1. Global Edition Chapter 12 Agency Collateralized Mortgage Obligations and Stripped Mortgage- Backed Securities

2. © 2013 Pearson Education Learning Objectives After reading this chapter, you will understand  why and how an agency collateralized mortgage obligation is created  what is meant by REMIC and why CMOs are referred to as REMICs or REMIC structures  what a sequential-pay CMO is  how the average life of a sequential-pay CMO compares to that of the collateral from which it is created  what an accrual tranche is and its effect on the average life of sequential-pay tranches in the CMO structure  how a floater and an inverse floater are created from a CMO tranche

3. © 2013 Pearson Education Learning Objectives (continued) After reading this chapter, you will understand  what a planned amortization class tranche is and how it is created  how the prepayment protection for a planned amortization class changes over time  what a support tranche is and the substantial prepayment risk to which it exposes investors  what a support bond with a schedule is  what a notional IO is and how it is created  how agency stripped mortgage-backed securities are created  the various types of agency stripped mortgage-backed securities  the investment characteristics of agency stripped mortgage- backed securities

4. © 2013 Pearson Education 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 among different classes of bondholders. The bond classes created are commonly referred to as tranches. The principal payments from the underlying collateral are used to retire the tranches on a priority basis according to terms specified in the prospectus.  Entities 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 as CMOs but as REMICs. REMIC means Real Estate Mortgage Investment Conduit and is a provision in the Tax Reform Act of 1986.

5. © 2013 Pearson Education Agency Collateralized Mortgage Obligations (continued)  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 based on payment rules. There are separate rules for the payment of the coupon interest and the payment of principal, the principal being the total of the regularly scheduled principal payment and any prepayments. The payment rules at the bottom of Exhibit 12-1 (see Overhead 12-6) describe how the cash flow from the pass-through (i.e., collateral) is to be distributed to the four tranches.

6. © 2013 Pearson Education Exhibit 12-1 FJF-01: Hypothetical Four-Tranche Sequential-Pay Structure a TranchePar AmountCoupon Rate A$194,500,0007.5% B 36,000,0007.5% C 96,500,0007.5% D 73,000,0007.5% $400,000,000 a Payment rules: 1. For payment of periodic coupon interest: Disburse periodic coupon interest to each tranche on the basis of the amount of principal outstanding at the beginning of the period. 2. For disbursement of principal payments: Disburse principal payments to tranche A until it is paid off completely. After tranche A is paid off completely, disburse principal payments to tranche B until it is paid off completely. After tranche B is paid off completely, disburse principal payments to tranche C until it is paid off completely. After tranche C is paid off completely, disburse principal payments to tranche D until it is paid off completely.

7. © 2013 Pearson Education  Sequential-Pay Tranches Each tranche receives periodic coupon interest payments based on the amount of the outstanding balance at the beginning of the month. The disbursement of the principal, however, is made in a special way. A tranche is not entitled to receive principal until the entire principal of the preceding tranche has been paid off. 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. Agency Collateralized Mortgage Obligations (continued)

8. © 2013 Pearson Education  Sequential-Pay Tranches There is considerable variability of the average life for the tranches. Exhibit 12-3 (see Overhead 12-9) reports the average life of the collateral and the four tranches assuming different prepayment speeds.  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 comes from the other tranches. At the same time these other tranches are provided protection against contraction risk. Agency Collateralized Mortgage Obligations (continued)

9. © 2013 Pearson Education Exhibit 12-3 Average Life for the Collateral and the Four Tranches of FJF-01 Prepayment Speed (PSA) Average Life for CollateralTranche ATranche BTranche CTranche D 5015.117.4815.9821.0227.24 10011.664.9010.8615.7824.58 1658.763.487.4911.1920.27 2007.683.056.429.6018.11 3005.632.324.646.8113.36 4004.441.943.705.3110.34 5003.681.693.124.388.35 6003.161.512.743.756.96 7002.781.382.473.305.95

