Chapter Nine: Mortgage Markets

1. Background of Mortgages
Definition: A mortgage is a form of debt used to finance real estate purchases, secured by the
property itself.
Represents the difference between the down payment and the amount owed.
Specifies the mortgage rate, maturity, and collateral.
Common Maturity Terms:
Most common terms are 30 years or 15 years.
Role of Financial Institutions:
Originators of mortgages assess the creditworthiness of borrowers.
Charge an origination fee; profit from the spread between mortgage rates charged and funding
rates.
Serve as intermediaries by originating and financing mortgages.
2. Mortgage Market Participants
Primary Market: Financial intermediaries originate mortgages and finance home purchases.
Funded by household deposits and by selling originated mortgages to institutional investors.
Secondary Market:
Mortgages can be purchased by:
Savings institutions
Commercial banks
Insurance companies
Pension funds
Mutual funds
Purpose is to facilitate liquidity for further mortgage financing.
3. Mortgage Classifications
Prime Mortgages: Satisfy traditional lending standards.
Low debt-to-income ratios, high credit scores.
Subprime Mortgages: For borrowers not qualifying for prime.
Typically lower income, higher existing debt, smaller down payments.
Insured Mortgages: Federally insured, protecting lenders from default.
Conventional Mortgages: Not federally insured, but can have private insurance.
4. Types of Residential Mortgages
Fixed-Rate Mortgage (FRM): Locks in a consistent interest rate over the loan's term.
Amortization Schedule: Shows monthly payments, breaking down principal vs. interest.
Adjustable-Rate Mortgage (ARM): Interest rate adjusts with market conditions.
Helps stabilize lender profits.
Graduated Payment Mortgage (GPM): Small initial payments increase over the first 5-10 years,
then level off.
Growing Equity Mortgage: Similar to GPM, payments initially low but increase over time.
Second Mortgage: Used alongside a primary mortgage.
Shared Appreciation Mortgage: Lower interest rate in exchange for sharing in property
appreciation.
Balloon Payment Mortgage: Interest-only payments for 3-5 years, followed by a lump-sum
principal payment.
5. Valuation of Mortgages
Market Price (PM): Equals the present value of expected future cash flows.
Factors Affecting Value:
Risk-Free Rate (Rf): Increase leads to a higher required return and lower market price.
Risk Premium (RP): Increase leads to a higher required return and lower market price.
6. Risks in Mortgages
Credit Risk: Possibility of borrower default.
Mitigation: Purchase of Credit Default Swaps (CDS) as a hedge.
Interest Rate Risk: Mortgage values decline if interest rates rise.
Prepayment Risk: Borrowers may repay the mortgage early, often when interest rates fall.
7. Mortgage-Backed Securities (MBS)
Definition: Pooling individual mortgages into packages to sell to institutional investors.
Types of MBS:
GNMA (Ginnie Mae): Government-backed.
Private-Label Pass-Through Securities: Non-government-backed.
FNMA (Fannie Mae) and FHLMA (Freddie Mac): Participation certificates.
Collateralized Mortgage Obligations (CMOs).
Valuation Challenges: Limited transparency and reliance on rating agencies for assessments.
8. The 2008-2009 Credit Crisis
Overview: From 2003-2006, many financial institutions issued mortgages with poor credit
standards.
Led to a glut in the housing market and a decline in home values.
Many homeowners faced foreclosure, causing systemic impacts.
Consequences:
Fannie Mae and Freddie Mac faced massive losses.
Government takeover in September 2008.
Major financial institutions (Bear Stearns, Lehman Brothers, AIG) affected.
Ripple effects in the insurance industry and international markets.
9. Causes of the Crisis
Mortgage Originators: Failed to screen borrower creditworthiness.
Credit Rating Agencies: Leniency in mortgage-backed securities ratings.
Securities Firms and Commercial Banks: Over-reliance on rating agencies.
Institutional Investors: Insufficient due diligence on MBS quality.
Speculators: Capitalized on the mortgage market's collapse.
10. Government Responses to the Crisis
Housing and Economic Recovery Act of 2008: Aimed to reduce foreclosure rates and excess
housing supply.
Emergency Economic Stabilization Act of 2008:
Injected $700 billion to stabilize financial institutions.
Included the Troubled Asset Relief Program (TARP) for bank capitalization.
Financial Reform Act of 2010 (Dodd-Frank Act):
Strengthened mortgage application requirements.
Required lenders to verify borrower qualifications.
Obligated institutions to retain 5% of MBS portfolios unless deemed low-risk.
Aimed to ensure unbiased ratings from credit rating agencies.
11. Summary
Mortgage Market: Involves complex interactions among financial intermediaries, investors, and
borrowers.
Types of Mortgages: Various classifications provide options for different borrower needs.
Mortgage Risks: Include credit, interest rate, and prepayment risks.
Mortgage-Backed Securities: A major innovation but also a significant source of risk.
2008-2009 Credit Crisis: Highlighted systemic risks and led to major regulatory changes aimed
at preventing future crises.

