Investments & Securities Chapter 12 Agency Collateralized Mortgage Obligations And Stripped Mortgagebacked Securities Summary This

CHAPTER 12

AGENCY COLLATERALIZED MORTGAGE OBLIGATIONS

AND STRIPPED MORTGAGE-BACKED SECURITIES

CHAPTER SUMMARY

In this chapter we discuss two derivative mortgage-backed securities products: collateralized

mortgage obligations and stripped mortgage-backed securities. In the agency mortgage-backed

securities markets, these securities are referred to as derivative mortgage products since they

AGENCY COLLATERALIZED MORTGAGE OBLIGATIONS

Collateralized mortgage obligations(CMOs) are bond classes created by redirecting the cash

flows of mortgage-related products so as to mitigate prepayment risk. The mere creation of

a CMO cannot eliminate prepayment risk; it can only transfer the various forms of this risk

Sequential-Pay Tranches

The first CMO was created in 1983 and was structured so that each class of bond would be

retired sequentially. Such structures are referred to as sequential-pay CMOs.

A CMO is created by redistributing the cash flow (interest and principal) to the different tranches

average life different from that of the collateral.

There is considerable variability of the average life for the tranches. However, there is some

protection provided for each tranche against prepayment risk. This is because prioritizing the

distribution of principal (i.e., establishing the payment rules for principal) effectively protects the

shorter-term tranche against extension risk. This protection must come from somewhere, so it

The accrual bond has appeal to investors who are concerned with reinvestment risk. Because

there are no coupon payments to reinvest, reinvestment risk is eliminated until all the other

tranches are paid off.

Floating-Rate Tranches

Floating-rate tranches can be created from fixed-rate tranches by creating a floater and an

Assume that the reference rate is the one-month LIBOR of 3.75%, then the coupon rate on the

inverse floater takes the following form:

K– L×(one-month LIBOR)

whereK is the cap or maximum coupon rate for the inverse floater and L is the multiple that

determine the coupon rate for the inverse floater (L is referred to as the coupon leverage). If K is

the floating rate bond class cannot be negative. If there are no restrictions placed on the coupon

rate for the inverse floater, however, it is possible for the coupon rate for that bond class to be

negative. To prevent this, a floor, or minimum, can be placed on the coupon rate. In many

structures, the floor is set at zero. Once a floor is set for the inverse floater, a cap or ceiling is

imposed on the floater.

mid-1980s. In March 1987, the M.D.C. Mortgage Funding Corporation CMO Series 0 included

a class of bonds referred to as stabilized mortgage reduction term (SMRT) bonds; another

class in its CMO Series P was referred to as planned amortization class (PAC) bonds. The

Oxford Acceptance Corporation III Series C CMOs included a class of bonds referred to as a

planned redemption obligation (PRO) bonds. The greater predictability of the cash flow for

Most CMO PAC structures have more than one class of PAC bonds. From a PAC bond, we can

create other bonds with average lives that are stable and also where all average lives are either

much shorter or longer. Even if prepayments are faster than the initial upper collar, there may be

sufficient support bonds to assure the average life is unchanged. The degree of protection against

extension risk increases for shorter PAC bonds. The effective collar can be wider than the initial

and contraction risk) that a PAC offers must come from somewhere.

The prepayment protection comes from the support bonds. It is the support bonds that forego

principal payments if the collateral prepayments are slow; support bonds do not receive any

principal until the PAC bonds receive the scheduled principal repayment. This reduces the risk

that the PAC bonds will extend. Similarly, it is the support bonds that absorb any principal

Busted means that the prepayment protection is reduced. It is the term used in the CMO market

when a PAC schedule is broken. The initial collars are not particularly useful in assessing the

prepayment protection for a seasoned PAC bond. This is most important to understand, as it is

common for CMO buyers to compare prepayment protection of PACs in different CMO

structures, and conclude that the greater protection is offered by the one with the wider collar.

the lower range of the effective collar. This is because it will take faster prepayments to make up

the shortfall of the scheduled principal payments not made plus the scheduled future principal

payments.

The PAC schedule may not be satisfied even if the actual prepayments never fall outside the

initial collar. This may seem surprising because our previous analysis indicated that the average

The collateral can be used to create interest-only and principal-only tranches. These same types

of bond classes can be created from aPAC bond. The difference between the bond classes

described and those created from aPAC bond is simply the prepayment protection offered by the

PAC structure.

Targeted Amortization Class Bonds

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the TAC bond is less than that for a PAC bond.

The creation of a bond with a schedule of principal repayments based on a single prepayment

rate results in protection against contraction risk but not extension risk. Thus, whereas PAC

bonds are said to have two-sided prepayment protection, TAC bonds have one-sided prepayment

protection.

Very Accurately Determined Maturity Bonds

Accrual or Z bonds have been used in CMO structures as support for bonds called very

accurately determined maturity (VADM) or guaranteed final maturity bonds. In this case

the interest accruing (i.e., not being paid out) on a Z bond is used to pay the interest and principal

on a VADM bond.

0.075

where excess interest = collateral coupon rate – tranche coupon rate.

Support Bonds

The support bonds—or bodyguards—are the bonds that provide prepayment protection for the

PAC tranches. Consequently, they are exposed to the greatest level of prepayment risk. The

Synthetic-Coupon Pass-Throughs

The first generation of SMBS were synthetic-coupon pass-throughs was where two securities

were paid some interest and principal from a pass-through security but the distribution of interest

or principal are not equal. The result is two securities with a synthetic coupon rate that is

different from that of the underlying pass-through security from which they were created.

