CMOs

1. CMOs • In order to expand the base of investors in mortgages, we needed more than a simple pass-through security. We needed to modify the mortgage cash flows and make them more “bond like” • Make payments semiannually • Reduce uncertainty about the size of the periodic payment • Reduce uncertainty about the duration of the investment

2. CMOs • The basic problem with mortgages as investments is: • When rates rise, the mortgage behaves worse than a long duration fixed rate bond • Its duration increases as prepayment speeds fall • Its price falls very rapidly with increases in interest rates • discount rate effect+ duration effect work together • When rates fall, the mortgage behaves worse than a short duration investment • duration keeps falling with lower rates • “par cap”

3. CMOs • The desire to create a more “bond-like” security from mortgages led to the idea of Collateralized Mortgage Obligations (CMOs) • Take the cash flows from the underlying mortgages and manage them or reallocate them • Example: To avoid monthly payments, a third party could collect each monthly payment and invest it short term. After accumulating payments for six months, it could pay the total out to investors • Example 2: Instead of distributing pro-rata to each security holder, different payments could be made to different groups of investors

4. Structured Finance • Recall the pool of 8% mortgage loans we worked with earlier. • $100 million of mortgages • 1000 loans with a balance of 100,000 • 8% coupon rate • regular annual payment of $8,882.74 • The following table shows the principal and interest received in the first year under different prepayment assumptions

6. Fast Pay/Slow Pay • Consider the following rule for allocating cash flows • Create two classes of securities: fast pay and slow pay. • Each security has an initial principal amount of $50,000,000 • Each security earns interest at a rate of 8% on the beginning of the period balance • All principal collected from the pool is paid to the “fast pay” security holders until it is paid off • Then allocate principal to the slow pay class

7. Fast Pay/Slow Pay

8. Fast Pay/Slow Pay • Total of payments to security holders equals the total cash received from the mortgages • Under this rule, the payment to the slow-pay security holder is the same over a wide range of possible prepayment scenarios • The price we paid to achieve this was making the fast-pay security very sensitive to prepay speeds • More sensitive than the underlying mortgages themselves

9. 15% CPR • Using the 15% CPR case, the balances at the start of year 2 would be: • fast-pay slow pay • $34.25 million $50 million • If loans continue to pay at 15% CPR • Total cash flow: $20.066 • Interest; $6,740 • Principal: $13,326

10. Fast-Pay 8% interest on 34.25MM $2.74MM All principal collected $13.326MM Total Cash To Investor: $16.066MM Slow-Pay 8% interest on $50 MM $4MM No principal because Fast-Pay is not paid off Total Cash To Investor $4MM Year 2

11. Year 2 • In Year 2 we have • Total payment to security holders equals total collected from mortgages • Slow pay security still gets bond-like payment of the coupon rate of interest • This would continue until year 5 • In year 5 (at 15% CPR) the fast-pay would be completely paid off • slow pay would begin to amortize

12. Result • The fast pay/slow pay structure has “transformed” one stream of uncertain cash flows with a medium to long average life into two different streams • A short expected life • Highly uncertain cash flows • A longer expected life security • annual cash flows in first few years are known with a high degree of certainty

13. Tax Problems • “Active” management of the cash flows was prohibited prior to 1986 • tax laws treated the intermediary as a corporation and taxed the interest income but treated the payments to the security holders as dividends • 1986 Tax Act • Created Real Estate Mortgage Investment Conduits • “REMIC”

14. REMIC • A corporation can elect REMIC status • As long as it adheres to the rules on types of investments and certain other requirements, it is free to carve up the cash flows from a pool of mortgages in any way that makes economic sense. • Sequential pay CMOs • More complex version of fast pay/slow pay • IO/PO securities • Floaters and Inverse floaters • PACs & TACs

15. Sequential Pay CMO • The four class, sequential pay CMO is the basic structure from which the more esoteric CMO securities have come • CMOs are like ice cream • I generally can’t find any vanilla amongst the cookies and cream, kahlua, almond brittle etc • You won’t find plain vanilla CMOs issued today • But you can’t understand the fancy versions if you don’t go back to the basic cream and sugar recipe

