Saturday, September 20, 2008
Calculation of Monthly Mortgage Payments
With mortgages, we want to find the monthly payment required to totally pay down a borrowed principal over the course a number of payments. The standard mortgage formula is:
| Monthly Payment = |  |
| where P = | Principal |
| i = | Interest over Payment Frequency |
| n = | No. of monthly payments |
Similarly, the monthly mortgage payments can also be calculated by using the following formula:
Yield to Maturity
The yield to maturity is the annual return annual rate (discounted) earned over a bond kept until maturity. The yield to maturity is the discount rate estimated mathematically that equals the cash flow of payment of interest and principal received with the purchasing price of the bond.
This term is also referred to as internal rate of return or as the expected rate of return of the bond and it is the yield in which most bond investors are interested in.
Yield-to-Maturity Approximation Formula
| Yield to Maturity = | |
Using the approximation formula, the yield understates the true yield-to-maturity that is calculated using a computer. The reason is that the approximation formula does not use the time value of money for compounding of the coupon payments.
The yield-to-maturity depends on two assumptions:
- The bonds are held to maturity
- The interest payments received are reinvested at the same rate as the yield-to-maturity
If the bond is not kept until maturity, you could estimate the internal return rate of the bond by substituting the sales price of the bond for that of its maturity value and the period kept until the selling date for its maturity date.
The yield-to-maturity rate assumes that bondholders reinvest the received interests from the same yield-to-maturity. If this does not happen the owners return rate will differ from that of the quoted yield-to-maturity rate. For example, if the interest received is spent and not reinvested, the interest does not earn interest; the investor earns much lesser (or greater) rates, the 8% is not achieved. In reality matching the yield-to-maturity rate from the interest received is difficult because interest rates are changing constantly. The interest received is usually reinvested at different rates from the stated yield-to-maturity rate.
However, the yield-to-maturity is useful to compare and evaluate different bonds with variable qualities with different coupon rates and prices. For example when comparing the yield-to-maturity of an A&A-rated bond with a BBB-rated bond you can easily notice in how much would the yield increase when choosing the longer-rated bond. Also you will observe the yield differential between bonds with different periods of maturity.
The concept of current yield is closely related to other bond concepts, including yield to maturity, and coupon yield. The relationship between yield to maturity and coupon rate is as follows:
- When a bond sells at a discount, YTM > current yield > coupon yield.
- When a bond sells at a premium, coupon yield > current yield > YTM.
- When a bond sells at par, YTM = current yield = coupon yield.
Wednesday, September 17, 2008
AIG Fights For Survival
If we have learned anything over the last few days from the sudden demise of Lehman Brothers, it is that the markets are impatient and hate uncertainty, even if it leads to messy results.
American International Group (nyse: AIG - news - people ) is desperately trying to raise more capital to avoid meeting the same fate.
AIG has found a protector in the State of New York and its governor, David A. Paterson. Patterson, along with Eric R. Dinallo, New York’s superintendent of insurance, have made an exception to the rules governing the regulation of insurers that will allow AIG to tap into its own reserves that will perhaps enable it to obtain some sort of credit facility or additional capital. It will be used to help maintain the company’s credit rating. It may also be used as collateral.
AIG is in dire need of liquidity to tide it over until it raises additional financing.
New York’s governor has asked the Federal Reserve to provide short-term funding to AIG in order to send a strong message to Wall Street: The problems at AIG are not rooted in its fundamental business, but stem from a crisis of confidence. Should the Federal Reserve agree, it would be an unprecedented step, as it has never before provided liquidity to an insurer. Goldman Sachs (nyse: GS - news - people ) and JP Morgan Chase (nyse: JPM - news - people ) are also believed to be working together to try to arrange a $75 billion bridge loan that would involve a number of lenders.
Certainly, the Fed drew a line with Lehman, declining to provide actual support in terms of assuming potential losses. AIG knows that the government’s wallet has been slammed shut, so what it is seeking is a collateralized $40 billion bridge loan that would be paid back immediately upon it raising capital. A collateralized bridge loan would present no risk to taxpayers. The creation of a credit facility has also been discussed.
