A collateralized mortgage obligation (CMO) has the characteristics below.
Return on assets 8.75%
Senior tranche $400,000,000
Subordinated tranche A $120,000,000
Subordinated tranche B $50,000,000
Value of collateral $600,000,000
Interest paid on liabilities of SPE 7.50%
Fees and expenses 0.60%
Which of the following are most accurate regarding its credit enhancement?
I. There is over collateralization.
II. The investors gain credit enhancement through the excess spread.
A. I only.
B. II only.
C. Both I and II.
D. Neither I nor II.
Option C is correct, Both I & II only.
There is over collateralization, that is collateral is more than securities issued.
Collaterelization = value of pool = $ 600,000,000
Value of securities issued = $500,000,000 + $120,000,000 + $50,000,000 = $ 670,000,000
Therefore there is over collateralization.
Excess spread is balance of interest income net off fees and interest paid on securities earned by financial institution.
Excess spread = interest on CMO - Interest paid on securities - fees
In case of any kind of defaults or non-performance of assets, excess spread is used to pay investors of securities.
Thus this enhances the creditability of securities.
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