Question

Explain the different structures of Collateralized mortgage obligations ( CMOs)

Answer 1

A Icollateralized Imortgage Iobligation I(CMO) Irefers Ito Ia Itype Iof Imortgage-backed Isecurity Ithat Icontains Ia Ipool Iof Imortgages Ibundled Itogether Iand Isold Ias Ian Iinvestment. IOrganized Iby Imaturity Iand Ilevel Iof Irisk, ICMOs Ireceive Icash Iflows Ias Iborrowers Irepay Ithe Imortgages Ithat Iact Ias Icollateral Ion Ithese Isecurities. IIn Iturn, ICMOs Idistribute Iprincipal Iand Iinterest Ipayments Ito Itheir Iinvestors Ibased Ion Ipredetermined Irules Iand Iagreements.

Collateralized Imortgage Iobligations Iconsist Iof Iseveral Itranches, Ior Igroups Iof Imortgages, Iorganized Iby Itheir Irisk Iprofiles. IAs Icomplex Ifinancial Iinstruments, Itranches Itypically Ihave Idifferent Iprincipal Ibalances, Iinterest Irates, Imaturity Idates, Iand Ipotential Iof Irepayment Idefaults. ICollateralized Imortgage Iobligations Iare Isensitive Ito Iinterest Irate Ichanges Ias Iwell Ias Ito Ichanges Iin Ieconomic Iconditions, Isuch Ias Iforeclosure Irates, Irefinance Irates, Iand Ithe Irates Iat Iwhich Iproperties Iare Isold. IEach Itranche Ihas Ia Idifferent Imaturity Idate Iand Isize Iand Ibonds Iwith Imonthly Icoupons Iare Iissued Iagainst Iit. IThe Icoupon Imakes Imonthly Iprincipal Iand Iinterest Irate Ipayments.

The IVarious ITypes Iof ICMOs

1. ISequential IPay

The Imost Ibasic ICMO Istructure Ihas Itranches Ithat Ipay Iin Ia Istrict Isequence. IEach Itranche Ireceives Iregular Iinterest Ipayments, Ibut Ithe Iprincipal Ipayments Ireceived Iare Imade Ito Ithe Ifirst Itranche Ialone, Iuntil Iit Iis Icompletely Iretired. IOnce Ithe Ifirst Itranche Iis Iretired, Iprincipal Ipayments Iare Iapplied Ito Ithe Isecond Itranche Iuntil Iit Iis Ifully Iretired, Iand Ithe Iprocess Icontinues Iuntil Ithe Ilast Itranche Iis Iretired. IThe Ifirst Itranche Iof Ithe Ioffering Imay Ihave Ian Iaverage Ilife Iof I2-3 Iyears, Ithe Isecond Itranche I5-7 Iyears, Ithe Ithird Itranche I10-12 Iyears, Iand Iso Iforth. IThis Itype Iof ICMO Iis Iknown Ias Ia I“sequential Ipay,” I“clean,” Ior I“plain Ivanilla” Ioffering.

2. IPlanned IAmortization IClass I(PAC) ITranches

PAC Itranches Iuse Ia Imechanism Isimilar Ito Ia I“sinking Ifund” Ito Iestablish Ia Ifixed Iprincipal Ipayment Ischedule Ithat Idirects Icash-flow Iirregularities Icaused Iby Ifaster- Ior Islower-than-expected Iprepayments Iaway Ifrom Ithe IPAC Itranche Iand Itoward Ianother I“companion” Ior I“support” Itranche I(see Ibelow). IWith Ia IPAC Itranche, Ithe Iyield, Iaverage Ilife, Iand Ilockout Iperiods Iestimated Iat Ithe Itime Iof Iinvestment Iare Imore Ilikely Ito Iremain Istable Iover Ithe Ilife Iof Ithe Isecurity.

