1. Collateralized Mortgage Obligations and Stripped MBS Chapter 12

2. CMO securities developed to better deal with prepayment risk associated with PTs  bond classes created by redirecting CFs of mortgage-related products  prepayment risk is still present but creation of CMO allows separation of prepayment risk into different securities parties who can better handle one type of risk (extension or contraction) will now invest in ones best for them – have created different securities that have different risk- return characteristics

3. CMO Structure backed by pool of PTs, loans, or stripped MBS  CMOs have different classes of bonds that have different maturities  tranches  classes retired on priority basis Sequential Pay CMOs  tranches retired sequentially  periodic interest to all tranches with first tranche receiving all principal payments (expected and prepays)  principal pay-down window – time period between beginning and ending of principal payments for specific tranche  accrual tranche or Z bond – receives no interest

4. Example TranchePar AmountCoupon Rate A$194,500,0007.5% B 36,000,0007.5% C 96,500,0007.5% D 73,000,0007.5%

6. Average Life

7. Z bond

8. Floating Rate Tranches like with other securities, CMOs have varying structures to make more appealing to investors  can create a floating rate tranche by taking class and making floater and inverse floater

9. Floating Rate Tranches in example, floating tranche will be $72,375,000 or 75% of $96.5m  K is cap for inverse floater and L is coupon leverage K set at 28.5% and L set at 3 for this example K – L (one-month LIBOR) is rate on inverse floater low leverage – medium leverage – high leverage  weighted average coupon rate has to equal 7.5% assume LIBOR is 9%  floater rate 9.0% + 0.5% = 9.5%  inverse floater rate 28.5 – 3(9%) = 1.5%  WAC 0.75(9.5%) + 0.25(1.5%) = 7.5%

10. Planned Amortization Class Tranches PAC bonds – priority over other classes in area of principal payment  allows greater certainty of timing of CFs  all prepayments go to support or companion bonds (other tranches)  use initial collars to determine monthly expected payments to PAC bonds – if prepayment speeds differ from those in initial collar, then average life changes

11. Payment Rules for PAC Tranche

13. Terminology for PACs planned amortization bonds / support bonds  initial PAC collars  busted – term used when PAC schedule is broken  effective collar – once PAC bond is seasoned, the initial collars are not helpful in finding prepayment protection – effective collar is used to help to give greater prepayment protection to PACs  lockout structure – CMO structure with no principal payments to PAC bond class in earlier years (because create more support bonds)  reverse structure – requires any excess principal payments to be made to the longer PAC bonds after all support bonds are paid off

14. CMO Terminology agency CMOs / nonagency CMOs private label CMO – private entity issues CMO but underlying collateral is pool of PTs guaranteed by an agency whole loan CMO – collateral for CMO is pool of unsecuritized mortgage loans (interchangeable with nonagency CMO because most common type of nonagency is whole loan) CMO should be a REMIC in order to get tax benefits

15. Stripped MBS alter distribution of CFs to one of unequal distribution to different classes types  synthetic coupon PTs – first generation of stripped MBSs  interest-only/principal-only securities – mortgage strips  CMO strips (structured IOs) – one of CMO classes is IO or PO

16. Mortgage Strips PO purchased at big discount from par  yield depends on speed of prepayments – the faster the prepayments the higher the yield when mortgage rates fall, prepayments are expected to speed up so CF to PO holder accelerates so price of PO increases (result is also in part due to lower discount rate)

17. Mortgage Strips IO has no par value  investor in IO wants prepayments to slow because receive interest only on principal outstanding if prepayments are too fast, investor may not recover cost of IO if rates decline, prepayments are expected to increase which results in loss in expected CF but CF discounted using lower rate (net result usually though is decline in price) if rates rise, expected CFs improve but CFs discounted at higher rate – net result can be rise or fall in price of IO price tends to move in same direction as change in rates when  rates fall below coupon rate  and for some range of rates above the coupon rate