April 1, 2010
Ruben Hovhannisyan
Vice President
U.S. Fixed Income
Fixed Income Research Commentary
Collateralized Mortgage Obligations:
An Introduction to Sequentials, PACs, TACs, and VADMs
The Evolution of Mortgage Securities
The U.S. mortgage market is the largest and perhaps most
diverse sector of the fixed income landscape. Mortgage
securities are segmented according to whether they are
guaranteed by an agency or an instrumentality of the Federal
government (so-called agency mortgages) or whether their
credit enhancement is a function of the underlying collateral
(the mortgage loans themselves) in combination with
various forms of structural credit enhancement built
into the actual bonds.
The most basic form of claim in the mortgage market
is the pass-through. Essentially, an underwriter (typically
a Wall Street firm) buys some number of mortgage loans
from an originator (a bank or mortgage broker) and places
them into a bankrupt-remote trust, generally a so-called
REMIC (a real-estate mortgage investment conduit)1.
The homeowners make their monthly payments to their
respective mortgage servicer who then remits the monies
(principal and interest) to the REMIC. The cash is then
distributed to the mortgage pass-through note holders
in a pro rata manner. Hence, the pass-through in and
of itself is simply a mechanism by which "shares"
in a pool of mortgages can be securitized and distributed.
The mortgage market, a financial innovation of the late
1970s, was designed to solve one of the problems brought
on by the combination of Regulation T (which prevented
banks and S&Ls from paying more than 5 1/4% on deposits)
and various laws which restricted interstate banking activity.
The mortgage market became a mechanism by which
prospective homeowners in fast growth states (think
“Sunbelt” states in the in the late 1970s) could gain access
to savers from slow growth states (think “Snowbelt” from
the same era). In essence, the advent of mortgage
securitization expanded the pool of available mortgage
lenders beyond the state level to the nation as a whole
and, now, worldwide.
To improve mortgage product distribution, Wall Street
further developed the mortgage market with the creation
of the Collateralized Mortgage Obligation (CMO).
The CMO became a means by which the principal and
interest payments coming off the mortgage pools could
be redistributed in a variety of cash flow packages. Initially,
these packages took the form of the "sequential pay" CMO,
which over time was expanded to include a very wide variety
of structures and cash flows designed to suit the individual
preferences of investors (and to enhance the profitability
of the Wall Street underwriters). Although there can seem
to be an overwhelming number of CMO variations, these
variations all ultimately derive from the rules governing
payment of principal and a complimentary set of rules
specifying payment of interest.
1 In the case of agency MBS, the originator packages the loans and “swaps” them for MBS pass-throughs with an agency (Government Sponsored Enterprise), which charges a
“guarantee fee” to ensure timely interest and principal payments. The originator then sells the pass-throughs to Wall Street firms.
Fixed Income Research Commentary
Collateralized Mortgage Obligations:
An Introduction to Sequentials, PACs, TACs, and VADMs (cont’d)
The scope of this brief is to provide an overview of that group
of CMOs referred to as sequentials, PACs, TACs and VADMs.
As a general rule, these CMO types are those which present
a relatively stable cash flow profile, even as prepayments
fluctuate. In so doing, Wall Street is servicing the demand
for lower volatility mortgage assets. Of course, it goes almost
without saying that the presence of prepayment-protected
CMOs forces into existence those CMOs that exhibit an
exaggerated response to fluctuating prepayments. In effect,
the CMO marketplace is a mechanism by which some
investor (the buyer of a PAC) is able to express his preference
for more stability by sacrificing yield. Conversely, other
investors (buyers of companion tranches) can receive
higher yield by accepting the relatively elevated prepayment
risk of their CMO holdings.
As it relates to the modalities of principal payment structures,
the basic menu as to how a CMO can pay is as follows:
Pass-through/Pro-rata
Sequential
Planned Amortization Class (PAC)
Targeted Amortization Class (TAC)
Companion
Very Accurately Defined Maturity (VADM)
Interest-Only
Principal-Only
The menu of options for paying interest is as follows:
Fixed rate
Floating rate
Sequential “Plain Vanilla” CMOs
Inverse Floating rate
The sequential CMO is perhaps the simplest to describe
in terms of structure. A pool of say 30-year mortgage passthroughs is placed into a REMIC trust. Assume the entire
pool is carved up into a sequential CMO. In that event,
the claims priority on the cash flows initially resembles:
Interest-Only
TTIB (Two-tiered Indexed bond)
Principal-Only
Accrual (pay-in-kind, known as Z bonds)
Super Floaters
Pool of
Mortgage
Pass-Throughs
A basic way to understand the CMO market is simply to
recognize that the CMO is a mechanism for repackaging
and re-arranging cash flows generated by pools of mortgage
pass-throughs. Significantly, the structuring desks can mix
and match the aforementioned principal payment structures
with the various interest payment structures. It is via these
combinations that the seeming menagerie of CMO bonds
proliferates. For instance, a sequential-pay bond can be
either a fixed rate or floating rate sequential. Alternatively,
a fixed rate pass-through may be used to create an
inverse IO and a floating rate bond.