PAC Ipayment Ischedules Iare Iprotected Iby Ipriorities Iwhich Iassure Ithat IPAC Ipayments Iare Imet Ifirst Iout Iof Iprincipal Ipayments Ifrom Ithe Iunderlying Imortgage Iloans. IPrincipal Ipayments Iin Iexcess Iof Ithe Ischeduled Ipayments Iare Idiverted Ito Inon-PAC Itranches Iin Ithe ICMO Istructure Icalled Icompanion Ior Isupport Itranches Ibecause Ithey Isupport Ithe IPAC Ischedules. IIn Iother Iwords, Iat Ileast Itwo Ibond Itranches Iare Iactive Iat Ithe Isame Itime, Ia IPAC Iand Ia Icompanion Itranche. IWhen Iprepayments Iare Iminimal, Ithe IPAC Ipayments Iare Imet Ifirst Iand Ithe Icompanion Imay Ihave Ito Iwait. IWhen Iprepayments Iare Iheavy, Ithe IPAC Ipays Ionly Ithe Ischeduled Iamount, Iand Ithe Icompanion Iclass Iabsorbs Ithe Iexcess.

“Type II IPAC” Itranches Imaintain Itheir Ischedules Iover Ithe Iwidest Irange Iof Iactual Iprepayment Ispeeds—say, Ifrom I100% Ito I300% IPSA. I“Type III” Iand I“Type IIII IPAC” Itranches Ican Ialso Ibe Icreated Iwith Ilower Ipriority Ifor Iprincipal Ipayments Ifrom Ithe Iunderlying Iloans Ithan Ithe Iprimary Ior IType II Itranches. IThey Ifunction Ias Isupport Itranches Ito Ihigher-priority IPAC Itranches Iand Imaintain Itheir Ischedules Iunder Iincreasingly Inarrower Iranges Iof Iprepayments.

PAC Itranches Iare Inow Ithe Imost Icommon Itype Iof ICMO Itranche. IBecause Ithey Ioffer Ia Ihigh Idegree Iof Iinvestor Icash-flow Icertainty, IPAC Itranches Iare Iusually Ioffered Iat Ilower Iyields.

3. ITargeted IAmortization IClass I(TAC) ITranches.

TAC Itranches Ialso Iprovide Imore Icash-flow Icertainty Iand Ia Ifixed Iprincipal Ipayment Ischedule, Ibased Ion Ia Imechanism Isimilar Ito Ia Isinking Ifund, Ibut Ithis Icertainty Iapplies Iat Ionly Ione Iprepayment Irate Irather Ithan Ia Irange. IIf Iprepayments Iare Ihigher Ior Ilower Ithan Ithe Idefined Irate, ITAC Ibondholders Imay Ireceive Imore Ior Iless Iprincipal Ithan Ithe Ischeduled Ipayment. ITAC Itranches’ Iactual Iperformance Idepends Ion Itheir Ipriority Iin Ithe ICMO Istructure Iand Iwhether Ior Inot IPAC Itranches Iare Ialso Ipresent. IIf IPACs Iare Ialso Ipresent, Ithe ITAC Itranche Iwill Ihave Iless Icash-flow Icertainty. IIf Ino IPACs Iare Ipresent, Ithe ITAC Iprovides Ithe Iinvestor Iwith Isome Iprotection Iagainst Iaccelerated Iprepayment Ispeeds Iand Iearly Ireturn Iof Iprincipal. IThe Iyields Ion ITAC Ibonds Iare Itypically Ihigher Ithan Iyields Ion IPAC Itranches Ibut Ilower Ithan Iyields Ion Icompanion Itranches.

