Intermediate Microeconomics and Its Application 12th Edition by Walter Nicholson,Christopher Snyder

Exercise 15

Discounting Cash Flows and Derivative Securities
The concept of present value can be applied to any pattern of cash inflows or outflows. This provides a general way to think about transactions that are really quite complex. Here, we look at two examples.
Mortgage-Backed Securities
Mortgages on houses are the most prevalent type of loan individuals make. These loans commit homeowners to pay a fixed monthly charge, typically for 30 years. Most mortgages also permit early repayments with no penalties. Because mortgages are so long-lived, an active secondary market in them has been developed that permits the initial lender to sell the mortgage to someone else. Often, many mortgages are bundled together in order to achieve economies of scale in buying and selling. Recent innovations in financial markets have carried this process one step further by creating new securities that represent only one portion of the cash flow from a pool of mortgages. These new securities are called "collateralized mortgage obligations" (CMOs). For example, one CMO might promise only the monthly interest payments from a given pool of mortgages. Another might promise all of the actual mortgage repayments from the same pool.
Calculation of the present value of a CMO is in principle a straightforward application of Equation 14A.25 in the appendix 14 to this chapter. Each expected cash flow must be appropriately discounted to the present day. Unfortunately, the fact that people can change their mortgage payoff practices rather sharply as conditions change makes the actual calculation subject to considerable uncertainty in practice.
The Fannie Mae Fiasco
Fannie Mae was the largest dealer in mortgage-backed securities in the United States. Its quasi-governmental status permitted it to borrow at fairly low rates and use the proceeds to invest in a wide variety of mortgage products. The firm's troubles began in 2002, when it encountered a "mismatch" between the timing of its mortgage receipts and the time pattern of payments on the loans it had. The situation was significantly worsened during 2008 as many of the mortgages that Fannie Mae held fell behind on their payments. Ultimately, the government took over the company, posing major potential costs to taxpayers.
Hedging Risks with Credit Default Swaps
Any buyer of a stream of payments faces the possibility that the borrower will default on these payments. A form of insurance against this is provided by credit default swaps (CDSs). These securities represent a promise to duplicate the proposed stream of payments if the borrower does default. Firms that offer such products receive an "insurance premium" for doing so. Pricing this premium for credit default swaps is difficult, however, both because the underlying probability of default can only be guessed at, and the (unknown) timing of a default also affects pricing.
The AIG Fiasco
Although buying CDSs can make considerable sense for riskaverse lenders, selling this derivative product can itself pose special risks, as the insurance firm AIG discovered in 2008. AIG was the largest seller of CDSs in the world. As credit conditions worsened early in 2008, the firm's potential exposure to defaults expanded significantly. Because most CDS contracts required that AIG post collateral to ensure that they could pay off on their CDS contracts, the firm rapidly discovered that it did not have enough collateral for this purpose. Ultimately, it turned to the U.S. government for emergency loans to satisfy the demands of its CDS buyers. Through a series of transactions, the Federal government loaned about $182 billion to AIG over a short period of time. By the end of 2012, however, virtually all of those funds had been repaid.
Should the development of derivative securities be subject to extensive regulation? Or should we just rely on the market to develop and price such financial innovations? Should the government provide temporary aid to firms when things turn out badly?