Principal
2
Interest
A
B
C
Z
VADM
Tranche
Tranche
Tranche
Tranche
Tranche
Fixed Income Research Commentary
Collateralized Mortgage Obligations:
An Introduction to Sequentials, PACs, TACs, and VADMs (cont’d)
Beginning with the first tranche of a “vanilla deal,” each bond
receives all the principal payments until it is completely paid
down; then the next tranche begins to receive principal until
it is completely paid down. Obviously, fast prepayments
on sequential structures will shorten the average lives of
the individual bonds. However, plain vanilla CMOs have
some degree of protection against prepayments because
every preceding tranche has to be paid off in-full before
prepayments begin to affect sequentials situated further
back in the deal structure.
such that the cash flow schedule is guaranteed as long
as prepayment speeds2 stay within a stated range called
the PAC band. The PAC band specifies the low and high
future prepayment rates within which the bond’s payments
remain exactly defined. As such, a PAC is said to offer “call”
protection (i.e. protection against the risk of the shortening
of the bond’s average life due to elevated prepayment rates)
as well as “extension” protection (i.e. protection from the
bond lengthening its average life due to slower prepayments).
Scheduled principal payments to PAC bonds are protected
from prepayment risk by surrounding classes of securities
known as the companion bonds or support classes.
The companion tranches around the PAC absorb excess cash
flow in times of high prepayments, and “release” principal
in times of low prepayments. Because the companion bonds
around the PAC serve as a “principal buffer,” the PAC itself
has added stability. Conversely, the effect of principal
prepayments on the average life and cash flow of the
companion bonds becomes exaggerated. Once again,
stability of cash flow in one part of the capital structure
of a CMO can only be enhanced at the expense of another
part of the CMO, hence the inverse stability relationship
between a PAC and its corresponding companion bond.
The average lives of sequential bonds are generally stable,
but can be greatly influenced by the presence of Z-bonds
in the deal structure. Z-bonds are accrual structures which
receive no interest (only payment-in-kind) until their
principal begins to pay down. Interest accrued on a Z-bond
is deferred and added to the principal of the Z-bond
(“Z accretion”), while the interest cash flows are applied
to VADM bonds. The presence of a long sequential Z-bond
adds stability to the earlier sequential tranches.
Sequential bonds are ordinarily priced on the basis of some
spread over that Treasury whose maturity corresponds to
the tranche’s expected average life. In upwardly sloped yield
curve environments, Wall Street underwriters prefer to use
faster rather than slower prepayment assumptions. In so
doing, all tranches are assumed to have shorter average
lives and get priced off lower yielding (higher priced) parts
of the Treasury curve. Generally, sequential spreads will be
wider than protected classes (like PACs), but narrower than
more volatile average life bonds (like companions).
Prepayment Speed
6 CPR
Avg Life 1.68 yrs
10 CPR
15 CPR
18 CPR
20 CPR
1.14 yrs
1.14 yrs
1.14 yrs
1.07 yrs
PAC bond exhibits stable
characteristics when
prepayments2 remain within
the PAC band range.
Planned Amortization Class (PAC) Bonds
Planned Amortization Class (PAC) bonds were launched in
1986 to present the capital markets with a mortgage security
with a better defined trajectory of cash flows versus that
of a sequential payer. The payment rules for the PAC are
2 Prepayment speeds that form the PAC band generally follow PSA convention, which assumes that prepayment rate starts at zero, gradually increases in the first 30 months, and stays
constant thereafter.
3
Fixed Income Research Commentary
Collateralized Mortgage Obligations:
An Introduction to Sequentials, PACs, TACs, and VADMs (cont’d)
correspondingly lower degree of prepayment protection
versus that of a regular PAC, and are more readily “broken”
than a normal PAC.
The degree of call or extension protection offered by PAC
bonds depends upon the width of the band, which is largely
dependent on the size of the support classes. The higher the
percentage of companion bonds within the CMO structure,
the more stable the PAC bonds will be. PAC bands delimit
the range of prepayment speeds in which principal cash flow
is guaranteed. Outside the bands, PAC bond average lives
may shorten or extend significantly depending on the
structure of the CMO.