4. ICompanion ITranches.

Every ICMO Ithat Ihas IPAC Ior ITAC Itranches Iin Iit Iwill Ialso Ihave Icompanion Itranches I(sometimes Icalled Isupport Ibonds), Iwhich Iabsorb Ithe Iprepayment Ivariability Ithat Iis Iremoved Ifrom Ithe IPAC Iand ITAC Itranches. IOnce Ithe Iprincipal Iis Ipaid Ito Ithe Iactive IPAC Iand ITAC Itranches Iaccording Ito Ithe Ischedule, Ithe Iremaining Iexcess Ior Ishortfall Iis Ireflected Iin Ipayments Ito Ithe Iactive Icompanion Itranche. IThe Iaverage Ilife Iof Ia Icompanion Itranche Imay Ivary Iwidely, Iincreasing Iwhen Iinterest Irates Irise Iand Idecreasing Iwhen Irates Ifall. ITo Icompensate Ifor Ithis Ivariability, Icompanion Itranches Ioffer Ithe Ipotential Ifor Ihigher Iexpected Iyields Iwhen Iprepayments Iremain Iclose Ito Ithe Irate Iassumed Iat Ipurchase. ISimilar Ito IType III Iand IType IIII IPACs, ITAC Itranches Ican Iserve Ias Icompanion Itranches Ifor IPAC Itranches. IThese Ilower-priority IPAC Iand ITAC Itranches Iwill Iin Iturn Ihave Icompanion Itranches Ifurther Idown Iin Ithe Iprincipal Ipayment Ipriority. ICompanion Itranches Iare Ioften Ioffered Ifor Isale Ito Iretail Iinvestors Iwho Iwant Ihigher Iincome Iand Iare Iwilling Ito Itake Imore Irisk Iof Ihaving Itheir Iprincipal Ireturned Isooner Ior Ilater Ithan Iexpected.

5. IZ-Tranches I(also Iknown Ias IAccretion IBonds Ior IAccrual IBonds).

Z-tranches Iare Istructured Iso Ithat Ithey Ipay Ino Iinterest Iuntil Ithe Ilockout Iperiod Iends Iand Ithey Ibegin Ito Ipay Iprincipal. IInstead, Ia IZ-tranche Iis Icredited I“accrued Iinterest” Iand Ithe Iface Iamount Iof Ithe Ibond Iis Iincreased Iat Ithe Istated Icoupon Irate Ion Ieach Ipayment Idate. IDuring Ithe Iaccrual Iperiod Ithe Iprincipal Iamount Ioutstanding Iincreases Iat Ia Icompounded Irate Iand Ithe Iinvestor Idoes Inot Iface Ithe Irisk Iof Ireinvesting Iat Ilower Irates Iif Imarket Iyields Idecline. ITypical IZ-tranches Iare Istructured Ias Ithe Ilast Itranche Iin Ia Iseries Iof Isequential Ior IPAC Iand Icompanion Itranches Iand Ihave Iaverage Ilives Iof I18 Ito I22 Iyears. IHowever, IZ-tranches Ican Ibe Istructured Iwith Iintermediate-term Iaverage Ilives Ias Iwell. IAfter Ithe Iearlier Ibonds Iin Ithe Iseries Ihave Ibeen Iretired, Ithe IZ-tranche Iholders Istart Ireceiving Icash Ipayments Ithat Iinclude Iboth Iprincipal Iand Iinterest.

While Ithe Ipresence Iof Ia IZ-tranche Ican Istabilize Ithe Icash Iflow Iin Iother Itranches, Ithe Imarket Ivalue Iof IZ-tranches Ican Ifluctuate Iwidely, Iand Itheir Iaverage Ilives Idepend Ion Iother Iaspects Iof Ithe Ioffering. IBecause Ithe Iinterest Ion Ithese Isecurities Iis Itaxable Iwhen Iit Iis Icredited, Ieven Ithough Ithe Iinvestor Ireceives Ino Iinterest Ipayment, IZ-tranches Iare Ioften Isuggested Ias Iinvestments Ifor Itax-deferred Iretirement Iaccounts.

6. IPrincipal-Only I(PO) ISecurities.

Some Imortgage Isecurities Iare Icreated Iso Ithat Iinvestors Ireceive Ionly Iprincipal Ipayments Igenerated Iby Ithe Iunderlying Icollateral. IThese IPrincipal-Only I(PO) Isecurities Imay Ibe Icreated Idirectly Ifrom Imortgage Ipass-through Isecurities, Ior Ithey Imay Ibe Itranches Iin Ia ICMO. IIn Ipurchasing Ia IPO Isecurity, Iinvestors Ipay Ia Iprice Ideeply Idiscounted Ifrom Ithe Iface Ivalue Iand Iultimately Ireceive Ithe Ientire Iface Ivalue Ithrough Ischeduled Ipayments Iand Iprepayments.

