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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?.

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Collateralized Mortgage Obligations (CMOs) History and Application

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  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?

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