AIG is more than an insurance company. It is arguably the biggest player in the financial services industry. Most of the problems with its balance sheet were caused by AIG Financial Products Corp., a division that, like many investment banks, participated in financial risk-taking, including investments in credit default swaps written on collateralized debt obligations. These investments are now considered to be toxic. As of July 31, AIG’s total collateral related to this portfolio was $16.5 billion, and this figure is likely to climb.
If AIG fails, the implications would be truly extraordinary. It certainly won’t mean all of its underlying subsidiaries are unsound. The insurance divisions that make up its core would likely be salvaged, as they can be separated from the rest of the organization.
After the markets closed Monday, Fitch Ratings downgraded AIG’s long-term and short-term issuer default rating, as well as its senior unsecured debt and commercial paper program ratings. Fitch said AIG’s financial flexibility and ability to raise holding company cash are “extremely limited due to recent declines in the company’s stock price, widening credit spreads, and difficult capital market conditions."
Standard & Poor’s lowered its counterparty credit ratings (including long-term) and financial strength ratings on most of AIG's insurance operating subsidiaries. Moody's Investors Service downgraded the senior unsecured debt rating of AIG as well as the ratings of several AIG subsidiaries.
It would be in the interest of public policy for the regulators to separate the non-performing assets and problematic parts of the company from those that should and can continue. This would mean separating the insurance interests from the financial product divisions.
It wouldn’t make sense to let an insurer fail that is fully capable of paying claims and has adequate capital and financial strength. If there is an insolvency, it would be in the public’s best interest to allow the insurance entities to continue, however it will require a restructuring and even liquidation of the other assets within its portfolio. If that were not to happen, it would be destructive, as AIG is the largest commercial insurer in the U.S.
Should the company be split up, which is more than likely, it will probably hold onto its core property casualty business, spin off its auto insurance and life/annuities businesses, while selling its aircraft leasing division.
On Friday and Saturday, AIG was in discussions with Warren Buffett of Berkshire Hathaway (nyse: BRK - news - people ). Speculation was that they were negotiating a sale of the aircraft leasing division (Buffett owns NetJets). But at the same time, Berkshire Hathaway owns several large insurance entities, including Geico, so it may be interested in buying some of AIG’s insurance. It is doubtful, however, that Buffett would be interested in buying the whole enterprise.
A few minutes ago, CNBC's David Faber reported on the air that Buffett is "no longer" in talks with the insurer "about an investment or anything else."
"Don't count on Warren Buffett to "rescue" AIG as its white knight."
AIG [AIG 3.75
Faber reports that people familiar with the situation tell him that talks between Buffett's Berkshire Hathaway and AIG did take place last Friday and Saturday, but there's been nothing since then and nothing is happening now on that front.
Faber says AIG is focusing its attention on getting billions in bridge financing from the Federal Reserve, to allow for massive asset sales.
Current Berkshire stock prices:
Class A: [US;BRK.A 125000.0 
Class B: [US;BRK.B 4175.0
Tuesday, September 16, 2008
The collapse of Lehman Brothers
Why has Lehman Brothers collapsed?
In short, other banks refused to trade with it. Without the ability to trade, and without investors prepared to bet on its long-term viability, Lehman effectively had no business.
Why would the other banks not trade?
It is a repeat of the Northern Rock debacle. Lehman, while it was a large and complex business trading in a web of assets, also supported 100% mortgage loans offered by specialist lenders to people with few visible means of support. When interest rates jumped, borrowers could no longer afford their monthly payments.
Like Northern Rock, it mattered less that 80% of its assets were rock solid if 20% were considered toxic. We don't know the exact proportions at Lehman and neither do the bank's trading partners, which is why they refused in growing numbers to do business or buy it once the bank was up for sale.
Could the US government have stepped in?
The US treasury has reached the limit of taxpayer funds it is willing to gamble on propping up investment banks. Henry Paulson, the treasury secretary, committed £3 trillion last week to saving Fannie Mae and Freddie Mac. If they had failed, the mortgage market in the US would have collapsed and hundreds of banks around the world that invested in US property would suffer huge losses.
