MIDTERM COVERAGE- FINANCIAL
MARKETS AND INSTITUTIONS
 MORTGAGE MARKETS
Mortgages- Loans to individuals or
businesses to purchase a home, land,
or other real property.
Securitized- securitized packaged and
sold as assets backing a publicly traded
or privately held debt instrument.
PRIMARY MORTGAGE MARKET
Four basic categories of mortgages
1. Home- used to purchase one to four-
family dwellings.
2. Multifamily dwelling- used to finance
the purchase of apartment complexes,
townhouses and condominiums.
3. Commercial- used to finance the
purchase of real estate for business
purposes (e.g. office buildings, shopping
malls)
4. Farm- used to finance the purchase
of farms.
Mortgage Characteristics
 COLLATERAL- all mortgage
loans are backed by a specific
collateral.
Lien- a publicly record attached to the
title of the property that gives the
financial institution the right to sell the
property if the mortgage borrower
defaults.
 DOWNPAYMENT- a portion of
the purchase price of the property
a financial institution requires the
mortgage borrower to pay up
front.
-decreases the probability that the
borrower will default on the mortgage
-generally 20% downpayment is
required, borrowers that put up less than
20% are required to purchase PMI.
(which is purchased by the lender
(financial institution) but paid for by the
borrower)
Private mortgage insurance- insurance
contract purchased by a mortgage
borrower guaranteeing to pay the
financial institution the difference
between the value of the property and
the balance remaining on the mortgage.
 INSURED vs. CONVENTIONAL
MORTGAGES
Federally insured mortgages- originated
by financial institutions, with repayment
guaranteed by either the Federal
Housing Administration or the Veterans
Administration.
-0.5% of the loan amount
-FHA mortgages require as little a 3%
downpayment
Conventional mortgages-mortgages
held by financial institutions but are not
federally insured.
  MORTGAGE MATURITIES
*Mortgage generally has an original
maturity of either 15 or 30 years.
*30-year mortgage was the one most
frequently used.
*Mortgage borrowers are however
attracted to 15-year mortgage because
of the potential saving in total interest
paid. (lower degree on interest rate risk,
monthly mortgage payments are higher
than 30-year mortgage)
Amortized- a mortgage is amortized
when the fixed principal and interest
payments fully pay off the mortgage by
its maturity date.
Balloon payment mortgage- mortgage
that requires a fixed monthly interest
payment for a three- to five- year period.
Full payment of the mortgage principal
(the balloon payment) is then required at
the end of the period.
 INTEREST RATES- probably the
most important characteristic
identified in the mortgage
contract.
>FIXED vs. ADJUSTABLE-RATE
MORTGAGES
Fixed-rate mortgage- a mortgage that
locks in the borrower's interest rate and
thus the requires monthly payment over
the life of the mortgage, regardless of
how market rates changes.
Adjustable-rate mortgage (ARM)- a
mortgage in which the interest rate is
tied to some market interest rate. Thus,
the required monthly payments can
change over the life of the mortgage.
>DISCOUNT POINTS- are fees or
payments made when a mortgage loan
is issued. One discount point paid up
front is equal to 1 percent of the
principal value of the mortgage.
>OTHER FEES
Application Fees- covers the issuer's
initial costs of processing the mortgage
application and obtaining a credit report.
Title Search- confirms the borrower's
legal ownership of the mortgaged
property and ensures there are no
outstanding claims against the property.
Title insurance- protects the lender
against an error in the title search.
Appraisal fee- covers the cost of an
independent appraisal of the value of
the mortgage property.
Loan origination fee- covers the
remaining costs to the mortgage issuer
for processing the mortgage application
and completing the loan.
Closing agent and review fees- cover
the costs of the closing agent who
actually closes the mortgage.
Other costs- any other fees, such as VA
loan guarantees, or FHA or private
mortgage insurance.
>MORTGAGE REFINANCING- occurs
when a mortgage borrower takes out a
new mortgage and uses the proceeds
obtained to pay off the current
mortgage.
-mortgages are most often refinanced
when a current mortgage has an interest
rate that is higher than the current
interest rate.
-by refinancing the mortgage at a lower
interest rate, the borrower pays less
each month— even if the new mortgage
is for the same amount as the current
mortgage.
