Tara Stanley Emily Kenyon

CMOs Overview What is a CMO? History Associated Risk Advantages of CMOs Types of CMOs Role in Current Economy

What is a CMO? Collateralized Mortgage Obligation 1. Mortgages are pooled 2. The ‘pool’ is split into various tranches with varying degrees of risk, cash flows, and time frames. 3. Investors purchase securities 4. Mortgages are used as collateral for mortgage pass- through securities

History of CMOs Originated as a mortgage pass-through security Government-sponsored enterprises were created to attract investors & create a liquid secondary market. Fannie Mae, Ginnie Mae, & Freddie Mac were responsible for purchasing mortgages and issuing mortgage backed securities 1970 Ginnie Mae issued the first bonds backed by pools of mortgages to free up funds for more home loans 1977 The first private mortgage backed securities are sold 1983 Freddie Mac issues the first collateralized mortgage obligation, which allows investors to pick their level of risk

Risk of Mortgage Pass-Through Securities Prepayment Risk Unknown probability that the borrower will pay off the loan sooner than expected. Extension Risk Interest Rates increase therefore decreasing the probability of prepayment Contraction Risk Interest Rates decrease therefore increasing the probability of prepayment

Advantages of CMOs Reduce Prepayment risk Attract a wide variety of investors by offering various tranches Regular monthly or quarterly payments Guaranteed by the financial institution that issues the investment. Fannie Mae & Freddie Mac insure payment when borrower defaults Ginnie Mae insures “full faith and credit” to investors

Types of CMOs Sequential-Pay Accrual Tranche or Z-Bond Planned Amortization Class Targeted Amortization Class Principal-Only Interest-Only

Sequential-Pay CMO Tranches mature in chronological order Tranche 1 receives principal and interest payments while Tranche 2 & 3 receive interest only until Tranche 1 hits maturity After Tranche 1 is paid in full, Tranche 2 receives principal and interest payments while Tranche 3 continues to receive interest only payments Finally, Tranche 3 begins to receive principal and interest payments once Tranche 2 is complete Attracts a variety of investors by offering different levels of risk and investment periods

Accrual Tranches or Z-Bonds Similar to a Sequential-Pay CMO Instead of the last Tranche receiving interest payments while the other Tranches are paid, the interest is accrued The accrued interest is then used to help pay off the principal in the preceding tranches Once preceding tranches have matured, the last tranche receives principal and all accrued interest Eliminates Reinvestment Risk

Planned Amortization Class (PAC) Most popular CMO issued today Make up 50% of all first time issued CMOs Creates a schedule of fixed principal payments If prepayment occurs, investor receives fixed payment while additional funds are applied to a companion tranche Guarantee cash flow at given intervals Protected against Contraction & Extension Risk Minimal Risk = Lower Rates

Targeted Amortization Class (TAC) Similar to Planned Amortization Class Offered at a fixed rate versus a fixed payment Minimal Risk Excess cash flow is distributed to companion tranche Companion tranches offer higher rates No telling how fast or slow the tranche will mature

Principal-Only & Interest-Only Principal-Only Receives only principal payments Bought at discount Vulnerable to Interest Rate Changes Decrease in interest rates create an increase in prepayment Interest-Only Receives only interest payments Vulnerable to Interest Rate Changes Increase in interest rates create a decrease in prepayment

CMOs in the Current Economy How have CMOs contributed to the current economic meltdown? What can be done to prevent future problems?

How have CMOs contributed to the current economic meltdown? Subprime Lending Borrowers who do not qualify for prime loans Predatory Lending Targets individuals with a limited understanding of financial transactions Offers subprime loans to individuals who qualify for prime loans

How have CMOs contributed to the current economic meltdown? Conflicts of Interest Lack of training or licensing for mortgage brokers Brokers paid by both the borrowers and loan originators Some brokers received a ‘yield-spread premium’ for charging a higher interest rate than the borrower qualified for Companies rating CMOs Paid by company offering security, not buyers of securities Chastised by SEC Failed to protect investors Inadequate staffing Not tracking performance after giving initial rating

How have CMOs contributed to the current economic meltdown? Fraud Fraud for Profit Collusion between industry insiders Fraud for Property Material misrepresentation on loan application

How have CMOs contributed to the current economic meltdown? Lack of ethical behavior in the origination of mortgages led to higher possibility of default for mortgages underlying the CMO Collapse in housing prices End of 2-3 year fixed rate for Adjustable Rate Mortgages (ARMs) meant many could not make their new mortgage payment

How have CMOs contributed to the current economic meltdown? Once considered as safe as treasury bonds with a higher return Often invested in by institutions who could only invest in the highest grade securities Downgrades from investment quality to junk rocked financial markets

What can be done to prevent future problems? Licensing & training for mortgage brokers Make all parties bear default risk Eliminate conflicts of interest

Questions?

Quiz

Question #1 What does CMO stand for?

Answer Collateralized Mortgage Obligation

Question #2 What is the most popular type of CMO?

Answer Planned Amortization Class (PAC)

Question #3 What are 2 advantages of CMOs?

Answer Reduce Prepayment risk Attract a wide variety of investors by offering various tranches Regular monthly or quarterly payments Guaranteed by the financial institution that issues the investment.

Question #4 True or False? CMOs eliminate prepayment risk?

Answer False They only reduce prepayment risk by spreading it among tranches.

Question #5 This type of CMO pays tranches in chronological order and was the first type of CMO offered

Answer Sequential-Pay

Question #6 When interest rates rise creating less prepayment, this risk is called?

Answer Extension Risk

Question #7 What year was the first CMO offered?

Answer 1983