Chapter Ten: Stock Offerings and Investor Monitoring

1. Overview of Stock Markets
Stock markets facilitate equity investment into firms and allow for the transfer of equity
investments between investors.
There are eight major concepts covered:
Private Equity Market
Public Equity Market
Initial Public Offerings (IPOs)
Secondary Offerings and Stock Repurchases
Influence of Stock Market on Firm Management
Monitoring Publicly Traded Companies
Market for Corporate Control
Globalization of Stock Markets
2. Private Equity
Private Equity involves investments in privately held businesses, where shares are not available
to the public.
Founders and initial investors (e.g., friends and family) often provide initial capital.
Sources of private equity include:
Venture Capital (VC) Funds: Invest in early-stage businesses in exchange for minority stakes.
Exit strategy usually involves selling shares during an IPO.
Private Equity Funds: Typically acquire majority or full ownership of a company, focusing on
undervalued or mismanaged firms. Uses heavy borrowing to finance purchases.
Crowdfunding: Newer option, allowing firms to raise funds from many investors online via
platforms like Crowdfunder, Indiegogo, and Kickstarter.
3. Public Equity
Firms may go public to raise substantial equity, pay off debt, or allow founders to cash out.
Public offerings involve issuing stock in the Primary Market:
Common Stock: Shareholders have voting rights.
Preferred Stock: Typically no voting rights, but offers dividends.
The Secondary Market provides liquidity by enabling investors to trade previously issued
shares.
4. Initial Public Offerings (IPOs)
IPOs: A corporation’s first-time issuance of stock to the public to raise funds.
Process:
Developing a Prospectus.
Pricing & Book Building.
Allocation of Shares to underwriters.
IPO costs are around 7% of the funds raised.
Factors affecting post-IPO stock prices:
Investor actions (e.g., flipping).
Stabilization efforts by underwriters (e.g., over-allotment options, lock-up provisions).
Risks and challenges:
Overpricing.
Overly optimistic investors.
Potential for financial mismanagement or exaggerated financial statements.
5. Stock Offerings and Repurchases
Companies may issue new stock after going public through Secondary Offerings.
Firms repurchase shares if they believe the stock is undervalued, often to consolidate
ownership or manage capital structure.
6. Stock Exchanges
Secondary trading happens on organized exchanges or Over-The-Counter (OTC) markets.
Key US Stock Exchanges:
New York Stock Exchange (NYSE): Largest market with about 2400 companies.
NASDAQ: Focuses more on technology and growth companies with about 3600 listings.
Extended trading sessions are available beyond regular hours.
Stock Price Information: Available via financial websites, includes metrics like 52-week range,
P/E ratio, and trading volume.
Stock Indexes track market performance (e.g., Dow Jones, S&P 500).
7. Monitoring Publicly Traded Companies
Managers act as agents for shareholders; conflicts can arise (agency problems).
Analysts monitor firms, assigning ratings like "buy" or "sell."
The Sarbanes-Oxley Act (2002) aims to ensure accurate financial disclosures.
Shareholder Activism:
Influencing management through communication.
Engaging in proxy contests or legal actions.
Focusing on environmental, social, and governance (ESG) issues.
8. Market for Corporate Control
Poorly managed firms may be targets for acquisition.
Tools in corporate control:
Leveraged Buyouts (LBOs).
Barriers to acquisition:
Anti-Takeover Amendments.
Poison Pills.
Golden Parachutes.
9. Globalization of Stock Markets
Removal or reduction of barriers between countries enables global investments.
Privatization of government firms creates opportunities for foreign investment.
Emerging Markets allow access to large capital and investment opportunities.
Investors have several options to access foreign stocks:
Direct purchase on local exchanges.
Purchase via American Depository Receipts (ADRs).
Investing in International Mutual Funds (IMFs).
Buying International Exchange-Traded Funds (ETFs).
10. Conclusion
Businesses begin with private equity but may later tap into public equity for growth.
Institutional investors play a significant role in the stock markets.
IPOs are a key tool for expanding businesses and offering returns to early investors.
Monitoring and regulation are critical to managing agency problems and ensuring transparency.
Global stock markets offer diversification and investment opportunities across borders.
These notes encapsulate the major themes and topics discussed in Chapter 10 on Stock
Offerings and Investor Monitoring.