10. © 2013 Pearson Education  Accrual Bonds In many sequential-pay CMO structures, at least one tranche does not receive current interest. Instead, the interest for that tranche would accrue and be added to the principal balance. Such a bond class is 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 the pay down of the principal balance of earlier bond classes. To understand this, consider FJF-02 in Exhibit 12-4 (see Overhead 12-11), which is a hypothetical CMO structure with the same collateral as FJF-01 and with four tranches, each with a coupon rate of 7.5%. The difference is in the last tranche, Z, which is an accrual. Agency Collateralized Mortgage Obligations (continued)

11. © 2013 Pearson Education Exhibit 12-4 FJF-02: Hypothetical Four-Tranche Sequential-Pay Structure with an Accrual Bond Class a TranchePar AmountCoupon Rate (%) A$194,500,0007.5 B 36,000,0007.5 C 96,500,0007.5 Z (accrual) 73,000,0007.5 $400,000,000 a Payment rules: 1. For payment of periodic coupon interest: Disburse periodic coupon interest to tranches A, B, and C on the basis of the amount of principal outstanding at the beginning of the period. For tranche Z, accrue the interest based on the principal plus accrued interest in the preceding period. The interest for tranche Z is to be paid to the earlier tranches as a principal pay down. 2. For disbursement of principal payments: Disburse principal payments to tranche A until it is completely paid off. After tranche A is paid off completely, disburse principal payments to tranche B until it is paid off completely. After tranche B is paid off completely, disburse principal payments to tranche C until it is paid off completely. After tranche C is paid off completely, disburse principal payments to tranche Z, until the original principal balance plus accrued interest is paid off completely.

12. © 2013 Pearson Education The average lives for tranches A, B, and C are shorter in FJF-02 than in FJF-01 because of the inclusion of the accrual bond. For example, at 165 PSA, the average lives are as follows: The reason for the shortening of the nonaccrual tranches is that the interest that would be paid to the accrual bond is being allocated to the other tranches. Tranche Z in FJF-02 will have a longer average life than that of tranche D in FJF-01. Structure FJF-02 Tranche B 2.90 7.87 Tranche A Tranche C 5.86 FJF-013.487.4911.19 Agency Collateralized Mortgage Obligations (continued)

13. © 2013 Pearson Education  Floating-Rate Tranches Floating-rate tranches can be created from fixed-rate tranches by creating a floater and an inverse floater. We can select any of the tranches from which to create a floating-rate and an inverse-floating-rate tranche. We can even create these two securities for more than one of the four tranches or for only a portion of one tranche. Exhibit 12-6 (see Overhead 12-14) describes FJF-03, which is Hypothetical Five-Tranche Sequential-Pay Structure with Floater, Inverse Floater, and Accrual Bond Classes. Any reference rate can be used to create a floater and the corresponding inverse floater. There is an infinite number of ways to cut up the monetary value between the floater and inverse floater, and final partitioning will be driven by the demands of investors. Agency Collateralized Mortgage Obligations (continued)

14. © 2013 Pearson Education Exhibit 12-6 FJF-03: Hypothetical Five- Tranche Sequential-Pay Structure with Floater, Inverse Floater, and Accrual Bond Class TranchePar AmountCoupon Rate (%) A$194,500,0007.5 B 36,000,0007.5 C 96,500,0001-month LIBOR + 0.50 IFL 24,000,00028.50 – 3 × (1-month LIBOR) Z (accrual) 73,000,0007.5 $400,000,000

15. © 2013 Pearson Education  Floating-Rate Tranches Unlike a floating-rate note in the corporate bond market, whose principal is unchanged over the life of the instrument, the floater’s principal balance declines over time as principal payments are made. The principal payments to the floater are determined by the principal payments from the tranche from which the floater is created. 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) where K 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) EXAMPLE. If K is set at 28.50% and L at 3, then the coupon rate for the month is: 28.50% – 3(3.75%) = 17.25%. The higher the coupon leverage, the more the inverse floater’s coupon rate changes for a given change in one-month LIBOR. Agency Collateralized Mortgage Obligations (continued)

