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Chapter Objectives
Fin5413 Chapter 20
THE SECONDARY MARKET:
CMO’S AND DERIVATIVE
SECURITIES
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„
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Differentiate between MPTs and MPTBs
Collateralized Mortgage Obligation
(CMO)
designed
„
to mitigate some prepayment risk
CMO vs. REMIC
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Slide 3
Real Estate Mortgage Investment
Conduits (REMICS)
Mortgage Pay-Through Bonds
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Hybrid securities
Issued against mortgage pools
Cash flows are passed to security holders
A bond
A debt obligation of the issuer, who retains
ownership - Unlike a MPT which represents a
undivided equity ownership
Over collateralized like MBBs
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The secondary mortgage industry wanted a way
to mitigate the effect of the uncertain timing of
mortgage payoffs of a pass through
The solution was the creation of the CMO
However, there was a potential tax problem
A REMIC is a tax status for a pool of mortgages
REMICs are only taxed at the CMO level and
not at the entity (pool) level
Must follow rules (as do mutual funds) to get
this special tax status
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Slide 5
Real Estate Mortgage Investment
Conduits (REMICS)
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Limited life and self liquidating with minimal
management
No taxation at the entity level
REMIC assets consist only of:
Qualified
mortgages
property only
Short term, passive, or interest bearing assets used
to reinvest funds not yet paid to out to investors
Qualified reserve fund (more important if assets are
not backed by GNMA, FNMA, or FHMLC)
Foreclosure
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Slide 6
Idea behind CMO’s
A pool of mortgages can be seen as a
set of cash flows, that can be spit into
pieces and sold as pieces rather than
as an undivided fraction of the pool
„ Like the Seinfeld episode where the
muffin tops were being sold separately
from the less desirable muffin bottom
„
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Collateralized Mortgage Obligation
(CMOs) Continued
Collateralized Mortgage
Obligation (CMOs)
All payments flow through to the bond
holders
„ Security holder assumes prepayment risk
„ Multiple classes of security (maturities) are
issued
„ Payment prioritization established by using
Tranches of different maturity dates
„
Mitigates some prepayment risk
„ CMOs are debt instruments
„ Pool of mortgages comprise the
collateral
„ Issuer retains ownership of the
mortgages and issue various classes of
bonds against the pool
„
Tranche
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is a French word meaning slice
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Slide 9
CMO - example
CMO - example
„
Mortgage Pool Consists of 102,000,000
of mortgages
„ Tranche A is 20,000,000 of (short term)
bonds which gets interest payments
plus all of the principal payments until
this class is paid off
„ Tranche B is 30,000,000 of medium
term bonds which receive interest only
until Tranche A is fully paid off, and
then receives all principal payments
„
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Slide 10
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Tranche Z is 50,000,000 of zero coupon like
bonds which get no payment (though they accrue
interest) until the first 2 Tranches are paid off, at
which time they get all the money paid into the
pool until they are paid off
If the average interest rate on the mortgages was
6%, Tranche A might earn 4.75%, Tranche B
5.25% and Tranche Z 5.75%
The residual cash goes to the Equity, which began
with $2,000,000, and represents the over
collateralization of the pool
Recall that the servicer and guarantor also get a
cut of the mortgage interest
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Slide 11
Weighted Average Coupon (WAC)
If the average interest rate on the
mortgages was 6%, Tranche A might earn
4.75%, Tranche B 5.25% and Tranche Z
5.75%
„ WAC = 0.2*4.75% + 0.3*5.25% +
0.5*5.75% = 5.40%
„ The rest of the coupon payment from the
underlying mortgages would go to pay the
servicing and guarantee fees and to pay
the equity portion of the pool
„
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Slide 12
CMO’s
Prepayment risk is now somewhat
mitigated as Tranche A absorbs the
earliest repayment, followed by Tranche
B. Tranche Z keeps its money invested
in the pool longer (Sequential Tranches)
„ When putting together CMO’s the
sponsor attempts to match investors
with the expected cash flow of the
Tranche
„
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Slide 13
CMO’s
Slide 14
CMO’s
Te reduce prepayment risk further, some
Tranches were set up as PAC’s (planned
amortization classes, and TAC’s, targeted
amortization classes) for which the
structure tried to keep the cash timing as
close as possible to projections
„ To take up the slack, companions were
also issued which took the prepayments if
they deviated from the expected pool
prepayment
„
As the CMO market grew, so did the
number of Tranches
„ It became increasingly common to sell
investors the type of Tranche the
investor desired
„ When all the desirable Tranches were
sold off, what was left were dubbed
“kitchen sink” bonds because the
originator had sold off everything but the
kitchen sink
„
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IO’s and PO’s
CMO’s
„
Another way to slice up the mortgage
cash flows is to separate the principal
and interest part of the cash flows
„ IO is an interest only strip
„ PO is a principal only strip
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An investor who buys a PO know for sure the
amount she will receive in cash payments (the
note amount). This investor does not know the
timing of these cash flows
An investor that buys an IO knows neither the
amount nor the timing of the cash flows (it
depends on the prepayment). IO’s are thus very
risky as if interest rates decline, refinancing will
rise, cutting off the future interest payments.
