Collateralized Mortgage Obligations

1
Collateralized Mortgage Obligations

• Fabozzi--Chapter 12

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Introduction to CMOs

• The major risk associated with agency
  pass-throughs is prepayment risk.
• Many investors wanted securities with predictable
  maturities.
• In 1983, CMOs were created to reduce prepayment
  risk.
• CMOs are like MPT in that cash flows come from a
  large pool of mortgages
• However, streams of principal and interest are
  distributed to different classes (called
  tranches) of bondholders.
• Each bond (tranche) usually has a different
  principal, coupon rate, maturity, and prepayment
  risk.
• The most basic type of CMO is called a sequential
  CMO (or sequential-pay CMO)
• Comprises three or four tranches that mature
  sequentially.

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Example of Sequential Pay CMO

• Suppose there is an underlying pool of mortgages
  with a face value of 750 million.
• Four different bonds (tranches) are issued.

• All tranches receive interest payments from the
  pool of mortgages.
• However, only tranche A receives principal
  (scheduled and prepays) until the tranche has
  been paid off.
• Then, tranche B will receive principal payments
  until it is paid off, and so on.
• The principal paydown window (maturity) is based
  on some assumed PSA speed (e.g. 165 PSA)

Tranche Maturity (months) Principal
A 24 to 48 300,000
B 60 to 84 200,000
C 120 to 144 100,000
Z 180 to 288 150,000
Total 750,000
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The Z-Tranche
Tranche Maturity (months) Principal
A 24 to 48 300,000
B 60 to 84 200,000
C 120 to 144 100,000
Z 180 to 288 150,000
Total 500,000

• One tranche (the Z-tranche) receives no interest

• Instead, interest going to the Z-tranche is used
  to speed up the principal payoff of the other
  tranches.
• This protects other tranches from extension risk
  and helps stabilize the prepayments of other
  tranches.
• Z-tranche receives no interest or principal
  payments until all other tranches have been paid
  off (behaves like zero-coupon bond).
• Z-tranche bond investors have less reinvestment
  risk since they receive nothing until all other
  tranches mature.
• A CMO may have no Z-tranches, or it can have
  several.

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Floating-Rate Tranches

• Many financial institutions prefer floating-rate
  assets (to match their liabilities).
• This sparked the creation of floating rate
  tranches.
• Floating-rate tranches are created from
  fixed-rate tranches by creating a floater and
  inverse-floater
• Floaters (and inverse floaters) can be created
  from several tranches, one tranche, or a portion
  of one tranche.

Tranche Par Coupon
A 300,000 7.5
B 200,000 7.5
C 100,000 7.5
Z 150,000 7.5

Tranche Par Coupon
A 300,000 7.5
B 200,000 7.5
FL 75,000 LIBOR1 0.50
IFL 25,000 28.5 3?(LIBOR1)
Z 150,000 7.5
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Comments on Floating-Rate Tranches

• Interest rate payments on a floating-rate tranche
  varies due to
• Changes in interest rates.
• Prepayments (reduces principal and reduces
  interest payments).
• The inverse-floater rate is K L ? (LIBOR1)
• K the cap interest rate for the inverse
  floater.
• L the coupon leverage
• NOTE the higher L is, the more that the inverse
  floaters coupon changes for a given change in
  LIBOR1.
• K and L are set so that
• FL coup rate IFL coup rate Original tranche
  coup rate
• Example
• 0.75 ? (FL rate) 0.25 ? (IFL rate) 7.50

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PAC Tranches

• In the 1980s, there corporate bond market faced
  two trends, both unattractive to investors
• 1. Increased event risk.
• 2. A decline in the number of AAA-rated bonds.
• Investors liked the safety of MBSs but
  increasingly demanded corporate bond like
  structures
• A bullet maturity, or
• A sinking fund schedule of principal payment.
• Firms began offering structures that are now
  referred to as Planned Amortization Class (PAC)
  bonds.
• PAC bonds offer greater predictability of cash
  flow, much like a sinking fund does for corporate
  bonds.

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PAC Bonds

• PAC bonds have a fixed principal payment schedule
  unless prepayments are drastically different than
  expected
• The greater principal repayment certainty comes
  at the expense of non-PAC tranches called support
  or companion bonds.
• How do PAC tranches work?
• Prepayment speeds for PAC tranches are assumed to
  be between 90 PSA and 300 PSA, and scheduled
  principal payments will be based on the minimum
  of the two.
• As long as prepayments are between 90 PSA and 300
  PSA, principal payments will be as scheduled.
• If speed is slower than 90 PSA or faster than 300
  PSA (a broken PAC), then principal payments will
  not materialize as scheduled.
• Different PAC collars can be used (e.g., 75 PSA
  and 400 PSA).
• A CMO can have more than one PAC tranche.

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Comments on PACs

• With MBSs it is impossible to make prepayment
  risk disappear, even for CMOs.
• The reduction in prepayment risk must come from
  somewhere!
• That somewhere is the support bonds
• Support bondholders must forego principal
  payments if PAC collateral prepayments are slow.
• Support bondholders receive no principal until
  the PAC bondholders receive their schedule
  principal payments.
• Important point
• The prepayment protection offered to PAC bonds
  hinges on the amount of support bonds
  outstanding.
• If the support bonds are paid off due to faster
  than expected prepayments, then the PAC
  protection disappears (and the PAC becomes a
  sequential-pay CMO)

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Support Bonds and PACs

• Will the PAC schedule be satisfied if prepayments
  are faster than the upper collar? (suppose we
  have 500 PSA). The answer is it depends on
• When speed first increases to 500 PSA (the later
  the better)
• What the speed is prior to increasing to 500 PSA
  (if it was at 90 PSA thats much better than
  being at 300 PSA).
• In fact if speed is on the slower end of the
  collar, several consecutive months at 500 PSA may
  have little effect.
• Will the PAC schedule be satisfied if prepayments
  stay within the collar?
• It depends on where speeds are within the collar
  and when.