16. © 2013 Pearson Education  Floating-Rate Tranches Inverse floaters with a wide variety of coupon leverages are available in the market. Participants refer to: i.low-leverage inverse floaters as those with a coupon leverage between 0.5 and 2.1 ii.medium-leverage as those with a coupon leverage higher than 2.1 but not exceeding 4.5 iii.high-leverage as those with a coupon leverage higher than 4.5. As in the case of the floater, the principal pay-down of an inverse floater will be a proportionate amount of the principal pay-down of the bond class from which it is created. Agency Collateralized Mortgage Obligations (continued)

17. © 2013 Pearson Education  Floating-Rate Tranches Because the reference rate (e.g., one-month LIBOR) is always positive, the coupon rate paid to 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. The cap for the floater and the inverse floater, the floor for the inverse floater, the coupon leverage, and the margin spread are not determined independently. Given four of these variables, the fifth will be determined. Agency Collateralized Mortgage Obligations (continued)

18. © 2013 Pearson Education  Floating-Rate Tranches The CMO innovations attracted many institutional investors who had previously either avoided investing in mortgage- backed securities or allocated only a nominal portion of their portfolio to this sector of the fixed-income market. Potential demand for a CMO product with less uncertainty about the cash flow increased in the 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. Agency Collateralized Mortgage Obligations (continued)

19. © 2013 Pearson Education  Floating-Rate Tranches The greater predictability of the cash flow for classes of PAC bonds occurs because there is a principal repayment schedule that must be satisfied. The greater certainty of the cash flow for the PAC bonds comes at the expense of the non-PAC classes, called support or companion bonds. It is these bonds that absorb the prepayment risk. Because PAC bonds have protection against both extension risk and contraction risk, they are said to provide two-sided prepayment protection. Agency Collateralized Mortgage Obligations (continued)

20. © 2013 Pearson Education  Floating-Rate Tranches Exhibit 12-8 (see Overhead 12-21) shows a CMO structure, FJF-04, created from the $400 million, 7.5% coupon pass-through with a WAC of 8.125% and a WAM of 357 months. There are just two bond classes in this structure: a 7.5% coupon PAC bond created assuming 90 to 300 PSA with a par value of $243.8 million, and a support bond with a par value of $156.2 million. The two speeds used to create a PAC bond are called the initial PAC collars (or initial PAC bands); in our case, 90 PSA is the lower collar and 300 PSA is the upper collar. Agency Collateralized Mortgage Obligations (continued)

21. © 2013 Pearson Education Exhibit 12-8 FJF-04: CMO Structure with One PAC Bond and One Support Bond a TranchePar AmountCoupon Rate (%) P (Pac) $243,800,0007.5 S (Support)156,200,0007.5 $400,000,000 a Payment rules: 1. For payment of periodic coupon interest: Disburse periodic coupon interest to each tranche on the basis of the amount of principal outstanding at the beginning of the period. 2. For disbursement of principal payments: Disburse principal payments to tranche P based on its schedule of principal repayments. Tranche P has priority with respect to current and future principal payments to satisfy the schedule. Any excess principal payments in a month over the amount necessary to satisfy the schedule for tranche P are paid to tranche S. When tranche S is paid off completely, all principal payments are to be made to tranche P regardless of the schedule.

