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the value of Freddie Mac’s equity is always equal to
the present value of its Asset Spread to Market plus
the value of its Favourable Financing Assets. Thus, if
the present value of the Asset Spread to Market is
negative, the value of the Favourable Financing Assets
will exceed the value of equity. * * *
In order to illustrate this point, Professor Schaefer used the
following example:
A more concrete example is provided by the S&L crisis,
which featured negative Asset Spreads to Market, and
therefore Favourable Financing Assets with a higher
value than equity. In the early 1980s, when interest
rates rose sharply, the condition of many S&Ls
deteriorated as the value of their fixed-rate mortgage
assets fell. Suppose that, in September 1981 when
mortgage rates were above 15%, an S&L held fixed-rate
mortgages paying a rate of 6% and therefore selling at
around 40% of their face amount. Suppose further that
this S&L was fortunate in the sense that it was
entirely financed with core deposits * * * that paid 2%
and therefore, despite earning 6% on its assets when
market rates were 15%, it nonetheless earned a positive
spread of 4% (equal to the rate on its assets of 6%
less 2% paid on its liabilities).
To the extent that the core deposits remain in place,
this S&L is solvent. However, its positive net worth
does not come from its assets--these have fallen in
value by 60%--but from its liabilities. The total
spread of 4% is made up of a substantial and negative
Asset Spread to Market of--9% (a 6% asset return less a
15% market rate) and a large and positive Favourable
Financing benefit of 13% (the 15% market rate less the
2% paid on deposits). The value of the Favourable
Financing Assets for this S&L (the present value of the
13% spread) would clearly exceed the value of its
equity (the present value of the 4% spread).
17(...continued)
represents the “favourableness” of the firm’s assets,
just as the difference between the market and actual
financing rates represents the “favourableness” of the
firm’s liabilities. * * *
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