Another “variety” of PAC is the so-called PAC II. The PAC II
actually has some characteristics of companion (support)
bonds; hence, the name is a bit misleading. Suffice it to
say that a PAC II provides some principal payment stability
within a much narrower range of prepayments than is typical
for a regular PAC (i.e. a so-called PAC I).
When a PAC bond is subjected to prepayment rates outside
those of the band for a sustained period or if prepayments
are within the band, but are not stable month to month,
the PAC may, at some point, become “broken.” A broken
PAC no longer possesses the desirable traits of a well-defined
cash flow profile. Although “breaking” a PAC’s schedule will
generally have an unfavorable effect on the valuation of a PAC
bond, the net effect will also be impacted by the bond’s
coupon level relative to the prevailing market yields.
Breaking the lower band of a PAC which pays a premium
coupon will have a net positive effect on the yield
of the bond as the holders of the bond will enjoy higher
coupon rates for a longer time horizon. Similarly, breaking
the upper band of a discount coupon PAC will result in
the earlier receipt of principal and, consequently, will have
a positive impact on the yield of the PAC bond, although
the bond may be paid off sooner than originally anticipated.
Targeted Amortization Class (TAC) Bonds
Unlike PAC bonds which offer both call and extension
protection, TACs offer only one-sided protection, against call
risk only. When rates fall and prepayments rise, the principal
cash flow to the TAC will remain fairly stable. When rates
rise and prepayments slow, TACs will ordinarily extend
(sometimes dramatically) their average life. In this sense,
a TAC bond has characteristics similar to that of a companion
bond. Indeed, a TAC is often used as a companion class to
a PAC bond. TACs are able to adhere to their principal
payment schedules because of still other companion bonds
that absorb excess cash flow when prepayments are high.
High prepayments cause the companion bonds which
support the TAC to be paid off before the TAC is fully paid
down. Once all the companion bonds are retired, the TAC
receives all the principal cash flow from the remaining
collateral. This cash flow may not be enough to meet the TAC’s
initial principal payment schedule. Hence, the TAC may
receive cash flows beyond its original maturity date.
In response to the very high level of prepayment instabilities
which the mortgage markets have witnessed over the past
twenty years, Wall Street has invented the Super-PAC.
The Super-PAC works in conjunction with one or more
subordinate PACs in order to create a bond which has
a broader measure of protection than a regular PAC.
A Super-PAC is meant to be highly resistant to becoming
“broken.” Of course, the subordinate PACs have a
TACs are priced at some spread over the Treasury curve.
Generally speaking, TAC spreads will be wider than PAC
bonds of similar average life, reflecting the lesser stability
of the TAC.
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Fixed Income Research Commentary
Collateralized Mortgage Obligations:
An Introduction to Sequentials, PACs, TACs, and VADMs (cont’d)
Very Accurately Defined Maturity (VADM) Bonds
Conclusion
Very Accurately Defined Maturity (VADM) bonds represent
yet another structure designed to protect investors from
extension risk caused by rising interest rates. The first VADM
bonds were created in the 1990s in response to government
regulation which required banks and thrifts to invest a
fraction of their assets in high-quality, short-term securities
guaranteed not to extend beyond a certain date. Wall Street
was quick to meet the new demand by designing VADM
bonds, which derive all their cash flows from the interest
accrued to (but not paid to) a Z-bond. Given that Z-bonds
will continue accruing interest even under zero prepayments
scenarios, there is virtually no event that may cause an
extension of a VADM bond. Conversely, even if interest rates
fall sharply and prepayments skyrocket, VADM bonds still
cushion against call risk. This (limited) protection against
call risk is predicated on the fundamental cash flow
characteristics of underlying Z-bonds, which are usually
the last tranche in a CMO structure to receive principal.
Sequentials, PACs, TACs and VADMs represent the most
basic CMO types and the ones with generally more stable
average life and duration profiles. The stability of these
CMO structures is achieved through “pairing” these bonds
with one or more CMO tranches with more volatile
prepayment response profiles, such as companions or
Z-bonds, which act as “buffers” and absorb some of
the impact from interest rate and prepayment rate volatility.
An overview of some of these more volatile CMO types
as well as mortgage derivative securities (e.g. IOs, POs,
inverse floaters, etc.) will follow in subsequent briefs.
This publication is for information purposes only. While the information and statistical data contained herein are based on sources believed to be reliable, we do not represent that it is
accurate and should not be relied on as such or be the basis for an investment decision. Any opinions expressed are current only as of the time made and are subject to change without
notice. TCW assumes no duty to update any such statements. Copyright TCW 2010
METWEST IS A WHOLLY-OWNED SUBSIDIARY OF THE TCW GROUP, INC.
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