Collateralized Mortgage Obligations outline

Collateralized Mortgage Obligations (CMOs)

·        Issued in recent years

·        Issued by broker/dealers (B/D)

·        CMOs include GNMA, FNMA, Freddie Mac, Plain Vanilla, PAC, TAC CMO include 15,20,25 and 30 year home loans

·        Tranche-French for slice

·        Trance-life expectancy of a bond issued backed by GNMA, FNMA, other mortgage backed security

·        Mortgage backed debt such as GNMA includes a pool a mortgages from different banks, different borrowers

·        Debt is backed by mortgages on real property

·        Debt is secured by deeds of trusts, mortgage paper, or underlying properties

·        When CMOs are issued, each tranche will have its own interest and maturity

·        Weighted Average Coupon, interest produced from the interest from mortgages on underlying property

·        Weighted Average Maturity, made from average length of mortgages on property

·        WAC and WAM-separate calculations

·        Prepayment speed assumptions, PSA, benchmark of assumed principal speeds based on past prepayments for home loans

·        Prepayment speed based on interest of held loans and new interest rates

·        Present interest rates and future interest rates are factors in deciding yearly payment amount

·        PSA-benchmark-assumed yearly payback amount

·        Tranches issued in $1000 amounts

·        GNMA issued in $25,000 amounts

·        Tranches pay interest monthly, quarterly, semiannually

·        CMOs pay monthly

·        Interest rates decrease, prepayments on CMOs and companion tranches increase

·        Interest rates increase, prepayments on CMOs and companion tranches decrease or stop

 

CMO risk

·        Backed by pool of mortgages

·        Should decrease risk of unpaid repayment

·        GNMA, backed by government agency

·        Interest and principal are not guaranteed by U.S. government

·        Underlying securities-guaranteed

·        Payments-not guaranteed

·        When GNMA doesn’t back CMO, issuer backs CMO

·        No guarantees allowed-of yield, maturity, market value-vary by tranche

·        High rating, If backed by government agency

·        Rating by asset, if backed by other mortgage security

Plain vanilla CMOs

·        Plain vanilla, first CMOs, collateralized mortgage obligations

·        Newest CMOs-PAC and TAC

·        Plain vanilla, original CMOs

·        Created by B/D who bought a pool of mortgages or a pass through of securities-GNMA for their account and split them into tranches

·        Trustee holds pool of mortgages or pass-throughs as collateral for tranches

·        CMO creator breaks principal and interest apart into tranches

·        Shorter tranches, for early principal payments

·        Long maturity mortgages, interest for later

·        Yearly individuals pay principal and interest off on mortgage, excess can pay off principal in other tranches

·        Individuals may pay back less principal, tranches aren’t paid, due dates are extended

·        Interest on all tranches will be paid eventually

·        Principal is paid in a sequence

·        Earliest tranches paid with first principal

·        Interest is applied to tranches at tranche’s interest rate

·        Early payments of principal, applied to earliest tranches

·        Mortgage pool cash flows separated, variety of maturing mortgages decreases prepayment risk-create many tranches with individual Weighted Average Coupon and Weighed Average Maturity (WAM)

·        Cons: plain vanilla CMO-principal amount can take a long amount of time to be repaid or issue can be called early

PAC and TAC tranches

·        PAC and TAC companion securities reduce risk of prepayment of principal

·        If too much principal is paid, excess goes into prepayment companion-next earliest year-not into main tranche. As a result main tranche is more certain.