MORTGAGE AMORTIZATION
Amortization schedule- schedule
showing how the monthly mortgage
payments are split between principal
and interest.
OTHER TYPES OF MORTGAGES
1. Jumbo mortgages- are those
mortgages that exceed the conventional
mortgage conforming limits.
2. Subprime mortgages- mortgages to
borrowers who have weakened credit
histories. (do not qualify for prime
mortgages)
3. Alt-A mortgages- Alternative-A paper
are mortgages that are considered
riskier than a prime mortgage and less
risky than a subprime mortgage.
-characterized by borrowers with less
than full documentation, lower credit
scores, higher loan-to-value ratios and
more investment properties than prime
mortgage borrowers, but more extensive
documentation, higher credit scores,
lower loan-to-value ratios and fewer
investment properties than subprime
mortgage borrowers.
-determined by credit risk.
4. Option ARMs- adjustable rate
mortgages that offer the borrower
several monthly payment options.
-also called pick-a-payment or pay-
option ARMs (15- or 30-year ARMs)
4.1 Minimum Payment Options- lowest
of the four payment options and carries
the most risk. The monthly payment if
set for 12 months at an initial interest
rate. The payment changes annually,
and a payment cap limits how much it
can increase or decrease each year
(generally 7.5%)
*Negative Amortization- the unpaid
interest is added to the principal
balance.
4.2 Interest-Only Payment- requires the
borrower to pay only the interest on the
loan during the initial period of the loan.
No principal must be repaid.
4.3 30-year fully amortizing payment-
the borrower pays both principal and
interest on the loan. By making this
payment each month, the borrower is
ensured that all interest and principal
payments are fully paid on schedule
based on a 30-year term.
4.4 15-year fully amortizing payment-
larger amount of principal paid each
month. This includes all of the interest
charged on the loan for the previous
month plus principal to pay off the loan
based on a 15-year term.
-accelerated amortization schedule
5. Second mortgages- loans secured by
a piece of real estate already used to
secure a first mortgage. Generally
higher interest rates than first
mortgages. Should a default occur, the
second mortgage holder is paid only
after the first mortgage is paid off.
Home equity loans- loans that let
customers borrow on a line of credit
secured with a second mortgage on
their homes.
Reverse-annuity mortgage (RAM)- a
mortgage for which a mortgage
borrower receives regular monthly
payments from a financial institution
rather than making them. When the
RAM matures (or the borrower dies), the
borrower (or the estate of the borrower)
sells the property to retire the debt.
SECONDARY MORTGAGE MARKETS
The secondary mortgage markets were
created by the federal government to
help boost U.S. economic activity. The
sale/securitization of mortgages in the
secondary mortgage markets reduces
the liquidity risk, interest rate risk and
credit risk. The major reason that
financial institutions sell loans is to
manage their credit risk better.
Mortgage sales remove assets from the
balance sheet and allow financial
institutions to achieve better asset
diversification.
MORTGAGE SALES
Correspondent banking- a relationship
between a small bank and a large bank
in which the large bank provides a
number of deposit, lending, and other
services.
Mortgage sale- sale of a mortgage
originated by a bank with or without
recourse to an outside buyer.
Recourse- the ability of a loan buyer to
sell the loan back to the originator
should it go back.
SEVEN MAJOR BUYERS OF
PRIMARY MORTGAGE LOANS:
investment banks, vulture funds,
domestic banks, foreign banks,
insurance companies and pension
funds, closed-end bank loan mutual
funds and nonfinancial corporations.
MAJOR SELLERS OF MORTGAGE
LOANS: money center banks, small
regional or community banks, foreign
banks, investment banks, hedge funds,
and US government.
MORTGAGE-BACKED SECURITIES
1. Pass-through mortgage security-
“pass through” promised
payments of principal and interest
on pools of mortgages created by
financial institutions to secondary
market participants holding
interest in the pools.
Timing insurance- a service provided by
a sponsor of pass-through securities
guaranteeing the bond holder interest
and principal payments at the calendar
date promised.
