Academic journal article ABA Banking Journal

When Investments Begin to Sound like Politics, Watch Your Wallet

Academic journal article ABA Banking Journal

When Investments Begin to Sound like Politics, Watch Your Wallet

Article excerpt

Recently there has been much discussion in Washington regarding our budget deficit. Much talk has centered on entitlement programs like Social Security. Neither party relishes the task of confronting reality. Regardless of your politics, it is interesting to observe how addressing these specific programs is presented to the public.

Since the average age in America is rising, such programs generate much interest among the group they most affect--also the segment that carries the largest vote. One political party accuses the other of "cutting" programs as a way to curb debt, while the other party flatly denies that it is "cutting" spending, rather it is cutting the rate of growth of spending. What gives?

It is all in the presentation. It will take an educated voter to sift through all the rhetoric. Unfortunately, too many voters only hear what they want to hear.

What does politics have to do with investments? Unfortunately, too many investors only hear what they want to hear. Politics aside, we want to address a topic that is grossly misunderstood by investors in adjustable rate securities: Bond Equivalent Effective Margin (BEEM) over the index it adjusts against.

The presentation of adjustable-rate securities

Just as the entitlement programs mentioned above generate significant reactions by voters, adjustable-rate securities versus fixed generate strong reactions by bank investors. For this article, we will focus on the presentation of GNMA adjustable-rate mortgages, although the principles apply to most adjustables.

Typically, GNMA ARMs are presented as some effective margin over the 1-year constant maturity treasury (BEEM). Although these securities carry a maturity significantly longer than a 1-year treasury (in most cases they are 30-year pools with around a 10-year average life), these securities are not viewed as long-term securities but rather as a short-term risk. The reason given is that they reprice every year at 150 basis points over the 1-year treasury subject to a 1% annual cap and a 5% life cap from the initial coupon. Let's look at the presentation of a new issue GNMA 6.00% ARM with a life cap of 11% at a price of $98.50. (See "The Facts," below left.)

Because this security reprices annually, the fact that it is a 30-year pool is viewed as of little consequence. Likewise, even though the investor is receiving a "teaser" coupon (6.00% versus 7.25%, which is the margin of 150 basis points over the 5.75% 1-year treasury), the BEEM is calculated at 154 basis points over the 1-year treasury. Many investors who hear this automatically assume that they will receive a 154 basis point margin over the 1-year treasury regardless of what happens to future interest rates (as long as the 1-year stays below 9.75% which would then cause the ARM to hit its life cap of 11%). In essence, investors flock to ARMs because they don't want the price volatility that fixed-rate pools endure due to swings in long-term interest rates.

THE FACTS:

GNMA 30 year pool

Index: One year Treasury

1-year treasury: 5.75%

Coupon: 6.00%

MBS margin: reprices annually at 150 basis points over the 1-year treasury

Caps: 1% annually 11% life

Price: $98.50

[Part 1 of 2]

TABLE 1: GNMA 6% ARM @ 98.5%

6/17/96      up 300   up 200   up 100    unch

YIELD        10.29%    9.29%    8.29%   7.29%
1 YEAR CMT    8.75%    7.75%    6.75%   5.75%
BEEM            154      154      154     154

[Part 2 of 2]

TABLE 1: GNMA 6% ARM @ 98.5%

6/17/96      down 100   down 200   down 300

YIELD           6.29%      5.29%      4.29%
1 YEAR CMT      4.75%      3.75%      2.75%
BEEM              154        154        154

[Part 1 of 2]

TABLE 2: GNMA 6% ARM @ 98. … 
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