ECONOMICS 3310 WRITING ASSIGNMENT
July, 2008: WORLDTOP is an investment bank headquartered in Boston, Massachusetts. As an investment bank, WORLDTOP does not accept deposits and is not subject to reserve requirements. WORLDTOP specializes in securitizing mortgages to create mortgage-backed securities (MBS’s). By bundling thousands of individual mortgages into a single MBS, it creates a security that is much like a bond. The MBS typically pays a higher rate of interest than many Treasury and Corporate bonds, and it has the additional advantage of built-in collateral (in the form of the real estate against which each mortgage is lent). In prior years WORLDTOP had rapidly sold the mortgage backed securities to third party investor as soon as each MBS was created, but starting in 2006 WORLDTOP has been retaining the MBS’s on its balance sheet. The WORLDTOP balance sheet is simple, with assets comprising $17 billion in MBS’s, plus $2 billion in cash and short-term US Treasury securities. Liabilities total $18 billion, with $2.4 billion in unsecured commercial paper (4 month average maturity, with one quarter of the commercial paper refinanced each month), and $15.6 billion in repo financing backed by the MBS’s as repo collateral. The repos have maturities of up to 1 month and are continuously “rolled over” or refinanced as they become due. WORLDTOP’s equity capital represents the total of primary sales of stock plus retained earnings over the years. Its current stock price is $50 per share, down from $85 per share one year ago.
At the current time (July 2008), investors and creditors of WORLDTOP are starting to worry about the firm’s prospects. The market value of MBS’s has started to fall as home prices have peaked and mortgage defaults and foreclosure rates have started to climb. Citibank, WORLDTOP’s banker, has begun to demand collateral to back the commercial paper it buys from WORLDTOP (in the past no collateral had to be posted). Citibank has accepted the pledge of $2 billion in cash and US Treasury securities as adequate collateral to back the $2.4 billion in commercial paper that is continually refinanced. But Citibank has also grown worried about the repo loans that it provides to WORLDTOP, which are backed by the MBS’s as collateral. Currently, the $17 billion in MBS assets on the balance sheet of WORLDTOP is more than enough to back the $15.6 billion in outstanding repos, but Citibank has put WORLDTOP on notice that the value of the MBS collateral must be at least equal to the repo amount borrowed. When interviewed for this article, the CEO of WORLDTOP said “We are a profitable firm, paying about 3% annual interest to acquire funds via commercial paper and repos, and holding mortgage-backed securities that yield over 6.5%. As long as we can maintain liquidity, we’re in great shape.”
Create a “T account” balance sheet for WORLDTOP and analyze their financial situation in terms of liquidity, capital ratio, capital adequacy, and other metrics that fully reflect the situation that this investment bank finds itself in. How can WORLDTOP improve its liquidity and capital adequacy? Describe in detail advantages and disadvantages for WORLDTOP if it takes these steps. Re-analyze WORLDTOP’s financial position (including quantitative measures of liquidity and capital ratios) if the value of its mortgage-backed securities falls by 5%. Use supply/demand graphical analysis to explain why the market value of MBS’s would be expected to fall if many financial intermediaries found themselves in the same situation as WORLDTOP. What is the overall prognosis for WORLDTOP? Comment on the quote from the WORLDTOP CEO. What should they do?
Instructions: Write a brief essay analyzing the italicized article, and performing the analysis as stated in the paragraph above. Use the analysis tools that we have developed in this course. Use graphs to illustrate your supply/demand analysis, and include calculations to back up your quantitative analysis. The goal is to rigorously analyze the situation, carefully explaining the meaning of any graphs and calculations using the theory we developed in this course. If further assumptions or financial data are needed for your analysis, state them in your essay. The objective of this assignment is to see what you are able to produce given only the information provided, without hints or advice from me or others. Do not collaborate with or consult anyone else regarding this assignment. It is to be entirely your own work. If you are confused about something, do the best you can and state your assumptions. Extended re-statement of the article’s content or material from the text is not satisfactory; the goal is to present your own analysis. You will be graded on the quality of your writing as well as on content. Start early, allowing yourself enough time to go through multiple drafts before submitting the final copy. You are limited to 2 pages of text (you can use additional space for graphs, balance sheets and calculations), so your writing must be clear but substantive. You must submit the essay on paper (not online) no later than the start of class on November 26; DO NOT TURN IT IN LATE.
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