GNMA- Government National Mortgage
Association or Ginnie Mae
FNMA- Federal National Mortgage
Association or Fannie Mae
FHLMC- Federal Home Loan Mortgage
Corporation or Freddie Mac
Private Mortgage Pass-through Issuers-
(commercial banks, thrifts, private
conduits) purchase nonconforming
mortgages, pool them, and sell pass-
through securities on which the
mortgage collateral does not meet the
standards of a government-related
mortgage issuer. (PRIVATE
CONDUITS: GE Capital Mortgages,
Chase Mortgage Finance,
Citigroup/Citibank Housing)
2. Collateralized Mortgage
Obligations- a mortgage-backed
bond issued in multiple classes or
tranches.
Tranche- a bond holder class
associated with CMO.
Prepayment risk- risk due to very rapid
prepayments
3. Mortgage-backed bonds- bonds
collateralized by a pool of assets.
Also called asset-backed bond.
 STOCK MARKETS
Stock markets allow suppliers of funds
to efficiently and cheaply get equity
funds to public corporations (users of
funds).
Stock Market Securities
Common Stock- the fundamental
ownership claim in a public or private
corporation.
Common stock characteristics:
 Discretionary dividend payments
 Residual claim status
 Limited liability
 Voting rights
DIVIDENDS. The payment of size of
dividends are determined by the board
of directors of the issuing firm.
-Common stockholders have no
recourse if dividends are not received.
-They are taxed twice—once at the first
level and once at the personal level.
-Stockholders can sell their stock for a
profit and pay capital gains taxes rather
than ordinary income taxes on dividend
income.
RESIDUAL CLAIM. In the event of
liquidation, common stockholders have
the lowest priority in terms of any cash
distribution.
LIMITED LIABILITY. No matter what
financial difficulties the issuing
corporation encounters, neither it nor its
creditors can seek repayment from the
firm’s common stockholders. This
implies that common stockholders’
losses are limited to their original
amount of investment.
VOTING RIGHTS. A fundamental
privilege assigned to common stock.
1. Dual class firms- two classes of
common stock are outstanding,
with differential voting and/or
dividend rights assigned to each
class.
2. Cumulative voting- all directors
for election are voted on the
same time. The number of votes
assigned to each stockholder
equals the number of shares held
multiplied by the number of
directors to be elected.
*Proxy- a voting ballot sent by a
corporation to its stockholders. When
returned to the issuing firm, a proxy
allows stockholders to vote by absentee
ballot or authorizes representatives of
the stockholders to vote on their behalf.
Preferred Stock- a hybrid security that
has characteristics of both bonds and
common stock.
-senior to common stock but junior to
bonds
-pays a fixed periodic payment
Drawbacks: (a) if a preferred dividend
payment is missed, new investors may
be reluctant to make investments in the
firm; (b) unlike coupon interest paid on
corporate bonds, dividends paid on
preferred stock are not a tax-deductible
expense—preferred dividends are paid
out of after-tax earnings.
-preferred stockholders generally DO
NOT HAVE VOTING RIGHTS in the
firm.
Nonparticipating preferred stock-
preferred stock in which the dividend is
fixed regardless of any increase or
decrease in the issuing firm’s profits
Cumulative preferred stock- preferred
stock in which missed dividend
payments go into arrears and must be
made up before any common stock
dividends can be paid.
Participating preferred stock- preferred
stock in which actual dividends paid in
any year may be greater than the
promised dividends.
Noncumulative preferred stock-
preferred stock in which dividend
payment do not go into arrears and are
never paid.
PRIMARY STOCK MARKETS- Markets
in which corporations raise funds
through new issues of stocks.
Net proceeds- the price at which the
investment bank purchases the stock
from the issuer.
Gross proceeds- the price at which the
investment banks resells the stock to
investors.
Underwiter’s spread- the difference
between the gross proceeds and the net
proceeds
Syndicate- the process of distributing
securities through a group of investment
banks.
Originating houses- the lead banks in
the syndicate, which negotiate with the
issuing company on behalf of the
syndicate.
Initial public offering- the first public
issue of a financial instrument by a firm.
Seasoned offering- the sale of additional
securities by a firm whose securities are
currently publicly traded.
Preemptive rights- a right of existing
stockholders in which new shares must
be offered to existing shareholders first
ion such a way that they can maintain
their proportional ownership in the
corporation.