16. Sequential Pay CMO • Four Classes of debt plus a residual class • Think of a corporation that sells four different debt securities that vary by maturity and common stock • The CMO debt classes are like short medium and long term debt • The residual is like the common stock

17. Sequential Pay CMO • The four debt classes • Class A. Pays interest at a fixed coupon rate on the outstanding balance and is allocated all principal until it is paid in full • Think of the fast pay security • Class B. Pays interest at a fixed coupon rate. Receives no principal until Class A is retired. At that time it is allocated all principal until it is paid off. • Class C. Pays interest at a fixed coupon rate. Receives no principal until B is paid off. At that time it is allocated all principal until it is paid off. • Class Z Receives No Cash flow at all until C is paid off. At that time it receives all cash flow. (Cont.)

18. Sequential Pay CMO • Z-Class or “Accrual Bond” • This class of debt has a contractual interest rate but receives no cash flow initially. While any of A, B or C is outstanding, interest is accrued but not paid in cash. The outstanding balance negatively amortizes over time. • Once the Class C is paid in full, The Z-class receives all the mortgage cash flow • Both principal and interest • Each cash payment covers both interest and principal • Like an amortizing mortgage

19. What Happens to the Z-Class Payment? • During each period while the Z-class is accruing interest and its balance is increasing, the amount of interest due but not paid to the Z-class holders is paid to either the A, B, or C class and treated as a principal paydown for that class • Note that this keeps the balance of the CMOs outstanding equal to the balance of the mortgages • The increase in balance on the Z-class is exactly offset by the extra reduction of principal balance of the earlier class

20. Residual • The residual is just like common equity • It receives all the cash flow that is left over after the payments are made to the debt holders • Taxable income is calculated for the corporation treating all interest paid and accrued on the debt classes as expense and the interest received from the mortgages as income. • The owner of the residual is responsible for any taxes due on the whole REMIC

21. CMO Example • Assume the underlying mortgage cash flows are those described earlier • 8% Mortgages • Annual Payments • No Servicing Cost • Assume we sell the following securities • Class A: $30 million @ 7.25% • Class B: $25 million @ 7.5% • Class C: $20 million @ 8.0% • Z-Class: $20 million with an interest rate of 8.5% • makes no payment until all of A,B, and C are paid in full • Residual $5 million

22. Class A Cash Flows

23. Class B Cash Flows

24. Class C Cash Flows

25. Class Z Cash Flows

27. Sensitivity of Residual IRR to CPR IRRs: 0% 7.31; 6% 7.153 ; 15% 7.50 ; 25% 7.73

28. Summary of Objectives of CMO Design

29. IO/PO • Another logical way to divide up mortgage cash flows is by interest and principal • Owner of interest only strip receives all the interest from the mortgages • Owner of the principal only strip receives all of the principal from the mortgages

30. IO/PO Strips • Recall the figures showing the interest and principal cash flows from the mortgage pools • No matter what CPR assumption is used, the total principal cash flow is the same • The faster the loans prepay, the quicker the investor gets paid off. • Zero coupon discount bond • The sooner the better • When interest rates decrease, PO gets paid off more quickly and the discount rate applied to those cash flows declines • Effect on price is unambiguous • Decreases in rates lead to increases in price and vice versa

31. IO/PO Strips • Total interest paid on a pool varies with the CPR • Total interest collected increases when mortgages prepay slowly and decreases when they prepay quickly • Think of extremes • When interest rates increase, total cash flows to the owner of an IO increases (+) • The discount rate applied to those cash flows also increases (-) • The effect of a change in interest rates on the price of an IO depends on which effect is greater

32. IO/PO Strips • One way to remember what happens to IO cash flows is to consider extreme situations • If all loans in the pool prepay one day after origination, almost no interest would be collected. • Cash flow to the owner of an IO would be near zero • If some loans do not prepay immediately, those borrower will have to pay interest • Cash flow to the IO will increase as more borrowers wait to prepay and as borrowers delay prepayment longer

