Collateralized Mortgage Obligations (CMOs) History and Application

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Collateralized Mortgage Obligations(CMOs)History
and Application

• Michael Wallace
• BA543-1

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Agenda

• What is a CMO?
• History
• Risk
• Example (Sequential-Pay CMO)
• Types of CMOs
• Conclusion

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What is a CMO?

• Pools of securitized mortgages whose cash flows
  have been dedicated to two or more types of bond
  classes designed to better meet investor needs.
• Derivative mortgage securities

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What is a CMO?
Pass-through Pooled mortgage loans
Monthly Cash Flow
Loan 1
Interest Scheduled principal payments Prepayments
Loan 2
Interest Scheduled principal payments Prepayments
Rule for distribution of cash flow (i.e. Pro rata
basis)
Loan 3
Interest Scheduled principal payments Prepayments
Loan 4
Interest Scheduled principal payments Prepayments
CMO
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Who issues CMOs?

• Agencies (i.e. Freddie Mac, Ginnie Mae..etc)
• Non-agency (i.e. Countrywide)
• Private-label
• Whole-loan

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History

• The first CMO was issued in 1983 by Freddie Mac
• Volatility of interest rates in previous decade
  gt high prepayment risk
• Sears/Dean Witter, Reynolds attempted CMO
  issuance in 1984
• IRS ruling made CMOs uncompetitive
• Tax Reform Act of 1986
• Creation of the Real Estate Mortgage Investment
  Conduit (REMICs)
• Required accrual-based accounting for investors

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Characteristics

• Maturity Matures when investor receives final
  principal payment
• Weighted average maturity (WAM)
• Yield
• Assumed prepayment rates
• Tranches
• Interest
• Principal active tranche

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The Three Relationships

• Prices and Rates

Interest Rates
Interest Rates
CMO Prices
CMO Prices

• Prices and Time

CMO Prices
CMO Life
CMO Prices
CMO Life

• Prepayments and Time

Interest Rates
Interest Rates
Prepayment
Prepayment
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Risk

• Why not invest directly in mortgages?
• Exposure credit risk, liquidity risk, price
  risk, prepayment risk
• Types of Risk
• Price Risk
• Return Risk
• Prepayment (Call) Risk

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Prepayment Risk

• Contraction Risk-Decline in mortgage rates that
  effectively shortens the life of a pass-through
  security
• Extension Risk-Increase in mortgage rate that
  effectively lengthen the life of a pass-through
  security

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Prepayment Speed Assumptions (PSA) Model

• Created by the Bond Market Association
• Based on Constant Prepayment Rate (CPR)
• Annualized amount of outstanding principal
  prepaid each month (SMM)
• Ex. 100 PSA gt 0.2CPR in first month, 0.4 CPR
  in second month, and increases until rate reaches
  6

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Example Sequential-Pay CMO
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Classes of CMOs

• Sequential-Pay
• Planned Amortization PAC Companion Tranches
• Type I PAC 100 to 300 PSA
• Target Amortization
• Companion Tranches Higher yield, greater
  uncertainty
• Z-Tranches
• Principal-Only (PO)
• Interest-Only (IO)
• Floating-Rate tied to interest rate index (i.e.
  LIBOR)
• Residuals

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Conclusion
CMO Issuance

• Why invest in CMOs?
• High credit rating (AAA)
• Low minimum cost to buy into (1,000)
• Competitive yield
• Flexibility to meet investor needs (maturity)
• Ability to receive monthly cash flow
• Hedging against prepayment risk
• Liquidity

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Questions?