Question

This bank uses its mortgage loans of $600 million as collateral to issue two different trenches of securities (CMOs) in mortgage markets, Trench A and Trench B. The information is given below. Assume the coupon payment is made annually.

Loan value: $600 million

Interest rate: 6.5%

Maturity: 10 years

CMOs:                          Par value                        Interest rate

Trench A                        $350 million                  4.5%

Trench B                        $250 million                  6.25%

1)Please estimate the profits from the CMO

2)The bank would like to make a profit of $20 million from the CMO by adjusting the interest rate for Trench B. Please estimate what should be the new interest rate.

Answer 1

1)Please estimate the profits from the CMO

Profit is 7.625 Million

Loan	600 M
Interest	0.065
Total interest Earned	39 M
Tranche A	350 M	0.045	15.75 M
Tranche B	250 M	0.0625	15.625 M
Total interest paid			31.375 M
Profit for CMO (Total interest Earned- Total interest paid)	(39-31.375)	7.625 M

2)The bank would like to make a profit of $20 million from the CMO by adjusting the interest rate for Trench B. Please estimate what should be the new interest rate.

The new interest rate for Trench B should be 1.3%.

Out of Total interest Earned $39 M, Tranche A interest paid is 15.75 M. Hence, to make a profit of $20 million, bank has to pay remaining 39-20-15.75 = 3.25M interest to Tranche B, which is 3.25M/250M= 1.3%