Why Is The Allocation Of Credit Risk Less Of An Issue For Brady Bonds

4. When mortgages are pooled into securities, the pass-through agencies (Freddie Mac and Fannie Mae) typically guarantee the underlying mortgage loans. If the homeowner defaults on the loan, the pass-through agency makes good on the loan; the investor in the mortgage-backed security does not bear the credit risk.

a. Why does the allocation of risk to the pass-through agency rather than the security holder make economic sense?

b. Why is the allocation of credit risk less of an issue for Brady bonds?

bundling, unbundling

Creation of new securities either by combining primitive and derivative securities into one composite hybrid or by separating returns on an asset into classes.

Financial Engineering

Financial engineering refers to the creation of new securities by unbundling—breaking up and allocating the cash flows from one security to create several new securities—or by bundling—combining more than one security into a composite security. Such creative engineering of new investment products allows one to design securities with custom-tailored risk attributes. An example of bundling appears in Figure 1.3.

Boise Cascade, with the assistance of Goldman, Sachs and other underwriters, has issued a hybrid security with features of preferred stock combined with various call and put option contracts. The security is structured as preferred stock for four years, at which time it is converted into common stock of the company. However, the number of shares of common stock into which the security can be converted depends on the price of the stock in four years, which means that the security holders are exposed to risk similar to the risk they would bear if they held option positions on the firm.

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Lessons From The Intelligent Investor

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    why is the allocation of credit risk less of an issue for brady bonds
    7 years ago

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