1 / 15

Collateralized Mortgage Obligations (CMOs) History and Application

Collateralized Mortgage Obligations (CMOs) History and Application. Michael Wallace BA543-1. Agenda. What is a CMO? History Risk Example – (Sequential-Pay CMO) Types of CMOs Conclusion. What is a CMO?.

chumani
Download Presentation

Collateralized Mortgage Obligations (CMOs) History and Application

An Image/Link below is provided (as is) to download presentation Download Policy: Content on the Website is provided to you AS IS for your information and personal use and may not be sold / licensed / shared on other websites without getting consent from its author. Content is provided to you AS IS for your information and personal use only. Download presentation by click this link. While downloading, if for some reason you are not able to download a presentation, the publisher may have deleted the file from their server. During download, if you can't get a presentation, the file might be deleted by the publisher.

E N D

Presentation Transcript

  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. 300 200 400 100 500 0 600 PSA 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 => 0.2%CPR 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?

More Related