Transcript Introduction to Bond Markets, Analysis, and Strategies

Collateralized Mortgage
Obligations and Stripped MBS
Chapter 12
CMO
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securities developed to better deal with
prepayment risk associated with PTs
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bond classes created by redirecting CFs of
mortgage-related products
prepayment risk is still present but creation of
CMO allows separation of prepayment risk into
different securities
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parties who can better handle one type of risk (extension
or contraction) will now invest in ones best for them –
have created different securities that have different riskreturn characteristics
CMO Structure
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backed by pool of PTs, loans, or stripped MBS
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CMOs have different classes of bonds that have different
maturities
tranches
classes retired on priority basis
Sequential Pay CMOs
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tranches retired sequentially
periodic interest to all tranches with first tranche receiving
all principal payments (expected and prepays)
principal pay-down window – time period between
beginning and ending of principal payments for specific
tranche
accrual tranche or Z bond – receives no interest
Example
Tranche
A
B
C
D
Par Amount
Coupon Rate
$194,500,000
7.5%
36,000,000
7.5%
96,500,000
7.5%
73,000,000
7.5%
Average Life
Z bond
Floating Rate Tranches
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like with other securities, CMOs have varying
structures to make more appealing to
investors
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can create a floating rate tranche by taking class
and making floater and inverse floater
Floating Rate Tranches
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in example, floating tranche will be
$72,375,000 or 75% of $96.5m
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K is cap for inverse floater and L is coupon
leverage
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K set at 28.5% and L set at 3 for this example
K – L (one-month LIBOR) is rate on inverse floater
low leverage – medium leverage – high leverage
weighted average coupon rate has to equal 7.5%
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assume LIBOR is 9%
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floater rate 9.0% + 0.5% = 9.5%
inverse floater rate 28.5 – 3(9%) = 1.5%
WAC 0.75(9.5%) + 0.25(1.5%) = 7.5%
Planned Amortization Class Tranches
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PAC bonds – priority over other classes in
area of principal payment
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allows greater certainty of timing of CFs
all prepayments go to support or companion
bonds (other tranches)
use initial collars to determine monthly expected
payments to PAC bonds – if prepayment speeds
differ from those in initial collar, then average life
changes
Payment Rules for PAC Tranche
Terminology for PACs
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planned amortization bonds / support bonds
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initial PAC collars
busted – term used when PAC schedule is broken
effective collar – once PAC bond is seasoned, the initial
collars are not helpful in finding prepayment protection –
effective collar is used to help
to give greater prepayment protection to PACs
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lockout structure – CMO structure with no principal
payments to PAC bond class in earlier years (because
create more support bonds)
reverse structure – requires any excess principal payments
to be made to the longer PAC bonds after all support bonds
are paid off
CMO Terminology
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agency CMOs / nonagency CMOs
private label CMO – private entity issues CMO but
underlying collateral is pool of PTs guaranteed by an
agency
whole loan CMO – collateral for CMO is pool of
unsecuritized mortgage loans (interchangeable with
nonagency CMO because most common type of
nonagency is whole loan)
CMO should be a REMIC in order to get tax benefits
Stripped MBS
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alter distribution of CFs to one of unequal
distribution to different classes
types
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synthetic coupon PTs – first generation of stripped
MBSs
interest-only/principal-only securities – mortgage
strips
CMO strips (structured IOs) – one of CMO
classes is IO or PO
Mortgage Strips
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PO purchased at big discount from par
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yield depends on speed of prepayments – the
faster the prepayments the higher the yield
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when mortgage rates fall, prepayments are expected to
speed up so CF to PO holder accelerates so price of PO
increases (result is also in part due to lower discount
rate)
Mortgage Strips
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IO has no par value
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investor in IO wants prepayments to slow because receive
interest only on principal outstanding
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if prepayments are too fast, investor may not recover cost of
IO
if rates decline, prepayments are expected to increase which
results in loss in expected CF but CF discounted using lower
rate (net result usually though is decline in price)
if rates rise, expected CFs improve but CFs discounted at
higher rate – net result can be rise or fall in price of IO
price tends to move in same direction as change in rates when
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rates fall below coupon rate
and for some range of rates above the coupon rate