Collateralized Mortgage Obligations and Stripped MBS

Chapter 12

CMO

securities developed to better deal with prepayment risk associated with PTs

bond classes created by redirecting CFs of mortgage-related products prepayment risk is still present but creation of CMO allows separation of prepayment risk into different securities

parties who can better handle one type of risk (extension or contraction) will now invest in ones best for them have created different securities that have different riskreturn characteristics

CMO Structure

backed by pool of PTs, loans, or stripped MBS

CMOs have different classes of bonds that have different maturities tranches classes retired on priority basis
tranches retired sequentially periodic interest to all tranches with first tranche receiving all principal payments (expected and prepays) principal pay-down window time period between beginning and ending of principal payments for specific tranche accrual tranche or Z bond receives no interest

Sequential Pay CMOs

Example
Tranche A B C D Par Amount Coupon Rate $194,500,000 7.5% 36,000,000 7.5% 96,500,000 7.5% 73,000,000 7.5%

Average Life

Z bond

Floating Rate Tranches

like with other securities, CMOs have varying structures to make more appealing to investors

can create a floating rate tranche by taking class and making floater and inverse floater

Floating Rate Tranches

in example, floating tranche will be $72,375,000 or 75% of $96.5m

K is cap for inverse floater and L is coupon leverage

K set at 28.5% and L set at 3 for this example K L (one-month LIBOR) is rate on inverse floater low leverage medium leverage high leverage

weighted average coupon rate has to equal 7.5%

assume LIBOR is 9%

floater rate 9.0% + 0.5% = 9.5% inverse floater rate 28.5 3(9%) = 1.5% WAC 0.75(9.5%) + 0.25(1.5%) = 7.5%

Planned Amortization Class Tranches

PAC bonds priority over other classes in area of principal payment

allows greater certainty of timing of CFs all prepayments go to support or companion bonds (other tranches) use initial collars to determine monthly expected payments to PAC bonds if prepayment speeds differ from those in initial collar, then average life changes

Payment Rules for PAC Tranche

Terminology for PACs

planned amortization bonds / support bonds

initial PAC collars busted term used when PAC schedule is broken effective collar once PAC bond is seasoned, the initial collars are not helpful in finding prepayment protection effective collar is used to help
lockout structure CMO structure with no principal payments to PAC bond class in earlier years (because create more support bonds) reverse structure requires any excess principal payments to be made to the longer PAC bonds after all support bonds are paid off

to give greater prepayment protection to PACs

CMO Terminology

agency CMOs / nonagency CMOs private label CMO private entity issues CMO but underlying collateral is pool of PTs guaranteed by an agency whole loan CMO collateral for CMO is pool of unsecuritized mortgage loans (interchangeable with nonagency CMO because most common type of nonagency is whole loan) CMO should be a REMIC in order to get tax benefits

Stripped MBS

alter distribution of CFs to one of unequal distribution to different classes types

synthetic coupon PTs first generation of stripped MBSs interest-only/principal-only securities mortgage strips CMO strips (structured IOs) one of CMO classes is IO or PO

Mortgage Strips

PO purchased at big discount from par

yield depends on speed of prepayments the faster the prepayments the higher the yield

when mortgage rates fall, prepayments are expected to speed up so CF to PO holder accelerates so price of PO increases (result is also in part due to lower discount rate)

Mortgage Strips

IO has no par value

investor in IO wants prepayments to slow because receive interest only on principal outstanding

if prepayments are too fast, investor may not recover cost of IO if rates decline, prepayments are expected to increase which results in loss in expected CF but CF discounted using lower rate (net result usually though is decline in price) if rates rise, expected CFs improve but CFs discounted at higher rate net result can be rise or fall in price of IO price tends to move in same direction as change in rates when

rates fall below coupon rate and for some range of rates above the coupon rate