Three Discussion Questions / Finance

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CHAPTER 20: THE SECONDARY MORTGAGE MARKET: CMOS AND DERIVATIVE SECURITIES

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Mortgage Pay-Through Bonds (MPTBs)

• Bond, not an equity ownership interest
• Debt obligation of issuer
• Pass-through of interest and principal
• Credit rating derives from three things
• Riskiness of mortgages
• Extent of over collateralization
• Whether or not there are US gov’t bonds or agency obligations as excess collateral

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Collateralized Mortgage Obligations

• Collateralized Mortgage Obligations (CMOs)
• Debt instrument
• Mortgage pool owned by issuer
• Pass-through of interest and principal
• Multiple classes of securities issued
• Different maturity classes
• Different priority for payment of principal and interest
• Tranches

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Collateralized Mortgage Obligations

• Overcollateralization
• Represents equity interest of issuer
• Residual cash flow is return to issuer
• Cash flow = interest earned – interest paid
• Prepayment problem
• Reinvestment problem
• Calamity call

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Collateralized Mortgage Obligations

• Sequential Payout Tranche Structure
• Tranche Z: Paid Last
• Tranche A: Principal, Prepayments, & Interest Received First
• Tranche B: Interest Only Until Tranche A is Paid
• And so on for any additional tranches

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Collateralized Mortgage Obligations

• Expected Maturities
• Pricing & Prepayment
• Tranche Variations
• Sinking Fund Structure

Planned amortization class tranche

Targeted amortization class

Pricing speed

Companion tranche

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Collateralized Mortgage Obligations

• Floating Rate Tranches
• Floater Tranche

Coupon rates adjust periodically

• Inverted Floating Rate Tranche

Coupon rate adjusts opposite to its index

• Scaling
• Used as a Hedge
• Yield Enhancement

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Collateralized Mortgage Obligations

• Principal-Only Tranches
• Similar to a Zero Coupon Bond
• Interest-Only Tranches
• Convexity

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Exhibit 20-15
Summary of Important Investment Characteristics of Mortgage-Related Securities

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Commercial Mortgage-Backed Securities (CMBSs)

• Similar in form to residential MBSs
• Default risk differs significantly
• Assets in mortgage pool
• Often interest-only
• Lump sum principal payment

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Commercial Mortgage-Backed Securities (CMBSs)

• Senior Tranche (A piece)
• Subordinate Tranche (B piece)
• Prepayment is less likely than residential mortgages
• Lockouts
• Yield Maintenance
• Extension Risk

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Commercial Mortgage-Backed Securities (CMBSs)

• First Loss Position
• Credit Ratings
• Credit Enhancements
• Issuer or 3rd party guarantee
• Surety bonds and letters of credit
• Advance payment agreements

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Commercial Mortgage-Backed Securities (CMBSs)

• Credit Enhancements
• Loan substitutions and repurchase agreements
• Lease assignments
• Over collateralization
• Cross-collateralization and cross-default

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Commercial Mortgage-Backed Securities (CMBSs)

• Collateralized Debt Obligations (CDOs)
• Broader range of collateral
• B notes (subordinated position of mortgage)
• Lower rated Commercial Mortgage-Backed Securities
• Mezzanine Loans
• Preferred Equity
• While they are often well diversified, the underlying risk is still substantial. The assets are risky.
• Managed Collateralized Debt Obligations

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Exhibit 20-19
Illustration of CDO Structure

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Commercial Mortgage-Backed Securities (CMBSs)

• Real Estate Mortgage Investment Conduits (REMICs)
• Creation of Tax Reform Act of 1986. All assets must be one of the four following:
• Qualified Mortgages
• Foreclosed Property
• Interest Bearing Assets
• Qualified Reserve Fund