Paulson bailed out Bear Stearns earlier this year, but he appears to believe a trading house like Lehman, which has little direct connection with retail markets and ordinary homeowners, could be allowed to go bust without causing the kind of systemic risk posed by Fannie and Freddie.
Why was Barclays interested?
Barclays joined the talks at the weekend to buy Lehman because it was interested in picking up the bank on the cheap. It is a re-run of the proposed deal for Northern Rock by Lloyds TSB at the time of its collapse last summer.
Lloyds TSB offered to buy Northern Rock and accept its liabilities if the government was prepared to set aside £30bn in discounted loans to support the takeover. Barclays asked Paulson for the same kind of guarantee. He refused. The main City regulator, the Financial Services Authority, was also believed to have expressed concerns to Barclays boss John Varley that it was unwise to buy a US investment bank at this time.
Will everyone at Lehman's get the sack?
The administrators, PricewaterhouseCoopers, said the bank was centrally run from New York and therefore all its main businesses across Europe are wrecked. That puts 5,000 people who are employed at the bank, largely in Canary Wharf, out of work.
Will the whole bank be liquidated?
Not yet. Chapter 11 administration in the US allows PwC to take its time while it tries to find buyers for the least affected businesses. The year-long protection offered by Chapter 11 shields a company from creditors while it is reshaped or sold as a whole or in parts.
PWC said a number of group companies remain solvent and will continue to trade. "These companies include Lehman Brothers Asset Management (Europe) and a series of special-purpose vehicles designed to manage portfolios of residential and commercial real estate assets and non-performing loans."
What are the risks for other banks?
Share prices have tumbled and are likely to fall further as investors take flight from a sector that appears to be run by a group of bankers who are in denial about the extent of their mistakes and the problems their firms now face.
A flight of investors will make their situation worse because they are to a great extent dependent on their shareholders for capital. The capital provided by shareholders is the bedrock for their lending and without it they cannot continue trading.
What is the position with Bank of America and Merrill Lynch?
In many ways the sale of Merrill Lynch to Bank of America is a more startling development in the year-long credit crunch than the collapse of Lehman. It is understood that once it was obvious Lehman's was going under, Merrill realised it was vulnerable. The "thundering herd", as Merrill is affectionately known, was approached by Bank of America earlier this year, but rebuffed takeover talks. Now it was Merrill that went cap in hand to the US's largest retail bank for a rescue deal. Sceptics say the deal does little to resolve the problems faced by both firms, which are heavily mired in the US sub-prime home debacle.
What's going on at AIG?
American International Group (AIG), which sponsors Manchester United FC, was hit hard by deterioration in the credit markets last week and yesterday issued a statement that said it was reviewing its operations. Its stock dropped 45% since the start of the week amid concerns about the security of its assets, many of which are linked to the financial turmoil on Wall Street. Over the weekend it crafted a $40bn loan facility from the federal reserve, which had obviously taken the view that AIG posed more of a systemic risk than Lehman.
Who's next?
Washington Mutual is named by several analysts as the next to find itself in serious trouble. It was the subject of a rescue led by private equity firm Texas Pacific group in the spring. But the billions poured into its coffers no longer look sufficient to satisfy investors and they are taking flight. It is possible shareholders will flee Bank of America, if they consider Merrill Lynch a bad buy.
Another victim could be the US mono line insurers, so called because they only insure the bonds of large companies, including mortgage lending institutions. Like AIG, the insurance cover they provide could be invoked by customers and, like a tsunami, overwhelm their finances.
In the UK, mortgage banks such as Halifax owner HBOS, Alliance & Leicester and Bradford & Bingley, could suffer further if investors switch to safer havens.
Will it make a recession worse?
Yes. The CBI predicts a "shallow recession" next year, but this now appears optimistic. If the last five years of our decade-long economic boom were characterised by reckless lending, then living standards, along with property prices, have a long way to fall.
We are all spending money we simply don't have and when we stop it will spell the end for many jobs in retail, hospitality and may other industries. A fall in the value of the pound will help exporters and that will offset the worst of the economy's problems. But without banks willing or able to lend money to millions of people, except at sky-high interest rates, a long and deep recession seems inevitable.