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Effective Collar (End Class 11/24)

• Often initial collars are not particularly useful
  for assessing the prepayment protection for a
  seasoned PAC bond.
• A better measure for seasoned PAC bonds is the
  effective collar
• This is the lower and upper PSA that can occur in
  the future and still preserve the scheduled
  principal payments.
• The effective collar changes each month
• If speeds remain below the upper PSA, then the
  upper PSA will increase over time because there
  is greater support than originally expected.
• If speeds remain below the lower PSA, then the
  lower PSA will increase over time because, it
  will take faster prepays to make up the shortfall
  needed for the scheduled PAC prepays.

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Ways To Create Greater PAC Protection

• Lockout structure
• Issue fewer PAC bonds relative to support bonds.
• Especially issue fewer PACs with shorter
  maturities (when the mortgages are paying a
  greater proportion of interest relative to
  principal).
• Reverse PAC structure
• Alter the payment rules so that excess principal
  payments go to the longest maturity PAC.

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Other PAC Tranches

• Targeted Amortization Class Bonds (TAC Bonds)
• Very Accurately Determined Maturity Bonds (VADM
  Bonds)
• Interest-Only Tranche
• Principal-Only Tranche
• Notional IOS

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TAC Bonds

• Are like PAC bonds except have a single PSA
• Principal payments will be met only if a single
  prepayment rate is met.
• Provides protection against contraction risk, but
  not extension risk (i.e., only one-sided payment
  protection).
• At other prepayment rates, TACs experience either
  excess or shortfalls.
• Offer more stability than sequential-pay CMO but
  less than a PAC.

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VADM Bonds

• A CMO structure where Z-bond interest accrues and
  is used to pay interest and principal on a VADM
  bond as scheduled.
• The VADM tranche receives scheduled prepayments
  even if no prepayments are made on the pool of
  underlying mortgages.
• VADMs have considerable protection against
  extension risk and some protection against
  contraction risk.

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Interest- and Principal Only Tranche

• Some bond classes are created so that they
  receive all the interest or all principal from a
  pool of mortgages.
• These are called either an IO bond class or PO
  bond class.
• Used in creating stripped mortgage backed
  securities.

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Notional IOS

• This is an interest-only tranche with no physical
  principal (it is notional).
• Most CMO deals pay a different coupon rate for
  each tranche
• Coupon rates are based on the term structure of
  interest rates, average life of the tranche, risk
  of the tranche, etc.
• Suppose the collateral (pool of mortgages) is
  paying 7.50, but a particular tranche receives
  only 6.0
• Where does the excess 150 bps go? To the
  notional tranche.
• The notional amount is the amount that yields the
  desired coupon rate.

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Support Bonds

• These are the bonds that provide prepayment
  protection for PAC tranches.
• They are most exposed to prepayment risk.
• Support bonds themselves can be further
  partitioned with into different classes of
  support bonds
• A PAC schedule can be formed from one of these
  classes and supported from the cash flows of
  subordinate support bonds (called PAC II bonds).
• PAC II bonds are more risky than PAC bonds, but
  offer higher yields.
• Likewise there are PAC III bonds (formed from the
  cash flows from support bonds of PAC II bonds)
  can be created.

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CMO Credit Risk

• As with mortgage pass-throughs, CMOs are
  classified as agency CMOs and non-agency CMOs
• Credit risk depends on whether the issuer is an
  agency (Freddie Mac, Fannie Mae, or Ginnie Mae)
  or a private institution.
• Non-agency CMOs are classified into two types
• Private-label CMO collateral for the CMO is a
  pool of agency (and therefore guaranteed)
  pass-throughs.
• Whole loan CMO collateral for the CMO is a pool
  of unsecuritized mortgage loans.
• Today, the most common type of non-agency CMO is
  a whole loan CMO.

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Stripped MBS PO Strips

• Principal-Only (PO) Strips
• A PO security is purchased at a substantial
  discount from par value.
• The yield realized by the investor depends on the
  speed of prepayments
• Faster prepayments?higher yield
• Slower prepayments ?lower yield
• Example Consider 400 million par value 30-year
  mortgages purchased at 175 million.
• The PO strips will increase 225 million to 400
  million over 30 years if there are no
  prepayments.
• However, if interest rates drop, prepayments
  could occur rapidly causing the investor to reap
  the 225 million much sooner.
• PO strip prices move inversely with mortgage
  rates.

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Stripped MBS IO Strips

• With an IO strip, there is no par value.
• The IO investor wants slow prepayments. Why?
• The interest payment received depends on the
  principal outstanding.
• As principal is paid, the outstanding balance
  declines and interest payments decline.
• If prepayments are too fast, the interest
  received may be less than the price paid for the
  IO.
• Interestingly, IO strip prices tend to move with
  mortgage rates.