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Chapter 20: The Secondary Mortgage Market: CMOs and Derivative Securities

Chapter 20: The Secondary Mortgage Market: CMOs and Derivative Securities. Secondary Mortgage Market. Mortgage Pay-Through Bonds Bond, not an equity ownership interest Debt obligation of issuer Pass-through of interest and principal Credit rating derives from three things

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Chapter 20: The Secondary Mortgage Market: CMOs and Derivative Securities

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  1. Chapter 20: The Secondary Mortgage Market: CMOs and Derivative Securities

  2. Secondary Mortgage Market Mortgage Pay-Through Bonds Bond, not an equity ownership interest Debt obligation of issuer Pass-through of interest and principal Credit rating derives from three things Riskiness of mortgages Extent of over collateralization Whether or not there are US gov’t bonds or agency obligations as excess collateral

  3. Secondary Mortgage Market Collateralized Mortgage Obligations Debt instrument Mortgage pool owned by issuer Pass-through of interest and principal Multiple classes of securities issued Different maturity classes Different priority for payment of principal and interest Tranches

  4. Secondary Mortgage Market Collateralized Mortgage Obligations Over collateralization Represents equity interest of issuer Residual cash flow is return to issuer Cash flow = interest earned – interest paid Prepayment problem Reinvestment problem Calamity call

  5. Secondary Mortgage Market Collateralized Mortgage Obligations Sequential Payout Tranche Structure Tranche Z: Paid Last Tranche A: Principal, Prepayments, & Interest Received First Tranche B: Interest Only Until Tranche A is Paid Etc. for any additional tranches

  6. Secondary Mortgage Market Collateralized Mortgage Obligations Expected Maturities Pricing & Prepayment Tranche Variations Sinking Fund Structure Planned amortization class tranche Targeted amortization class Pricing speed Companion tranche

  7. Secondary Mortgage Market Collateralized Mortgage Obligations Floating Rate Tranches Floater Tranche Coupon rates adjust periodically Inverted Floating Rate Tranche Coupon rate adjusts opposite to its index Scaling Used as a Hedge Yield Enhancement

  8. Secondary Mortgage Market Collateralized Mortgage Obligations Principal Only Tranches Similar to a Zero-Coupon Bond Interest Only Tranches Convexity

  9. Exhibit 20-15Summary of Important Investment Characteristics of Mortgage-Related Securities

  10. Secondary Mortgage Market Commercial Mortgage-Backed Securities Similar in form to residential MBSs Default risk differs significantly Assets in mortgage pool Often interest-only Lump sum principal payment

  11. Secondary Mortgage Market Commercial Mortgage-Backed Securities Senior Tranche (A piece) Subordinate Tranche (B piece) Prepayment is less likely than residential mortgages Lockouts Yield Maintenance Extension Risk

  12. Secondary Mortgage Market Commercial Mortgage-Backed Securities First Loss Position Credit Ratings Credit Enhancements Issuer or 3rd party guarantee Surety bonds and letters of credit Advance payment agreements

  13. Secondary Mortgage Market Commercial Mortgage-Backed Securities Credit Enhancements Loan substitutions and repurchase agreements Lease assignments Over collateralization Cross-collateralization and cross-default

  14. Secondary Mortgage Market Collateralized Debt Obligations Broader range of collateral B notes (subordinated position of mortgage) Lower rated Commercial Mortgage-Backed Securities Mezzanine Loans Preferred Equity While they are often well diversified, the underlying risk is still substantial. The assets are risky. Managed Collateralized Debt Obligations

  15. Exhibit 20-19Illustration of CDO Structure

  16. Secondary Mortgage Market Real Estate Mortgage Investment Conduits (REMICs) Creation of Tax Reform Act of 1986 Qualified Mortgages Foreclosed Property Interest Bearing Assets Qualified Reserve Fund

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