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CMO and Stripped MBS

CMO and Stripped MBS. Collateralized Mortgage Obligations – ch12 Stripped Mortgage-backed Securities – ch 12. CMOs. Bond classes created by redirecting the cash flows of mortgage-related products so as to mitigate prepayment risk.

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CMO and Stripped MBS

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  1. CMO and Stripped MBS • Collateralized Mortgage Obligations – ch12 • Stripped Mortgage-backed Securities – ch 12

  2. CMOs Bond classes created by redirecting the cash flows of mortgage-related products so as to mitigate prepayment risk. Pay-through structure: there are more than one class of bondholders with the same level of credit priority Tranches: different bond classes

  3. Materials Covered under CMOs • Sequential-Pay Tranches (basic) • Accrual Tranche • Floater and Inverse Floater • Planned Amortization Class versus Support Class

  4. Sequential-Pay Tranches • The collateral for the hypothetical CMO is a hypothetical pass-through with total par value of $400 million and the following characteristics : • The pass-through coupon rate is 7.5% • WAC=8.125% • WAM=357 month • 165PSA • (page 263):

  5. FJF-01 • Tranche Par Amount Coupon Rate(%) • A 194,500,000 7.5 • B 36,500,000 7.5 • C 96,500,000 7.5 • D 73,000,000 7.5 • ? • For payment of periodic coupon interest: Disburse periodic coupon interest to each tranche on the basis of the amount of principal outstanding at the beginning of the period • For disbursement of principal payments: Disburse principal prepayments to tranche A until it is paid off completely. After tranche A is paid off completely, disburse principal payments to tranche B until it is paid off completely. After … After tranche C is paid off completely, disburse principal payments to tranche D until it is paid off completely.

  6. Cash flow from Pass through (page 263) • In month 1: total payment=$709,923; • Interest=$250,000 • In month 81: total payment=

  7. Cash flow from the CMO • Exhibit 12-2 – split the principal; CMO specifies the order of principal payment • The principal pay-down window • Average lives for the collateral and four tranches of the CMO – page 265 (ex 12-3).

  8. Accrual Bond • One tranches (or more) does (do) not receive current interest. This is an accrual tranche, or Z bond.

  9. FJF-02 • Tranche Par Amount Coupon Rate(%) • A 194,500,000 7.5 • B 36,500,000 7.5 • C 96,500,000 7.5 • Z 73,000,000 7.5 • ? • For payment of periodic coupon interest • For disbursement of principal payments • Solution: see Exhibit 5 – page 267.

  10. FJF-03: Floating-rate Tranches • Tranche Par Amount Coupon Rate(%) • A 194,500,000 7.5 • B 36,500,000 7.5 • FL 72,375,000 1-month LIBOR + 0.50 • IFL 24,125,000 28.5-3*(1-month LIBOR) • Z 73,000,000 7.5 • ? • For payment of periodic coupon interest • For disbursement of principal payments

  11. Planned Amortization Class (PAC) • Exhibit 12-8 • Tranche Par Amount Coupon rate (%) • P $243,800,000 7.5 • S 156,200,000 7.5 • 400,000,000 • For payment of periodic coupon interest • For disbursement of principal payments

  12. Principal Payments under PAC • Disburse principal payments to tranche P based on its schedule of principal repayments. Tranche P has priority with respect to current and future principal payments to satisfy the schedule. Any excess principal payments in a month over the amount necessary to satisfy the schedule for tranche P are paid to tranche S. When tranche S is paid off completely, all principal payments are to be made to tranche P regardless of the schedule.

  13. Support Bonds • Bodyguards for the PAC bondholders • Can be partitioned into classes, I.e, bodyguards have ranks and titles, too.

  14. Objective • To eliminate the contraction risk and the extension risk • Contraction risk: when interest rate goes down • Extension risk: when interest rate goes up

  15. Series of PAC Bonds • Combination of PAC and sequential-pay CMO • Page 275 • At different prepayment rate, the average lives of 6 PAC bonds are different (ex 12-11). • What do you see from there?

  16. TAC • One-side prepayment protection. • Has a single PSA rate from which the schedule of principal repayment is protected • Typically protected when prepayment is high, thus avoid contraction risk.

  17. Credit Risk and Tax Treatment of CMOs • Agency CMOs • Nonagency CMOs • Interest and principal payments are not taxable.

  18. Stripped Mortgage-Backed Securities • Principal-only (PO) securities • when current mortgage rate < coupon rate, prepayment speeds up.  price goes up • when current mortgage rate > coupon rate, price drops. • Interest-only (IO) securities • current mortgage rate < coupon rate, mixed • Exhibit 12-145(page 282) • CMO strips: one class in CMO structure could be PO or IO.

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