22. © 2013 Pearson Education  Floating-Rate Tranches Exhibit 12-9 (see Overhead 12-23) reports the average life for the PAC bond and the support bond in FJF-04 assuming various actual prepayment speeds. Notice that between 90 PSA and 300 PSA, the average life for the PAC bond is stable at 7.26 years. However, at slower or faster PSA speeds, the schedule is broken, and the average life changes, lengthening when the prepayment speed is less than 90 PSA and shortening when it is greater than 300 PSA. Even so, there is much greater variability for the average life of the support bond. Agency Collateralized Mortgage Obligations (continued)

23. © 2013 Pearson Education Exhibit 12-9 Average Life for Pac Bond and Support Bond in FJF-04 Assuming Various Prepayment Speeds Prepayment Rate (PSA)PAC Bond (P)Support Bond (S) 1015.9727.26 509.4424.00 907.2618.56 1007.2618.56 1507.2612.57 1657.2611.16 2007.268.38 2507.265.37 3007.263.13 3506.562.51 4005.922.17 4505.381.94 5004.931.77 7003.701.37

24. © 2013 Pearson Education  Creating a Series of PAC Bonds Most CMO PAC structures have more than one class of PAC bonds. We created six PAC bonds from FJF-04, which we call FJF-05. Information about this CMO structure is reported in Exhibit 12-10 (see Overhead 12-25). The total par value of the six PAC bonds is equal to $243.8 million, which is the amount of the single PAC bond in FJF-04. Agency Collateralized Mortgage Obligations (continued)

25. © 2013 Pearson Education Exhibit 12-10 FJF-05: CMO Structure with Six PAC Bonds and One Support Bond a TranchePar AmountCoupon Rate (%) P-A$ 85,000,0007.5 P-B 8,000,0007.5 P-C 35,000,0007.5 P-D 45,000,0007.5 P-E 40,000,0007.5 P-F 30,800,0007.5 S 156,200,0007.5 $400,000,000 a Payment rules: 1.For payment of periodic coupon interest: Disburse periodic coupon interest to each tranche on the basis of the amount of principal outstanding at the beginning of the period. 2.For disbursement of principal payments: Disburse principal payments to tranches P-A to P-F based on their respective schedules of principal repayments. Tranche P-A has priority with respect to current and future principal payments to satisfy the schedule. Any excess principal payments in a month over the amount necessary to satisfy the schedule for tranche P-A are paid to tranche S. When tranche P-A is paid off completely, tranche P-B has priority, then tranche P-C, and so on. When tranche S is paid off completely, all principal payments are to be made to the remaining PAC tranches in order of priority regardless of the schedule.

26. © 2013 Pearson Education  Creating a Series of PAC Bonds Exhibit 12-11 (see Overhead 12-27) shows the average life for the six PAC bonds and the support bond in FJF-05 at various prepayment speeds. From a PAC bond in FJF-04 with an average life of 7.26, we have created six bonds with an average life as short as 2.58 years (P-A) and as long as 16.92 years (P-F) if prepayments stay within 90 PSA and 300 PSA. Whereas the initial collar may be 90 to 300 PSA, the effective collar is wider for the shorter PAC tranches. Exhibit 12-12 (see Overhead 12-28) shows the effective collar for the six PAC tranches in FJF-04. Agency Collateralized Mortgage Obligations (continued)

27. © 2013 Pearson Education Exhibit 12-11 Average Life for the Six PAC Bonds in FJF-05 Assuming Various Prepayment Speeds Prepayment Rate (PSA) PAC Bonds P-AP-BP-CP-DP-EP-F 08.4614.6116.4919.4121.9123.76 503.586.828.3611.3014.5018.20 902.584.725.787.8910.8316.92 1002.584.725.787.8910.8316.92 1502.584.725.787.8910.8316.92 1652.584.725.787.8910.8316.92 2002.584.725.787.8910.8316.92 2502.584.725.787.8910.8316.92 3002.584.725.787.8910.8316.92 3502.584.725.496.959.2414.91 4002.574.374.916.178.3313.21 4502.503.974.445.567.4511.81 5002.403.654.075.066.7410.65 7002.062.823.103.754.887.51