High prepayment is bad for IO holders and good
for PO
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Slide 17
The PSA Assumption
Slide 18
Interest, Principal, CF
100% PSA and Principle Balance (30 year term at 6%)
Cash Flow for 0% PSA
100%
6%
90%
$600
80%
$500
4%
60%
50%
3%
40%
Rate
Balance
2%
1%
30%
$400
$300
$200
$100
20%
10%
0%
$0
1
0%
0
McGraw-Hill/Irwin
Month
70%
Balance
AnnualRate
5%
0% PSA CF
Interest
Principle
$700
12
24
36
48
60
72
Month
84
96
108
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13 25
37
49 61
73 85
97 109 121 133 145 157 169
Monthly Cash Flow
120
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Interest, Principal, CF
Cash Flow for 100% PSA
Slide 20
Interest, Principal, CF
Cash Flow for 200% PSA
100% PSA CF
Interest
Principle
$1,200
200% PSA CF
Interest
$1,600
Principle
$1,400
$1,000
$1,200
Month
Month
$800
$600
$1,000
$400
$800
$600
$400
$200
$200
$0
$0
1
1
13 25 37 49 61 73 85 97 109 121 133 145 157 169
13 25 37 49 61 73 85 97 109 121 133 145 157 169
Monthly Cash Flow
Monthly Cash Flow
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Slide 21
PV of IO/PO by PSA
Slide 22
Floating Tranches
$80,000
„
PV Interest
PV Principle
$70,000
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$60,000
„
$50,000
$40,000
„
$30,000
$20,000
$10,000
„
$0
0% PSA
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100%PSA
200%PSA
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Slide 23
Derivative Security
Derives its value from another security
index, or financial claim
„ MPTs and CMOs are based on pools of
mortgages
„ Derivatives may be purchased to protect
the yield on another portfolio of mortgages
or bonds
„
Some Tranches have variable interest rates
May be from ARM mortgages
Fixed rate mortgages may also be used as a
pool for creating floater
Inverse floaters are used to balance off
floaters if fixed rates mortgages back up the
pool
If interest rates increase, the payments to
floaters increases, and the payments to
inverse floaters decrease
Investment Characteristics of
Mortgage Related Securities
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Slide 24
MBB
MPT
MPTB
CMO
Type of security
interest acquired
Debt
Equity
Debt
Debt
# of security classes
One
One
One
Multiple
Pass-through of
principal
None
Direct
Direct
Prioritized
Party bearing
prepayment risk
Issuer Investor Investor
Overcollateralization
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No
Yes
No
Investor
Yes
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Investment Characteristics of Mortgage Related
Securities Continued
MBB
MPT
MPTB
CMO
Overcollateral
marked to
market
Yes
NA
No
Price
No
(Pts-32ds)
Credit
Yes
enhancements
used?
No
Maturity period Yes
known?
No
Call provisions
Cleanup
Possibly
Off- balance
No
sheet financing
possible?
McGraw-Hill/Irwin
CMO data, WSJ, April 10, 2008
Yes
Yes
No
Possibly
No
No
No
Calamity
and
nuisance
yes
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PSA
Yield
(Prepay
to
Spread)
Maturity
*
FMAC GOLD
5.50%
101-03
273
5.28
FMAC GOLD
6.00%
102-24
691
4.93
FMAC GOLD
6.50%
103-28
642
4.81
FNMA
5.50%
101-02
273
5.25
FNMA
6.00%
102-20
664
4.95
FNMA
6.50%
103-25
707
4.64
GNMA **
5.50%
102-02
259
5.07
GNMA **
6.00%
103-09
555
4.78
GNMA **
6.50%
103-31
831
4.08
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Commercial Mortgage-Backed
Securities CMBS
CMO data, WSJ, April 10, 2008
Spreads in bp from Treasury with corresponding maturity
Maturity
Spread
Spread
2-year
5-year
7-year
10-year
20-year
SEQUENTIALS
185
183
170
168
132
PACs
160
156
156
156
120
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Take the form of MBB, MPT, or CMO
Default risk is greater
Secured by income properties
Non-recourse loans must look to security to
satisfy loan
Shorter maturities
Senior and subordinated Tranches
In
other words, in the case of defaults some Tranches
absorb more of the defaults than others
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Slide 29
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CMBS General Bond Risk
Conditions
Commercial Mortgage-Backed
Securities CMBSs Continued
Rating
Prepayment risk mitigated by “lockouts”
or other forms of prepayment penalties
„ Extension risk
„
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Subordinati
on
DSCR
LTV
Price
AAA
30%
2.00
52.50%
AA
24%
1.84
57.00%
102
101
A
18%
1.71
61.50%
100
BBB
11%
1.57%
66.75%
98
BB
6%
1.49
70.50%
75
B
3%
1.44
72.75%
65
NR
0%
1.40
75.00%
35
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CMBS- Enhancements
Third party guarantees
„ Surety bonds, LC’s
„ Advance payment guarantees
„ Repurchase agreements
„ Lease assignments
„ Overcollateralization
„ Cross default provisions
„
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