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Collateralized Mortgage Obligations CMO

Collateralized Mortgage Obligations CMO.

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Collateralized Mortgage Obligations CMO

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  1. Collateralized Mortgage Obligations CMO • To mitigate prepayment risk, a class of derivative securities is created by redircting the interest and principal from the pass-throughs and pool of whole loans such that the new derivative class will have different coupon rate and varying risk return profile that meets the needs and expectation of investors, thus broadening the appeal of the mortgage backed securities. When CMO created this way, it has more than one class of bond holders at a given level of credit priority known as pay-through structure.

  2. CLO and CBO Mortgage Derivatives

  3. Prepayment Risk

  4. Contraction Risk • Contraction risk arises in the event of falling interest rates, as prepayments speed up. The fall in interest rates makes refinancing attractive for mortgagors or individuals relocating and selling property. The pass-through life therefore shortens and subjects investors to contraction risk.

  5. Extension Risk • Extension risk arises as the pass-through underlying mortgage pays slowly as interest rates rise. When interest rates rise, prepayments decline, as prepaying mortgages does not pay off. Rather, mortgagors find it more attractive to invest their funds rather than prepay.

  6. Shifting Interest Structure • All securitization programs involving senior/subordinated structures have incorporated a shifting interest structure, which allows disproportionate redistribution of prepayments of the underlying collateral from subordinate class to senior class according to a well-defined pre-specified schedule.

  7. Example: Shifting Interest Structure

  8. Structuring and Pricing CDO • SPV Tranches Pool AAA BBB BB B NR/equity Senior Mezzannine Junior 75% Corporate bonds 8% 7% 5% 5%

  9. Example: Creating Synthetic CDO • Consider the underlying collateral is $1.5 billion worth of corporate debts with 150 obligors each $10 million with WAM of 10 years, WAC of 7.5 percent and weighted average duration of 7.2 years. • Creating MBS, CMOs, CDOs • SPV issues multiple tranches • The senior tranche is $1.125 billions • The mezzanine tranche is $300 millions. • The equity tranche is $75 millions or 5 % of the underlying collateral.

  10. The equity tranche is not rated. Due to leverage and priority rules, the return and risk are very high for this tranche. • The equity tranche is exposed to 5% first loss. • For example, cumulative loss of $75 millions can wipe out equity tranche. • What ever transformation is executed on the collateral, the package of new securities must obey basic laws of conservation, namely…..

  11. PO & IO Derivatives • Stripped mortgage-backed securities issued in early 1987 separated coupons from the corpus of the underlying pool of mortgages into a class of securities known as: • interest-only (IO) securities, with all of the principal going to another class known as • principal-only (PO) securities.

  12. Shift to Securitization in 1980 • Deterioration of the credit quality of the major banks portfolio as a result of less developing countries’ LDC debt crisis of 1982. • Mushrooming innovative products induced by liberalization of regulatory landscape that transferred risk from banks & other intermediaries to ultimate investors. • Return to a more favorable macro-economic conditions, i.e., reappearance of positive real interest rates and upward sloping yield curves • Disintermediation of credits induced through securitization

  13. Example • Suppose the pass-through underlying the collateral is $200 million mortgage securities with 6.5 percent coupon and priced at par with maturity of 25 years. • The PO backed by this pass-through is worth $50 million, since it is a deep-discount bond. The PO investors (who receive no coupon interest) will receive a dollar return of $150 million ($200 million principal less initial investment of $50 million) over 25 years, or 5.7 percent annualized return.

  14. Negative Convexity of IO

  15. Sequential pay Tranches • Each class is retired sequentially • Accrual Bonds • PAC, protected from both contraction and extension risk, providing two-sided prepayment protection. • TAC, while PAC provides protection against both contraction and extension risk over a wide range of PSA, TAC bond provide has a single PSA rate from which the schedule of principal repayment is protected, therefore, the prepayment protection af

  16. Sequential-Pay

  17. Reverse PAC is a CMO structure requiring any excess principal payments to be made to the longer PAC after all support bonds are paid off. • VADM is a Z bond, providing protection against extension risk, even if prepayment slow down • IO and PO

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