Transcript Collateralized Mortgage Obligations (CMOs)

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
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 passthrough securities
1.
History of CMOs
 Originated as a mortgage pass-through security
 Government-sponsored enterprises were created to attract
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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
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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
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Decrease in interest rates create an increase in prepayment
 Interest-Only
 Receives only interest payments
 Vulnerable to Interest Rate Changes
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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
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Some brokers received a ‘yield-spread premium’ for charging a
higher interest rate than the borrower qualified for
 Companies rating CMOs
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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
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Collusion between industry insiders
 Fraud for Property
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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