·        PAC CMOs have extension risk companion

·        TAC CMO, no extension risk companion

·        Prepayment companion security-life decreases when interest rates decrease

·        Extension risk companion security-life increases when interest rates increase

·        Companion securities have higher yields than original PACs or TACS, if companion securities called, investors don’t receive higher yields

Difference between PAC tranche and TAC tranche:

·        PAC CMO has main tranche, 2 companion securities-1 for early payment of principal, 1 for extension risk: payments made late by mortgage holders

·        TAC CMO has main tranche, 1 companion security-prepayment companion security-more likely to be retired late than PAC

·        Investor in PAC or TAC CMO can a)invest in main tranche, b)invest in 1 of companion securities, c) spread investment dollars into a combination of one of the tranches and 1 of companion securities

·        Main tranche-greater chance of quick payment, on time

·        Companion securities a)risk of early call-prepayment companion, b) longer payment period-extension risk companion securities

·        Buy PAC, more likely to get paid at end of tranche

·        Buy TAC, longer period more likely but more protection against early calls

·        Buy PAC or TAC-likely to be paid early-prepayment companion or have longer pay back period-extension risk companion

CMOs and regular bonds

·        Regular government, corporate and municipal bonds are issued at face value a)pay interest 2x a year, b)return principal at maturity

·        Plain Vanilla CMOs, TACs, PACs, a)issued at face value, b)pay interest monthly, 4 times a year, 2x a year, c)principal might or might not be paid on expiration date

·        CMOs-investment return may vary a)concern: prepayment b)concern: extension of payment c)concern: changing interest rates

·        CMOs described by “average life” instead of maturity date

·        Average life, average time each principal $ will take to be paid back

Four classes

·        A tranche: get interest 12x a year or 2x a year

·        B tranche: get interest 12x a year or 2x a year

·        C tranche: get interest 12x a year or 2x a year

·        Y tranche: receive interest after other classes are paid off

·        Z tranche: receive interest after other classes are paid off, similar to zero coupon bond

Which of the following is true regarding Collateralized Mortgage Obligation issues?

·        Each tranche of a CMO has its own maturity and interest rate

·        Each tranche is a bond of $1000 increment

·        Interest rates increase, prepayments decrease, mortgage holders don’t refinance

·        No guarantee by U.S. government

·        Backed by underlying mortgage securities GNMAs

 

 

Government securities outline

Government securities outline

• U.S. government securities: U.S. government issues bonds to get $ for day-to-day operations of the federal government as well as past debts
• considered safe, stable, easy to sell
• only issued in book entry form
• buyer receives conformation from government or broker/dealer (B/D)
• discontinued: certificate form

bills

·         maturity less < 1 year

·         sold as 4,13,26,52 week maturity instruments

·         1 mo, 3 mo, 6mo, 1 year bills

·         Do not exist: 9 mo bills

·         Department of the treasury (DOT) sells treasury bills under direction of the Federal Open Market Committee (FOMC)

·         FOMC run by members of Federal Reserve Board (FRB)

·         T-bills are sold at a discounted purchase price=yield to investor

·         Buy at discount, mature at face value

·         FOMC tells DOT amount to issue @ maturity dates and sets a max interest rate for auction

·         Sold at auction on Mondays and Tuesdays

·         Paid for on following Thursday

·         Competitive bidders who submitted lowest bids get their bills at the highest bid

·         Noncompetitive buyers receive their T-bills at the highest yield same as competitive bidders

·         Discount depends on length of time before maturity and %age yield at which t-bill purchased

·         Purchased by banks, financial institutions, mutual funds, broker/dealers(B/Ds)

·         Individual investors purchase them for their short term investments

Notes

·         Bonds, maturity 1-10 years

·         2,3,5,7, 10 year maturities

·         Min. $1,000, usually sold in $5,000 to $1,000,000

·         Fixed rate of interest, paid 2x a year

Bonds

·         Maturity: 30 years

·         $1,000 minimum, usually $5,000 to $1,000,000

·         Fixed rate of interest, paid 2x a year

·         Interest calculated by actual # of days and 365 day year

·         Might be callable, if call date included

·         Not all callable

·         Callable, Treasury can refinance its debt if interest rates fall

STRIPS

·         Treasury introduced-1997

·         Variable rate government security

·         Newest of issued securities

·         Principal-adjusted for inflation

·         Same interest rate

·         Issued interest rate is set, remains same until maturity

·         Principal adjusted for inflation but never below par

·         Value of principal at maturity is paid even if more than original amount paid