28. © 2013 Pearson Education Exhibit 12-12 Effective Collars for Each Pac Tranche in FJF-04 Amount of Support Bonds: $156.2 Million TrancheEffective Collar P-A90–450 PSA P-B90–350 PSA P-C90–300 PSA P-D90–300 PSA P-E90–300 PSA P-F90–300 PSA

29. © 2013 Pearson Education  PAC Window A PAC window can be wide or narrow. The narrower a PAC window, the more it resembles a corporate bond with a bullet payment. PAC buyers appear to prefer tight windows, although institutional investors facing a liability schedule are generally better off with a window that more closely matches the liabilities. Investor demand dictates the PAC windows that issuers will create. Investor demand in turn is governed by the nature of investor liabilities. Agency Collateralized Mortgage Obligations (continued)

30. © 2013 Pearson Education  Effective Collars and Actual Prepayments The creation of a mortgage-backed security cannot make prepayment risk disappear. The reduction in prepayment risk (both extension risk and contraction risk) that a PAC offers must come from somewhere. The prepayment protection come 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. It is the support bonds that absorb any principal payments in excess of the scheduled principal payment that are made. This reduces the contraction risk of the PAC bonds. Agency Collateralized Mortgage Obligations (continued)

31. © 2013 Pearson Education  Effective Collars and Actual Prepayments The key to the prepayment protection offered by a PAC bond is the amount of support bonds outstanding.  If the support bonds are paid off quickly because of faster-than-expected prepayments, there is no longer any protection for the PAC bonds.  The support bonds can be thought of as bodyguards for the PAC bondholders. When the bullets fly (i.e., prepayments occur) it is the bodyguards that get killed off first. The bodyguards are there to absorb the bullets. When all the bodyguards are killed off (i.e., the support bonds paid off with faster-than-expected prepayments), the PAC bonds must fend for themselves: they are exposed to all the bullets. Agency Collateralized Mortgage Obligations (continued)

32. © 2013 Pearson Education  Effective Collars and Actual Prepayments Busted means that the prepayment protection is reduced and is 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. This approach is inadequate because it is actual prepayment experience that determines the degree of prepayment protection as well as the expected future prepayment behavior of the collateral. The way to determine this protection is to calculate the effective collar for a seasoned PAC bond. An effective collar for a seasoned PAC is the lower PSA and the upper PSA that can occur in the future and still allow maintenance of the schedule of principal repayments. Agency Collateralized Mortgage Obligations (continued)

33. © 2013 Pearson Education  Effective Collars and Actual Prepayments The effective collar changes every month. An extended period over which actual prepayments are below the upper range of the initial PAC collar will result in an increase in the upper range of the effective collar. This is because there will be more bodyguards around than anticipated. An extended period of prepayments slower than the lower range of the initial PAC collar will raise 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. Agency Collateralized Mortgage Obligations (continued)

34. © 2013 Pearson Education  Effective Collars and Actual Prepayments 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 life would not change if prepayments are at either extreme of the initial collar; however, our previous analysis has been based on a single PSA speed for the life of the structure. Exhibit 12-14 (see Overhead 12-35) shows the average life two years from now for the PAC bond in FJF-04 assuming that prepayments are 300 PSA for the first 24 months. Notice that the average life is stable at six years if the prepayments for the following months are between 115 PSA and 300 PSA. That is, the effective PAC collar is no longer the initial collar. Instead, the lower collar has shifted upward. This means that the protection from year 2 on is for 115 to 300 PSA, a narrower band than initially even though the earlier prepayments did not exceed the initial upper collar. Agency Collateralized Mortgage Obligations (continued)

35. © 2013 Pearson Education Exhibit 12-14 Average Life Two Years from Now for PAC Bond of FJF-04 Assuming Prepayments of 300 PSA for First 24 Months PSA from Year 2 onAverage Life (years) 956.43 1056.11 1156.01 1206.00 1256.00 3006.00 3055.62

