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
