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value at maturity, and is a different measure than yield to maturity. The differences are ex-
plored in Part Three.

Mortgages and Mortgage-Backed Securities
Thirty years ago, your investments text probably would not have included a section on mort-
gage loans, for investors could not invest in these loans. Now, because of the explosion in
mortgage-backed securities, almost anyone can invest in a portfolio of mortgage loans, and
these securities have become a major component of the fixed-income market.
Until the 1970s, almost all home mortgages were written for a long term (15- to 30-year
maturity), with a fixed interest rate over the life of the loan, and with equal, fixed monthly
payments. These so-called conventional mortgages are still the most popular, but a diverse set
of alternative mortgage designs have appeared.
Fixed-rate mortgages can create considerable difficulties for banks in years of increasing
interest rates. Because banks commonly issue short-term liabilities (the deposits of their cus-
tomers) and hold long-term assets, such as fixed-rate mortgages, they suffer losses when in-
terest rates increase. The rates they pay on deposits increase, while their mortgage income
remains fixed.
A response to this problem is the adjustable-rate mortgage. These mortgages require the
borrower to pay an interest rate that varies with some measure of the current market interest
rate. The interest rate, for example, might be set at two points above the current rate on one-
year Treasury bills and might be adjusted once a year. Often, the maximum interest rate
change within a year and over the life of the loan is limited. The adjustable-rate contract shifts
the risk of fluctuations in interest rates from the bank to the borrower.
Because of the shifting of interest rate risk to their customers, lenders are willing to offer
lower rates on adjustable-rate mortgages than on conventional fixed-rate mortgages. This has
encouraged borrowers during periods of high interest rates, such as in the early 1980s. But as
interest rates fall, conventional mortgages tend to regain popularity.
A mortgage-backed security is either an ownership claim in a pool of mortgages or an ob-
ligation that is secured by such a pool. These claims represent securitization of mortgage
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38 Part ONE Elements of Investments

loans. Mortgage lenders originate loans and then sell packages of these loans in the secondary
market. Specifically, they sell their claim to the cash inflows from the mortgages as those
loans are paid off. The mortgage originator continues to service the loan, collecting principal
and interest payments, and passes these payments along to the purchaser of the mortgage. For
this reason, these mortgage-backed securities are called pass-throughs.
Mortgage-backed pass-through securities were introduced by the Government National
Mortgage Association (GNMA, or Ginnie Mae) in 1970. GNMA pass-throughs carry a guar-
antee from the U.S. government that ensures timely payment of principal and interest, even if



$ billion





F I G U R E 2.8
Mortgage-backed securities outstanding
Source: Flow of Funds Accounts of the U.S., Board of Governors of the Federal Reserve System, June 2001.

Subprime Mortgage Lending
Go to the Federal Reserve Bank of San Francisco™s website, http://www.frbsf.org/
publications/economics/letter/2001/el2001-38.pdf , to access Elizabeth Laderman™s
article “Subprime Mortgage Lending and the Capital Markets.”
After reading this article, answer the following questions:
1. What is subprime lending?
2. Describe the growth characteristics of this market. What role has securitization
played in development of subprime lending?
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2 Global Financial Instruments

the borrower defaults on the mortgage. This guarantee increases the marketability of the pass-
through. Thus, investors can buy and sell GNMA securities like any other bond.
Other mortgage pass-throughs have since become popular. These are sponsored by FNMA
(Fannie Mae) and FHLMC (Freddie Mac). By 2001, more than $2.5 trillion of outstanding
mortgages were securitized into mortgage-backed securities, making the mortgage-backed
securities market larger than the $2.4 trillion corporate bond market and nearly the size of the
$3 trillion market in Treasury securities. Figure 2.8 illustrates the explosive growth of these
securities since 1979.
The success of mortgage-backed pass-throughs has encouraged the introduction of pass-
through securities backed by other assets. These “asset-backed” securities have grown rapidly,
from a level of about $316 billion in 1995 to $1,202 billion in 2001.

Common Stock as Ownership Shares
Common stocks, also known as equity securities, or equities, represent ownership shares in common stocks
a corporation. Each share of common stock entitles its owners to one vote on any matters of Ownership shares
corporate governance put to a vote at the corporation™s annual meeting and to a share in the fi- in a publicly held
nancial benefits of ownership1 (e.g., the right to any dividends that the corporation may choose corporation.
Shareholders have
to distribute).
voting rights and may
A corporation is controlled by a board of directors elected by the shareholders.2 The board,
receive dividends.
which meets only a few times each year, selects managers who run the corporation on a day-
to-day basis. Managers have the authority to make most business decisions without the
board™s approval. The board™s mandate is to oversee management to ensure that it acts in the
best interests of shareholders.
The members of the board are elected at the annual meeting. Shareholders who do not at-
tend the annual meeting can vote by proxy, empowering another party to vote in their name.
Management usually solicits the proxies of shareholders and normally gets a vast majority of
these proxy votes. Thus, management usually has considerable discretion to run the firm as it
sees fit, without daily oversight from the equityholders who actually own the firm.
We noted in Chapter 1 that there are several mechanisms to alleviate the potential agency
problems that might arise from this arrangement. Among these are compensation schemes that
link the success of the manager to that of the firm; oversight by the board of directors as well
as outsiders such as security analysts, creditors, or large institutional investors; the threat of a
proxy contest in which unhappy shareholders attempt to replace the current management
team; or the threat of a takeover by another firm.
The common stock of most large corporations can be bought or sold freely on one or more
of the stock exchanges. A corporation whose stock is not publicly traded is said to be closely
held. In most closely held corporations, the owners of the firm also take an active role in its
management. Takeovers generally are not an issue.

