Cross Calling

A method of redeeming bonds using surplus funds provided from an unrelated bond issue. Cross calling occurs when a lender, which repackages its loans into new securities, uses prepayments from low interest rate loans to repay principal on the high-yield securities.

The practice of cross-calling is seen in the mortgage-backed securities (MBS) market. However, it is seen as taboo because it shifts risk from high-yield investors to low-yield ones.

For example, let's examine a simple bank that has issued two mortgages with interest rates of 5% and 10%. The bank converts these into mortgage-backed securities and sells them to investors with coupon rates of 7% and 15%, respectively. Cross calling involves using prepayments from the 5% mortgage to pay principal on the 15% MBS. While this pays off the more risky bond faster, it forces the 7% bondholders to rely on risky payments from the 10% mortgage. The 7% bondholders are not compensated for the additional risk and the bank saves by making smaller interest payments.