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Collateralized Mortgage Obligations CMOs

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The pool' is split into various tranches with varying degrees of risk, cash ... No telling how fast or slow the tranche will mature. Principal-Only & Interest-Only ... – PowerPoint PPT presentation

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Title: Collateralized Mortgage Obligations CMOs


1
Collateralized Mortgage Obligations (CMOs)
  • Tara Stanley
  • Emily Kenyon

2
CMOs Overview
  • What is a CMO?
  • History
  • Associated Risk
  • Advantages of CMOs
  • Types of CMOs
  • Role in Current Economy

3
What is a CMO?
  • Collateralized Mortgage Obligation
  • Mortgages are pooled
  • The pool is split into various tranches with
    varying degrees of risk, cash flows, and time
    frames.
  • Investors purchase securities
  • Mortgages are used as collateral for mortgage
    pass-through securities

4
(No Transcript)
5
History of CMOs
  • Originated as a mortgage pass-through security
  • Government-sponsored enterprises were created to
    attract investors create a liquid secondary
    market.
  • Fannie Mae, Ginnie Mae, Freddie Mac were
    responsible for purchasing mortgages and issuing
    mortgage backed securities
  • 1970 Ginnie Mae issued the first bonds backed by
    pools of mortgages to free up funds for more home
    loans
  • 1977 The first private mortgage backed securities
    are sold
  • 1983 Freddie Mac issues the first collateralized
    mortgage obligation, which allows investors to
    pick their level of risk

6
Risk of Mortgage Pass-Through Securities
  • Prepayment Risk
  • Unknown probability that the borrower will pay
    off the loan sooner than expected.
  • Extension Risk
  • Interest Rates increase therefore decreasing the
    probability of prepayment
  • Contraction Risk
  • Interest Rates decrease therefore increasing the
    probability of prepayment

7
Advantages of CMOs
  • Reduce Prepayment risk
  • Attract a wide variety of investors by offering
    various tranches
  • Regular monthly or quarterly payments
  • Guaranteed by the financial institution that
    issues the investment.
  • Fannie Mae Freddie Mac insure payment when
    borrower defaults
  • Ginnie Mae insures full faith and credit to
    investors

8
Types of CMOs
  • Sequential-Pay
  • Accrual Tranche or Z-Bond
  • Planned Amortization Class
  • Targeted Amortization Class
  • Principal-Only
  • Interest-Only

9
Sequential-Pay CMO
  • Tranches mature in chronological order
  • Tranche 1 receives principal and interest
    payments while Tranche 2 3 receive interest
    only until Tranche 1 hits maturity
  • After Tranche 1 is paid in full, Tranche 2
    receives principal and interest payments while
    Tranche 3 continues to receive interest only
    payments
  • Finally, Tranche 3 begins to receive principal
    and interest payments once Tranche 2 is complete
  • Attracts a variety of investors by offering
    different levels of risk and investment periods

10
Accrual Tranches or Z-Bonds
  • Similar to a Sequential-Pay CMO
  • Instead of the last Tranche receiving interest
    payments while the other Tranches are paid, the
    interest is accrued
  • The accrued interest is then used to help pay off
    the principal in the preceding tranches
  • Once preceding tranches have matured, the last
    tranche receives principal and all accrued
    interest
  • Eliminates Reinvestment Risk

11
Planned Amortization Class (PAC)
  • Most popular CMO issued today
  • Make up 50 of all first time issued CMOs
  • Creates a schedule of fixed principal payments
  • If prepayment occurs, investor receives fixed
    payment while additional funds are applied to a
    companion tranche
  • Guarantee cash flow at given intervals
  • Protected against Contraction Extension Risk
  • Minimal Risk Lower Rates

12
Targeted Amortization Class (TAC)
  • Similar to Planned Amortization Class
  • Offered at a fixed rate versus a fixed payment
  • Minimal Risk
  • Excess cash flow is distributed to companion
    tranche
  • Companion tranches offer higher rates
  • No telling how fast or slow the tranche will
    mature

13
Principal-Only Interest-Only
  • Principal-Only
  • Receives only principal payments
  • Bought at discount
  • Vulnerable to Interest Rate Changes
  • Decrease in interest rates create an increase in
    prepayment
  • Interest-Only
  • Receives only interest payments
  • Vulnerable to Interest Rate Changes
  • Increase in interest rates create a decrease in
    prepayment

14
CMOs in the Current Economy
  • How have CMOs contributed to the current economic
    meltdown?
  • What can be done to prevent future problems?

15
How have CMOs contributed to the current economic
meltdown?
  • Subprime Lending
  • Borrowers who do not qualify for prime loans
  • Predatory Lending
  • Targets individuals with a limited understanding
    of financial transactions
  • Offers subprime loans to individuals who qualify
    for prime loans

16
How have CMOs contributed to the current economic
meltdown?
  • Conflicts of Interest
  • Lack of training or licensing for mortgage
    brokers
  • Brokers paid by both the borrowers and loan
    originators
  • Some brokers received a yield-spread premium
    for charging a higher interest rate than the
    borrower qualified for
  • Companies rating CMOs
  • Paid by company offering security, not buyers of
    securities
  • Chastised by SEC
  • Failed to protect investors
  • Inadequate staffing
  • Not tracking performance after giving initial
    rating

17
How have CMOs contributed to the current economic
meltdown?
  • Fraud
  • Fraud for Profit
  • Collusion between industry insiders
  • Fraud for Property
  • Material misrepresentation on loan application

18
How have CMOs contributed to the current economic
meltdown?
  • Lack of ethical behavior in the origination of
    mortgages led to higher possibility of default
    for mortgages underlying the CMO
  • Collapse in housing prices
  • End of 2-3 year fixed rate for Adjustable Rate
    Mortgages (ARMs) meant many could not make their
    new mortgage payment

19
How have CMOs contributed to the current economic
meltdown?
  • Once considered as safe as treasury bonds with a
    higher return
  • Often invested in by institutions who could only
    invest in the highest grade securities
  • Downgrades from investment quality to junk rocked
    financial markets

20
What can be done to prevent future problems?
  • Licensing training for mortgage brokers
  • Make all parties bear default risk
  • Eliminate conflicts of interest

21
(No Transcript)
22
  • Questions?

23
Quiz
24
Question 1
  • What does CMO stand for?

25
Answer
  • Collateralized Mortgage Obligation

26
Question 2
  • What is the most popular type of CMO?

27
Answer
  • Planned Amortization Class (PAC)

28
Question 3
  • What are 2 advantages of CMOs?

29
Answer
  • Reduce Prepayment risk
  • Attract a wide variety of investors by offering
    various tranches
  • Regular monthly or quarterly payments
  • Guaranteed by the financial institution that
    issues the investment.

30
Question 4
  • True or False?
  • CMOs eliminate prepayment risk?

31
Answer
  • False
  • They only reduce prepayment risk by spreading it
    among tranches.

32
Question 5
  • This type of CMO pays tranches in chronological
    order and was the first type of CMO offered

33
Answer
  • Sequential-Pay

34
Question 6
  • When interest rates rise creating less
    prepayment, this risk is called?

35
Answer
  • Extension Risk

36
Question 7
  • What year was the first CMO offered?

37
Answer
  • 1983
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