Sometimes a corporation issues two classes of common stock, one bearing the right to vote, the other not. Because
of their restricted rights, the nonvoting stocks sell for a lower price, reflecting the value of control.
The voting system specified in the corporate articles determines the chances of affecting the elections to specific di-
rectorship seats. In a majority voting system, each shareholder can cast one vote per share for each seat. A cumulative
voting system allows shareholders to concentrate all their votes in one seat, enabling minority shareholders to gain
Bodie’Kane’Marcus: I. Elements of Investments 2. Global Financial © The McGraw’Hill
Essentials of Investments, Instruments Companies, 2003
Fifth Edition

40 Part ONE Elements of Investments

Characteristics of Common Stock
The two most important characteristics of common stock as an investment are its residual
claim and its limited liability features.
Residual claim means stockholders are the last in line of all those who have a claim on the
assets and income of the corporation. In a liquidation of the firm™s assets, the shareholders
have claim to what is left after paying all other claimants, such as the tax authorities, employ-
ees, suppliers, bondholders, and other creditors. In a going concern, shareholders have claim
to the part of operating income left after interest and income taxes have been paid. Manage-
ment either can pay this residual as cash dividends to shareholders or reinvest it in the busi-
ness to increase the value of the shares.
Limited liability means that the most shareholders can lose in event of the failure of the
corporation is their original investment. Shareholders are not like owners of unincorporated
businesses, whose creditors can lay claim to the personal assets of the owner”such as
houses, cars, and furniture. In the event of the firm™s bankruptcy, corporate stockholders at
worst have worthless stock. They are not personally liable for the firm™s obligations: Their
liability is limited.

3. a. If you buy 100 shares of IBM common stock, to what are you entitled?
b. What is the most money you can make over the next year?
CHECK c. If you pay $95 per share, what is the most money you could lose over the

Stock Market Listings
Figure 2.9 is a partial listing from The Wall Street Journal of stocks traded on the New York
Stock Exchange. The NYSE is one of several markets in which investors may buy or sell
shares of stock. We will examine issues of trading in these markets in the next chapter.
To interpret the information provided for each stock, consider the highlighted listing for
General Electric. The first column is the percentage change in the stock price from the start of
the year. GE shares have fallen 22.3% this year. The next two columns give the highest and
lowest prices at which the stock has traded during the previous 52 weeks, $57.88 and $28.50,
respectively. Until 1997, the minimum “tick size” on the New York Stock Exchange was $1„8,
which meant that prices could be quoted only as dollars and eighths of dollars. In 1997, all
U.S. exchanges began allowing price quotes in increments of $ 1„16. By 2001, U.S. markets

F I G U R E 2.9
Listing of stocks traded
on the New York Stock
Source: From The Wall Street
Journal, October 19, 2001.
Reprinted by permission of
Dow Jones & Company, Inc.
via Copyright Clearance
Center, Inc. © 2001 Dow
Jones & Company, Inc. All
Rights Reserved Worldwide.
Bodie’Kane’Marcus: I. Elements of Investments 2. Global Financial © The McGraw’Hill
Essentials of Investments, Instruments Companies, 2003
Fifth Edition

2 Global Financial Instruments

moved to decimal pricing, which means that stock prices can be quoted in terms of dollars and
cents, as in Figure 2.9.
The .64 figure in the listing for GE means that the last quarter™s dividend was $.16 a share,
which is consistent with annual dividend payments of $.16 4 $.64. This value corre-
sponds to a dividend yield of 1.7%: Since GE stock is selling at 37.25 (the last recorded, or
“close,” price in the next-to-last column), the dividend yield is .64/37.25 .017, or 1.7%.
The stock listings show that dividend yields vary widely among firms. High dividend-yield
stocks are not necessarily better investments than low-yield stocks. Total return to an investor
comes from both dividends and capital gains, or appreciation in the value of the stock. Low
dividend-yield firms presumably offer greater prospects for capital gains, or else investors
would not be willing to hold the low-yield firms in their portfolios.
The P/E ratio, or price-to-earnings ratio, is the ratio of the current stock price to last year™s
earnings. The P/E ratio tells us how much stock purchasers must pay per dollar of earnings the
firm generates for each share. For GE, the ratio of price to earnings is 27. The P/E ratio also
varies widely across firms. Where the dividend yield and P/E ratio are not reported in Figure
2.9, the firms have zero dividends, or zero or negative earnings. We shall have much to say
about P/E ratios in Part Four.
The sales column (“Vol”) shows that 151,392 hundred shares of GE were traded on this


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