Interest-Only/Principal-Only Strips

In the synthetic coupon pass-throughs, at least some interest and principal is paid to the two

securities created. In an interest-only (IO) security and principal-only (PO) security, all of the

Collateralized Mortgage Obligation Strips

One of the classes in a CMO structure can be a principal-only or an interest-only class. These are

called CMO strips or structured IOs.

KEY POINTS

differs from that of the collateral.

• An accrual tranche allows the creation of even shorter-term and longer-term average life

tranches than in a sequential-pay CMO without the inclusion of an accrual tranche.

• From any of the fixed-rate tranches, a floater and an inverse can be created.

• An interest-only and a principal-only tranche can be created from a tranche. A notional IO is

• Targeted amortization class bonds are created so as to provide protection against contraction

risk but not against extension risk. A reverse TAC also provides one-sided protection:

protection against extension risk but not against contraction risk. A very accurately

determined maturity bond also provides protection against extension risk.

• Support bonds are the riskiest tranche within a CMO structure. From support bonds other

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• There are three types of SMBS: (1) synthetic-coupon pass–throughs, (2) interest-only/principal–only

securities, and (3) CMO strips.

ANSWERS TO QUESTIONS FOR CHAPTER 12

(Questions are in bold print followed by answers.)

1. How does a CMO alter the cash flow from mortgages so as to shift the prepayment risk

across various classes of bondholders?

Prepayment risk refers to the risk associated with the early unscheduled return of principal on a

fixed-income security. Collateralized mortgage obligations (CMOs) redirect cash flows from

2. What is the difference between a REMIC and a CMO?

All three entities (Ginnie Mae, Fannie Mae, and Freddie Mac) that issue agency pass-through

securities also issue CMOs, with Ginnie Mae being a late entry into the market, issuing its first

CMO in 1994. The CMOs are not referred to not as CMOs by these issuers. They are referred to

3. Answer the below questions.

(a) “By creating a CMO, an issuer eliminates the prepayment risk associated with the

underlying mortgages.” Do you agree with this statement?

(b) Wall Street often refers to CMOs as “customized securities.” Explain why.

4. In a discussion of the CMO market, the popular press sometimes refers to this sector of

the mortgage-backed securities market as the riskiest sector and the pass-through sector as

the safest sector. Comment.

5. Explain the effect on the average lives of sequential-pay structures of including an

accrual tranche in a CMO structure.

The effect of an accrual tranche is to decrease the average lives of the other tranches at the

expense of the accrual tranche. Background information on sequential-pay CMOs and more

details on the effect of an accrual tranche are given below.

allows the cash flow to be projected.

The principal pay-down window for a tranche is the time period between the beginning and the

ending of the principal payments to that tranche. Tranches can have average lives that are both

shorter and longer than the collateral, thereby attracting investors who have a preference for an

average life different from that of the collateral. However, there is considerable variability of the

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commonly referred to as an accrual tranche or a Z bond (because the bond is similar to a

zero-coupon bond). The interest that would have been paid to the accrual bond class is then used

to speed up or pay down of the principal balance of earlier bond classes. Thus, the average lives

for the other tranches become shorter because of the inclusion of the accrual bond.

6. What types of investors would be attracted to an accrual bond?

7. Suppose that a tranche from which an inverse floater is created has an average life of

seven years. What will be the average life of the inverse floater?

The coupon rate on the tranche from which two classes (floater and inverse floater) are created

can support the aggregate interest payments that must be made to them. As in the case of the

weightsfloaterinverse

‘

Let’s illustrate. Suppose that the floater and inverse floater are equally-weighted (each weight =

½). If so, then, we have:

weightsfloaterinverse

‘

Now assume that the average life for the floater and inverse floater are equal (X = Y). Further

solving gives: (1/2)X + (1/2)X = 7 years ➔ X = 7 years and Y = 7 years.

8. This quotation is taken from a 1991 issue of BondWeek:

First Interstate Bank of Texas will look into buying several different types of collateralized

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mortgage obligation tranches when it starts up its buy program sometime after the second quarter

of 1991, according to Jules Pollard. V.P. Pollard said he will consider replacing maturing

adjustable-rate mortgage pass-throughs with short companion tranches and planned amortization

classes because the ARMs have become rich. . . . Pollard did not provide a dollar figure on the

planned investments, which will be made to match fund the bank’s liabilities. When he does

invest he said he prefers government guaranteed securities or those with implied guarantees.

Answer the below questions.

(a) Explain the types of securities that Pollard is buying and selling.

Pollard wants to replace (or sell) adjustable-rate mortgage pass-throughs.

(b) Given the preference stated in the last sentence of the quotation, what issuers is he

likely to prefer? What issuers would he reject?

Given the last sentence, one would conclude that Pollard wants tranches backed by agency

CMOs. In particular, he would want Ginny Mae, Freddie Mae, and Fannie Mae. He would reject

any tranches backed by nonagency CMOs which are not (implicitly or explicitly) guaranteed by

the government. More details as to what Pollard would prefer are given below.

quicker. Thus, he wants to avoid contraction risk.

The mere creation of a CMO cannot eliminate prepayment risk; it can only transfer the various

forms of this risk among different classes of bondholders. Pollard wants a “short companion”

which indicates he wants a tranche where the principal is paid off early. This is not consistent

9. Describe how the schedule for a PAC tranche is created.

The schedule for a PAC tranche is set so that there will be greater predictability of the cash flow

through establishing a principal repayment schedule that must be satisfied. The schedule will be

set so that PAC bondholders have priority over all other classes in the CMO issue in receiving