Chapter 11: Stock Valuation and Risk:

Overview of Stock Valuation
Stock values change continuously due to various factors, and both institutional and individual
investors engage in stock valuation to identify investment opportunities. This chapter focuses on
methods to evaluate stocks and measure risks, covering seven learning objectives:
Stock Valuation Methods:
Investors use stock valuation to find undervalued stocks or decide when to sell.
Common methods include:
Price-Earnings (PE) Ratio: A straightforward method using the average PE ratio of industry
competitors multiplied by the expected earnings per share (EPS) of the firm.
Limitations: Forecast errors, creative accounting, and inconsistent industry norms.
Dividend Discount Model (DDM): Uses future dividends to estimate the present value of the
stock.
Two variants:
Constant Dividend: Assumes perpetual dividends.
Growing Dividends: Assumes dividends grow at a constant rate.
Limitations: Inaccuracies in estimating dividends, growth rate, or the required rate of return.
Free Cash Flow Model: Evaluates firms that do not pay dividends by using estimated future
cash flows and existing liabilities to determine the value per share.
Limitations: Difficulty in accurate free cash flow estimation.
Determining the Required Rate of Return on Stocks:
Capital Asset Pricing Model (CAPM):
Formula: Rj=Rf+Bj×(Rm−Rf)R_j = R_f + B_j \times (R_m - R_f)Rj​=Rf​+Bj​×(Rm​−Rf​)
Key Components:
RfR_fRf​: Risk-free rate (e.g., Treasury yield).
BjB_jBj​: Stock’s beta (sensitivity to market returns).
Rm−RfR_m - R_fRm​−Rf​: Market risk premium.
Example: Vaxon Inc. with a beta of 1.2, a risk-free rate of 6%, and a market risk premium of 7%,
has a required return of 14.4%.
Factors Affecting Stock Prices:
Economic Factors: Economic growth, interest rates, and exchange rates.
Market-Related Factors: Investor sentiment and the "January Effect."
Firm-Specific Factors: Dividend policies, earnings surprises, acquisitions, and tax laws.
Indicators of Inflation & Government Borrowing: Influence the risk-free rate and required return.
Measuring Stock Risk:
Volatility: Indicates uncertainty of future returns, often measured through standard deviation.
Beta: Reflects sensitivity to market movements.
Examples:
Low Beta (less market sensitivity): Limited movement under market changes.
High Beta (high market sensitivity): Greater fluctuation in adverse or favorable conditions.
Portfolio Risk: Calculated as a weighted average of the beta of individual stocks.
Value at Risk (VaR): Estimates the largest expected loss for a given confidence interval based
on historical data.
Criticism: Can underestimate risk if based on a calm historical period.
Measuring Risk-Adjusted Stock Performance:
Sharpe Index: Assesses risk-adjusted return using the standard deviation of stock returns.
Formula: Sharpe Index=Rˉ−Rfˉσ\text{Sharpe Index} = \frac{\bar{R} - \bar{R_f}}{\sigma}Sharpe
Index=σRˉ−Rf​ˉ​
Rˉ\bar{R}Rˉ: Average return of stock.
Rfˉ\bar{R_f}Rf​ˉ​: Average risk-free return.
σ\sigmaσ: Standard deviation of stock returns.
Treynor Index: Uses beta as the risk measure.
Formula: Treynor Index=Rˉ−RfB\text{Treynor Index} = \frac{\bar{R} - R_f}{B}Treynor
Index=BRˉ−Rf​​
Example: Sooner stock has a higher Sharpe Index due to lower risk but a higher Treynor Index
due to higher market sensitivity (beta).
Stock Market Efficiency:
Stock prices should reflect all available information, and market efficiency can be classified into
three forms:
Weak-Form Efficiency: Prices reflect all past market data. No abnormal returns from trading on
historical data.
Semi-Strong Efficiency: Prices incorporate all publicly available information.
Strong-Form Efficiency: Prices reflect all information, including private or insider data.
Foreign Stock Valuation and Performance:
Foreign stocks can be valued similarly to domestic stocks using the PE ratio or DDM, adjusted
for international factors.
Benefits of investing in foreign markets include diversification, especially in emerging markets
with high growth potential.
Challenges: Inefficiency in smaller foreign markets due to fewer analysts and participants.
Key Concepts to Remember:
Valuation Models: PE ratio, DDM, and Free Cash Flow.
Required Rate of Return: Estimated using CAPM.
Economic and Market Factors: Affect future cash flows and the required return.
Risk Measurement: Includes volatility, beta, VaR, Sharpe Index, and Treynor Index.
Market Efficiency: Determines how well prices reflect available information.
Diversification: Benefits of international investments for risk management.