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