1. BUS424 (Ch 12) 1 CMO and Stripped MBS 1.Collateralized Mortgage Obligations – ch12 2.Stripped Mortgage-backed Securities – ch 12

2. BUS424 (Ch 12) 2 CMOs Bond classes created by redirecting the cash flows of mortgage-related products so as to mitigate prepayment risk. Pay-through structure: there are more than one class of bondholders with the same level of credit priority Tranches: different bond classes

3. BUS424 (Ch 12) 3 Materials Covered under CMOs Sequential-Pay Tranches (basic) Accrual Tranche Floater and Inverse Floater Planned Amortization Class versus Support Class

4. BUS424 (Ch 12) 4 Sequential-Pay Tranches The collateral for the hypothetical CMO is a hypothetical pass-through with total par value of $400 million and the following characteristics : (1)The pass-through coupon rate is 7.5% (2)WAC=8.125% (3)WAM=357 month (4)165PSA (page 263):

5. BUS424 (Ch 12) 5 FJF-01 TranchePar AmountCoupon Rate(%) A194,500,0007.5 B 36,500,0007.5 C 96,500,0007.5 D 73,000,0007.5 ? 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 prepayments 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 … After tranche C is paid off completely, disburse principal payments to tranche D until it is paid off completely.

6. BUS424 (Ch 12) 6 Cash flow from Pass through (page 263) In month 1: total payment=$709,923; Interest=$250,000 In month 81: total payment=

7. BUS424 (Ch 12) 7 Cash flow from the CMO Exhibit 12-2 – split the principal; CMO specifies the order of principal payment The principal pay-down window Average lives for the collateral and four tranches of the CMO – page 265 (ex 12-3).

8. BUS424 (Ch 12) 8 Accrual Bond One tranches (or more) does (do) not receive current interest. This is an accrual tranche, or Z bond.

9. BUS424 (Ch 12) 9 FJF-02 TranchePar AmountCoupon Rate(%) A194,500,0007.5 B 36,500,0007.5 C 96,500,0007.5 Z 73,000,0007.5 ? 1.For payment of periodic coupon interest 2.For disbursement of principal payments 3.Solution: see Exhibit 5 – page 267.

10. BUS424 (Ch 12) 10 FJF-03: Floating-rate Tranches TranchePar AmountCoupon Rate(%) A194,500,0007.5 B 36,500,0007.5 FL 72,375,0001-month LIBOR + 0.50 IFL24,125,000 28.5-3*(1-month LIBOR) Z 73,000,0007.5 ? 1.For payment of periodic coupon interest 2.For disbursement of principal payments

11. BUS424 (Ch 12) 11 Planned Amortization Class (PAC) Exhibit 12-8 TranchePar AmountCoupon rate (%) P$243,800,0007.5 S 156,200,0007.5 400,000,000 For payment of periodic coupon interest For disbursement of principal payments

12. BUS424 (Ch 12) 12 Principal Payments under PAC 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.

13. BUS424 (Ch 12) 13 Support Bonds Bodyguards for the PAC bondholders Can be partitioned into classes, I.e, bodyguards have ranks and titles, too.

14. BUS424 (Ch 12) 14 Objective To eliminate the contraction risk and the extension risk Contraction risk: when interest rate goes down Extension risk: when interest rate goes up

15. BUS424 (Ch 12) 15 Series of PAC Bonds Combination of PAC and sequential-pay CMO Page 275 At different prepayment rate, the average lives of 6 PAC bonds are different (ex 12-11). –What do you see from there?

16. BUS424 (Ch 12) 16 TAC One-side prepayment protection. Has a single PSA rate from which the schedule of principal repayment is protected Typically protected when prepayment is high, thus avoid contraction risk.

17. BUS424 (Ch 12) 17 Credit Risk and Tax Treatment of CMOs Agency CMOs Nonagency CMOs Interest and principal payments are not taxable.

18. BUS424 (Ch 12) 18 Stripped Mortgage-Backed Securities Principal-only (PO) securities when current mortgage rate < coupon rate, prepayment speeds up.  price goes up when current mortgage rate > coupon rate, price drops. Interest-only (IO) securities current mortgage rate < coupon rate, mixed Exhibit 12-145(page 282) CMO strips: one class in CMO structure could be PO or IO.