Fixed-Income Society Collateralized Mortgage Obligations (CMOs)

1. Fixed-Income Society Collateralized Mortgage Obligations (CMOs) • Created to redirect cash flows of mortgage related products to various bond classes so as to mitigate prepayment risk • Mere creation of a CMO cannot eliminate prepayment risk • But it can isolate and channel the various forms of risk of mortgage bonds into different classes of new bonds called tranches.

2. CMO Structure • If there are several bond classes created than we have a Pay-Through structure • If there is only one bond class then we simply have a Pass-Through structure. • CMOs redistribute cash flows – interest and principal. There are separate rules for the payment of the coupon interest and the payment of the principal. • Many different types of CMO structures have been created

3. Sequential Pay Tranches • These are CMOs where the various bond classes are retired (paid off) sequentially • Each tranche receives periodic interest payments based on the amount outstanding • The disbursement of principal is done in sequence: a tranche is not entitled to receive principal until the entire principal of the preceding tranche has been paid off (prioritizing of principal payments) • Principal Pay-Down Window: time period between the beginning and end of principal payments • There is considerable variability in the average life for the various tranches

4. Accrual Bonds • In many CMO structures at least one tranche does not receive current interest. Such a bond class is called an Accrual Tranche or Z Bond. • The interest that would have been paid to the accrual bond class is used to speed up the pay down of the principal balance of earlier bond classes. Hence average lives of the non-accrual tranches are shortened. • Z-bonds appeal to bond investors who are concerned with coupon reinvestment risk.

5. Planned Amortization Class Tranches (PAC) • PACs provide two-sided prepayment protection through initial PAC collars (or bands). • The greater certainty for the PAC bonds comes at the expense of the non-PAC classes called Support or Companion bonds. These bonds absorb most of the prepayment risk. • Most CMO structures have more than one class of PAC bonds. The PAC window can be wide or narrow.

6. PAC (continued) • Key to the prepayment protection offered by a PAC bond is the amount of the support bonds outstanding. If the support bonds are paid off quickly because of faster than expected prepayments there is no longer any protection for the PAC bonds • Effective Collar: For a PAC this is the lower and upper PSA that can occur in the future and still allow maintenance of the schedule of principal repayments => usually different from the initial band.

7. Effective Collar • The effective collar changes every month • If there is an extended period over which actual prepayments are above the upper range of the initial PAC collar then this results in a decrease in the upper range of the effective collar • If there is an extended period over which actual prepayments are below the lower range of the initial PAC collar then this will increase the lower range of the effective collar • Also: A PAC schedule may not be satisfied even if the actual prepayments always fall within the initial collar

8. Stripped Mortgage-Backed Securities • They are created by paying all the principal to one bond class and all the interest to another bond class: PO (principal only) bond class and IO (interest only) bond class

9. IOs and POs • POs are purchased at a substantial discount to par value. The faster the prepayments the higher the yield the investor collects. They are sort of like zero-coupon bonds. • IOs don’t have a par value. An IO investor wants prepayments to be slow as interest is only paid as long as there is principal outstanding. If prepayments are very fast an IO investor may not even recover the amount paid for the IO. • Price of an IO moves in the same direction as that of interest rates.