ANALYSIS REPORT

COLLATERALIZED MORTGAGE OBLIGATION IN BANGLADESH MARKET

FINANCIAL MARKET & INSTITUTIONS
COURSE CODE - FIN433
SECTION - 03

SUBMITTED TO
MR. HASAN A. MAMUN [HMU]
SENIOR LECTURER
ACCOUNTING & FINANCE DEPARTMENT
NORTH SOUTH UNIVERSITY

SUBMITTED BY
TEAM X
MORSHED RAIHAN JOY ID: 1731076030
JUNAYED AHMED ID: 1811528630
MD. RAFIUZZAMAN ID: 1811626630
MAHBUB ALAM SHAWON ID: 1812384630
MEHRAB JAMI AUMIT ID: 1812818630

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 COLLATERALIZED MORTGAGE OBLIGATION (CMO)

CMOs are security of fixed income, using mortgage-backed securities as collateral. Like other
backed securities, CMOs are subdivided into graded risk classes, referred to as tranches that differ
in degree depending on mortgage maturity structure.
• CMOs are debt securities made up of bundled mortgages arranged according to their risk profile.
• They are comparable to Collateralized debt commitments, which represent a wider debt collection
through various financial instruments.
• CMOs played a positive role They ballooned in size during the 2008 financial crisis.

HOW DOES COLLATERALIZED MORTGAGE OBLIGATION WORK

When an investor buys a CMO, he or she buys some security class or tranche whose risk depends
on the mortgage maturity structure that supports it. Usually these tranches are designated as A,B,C
etc, and they increase the degree of risk as the letters ascend.

To illustrate, a CMO's Class A will be the lowest risk tranche offering the highest mortgage-based
rate of return that stays long-term until the lenders completely repay it. In this reason, they are
vulnerable not only to interest rate and default risk but also to the risk of prepayment, the possibility
that lenders may pay off the mortgage before the mortgage period such as15 years, 30 years etc
Class A will be the first of all tranches in this CMO to incur losses from failure by lenders to make
payments. But Class A will also be the first to receive prepayment money.

By comparison, a CMO's Class C will bring the holder with the least risk, but offer a much lower
return rate. This is because backing mortgages it is likely to reach their full repayment, meaning the
lender earns interest only, and maybe some principal payments from the remainder of the mortgage
term. Class C, CMOs will earn little to no prepayment returns for this purpose.

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 WHY COLLATERALIZED MORTGAGE OBLIGATION

Collateralized mortgage bonds give investors an ability to take advantage of a diversified collection
of mortgage-backed securities, and therefore risk-reduced. Subdivisions of CMOs into graduated
risk classes cater for prospective investors' risk preferences. In addition, similar to collateralized
loan obligations (or CLOs), CMOs offer a way for lending institutions to minimize interest and
default risk and increase their lending power through the transfer of structured securities debt to
investors.

HOW TO CREATE COLLATERALIZED MORTGAGE OBLIGATION

We know that CMO is created with regular payments which is from mortgages. Like other
mortgage CMO payments are made from different kind of bonds, which is called tranches. The
tranches pay the investors at different times and different rates. CMOs are sold to investors, so it
is clear that CMO is created by investment bank.

The process to create a CMO is to file a mortgage loan and then create tranches which represents
an ownership interest in the mortgage. Although, these trenches are also called bond, but have
little difference from the corporate and government bonds. So, to create a CMO an investment
bank, a bond market is necessary.

WHY CMO IN BD MARKET

In a developing country like Bangladesh, Collateralized Mortgage Obligations can play a huge
role in economic development. The banking sector of Bangladesh is in a vulnerable position. In
2018, seven state-owned and three private commercial banks were the victims of capital deficit
according to The Bangladesh Bank. Corruption and loopholes of the banking system are also
weakening the banking sector day by day. For the lack of proper usage of effective strategies and
proper monitoring policy, the banking sector of Bangladesh is facing a financial crisis. One of the
key reasons for this crisis is investors and borrowers are not paying back their money in due
time. Because of debt defaults, commercial banks are failing to operate their business operation
properly. Collateralized Mortgage Obligations will allow commercial banks to diversify their
loans and provide different types of loans based on how much risk each investor wants to take. It
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 can easily reduce the overall risk of debt defaults and help banks to earn more funds. Under the
supervision of investment banks, these loans will be provided. During a recession or financial
crisis, CMOs can also help the government to maintain economic stability. In 2008, CMOs
played a major role during the financial crisis. To fulfil investment objectives, CMOs can be the
key for the investors. In 2007, an agency issued $222.3 billion worth of CMOs. This CMOs
brought around $1.34 trillion worth of securities. In a word, we can say that Collateralized
Mortgage Obligations will allow commercial banks to lend and invest money safely as well as
give investors different options for their investment purpose. Overall it will help both investors
and commercial banks to ensure economic growth.

HOW TO LAUNCH CMO IN BD MARKET

• Investment banks, insurance company, pension funds and government agencies are needed to
conduct CMO.
• CMO bonds are different from normal bonds, so a bond market will be useful for CMO investors.
• Bangladesh doesn’t have a Strong bond market. So, the government has to establish a long-term
domestic bond market which will help to issue long term maturity bonds.
So, establishing the bond market will be easy to launch CMO in Bangladesh.