REGISTRATION
The investment bank must get SEC
Approval in accordance with the
Securities and Exchange Commission.
Red herring prospectus- a preliminary
version of the prospectus describing a
new security issue distributed to
potential buyers prior to the security’s
registration.
Quiet period- the period of time between
filing of the registration statement with
the SEC and the selling of shares.
Shelf registration- allows firms that plan
to offer multiple issues of stock over a
two-year period to submit one
registration statement summarizing the
firm’s financing plans for the period.
SECONDARY STOCK MARKETS- the
markets in which stocks, once issued,
are traded.
STOCK EXCHANGE MARKETS:
NYSE Euronext- New York Stock
Exchange Euronext
NASDAQ- National Association of
Securities Dealers Automated Quotation
The Trading Process
Trading post- a specific place on the
floor of the exchange where
transactions on the NYSE occur.
Specialist- exchange members who
have an obligation to keep the market
going, maintaining liquidity in their
assigned stock at all times.
Market order- an order to transact at the
best price available when the order
reaches the post.
Limit order- an order to transact at a
specified price.
Order book- a DMM’s record of
unexecuted limit orders.
Program trading- simultaneous buying
and selling of portfolio of at least 15
different stocks valued at more than $1
million, using computer programs to limit
the trade.
Reference price- is the mean price of
reported transactions over the past 5
minutes.
CONTROVERSIAL TRADING
PRACTICES
1. Flash Trading- for a fee, traders
are allowed to see incoming buy
or sell orders milliseconds earlier
than general market traders.
2. Naked access- allows some
traders to rapidly buy and sell
stocks directly on exchanges
using a broker’s computer code
without exchanges or regulators
always knowing who is making
the trades.
3. Dark pools of liquidity- trading
networks that provide liquidity but
that do not display trades on
order books.
Penny stocks- stocks that trade for less
than $5 per share
OTC Bulletin board- means for brokers
and dealers to get and post current price
quotes over a computer network.
CHOICE OF MARKET LISTING
1. NYSE Euronext
Basic qualifications: firm market value,
earnings, total assets, number of shares
outstanding, number of shareholders
and trading volume.
Why NYSE listing is attractive?
 Improved marketability of the
firm’s stock
 Publicity for the firm
 Improved access to the financial
markets
Electronic Communications Networks
and Online Trading
Opens at 9:30AM and closes at 4:00PM
eastern time
IEX Group, Inc.- uses speed bumps
(350 millionths of a second)
Stock market index- composite value of
a group of secondary market traded
stocks.
Market efficiency- the speed with
which financial security prices adjust to
unexpected news pertaining to interest
rates or a stock-specific characteristics.
Weak form market efficiency- current
stock prices reflects all historic price and
volume information about a company.
Semistrong form of market efficiency-
focuses on the speed with which public
information is impounded into stock
prices.
Strong-form market efficiency- states
that stock prices fully reflect all
information about the firm both public
and private.
 COMMERCIAL BANKS:
FINANCIAL STATEMENTS AND
ANALYSIS
Report of condition- balance sheet of a
commercial bank reporting information
at a single point in time.
Report of income- income statement of
a commercial bank reporting revenues,
expenses, net profit or loss and cash
dividends over a period of time.
Correspondent bank- a bank that
provides services to another commercial
bank.
ASSETS
Cash and due from depository
institutions-
Investment securities- consist of federal
funds sold, repurchase agreements, US
Treasury and agency securities,
securities issued by states and political
subdivisions, mortgage-backed
securities and other debt and equity
securities.
Loans and leases- major asset items on
a bank’s balance sheet and generate
the largest flow of revenue income.
-least liquid asset items; major sources
of credit and liquidity risk for most banks
Commercial and industrial loans- loans
used to finance a firm’s capital needs,
equipment purchases and plant
expansion.
*Secured loan- is backed by a specific
assets of the borrower.
*Unsecured loan- (or junior debt) gives
the lender only a general claim on the
assets of the borrower should default
occur.
Real estate loans- are primarily
mortgage loans and some revolving
home equity loans.
*Adjustable rate- the mortgage rate
differs according to whether the
mortgage has a fixed rate or a floating
rate.