·         Semiannual interest payments are based on inflation-adjusted principal at the time interest is paid and when the interest rate is applied to adjusted principal value the amount of payment increases

·         Redeemed at greater of inflation adjusted principal or par amount at maturity

Treasury STRIPS

·         Thought to be issued by the federal government but are actually issued by broker/dealers and backed by U.S. government securities

·         Known as Treasury receipts

·         CATs, TIGRs, LIONs-past

·         Separate Trading of Registered Interest and Principal Securities

·         Notes or bonds issued by Broker/Dealers and some banks who separated interest from principal of investment

·         Financial institution or broker/dealer will purchase the bond or note and “strip” the interest from principal for separate trading

·         Bond or note is sold at a discount with the discount equal to the interest that would have been paid on the bond

·         Interest payments are traded separately, a 10 yr note will be converted into 21 securities representing semiannual payment and final payment of the bond

·         Principal of note or bond is resold as a zero coupon debt security-no interest payments

·         Appreciation=interest at maturity

·         Difference between discount price and face value of the bond is the amount of interest that is paid to the investor

·         Stripped off interest is resold as a zero coupon security with maturities on each of interest payment dates

·         Investors holding STRIPS are paid at same time as government pays holders of original securities

·         Appreciation becomes interest, realized @ maturity of STRIPS @ face value

·         Amount of discount for STRIPs must be amortized (averaged) over the life of the bond and claimed as income on each year’s tax return and claimed as income on each year’s tax return during time bond is held, just as if interest had been received each year

·         At maturity, holder receives face value but only has to pay taxes on final year’s interest rather than paying them on total appreciation of bond

·         STRIPS/zero coupon bonds may be a suitable investment for a minor’s college fund because the bond interest is taxed at the minor’s income tax rate

·         Zero coupon bond may be suitable for an IRA account because the interest will not have to be reported each year

Maturity of securities

·         Treasury bills, T-bills, mature in 1mo, 3mo,6mo,12mo

·         Treasury notes,1-10 years mostly 2,3,5,7,10 years

·         Treasury bonds, 30 years

A U.S. government security that matures within one to ten years is called? A Treasury note

Guaranteed

·         When the federal government issues Treasury bills, notes or bonds it guarantees the principal and interest

·         Bills, notes, bonds-backed by the “full faith and credit” of the U.S. government

·         Federal agencies, corporations controlled and supervised by the federal government

·         Securities (bonds) are guaranteed by the full faith and credit of the U.S. government

·         Export-Import bank (Eximbank) used for trade between U.S. and foreign countries

·         Small business administration: provides loans and management assistance to small business

·         Government National Mortgage Association (GNMA)

·         GNMA aka Ginnie Mae

·         GNMA is under authority of the U.S. government (agency)

·         GNMA issues pass through certificates-bonds that represent a pool of mortgages including Department of Veterans Affairs and from the Federal Housing Administration-GNMA guaranteed, mortgages included in GNMA-not guaranteed

·         GNMA issued at 50 basis points less than pooled mortgages

·         GNMA issued with interest comparable to loans that are pooled

·         Issued in $25,000 minimum quantities

·         Investor receives monthly payments of interest & principal

·         Known as monthly pass throughs

·         Receipt of payments from borrowers of mortgage loans affects the principal and interest that is paid to the investor

·         A portion of principal is paid down each month by borrowers, refinancing of mortgages affects interest paid to investors

·         When investors buy these securities in the secondary market they do not have to pay the full $25,000 principal. They pay a %age of the $25,000 face value depending on how much has been paid in prepayments and in the monthly payments

·         Which of the following is true regarding GNMA issued securities? They are issued at a yield that is 50 basis points below the pool of mortgages. They are not for conventional loans or for farm loans. Must be purchased at least in $25,000 and then $5,000 increments after that.