36. © 2013 Pearson Education  Providing Greater Prepayment Protection for PACs There are two ways to provide greater protection for PAC bonds: i.lockouts ii.reverse PAC structures One obvious way to provide greater protection for PAC bonds is to issue fewer PAC bonds relative to support bonds. Such a CMO structure with no principal payments to a PAC bond class in the earlier years is referred to as a lockout structure. A CMO structure requiring any excess principal payments to be made to the longer PAC bonds after all support bonds are paid off is called a reverse PAC structure. Agency Collateralized Mortgage Obligations (continued)

37. © 2013 Pearson Education  Other PAC Tranches The collateral can be used to create a CMO with accrual bonds, floaters, and inverse floaters bonds. In addition, interest-only and principal-only tranches (described later) can be created. These same types of bond classes can be created from a PAC bond. The difference between the bond classes described and those created from a PAC bond is simply the prepayment protection offered by the PAC structure. Agency Collateralized Mortgage Obligations (continued)

38. © 2013 Pearson Education  Targeted Amortization Class Bonds A targeted amortization class (TAC) bond resembles a PAC bond in that it also has a schedule of principal repayment. The difference between a PAC bond and a TAC bond is that the former has a wide PSA range over which the schedule of principal repayment is protected against contraction risk and extension risk. A TAC bond, in contrast, has a single PSA rate from which the schedule of principal repayment is protected. As a result, the prepayment protection afforded the TAC bond is less than that for a PAC bond. Some institutional investors are interested in protection against extension risk but are willing to accept contraction risk. This is the opposite protection from that sought by the buyers of TAC bonds. The structures created to provide such protection are referred to as reverse TAC bonds. Agency Collateralized Mortgage Obligations (continued)

39. © 2013 Pearson Education  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.  Interest-Only and Principal-Only Tranches Stripped mortgage-backed securities are created by paying all the principal to one bond class and all the interest to another bond class. These two classes are referred to as the principal-only (PO) bond class and the interest only (IO) bond class. Agency Collateralized Mortgage Obligations (continued)

40. © 2013 Pearson Education  Notional IOS In the earlier CMO deals, all of the excess interest between the coupon rate on the tranches and the coupon interest on the collateral were paid to an equity class referred to as the CMO residual. This is no longer the practice today. Instead, a tranche is created that receives the excess coupon interest. This tranche is called a notional interest only (IO) class and also referred to as a structured IO. To see how a notional IO is created, consider the CMO structure shown in Exhibit 12-15 (see Overhead 12-41), FJF-06. The notional amount is the amount on which the interest payments will be determined, not the amount that will be paid to the holder of this bond. Mathematically, this notional amount is found as follows: where excess interest = collateral coupon rate – tranche coupon rate. Agency Collateralized Mortgage Obligations (continued)

41. © 2013 Pearson Education Exhibit 12-15 FJF-06: Hypothetical Five Tranche Sequential Pay with an Accrual Tranche and an Interest-Only Tranche a TranchePar AmountNotional AmountCoupon Rate (%) A$194,500,0006.00 B36,000,0006.50 C96,500,0007.00 Z73,000,0007.25 IO52,566,6677.50 a Payment rules: 1.For payment of periodic coupon interest: Disburse periodic coupon interest to tranches A, B, C, and C on the basis of the amount of principal outstanding at the beginning of the period. For tranche Z, accrue the interest based on the principal plus accrued interest in the preceding period. The interest for tranche Z is to be paid to the earlier tranches as a principal pay down. Disburse periodic interest to the IO tranche based on the notional amount at the beginning of the period. 2.For disbursement of principal payments: Disburse principal payments to tranche A until it is paid off completely. After tranche A is paid off completely, disburse principal payments to tranche B until it is paid off completely. After tranche B is paid off completely, disburse principal payments to tranches C until it is paid off completely, disburse principal payments to tranche Z until the original principal balance plus accrued interest is paid off completely.

