© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 1 CHAPTER TWENTY THE SECONDARY MARKET: CMO’S AND DERIVATIVE SECURITIES

© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 2 Chapter Objectives Differentiate between MPTs and MPTBs CMOs alleviate prepayment risk Investors rate of return CMO vs. REMIC

© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 3 Mortgage Pay-Through Bonds 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

© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 4 Collateralized Mortgage Obligation (CMOs) Alleviates reinvestment risk Alleviates prepayment risk CMOs are debt instruments Pool of mortgages as collateral Issuer retains ownership and issues bonds against the pool

© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 5 Collateralized Mortgage Obligation (CMOs) Continued All payments flow through Security holder assumes prepayment risk Multiple classes of security (maturities) prioritization established by using tranches- different maturity dates

© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 6 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

© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 7 Investment Characteristics of Mortgage Related Securities MBBMPTMPTBCMO Type of security interest acquired DebtEquityDebt # of security classes One Multiple Pass-through of principal NoneDirect Prioritized Party bearing prepayment risk IssuerInvestor Overcollateralization NoYesNoYes

© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 8 Investment Characteristics of Mortgage Related Securities Continued MBBMPTMPTBCMO Overcollateral market to market YesNANo Credit enhancements used? YesNoYesNo Maturity period known? YesNo Call provisions PossiblyCleanupPossiblyCalamity and nuisance Off- balance sheet financing possible? NoYesNoyes

© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 9 Commercial Mortgage-Backed Securities CMBSs Take the form of MBB, a pass through security or a collateralized mortgage obligation Default risk is greater Secured by income properties Non-recourse loans must look to security to satisfy loan Shorter maturities Senior and subordinated tranches

© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 10 Commercial Mortgage-Backed Securities CMBSs Continued Prepayment risk mitigated by “lockouts” and prepayment penalties Extension risk

© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 11 CMBS General Bond Risk Conditions RatingSubordinationDSCRLTVPrice AAA30% % AA24% % A18% %100 BBB11%1.57%66.75%98 BB6% %75 B3% %65 NR0% %35

© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 12 CMBSs- Enhancements Third party guarantees Surety bonds, LC’s Advance payment guarantees Repurchase agreements Lease assignments Overcollateralization Cross default provisions

© 2005 The McGraw-Hill Companies, Inc., All Rights Reserved McGraw-Hill/Irwin Slide 13 Real Estate Mortgage Investment Conduits (REMIC’S) Limited life Self liquidating Minimal management No taxation at the entity level Qualified mortgages Foreclosure property only Assets limited to S-T, passive, or interest bearing assets Qualified reserve fund