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Collateralized Mortgage Obligations CMOs History and Application

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Contraction Risk-Decline in mortgage rates that effectively shortens the life of ... Extension Risk-Increase in mortgage rate that effectively lengthen the life of a ... – PowerPoint PPT presentation

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Title: Collateralized Mortgage Obligations CMOs History and Application


1
Collateralized Mortgage Obligations(CMOs)History
and Application
  • Michael Wallace
  • BA543-1

2
Agenda
  • What is a CMO?
  • History
  • Risk
  • Example (Sequential-Pay CMO)
  • Types of CMOs
  • Conclusion

3
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

4
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
5
Who issues CMOs?
  • Agencies (i.e. Freddie Mac, Ginnie Mae..etc)
  • Non-agency (i.e. Countrywide)
  • Private-label
  • Whole-loan

6
History
  • The first CMO was issued in 1983 by Freddie Mac
  • Volatility of interest rates in previous decade
    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

7
Characteristics
  • Maturity Matures when investor receives final
    principal payment
  • Weighted average maturity (WAM)
  • Yield
  • Assumed prepayment rates
  • Tranches
  • Interest
  • Principal active tranche

8
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
9
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

10
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

11
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 0.2CPR in first month, 0.4 CPR
    in second month, and increases until rate reaches
    6

12
Example Sequential-Pay CMO
13
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

14
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

15
Questions?
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