Consumer loans- a third major category
of loans is the individual or consumer
loan— for example personal and auto
loans.
Other loans- wide variety of borrowers.
Unearned Income and Allowance for
Loan and Lease Losses- contra asset
accounts that are deducted from gross
loans and leases.
*Unearned income- amount of income
that the bank has received on a loan
from a customer but has not yet
recorded as income on the income
statement.
*Net write offs- actual loan losses less
loan recoveries.
*Earning assets- investment securities
plus net loans and leases.
Other assets-generally a small part on
the banks overall assets.
LIABILITIES
Deposits- demand deposits are
transaction accounts held by individuals,
corporations, partnerships, and
governments that generally pay no
explicit interest.
NOW Accounts- negotiable order of
withdrawal accounts are similar to
demand deposits but pay interest when
a minimum balance is maintained.
MMDAs-money market deposit
accounts with retail savings accounts
and some limited checking account
features.
Other savings deposit- all savings
accounts other than MMDAs.
Retail CDs- major categories of time
deposits; fixed maturity instruments with
face values under $100,000.
Wholesale CDs- time deposits with face
value of $100,000 or more.
Negotiable instrument- an instrument
whose ownership can be transformed in
the secondary market.
Brokered deposits- wholesale CDs
obtained through a brokerage house.
Core deposits- deposits of the bank that
are stable over short periods of time and
thus provide a long-term funding source
to a bank.
Purchased funds- rate-sensitive funding
sources of the bank.
Off-balance -sheet items are contingent
assets and liabilities that may affect the
future status of a financial institution’s
balance sheet.
Loan commitment- contractual
commitment to loan to a firm a certain
maximum amount at given interest rate
terms.
Up-front fee- the fee charged for making
funds available through a loan
commitment.
Commitment fee- the fee charged on the
unused component of a loan
commitment.
Commercial letters of credit (LCs)-
contingent guarantees sold by an FI to
underwrite the trade or commercial
performance of the buyers of the
guarantees.
Standby letters of credit (SLCs)-
guarantees issued to cover
contingencies that are potentially more
severe and less predictable than
contingencies covered under trade-
related or commercial letters of credit.
Loans sold- loans originated by the bank
and then sold to other investors that can
be returned to the originating institution.
Recourse- the ability to put an asset or
loan back to the seller should the credit
quality of the asset deteriorate.
Total operating income- the sum of the
interest income and noninterest income.
Extraordinary items-are events that are
both unusual and infrequent. This
includes such things as effects of
changes in acctg rules, corrections of
acctg errors made in previous years and
equity capital adjustments
ROE- Return on equity; measures all
profitability of the FI per dollar of equity.
ROA- return on assets; measures profit
generated relative to the FI’s assets.
Equity multiplier- EM; Measures the
extent to which assets of the FI are
funded with equity relative to debt.
Profit margin- measures the ability to
pay expenses and generate net income
from interest and noninterest income.
Asset utilization- measures the amount
of interest and noninterest income
generated per dollar of total assets.
Net interest margin-interest income
minus interest expense divided by
earning assets.
Spread- the difference between lending
and borrowing rates.
Overhead efficiency- a bank’s ability to
generate noninterest income to cover
noninterest expense.
or indirectly purchase securities
by investing in mutual or pension
funds managed directly or
indirectly by CBs.
6. Entry and chartering regulation-
entry and activity regulations limit
he number of CBs in any given
financial services sector, thus
impacting the charter values of
CBs operating in that sector.

 REGULATION OF
COMMERCIAL BANKS

SIX TYPES OF REGULATIONS

1. Safety and soundness regulation-

layers of regulation have been
imposed on CBs to protect
depositors an borrowers against
the risk of failure .
2. Monetary policy regulation-
regulators control and implement
monetary policy by requiring
minimum levels of cash reserves
to be held against commercial
bank deposits.
3. Credit allocation regulation-
regulations support the CB’s
lending to socially important
sectors such as housing and
farming.
4. Consumer protection regulation-
regulations are imposed to
prevent the CB from
discriminating unfairly in lending.
5. Investor protection regulation-
laws protect investors who
directly purchase securities and