Question

1)Collateralized Mortgage Obligations (CMOs) were created to _______ the cash flows of a MBS pool to different tranches for the purpose of making average life more predictable.

2) What are the underlying assets of a CMO?

3) Where in the payment/priority order for a typical CMO would you find the PAC tranche?

4) When considering a PAC tranche versus the A tranche of a Sequential Pay CMO, which of the two has the greater predictability of average life (maturity)?

5)Why is the Support tranche considered to be a ‘bodyguard’ for earlier tranches?

Answer 1

1)Collateralized Mortgage Obligations (CMOs) were created to borrowers repay the mortgage the cash flows of a MBS pool to different tranches for the purpose of making average life more predictable.

Ans. borrowers repay the mortgage .

2) What are the underlying assets of a CMO?

Ans. Collateralized mortgage obligation is one type of mortgage-backed security in which principal repayments are organized according to their maturities and into different classes based on risk. This belongs to mortagage only under lying with Long-term debt-based financial instruments last for more than a year. Under securities, these are bonds. Cash equivalents are loans. Exchange-traded derivatives are bond futures and options on bond futures. OTC derivatives are interest rate swaps, interest rate caps and floors, interest rate options, and exotic derivatives. The price of the option or future is derived from the price of an underlying asset. In an option contract, a seller must either buy or sell the underlying asset to the buyer on the specified date at the agreed-upon price. The buyer is not obligated to purchase the underlying asset, but he can exercise his right if he chooses to do so. If the option expires, and changes in the market make the purchase un favourable for the buyer, the buyer can then choose not to participate in the transaction.

3) Where in the payment/priority order for a typical CMO would you find the PAC tranche?

Ans

*CMO redirects cash flows making it possible to redistribute prepayment risk so that some investors reduce their prepayment risk exposure while others increase their prepayment risk exposure. Thus, one would agree with the statement that a CMO eliminates prepayment risk for certain investors, but would disagree with the statement that a CMO eliminates prepayment risk for all investors.

*Wall Street often refers to CMOs as “customized securities.” Explain why. CMOs are “customized securities” in the sense that they can be tailor-made to satisfy the preferences of investors. For example, classes of bonds or tranches can be created which are customized or structured for individual and institutional investors to meet a particular prepayment risk that each desires.

*The CMO market, the popular press sometimes refers to this sector of the mortgage—backed securities market as the riskiest sector and the pass-through sector as the safest sector.

* Collateralized mortgage obligations derive their cash ?ow from underlying mortgage collateral absorb the prepayment risk. Because PAC bonds have protection against both extension risk and contraction risk, they are said to provide two-sided prepayment protection that a savings and loan association has decided to invest in mortgage-backed securities .

*The cash?ow of a mortgage pass-through security depends on the cash ?ow of the underlying mortgages. A weighted average maturity (WAM) is found by weighting the remaining number of months to maturity for each mortgage loan in the pool by the amount of the mortgage outstanding.

*Gold PC, which has stronger guarantees than other PCs it issues and will be the only type of PC issued in the future. Speci?cally, non-Gold PCs that have been issued are modi?ed pass-throughs. This type of pass- through guarantees both interest and principal payments, but it guarantees only the timely payment of interest. The scheduled principal is passed through as it is collected, with a guarantee that the scheduled payment will be made no later than a speci?ed date.

4) When considering a PAC tranche versus the A tranche of a Sequential Pay CMO, which of the two has the greater predictability of average life (maturity)?

Ans.

A CMO is a security backed by a pool of pass-throughs, whole loans, or stripped mortgage-backed securities. CMOs are structured so that there are several classes of bondholders with varying stated maturities.

When there is more than one class of bondholders with the same level of credit priority, the structure is called a pay-through structure, as opposed to a pass-through structure in which there is only one class of bondholders at a given level of credit priority.

The bond classes created are commonly referred to as tranches. The principal payments from the underlying collateral are used to retire the tranches on a priority basis according to terms speci?ed in the prospectus. Despite the redistribution of prepayment risk with sequential-pay and accrual CMOs, there is still considerable prepayment risk. That is, there is still considerable average life variability for a given tranche. This problem has been mitigated by the creation of a planned amortization class (PAC) tranche.

This type of CMO tranche reduces average life variability. The bonds included in a CMO structure that provide the better protection for PAC tranches are the support or companion tranches. There are various ways in which greater prepayment protection can be provided for some or all of the PAC bonds within a CMO structure.

These include a lockout and a reverse PAC structure. From the above description, we see that both types are backed by same underlying mortgages and should share in the same credit risk. Thus, similar safety exists in terms of the creditability of the underlying assets. Thus, the savings and loan association can focus on matching assets and liabilities.

CMO issue in receiving principal payments from the underlying collateral. It is the support bonds that forego principal payments if the collateral prepayments are slow; support bonds do not receive any principal until the PAC bonds receive the scheduled principal repayment. This reduces the risk that the PAC bonds will extend.

On the other hand, it is the support bonds that absorb any principal payments in excess of the scheduled principal payment that are made. This reduces the contraction risk of the PAC bonds. The key to the prepayment protection offered by a PAC bond is the amount of support bonds outstanding.

If the support bonds are paid off quickly because of faster-than-expected prepayments, there is no longer any protection for the PAC bonds. Because the stability for the PAC bond comes at the expense of the support bond, the support bond will have more variability in its average life than the PAC bond. Thus, in terms of greatest to least average life variability,

5)Why is the Support tranche considered to be a ‘bodyguard’ for earlier tranches?

Ans.

Because there will be more bodyguards around than anticipated. An extended period of prepayments slower than the lower range of the initial PAC collar will raise the lower range of the effective collar. This is because it will take faster prepayments to make up the shortfall of the scheduled principal payments not made plus the scheduled future principal payments.

And more over this protection is to calculate the effective collar for a PAC bond. An effective collar for a PAC is the lower and the upper PSA that can occur in the future and still allow maintenance of the schedule of principal repayments.

The support tranche are the bonds that provide prepayment protection for the PAC tranches. Consequently, support tranches expose investors to the greatest level of prepayment risk. Because of this, investors must be particularly careful in assessing the cash flow characteristics of support bonds to reduce the likelihood of adverse portfolio consequences due to prepayments.