Collateralized Mortgage Obligations (CMOs) History and Application Michael Wallace BA543-1

Agenda What is a CMO? What is a CMO? History History Risk Risk Example – (Sequential-Pay CMO) Example – (Sequential-Pay CMO) Types of CMOs Types of CMOs Conclusion Conclusion

What is a CMO? Pools of securitized mortgages whose cash flows have been dedicated to two or more types of bond classes designed to better meet investor needs. Pools of securitized mortgages whose cash flows have been dedicated to two or more types of bond classes designed to better meet investor needs. Derivative mortgage securities Derivative mortgage securities

What is a CMO? Interest Scheduled principal payments Prepayments Interest Scheduled principal payments Prepayments Interest Scheduled principal payments Prepayments Interest Scheduled principal payments Prepayments Monthly Cash Flow Pass-through: Pooled mortgage loans CMO Loan # 1 Loan # 2 Loan # 3 Loan # 4 Rule for distribution of cash flow (i.e. Pro rata basis)

Who issues CMOs? Agencies (i.e. Freddie Mac, Ginnie Mae..etc) Agencies (i.e. Freddie Mac, Ginnie Mae..etc) Non-agency (i.e. Countrywide) Non-agency (i.e. Countrywide) Private-label Private-label Whole-loan Whole-loan

History The first CMO was issued in 1983 by Freddie Mac The first CMO was issued in 1983 by Freddie Mac Volatility of interest rates in previous decade => high prepayment risk Volatility of interest rates in previous decade => high prepayment risk Sears/Dean Witter, Reynolds attempted CMO issuance in 1984 Sears/Dean Witter, Reynolds attempted CMO issuance in 1984 IRS ruling made CMOs uncompetitive IRS ruling made CMOs uncompetitive Tax Reform Act of 1986 Tax Reform Act of 1986 Creation of the Real Estate Mortgage Investment Conduit (REMICs) Creation of the Real Estate Mortgage Investment Conduit (REMICs) Required accrual-based accounting for investors Required accrual-based accounting for investors

Characteristics Maturity – Matures when investor receives final principal payment Maturity – Matures when investor receives final principal payment Weighted average maturity (WAM) Weighted average maturity (WAM) Yield Yield Assumed prepayment rates Assumed prepayment rates Tranches Tranches Interest Interest Principal – “active” tranche Principal – “active” tranche

CMO Prices Interest Rates Prices and Rates Interest Rates CMO Prices The Three Relationships Prices and Time CMO Life CMO Prices Prepayments and Time CMO LifeCMO Prices Prepayment Interest Rates Prepayment

Risk Why not invest directly in mortgages? Why not invest directly in mortgages? Exposure: credit risk, liquidity risk, price risk, prepayment risk Exposure: credit risk, liquidity risk, price risk, prepayment risk Types of Risk Types of Risk Price Risk Price Risk Return Risk Return Risk Prepayment (“Call”) Risk Prepayment (“Call”) Risk

Prepayment Risk Contraction Risk-Decline in mortgage rates that effectively shortens the life of a pass-through security Contraction Risk-Decline in mortgage rates that effectively shortens the life of a pass-through security Extension Risk-Increase in mortgage rate that effectively lengthen the life of a pass-through security Extension Risk-Increase in mortgage rate that effectively lengthen the life of a pass-through security

Prepayment Speed Assumptions (PSA) Model Created by the Bond Market Association Created by the Bond Market Association Based on Constant Prepayment Rate (CPR) Based on Constant Prepayment Rate (CPR) Annualized amount of outstanding principal prepaid each month (SMM) Annualized amount of outstanding principal prepaid each month (SMM) Ex. 100% PSA => 0.2%CPR in first month, 0.4% CPR in second month, and increases until rate reaches 6% Ex. 100% PSA => 0.2%CPR in first month, 0.4% CPR in second month, and increases until rate reaches 6% PSA 600

Example Sequential-Pay CMO

Classes of CMOs Sequential-Pay Sequential-Pay Planned Amortization – PAC & Companion Tranches Planned Amortization – PAC & Companion Tranches Type I PAC – 100% to 300% PSA Type I PAC – 100% to 300% PSA Target Amortization Target Amortization Companion Tranches – Higher yield, greater uncertainty Companion Tranches – Higher yield, greater uncertainty Z-Tranches Z-Tranches Principal-Only (PO) Principal-Only (PO) Interest-Only (IO) Interest-Only (IO) Floating-Rate – tied to interest rate index (i.e. LIBOR) Floating-Rate – tied to interest rate index (i.e. LIBOR) Residuals Residuals

Conclusion Why invest in CMOs? Why invest in CMOs? High credit rating (AAA) High credit rating (AAA) Low minimum cost to buy into ($1,000) Low minimum cost to buy into ($1,000) Competitive yield Competitive yield Flexibility to meet investor needs (maturity) Flexibility to meet investor needs (maturity) Ability to receive monthly cash flow Ability to receive monthly cash flow Hedging against prepayment risk Hedging against prepayment risk Liquidity Liquidity CMO Issuance

Questions?