33. IO/PO • Recall the normal relationship between the price of a fixed income security. • Price equals the present value of future cash flows discounted at the market yield • Higher discount Rate >>> Lower Prices • Yields Up, prices Down • Yields Down, Prices Up

35. IO/PO • Investments with this type of sensitivity to interest rates have positive “duration” • Almost all fixed income securities have this relationship. • An instrument whose price went up when interest rates went up would be valuable as a “hedge” for fixed income portfolios • An investment whose value increases with an increase in interest rates is said to have negative duration

37. IO/PO • IO • Over one range, the prepayment effect dominates and value increases • After some point, the discount rate effect dominates and the value begins to fall • When rates get above a certain level, there is essentially no prepayment and the mortgage becomes a normal fixed income security • PO • The PO is “super sized” in that it has a steeper slope and more curvature than a normal fixed income security

38. IO/PO • The sum of the IO and the PO piece must equal the value of the underlying MBS • WHY?

39. Determining The CMO Structure • How Much CMO “Debt” Can I issue ? • Depends on the underlying collateral • The collateral is the only source of cash for making debt payments • Key here is the interest rate on the loans • Depends on the market’s current required yield for debt of different duration • The coupon rates on the tranches determine the debt service payments • Target: AAA rating for credit risk • Requirement: Structure must survive worst case scenarios • Minimum: Rating agencies generally require a minimum over collateralization • 5% not uncommon

40. Determining The CMO Structure • Two “Worst Case” Scenarios • 1.All loans prepay immediately • There must be enough cash flow from the mortgages to pay interest on the CMO debt until the bonds can be repaid • Monthly, quarterly, semi-annually payments mean debt could be accruing interest after mortgages have paid off • Trustee must invest cash at a safe rate until time to be repaid • for a few days if monthly, 1-3 months if monthly & 1-6 months if paid semi-annually • What rate will trustee earn?

41. Determining The CMO Structure • To determine the amount of CMO debt you can issue and meet this test; • Assume all loans prepay immediately after the CMO debt is issued • Calculate the weighted average coupon rate on all CMO debt. • Adjust for periodic rate until next payment date • Limit Debt so that

42. Determining The CMO Structure • Example (Worst Case 1 All Prepay Immediately): • $100 MM of mortgages prepay right after origination • Coupon rate on loans does not matter • Trustee receives $100 MM of cash • Four tranches of quarterly pay CMO Debt • 30 MM @7.25 • 25 MM @ 7.5 • 20 MM @ 8.0 • 20 MM @ 8.5 • WAC=7.74%

43. Determining The CMO Structure • Worst Case 2. No Loans Prepay: 0% CPR • Net cash flow from mortgages (after servicing) must be sufficient to meet debt service obligation associated with the CMO tranches • Suggests that the net present value of future net mortgage cash flows must exceed the present value of the debt • WAC of CMO debt tends to rise over time as lower cost tranches are paid off first and high cost Z tranche increases in size • The “Worst” thing that could happen is for only the highest coupon debt to be left when prepayments stop • Apply “Present Value Rule” using highest coupon rate from any tranche of the debt to calculate present value of future mortgage cash flows and limit face value of debt issued to this number.

44. Determining The CMO Structure • Present Value Rule: • Project the mortgage cash flows for their remaining maturity at 0% CPR • Use spreadsheet to get precise net cash flows or approximate using net after servicing coupon rate of mortgages and payments to maturity • In our example, cash flow from mortgages is $8.883 MM .yr • Discount those cash flows using a rate equal to the highest coupon rate on any tranche of CMO debt • In our example discount rate is 8.5% (>8.0%) and PV=$95.461MM • Limit the total CMO debt to a number less than the present value • There will always be enough cash flow to service the CMO debt • Can use principal flow from over collateralization to service CMO debt

45. Determining The CMO Structure • Set the Amount of CMO Debt equal to the smallest number • Floor (often 95% of mortgage principal) • Amount that can survive full & immediate prepayment ($98.10 MM in our example) • Amount that can survive 0% CPR ($95.4 MM in example) • Note that these rules only address “debt structure” and not credit risk • If credit guarantee is not “iron clad” then we need to deal with credit risk as well