The Imarket Ivalues Iof IPOs Iare Iextremely Isensitive Ito Iprepayment Irates Iand Itherefore Iinterest Irates. IIf Iinterest Irates Iare Ifalling Iand Iprepayments Iaccelerate, Ithe Ivalue Iof Ithe IPO Iwill Iincrease. IOn Ithe Iother Ihand, Iif Irates Irise Iand Iprepayments Islow, Ithe Ivalue Iof Ithe IPO Iwill Idrop. IA Icompanion Itranche Istructured Ias Ia IPO Iis Icalled Ia I“Super IPO.”

7. IInterest-Only I(IO) ISecurities.

Separating Iprincipal Ipayments Ito Icreate IPO Imortgage Isecurities Inecessarily Iinvolves Ithe Icreation Iof IInterest-Only I(IO) Isecurities. ICMOs Ithat Ihave IPO Itranches Iwill Itherefore Ialso Ihave IIO Itranches. IIO Isecurities Iare Isold Iat Ia Ideep Idiscount Ito Itheir I“notional” Iprincipal Iamount, Inamely Ithe Iprincipal Ibalance Iused Ito Icalculate Ithe Iamount Iof Iinterest Idue. IThey Ihave Ino Iface Ior Ipar Ivalue. IAs Ithe Inotional Iprincipal Iamortizes Iand Iprepays, Ithe IIO Icash Iflow Ideclines.

Unlike IPOs, IIOs Iincrease Iin Ivalue Iwhen Iinterest Irates Irise Iand Iprepayment Irates Islow; Iconsequently, Ithey Iare Ioften Iused Ito I“hedge” Iportfolios Iagainst Iinterest Irate Irisk. IIO Iinvestors Ishould Ibe Imindful Ithat Iif Iprepayment Irates Iare Ihigh, Ithey Imay Iactually Ireceive Iless Icash Iback Ithan Ithey Iinitially Iinvested.

The Istructure Iof IIOs Iand IPOs Iexaggerates Ithe Ieffect Iof Iprepayments Ion Icash Iflows Iand Imarket Ivalue. IThe Iheightened Irisk Iassociated Iwith Ithese Isecurities Imakes Ithem Iunsuitable Ifor Icertain Iinvestors.

8. IFloating-Rate ITranches.

First Ioffered Iin I1986, I“floating-rate ICMO” Itranches Icarry Iinterest Irates Ithat Iare Itied Iin Ia Ifixed Irelationship Ito Ian Iinterest Irate Iindex, Isuch Ias Ithe ILondon IInterbank IOffered IRate I(LIBOR), Ithe IConstant IMaturity ITreasury I(CMT), Ior Ithe ICost Iof IFunds IIndex I(COFI), Isubject Ito Ian Iupper Ilimit, Ior I“cap,” Iand Isometimes Ito Ia Ilower Ilimit, Ior I“floor.” IThe Iperformance Iof Ithese Iinvestments Ialso Idepends Ion Ithe Iway Iinterest Irate Imovements Iaffect Iprepayment Irates Iand Iaverage Ilives.

Sometimes Ithe Iinterest Irates Ion Ithese Itranches Iare Istated Iin Iterms Iof Ia Iformula Ibased Ion Ithe Idesignated Iindex, Imeaning Ithey Imove Iup Ior Idown Iby Imore Ithan Ione I“basis Ipoint” I(1/100 Iof Ione Ipercent) Ifor Ieach Ibasis Ipoint Iincrease Ior Idecrease Iin Ithe Iindex. IThese Iso-called I“superfloaters” Ioffer Ileverage Iwhen Irates Irise. IThe Iinterest Irates Ion I“inverse Ifloaters” Imove Iin Ia Idirection Iopposite Ito Ithe Ichanges Iin Ithe Idesignated Iindex Iand Ioffer Ileverage Ito Iinvestors Iwho Ibelieve Irates Imay Imove Idown. IThe Ipotential Ifor Ihigh Icoupon Iincome I