturity or “mark-to-market” their portfolio values
• Calculated by holding period return (HPR)

Question 27

holding period return (HPR) of a commerical mortgage

Answer 27

Question 28

Compare and contrast the volatility of ex-ante and ex-post yields of commercial
mortgages

Answer 28

• The volatility of ex-post mortgage total returns is higher than that of ex-ante yields comes from changes in the market value of the debt, D_t - Dt-1, and reflects two effects:
• 1. Changes in market interest rates
     2. Changes in perceived default risk of the mortgage

The average level of ex-post returns in a historical index reflects realized credit losses from defaults and the general trend in market interest rates

• Declining interest rates reflect positively to ex-post return (due to appreciation to market value)