HOW IT’ll WOKS IN BD MARKET

Let's say,

Collateral pool loans 1000

Each amounting to ৳100,000

Total Collateral pool value ৳ 100 million

This pool can be used as follows to establish three tranches of securities which have different
characteristics:

Suppose Mr. X needs CMO and he went the bank and applied for CMO which is amount to
৳100 million. The bank will introduce him about the whole CMO process and how does it work.

At first the bank will talk about the types of the Tranches.

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 There will be 3 types:

• Tranche A

• Tranche B

• Tranche C

These 3 tranches will divide the Total Collateral pool value which is ৳ 100 million into 3

sections (Par Value: ৳ 50 million, ৳ 30 million and ৳ 20 million). Now at this stage bank will

introduce about the Interest Payment Method. For, ৳ (50, 30 and 20) million, the interest

payment method will be Monthly Based and it will be based on Outstanding Principal
Balance. At the final stage bank will talk about the Principal Payment Method. In this particular
section, it will not be same as interest payment method. For ৳ 50 million, all principal payments

including (scheduled and unplanned) will be collected before all principal receives pay-off. For ৳

30 million, all principal payments will be received after Tranche A has been paid off fully.
Finally, for ৳ 20 million, all principal payments will be received after Tranche B has been paid

off fully. This is the whole process can be followed by both consumers and banks in CMO
process.

- CHARECTERISTICS

The above table described the broad structure of how tranches work in Collateralized Mortgage
Obligations. Let’s look at some of its characteristics:

• In conjunction with the remaining balance, all tranches are paying interest payments.

• Tranche - A shall collect all major payments until paid out in full. This tranche first bears
all the danger of payment in advance and thereby covers other tranches. However, the
overall probability of advance payment remains the same.

• The same characteristics and threats would apply to all securities within a group.

• The shortest maturity will also follow Tranche A, followed by Tranche B and Tranche C.

• In comparison with passing securities, the final maturity of each tranche is more certain.

• Every segment fulfils the portfolio needs of various investors in a unique way.

• The CMOs are extremely sensitive to changes in interest rates.

• CMOs can provide collateral for pass-through securities pools.

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 CHANGES WILL SEE AFTER LAUNCHING CMO IN BD MARKET

Collateralized Mortgage Obligations creates three different tranches for different people. For
example, through initial research, a class of investors (Suppose Pensions) can find mortgage-backed
security too risky. On the other hand, another group of investors may want to take more risks
(Suppose Hedge Funds) to get more returns. In this case, investment banks could lose investors for
not managing their risk and yield properly. But Collateralized Mortgage Obligations allow banks to
split all of the securities into different classes and creates different tranches. Three different tranches
are created based or high and low risk-taking capability of the investors. These tranches are called
senior, mezzanine and equity tranches. Firstly, the holders of the senior tranches securities will get
paid first. Secondly, the owners of the mezzanine tranches will get paid. Finally, the owners of
equity trances will get paid. The credit rating company will give a higher rating to the senior people
as they are going to be paid first before everyone else. Senior people will now get insurance on this
and get a credit default swap. That makes senior people safe as they don’t want to take too much
risk. On the other hand, investors holding equity funds will get more interest as they want to take
more risks. That’s how with the help of Collateralized Mortgage Obligations, commercial banks
ensure investor satisfaction by splitting up risks for different types of investors.
- Commercial banks can convert illiquid securities to liquid securities with the help of
Collateralized Mortgage Obligations.
- Collateralized Mortgage Obligations provides a much higher rate of interest than corporate
bonds. Normally the returns of CMOs are 2-3% higher than corporate bonds.
- From the investor point of view, Collateralized Mortgage Obligations ensure more
flexibility. Investors can create different combinations to minimize risks and maximize
rewards.
- Banks can sell CMOs and earn more funds. Then the banks can easily use these funds to
invest in different profitable business sectors or lend money to the respective customers.
- Collateralized Mortgage Obligations reduce the overall risk of default loans of commercial
banks.
- CMOs offer regular payments to its investors.
- Collateralized Mortgage Obligations help commercial banks to increase their share prices.
- To ensure more liquidity in the economy, Collateralized Mortgage Obligations play a major
role.

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 - CMOs help to create new jobs and help the unemployed people to get a job. For example,
In Wall Street Banks, thousands of people were allowed to write computer programs and
bundle loans to create CMOs. Thus thousands of people were hired for new jobs.

CONCLUSION

CMOs are complex financial structures that are governed by the various terms associated with the
pool mortgages. As such, assessing the associated risks and returns isn't very easy. Investors often
get so distracted by the income that is expected to come that they fail to determine the underlying
price. This misunderstanding contributed to the Subprime Mortgage Crisis. This has led to increased
supervision by the regulatory bodies. CMOs are good investment options because, like anything
else, before making investment decisions, they need to be analyzed for any potential risks and
losses.

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 REFERENCE

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