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Collateralized Mortgage Obligations (CMOs)

Collateralized Mortgage Obligations (CMOs). Tara Stanley Emily Kenyon. CMOs Overview. What is a CMO? History Associated Risk Advantages of CMOs Types of CMOs Role in Current Economy. What is a CMO?. Collateralized Mortgage Obligation Mortgages are pooled

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Collateralized Mortgage Obligations (CMOs)

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  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. 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

  5. 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

  6. 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

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

  8. 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

  9. 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

  10. 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

  11. 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

  12. 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

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

  14. 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

  15. 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

  16. 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

  17. 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

  18. 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

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

  20. Questions?

  21. Quiz

  22. Question #1 What does CMO stand for?

  23. Answer • Collateralized Mortgage Obligation

  24. Question #2 • What is the most popular type of CMO?

  25. Answer • Planned Amortization Class (PAC)

  26. Question #3 • What are 2 advantages of CMOs?

  27. 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.

  28. Question #4 • True or False? CMOs eliminate prepayment risk?

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

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

  31. Answer • Sequential-Pay

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

  33. Answer • Extension Risk

  34. Question #7 • What year was the first CMO offered?

  35. Answer • 1983

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