Decomposing Underwriting Spreads for GSEs and Frequent Issuer Financial Firms
Harrison, David M., Heuson, Andrea J., Seiler, Michael J., Journal of Real Estate Portfolio Management
Executive Summary. This paper investigates the determinants of underwriting fees charged to active government-sponsored enterprises (GSEs) and financial industry borrowers on debt issuances, how such fees change over time, and how they vary with the characteristics of the debt, underwriting mechanism, and issuer. We pay particular attention to how risk factors generated by the actions of individual mortgage borrowers, and the financing strategies put in place by the GSEs, impact underwriting spreads. We find spreads paid by both GSEs and privately-held financial firms were significantly influenced by risk-related developments in the market for housing finance well before the advent of the housing crisis.
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Securities underwriters are investment and commercial bankers who are intermediation experts that help borrowers market their new debt and equity issues to private and institutional investors in return for a fee.1 This fee, known as the underwriting spread, is the difference between the face amount issued and the proceeds actually received by the borrower. It compensates the underwriter for the distribution and information costs of publicizing the issue/issuer and for the risk inherent in bringing the issue to market.
During the housing boom, the size of the residential mortgage market, the degree to which mortgage-backed debt was integrated into asset portfolios held by large public and private U.S. financial intermediaries, and the intermediaries' reliance on bond market borrowing to fund investments in mortgage-backed securities all grew precipitously. In this paper, we investigate the extent to which the entities who underwrote the debt issues used (at least partially) to fund this investment in mortgages priced mortgage market risk factors and related financing strategies adopted by the corporate borrowers into their underwriting spreads.
We find that multiple housing-related risk factors had small, but sustained, statistically significant effects on the flotation costs paid by both housing and non-housing government-sponsored enterprises (GSEs) and by private financial firms that were active borrowers in the credit markets throughout our January 1995 to April 2010 sample period.2 First, underwriters reacted to decisions by individual borrowers that increased the uncertainty of payments on mortgage-backed debt (e.g., refinancing a primary loan or choosing adjustable instead of fixed-rate debt) by raising underwriting spreads. Second, financing and investment strategies adopted by the primary housing GSEs (Fannie Mae and Freddie Mac), as well as by the nonhousing GSEs (the Federal Home Loan Banks, the Farm Credit System, and Sallie Mae), had farreaching effects in that underwriting spreads rose as the GSEs consumed a larger and larger percentage of the overall funds raised in the credit market in the United States. Third, increased required returns in the marketplace, as measured by higher Treasury rates, higher credit risk spreads (the average yield on Baa-rated securities minus the average yield on Aaa-rated securities), and increased inflation expectations (measured by consumer surveys) all led to increased underwriting fees. Taken together, these results suggest the institutions that acted as underwriters of both GSE debt and issues floated by financial firms active in the credit market have a real-time, in-depth awareness of the characteristics of the debt and the financing/investment strategies of the issuer.
The remainder of this paper is organized as follows. The next section contains a brief review of the existing literature analyzing the pricing behavior of bond underwriters and identifies the various determinants of underwriting spreads. Then, our empirical model is developed and formalized. Estimation results, conclusions, and suggested extensions appear in the final section.
Determinants of Underwriting Spreads
Issue and Issuer Characteristics
Ederington (1975) develops and tests a simple model of the relationship between the risks involved in moving a bond issue through the primary market and the spread an underwriting syndicate charges for that service. …