1. Copyright © 2003 by South-Western/Thomson Learning. All rights reserved. CHAPTER 18 The Debt Markets

2. Copyright © 2003 by South-Western/Thomson Learning. All rights reserved. The Risk of Investing in Mortgages Default Risk The risk that the borrower will not make the principal and interest payments as scheduled. The longer the term it maturity, the greater the default risk because the more distance future becomes more uncertain. The lower the down payment, the greater the default risk. The borrower has less to lose by defaulting. If interest rates rise, the default risk on variable-rate loans increases because monthly payments rise and the borrower is less able to afford them. Interest Rate Risk The risk that interest rates rise and the value of long-term mortgages declines. Also, if long-term mortgages are funded with short-term deposits, the spread between the earnings on assets and costs of liabilities narrows and may become negative. The longer the term to maturity, the greater the interest rate risk. Variable-rate loans reduce the interest rate risk. Prepayment Risk The risk that mortgages will be prepaid early and that the funds will have to be reinvested at a lower return. Prepayment risk increases greatly when interest rates fall, particularly if they stay low for a significant period of time. Prepayment risk is much less for variable-rate loans than for fixed-rate loans.

3. Copyright © 2003 by South-Western/Thomson Learning. All rights reserved. Factors That Affect the Discount Factor for Bonds Factors that affect the risk-free rate: The stance of monetary policy Changes in inflationary expectations Changes in the level of economic activity Changes in capital inflows Changes in government borrowing Factors that affect the risk premium: The credit rating of the bond as determined by Moody’s and Standard & Poor’s The economic outlook The capital structure of the firm Other firm-specific conditions Losses in international markets Factors that affect servicing costs: Any factors that affect the servicing costs of the loan such as changes in technology that reduce servicing costs

4. Copyright © 2003 by South-Western/Thomson Learning. All rights reserved. Factors That Affect the Discount Factor for Mortgages Factors that affect the risk-free rate: The stance of monetary policy Changes in inflationary expectations Changes in the economic outlook and the level of economic activity Changes in capital inflows Changes in government borrowing Factors that affect the risk premium: Changes in the economic outlook and the level of economic activity (pertains to uninsured mortgages only) The prepayment risk that the mortgage will be prepaid early and the the lenders’ reinvestment options are less desirable than when the original mortgage was made (pertains to insured and uninsured mortgages) Changes in the relative liquidity of mortgages and mortgage-backed securities relative to Treasury securities