42. © 2013 Pearson Education  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 support bond typically is divided into different bond classes. The support bond can even be partitioned so as to create support bond classes with a schedule of principal repayments. That is, support bond classes that are PAC bonds can be created. Agency Collateralized Mortgage Obligations (continued)

43. © 2013 Pearson Education Agency Stripped Mortgage-Back Securities  Agency stripped mortgage-backed securities (SMBSs), introduced by Fannie Mae in 1986, are another example of derivative mortgage products.  A SMBS is created by altering the distribution of principal and interest from a pro rata distribution to an unequal distribution. There are three types of SMBS: i.synthetic-coupon pass-throughs ii.interest-only/principal-only securities iii.CMO strips

44. © 2013 Pearson Education Agency Stripped Mortgage-Back Securities (continued)  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.

45. © 2013 Pearson Education  Interest-Only/Principal-Only Strips In early 1987, stripped MBS began to be issued where all the interest is allocated to one class (the IO class) and all the principal to the other class (the PO class). The IO class receives no principal payments. IOs and POs are referred to as mortgage strips. Agency Stripped Mortgage-Back Securities (continued)

46. © 2013 Pearson Education  Interest-Only/Principal-Only Strips The PO security is purchased at a substantial discount from par value. The yield an investor will realize depends on the speed at which prepayments are made. The faster the prepayments, the higher the yield the investor will realize. For the IO, there is no par value. In contrast to the PO investor, the IO investor wants prepayments to be slow. The reason is that the IO investor receives only interest on the amount of the principal outstanding. As prepayments are made, the outstanding principal declines, and less dollar interest is received. An interesting characteristic of an IO is that its price tends to move in the same direction as the change in mortgage rates. This effect occurs (1) when mortgage rates fall below the coupon rate, and (2) for some range of mortgage rates above the coupon rate. Agency Stripped Mortgage-Back Securities (continued)

47. © 2013 Pearson Education  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. Agency Stripped Mortgage-Back Securities (continued)

48. © 2013 Pearson Education Key Points ● Agency CMOs, referred to by the agencies that issue them as REMICs, are bond classes created by redirecting the cash flows of mortgage-related products (mortgage pass-through securities). ● The creation of a CMO cannot eliminate prepayment risk; it can only redistribute the various forms of this risk among different classes of bonds called tranches. ● The credit risk of an agency CMO carries the same credit risk as that of an agency pass-through security. ● In a CMO, there are rules for the distribution of interest and principal from the collateral. ● The first CMOs were structured so that each class of bond would be retired sequentially, and hence such structures are referred to as sequential-pay CMOs. The average life of the tranches 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.

49. © 2013 Pearson Education Key Points (continued) ● An interest-only and a principal-only tranche can be created from a tranche. A notional IO is a tranche created from the difference between the collateral’s coupon interest and the total coupon interest paid to the tranches. ● Despite the redistribution of prepayment risk with sequential-pay and accrual CMOs, there is still considerable prepayment risk. That is, there is still considerable average life variability for a given tranche. This problem has been mitigated by the creation of a planned amortization class tranche. This type of CMO tranche reduces average life variability. ● The bonds included in a CMO structure that provide the better protection for PAC tranches are the support or companion tranches. There are various ways in which greater prepayment protection can be provided for some or all of the PAC bonds within a CMO structure. These include a lockout and a reverse PAC structure.

50. © 2013 Pearson Education ● 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 types of bonds can be created. For example, a part of the support bonds can be carved up to create support bonds with a principal repayment schedule. Such bonds are referred to as PAC II or level II PAC bonds. ● A stripped MBS is created by assigning distribution of principal and interest of the underlying pass-through security in unequal portions to two classes of bonds. The result is that the two bonds will have a different price/yield relationship from that of the underlying pass- through. ● There are three types of SMBS: (1) synthetic-coupon pass-throughs, (2) interest-only/principal-only securities, and (3) CMO strips. Key Points (continued)