Chapters12&13

Team Members: Kaushambi Ghosh (B08012)

Nikhil Verma (B08019)

Rupesh Agrawal (B08026)

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Collateralized Mortgage Obligations (CMO)• Definition

• Structure

• Credit Risk

• Tax Considerations

Stripped Mortgage- Backed Securities (MBS)• Synthetic-Coupon Pass- Throughs

• Interest- Only/ Principal- Only Securities

• CMO Strips

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Definition

Security backed by a pool of Pass- through, whole loans, or

stripped Mortgage Backed Securities

Structured in such a way that they include several classes of

bondholders with varying stated maturities

Objective

Bond classes created by redirecting cash flows of Mortgage-

related products so as to ‘mitigate’ (not eliminate) prepayment risk

associated with Pass- throughs

• Transfers this risk among different classes of bondholders

Parties who can better handle one type of risk (extension or

contraction) invest in ones best for them

Exception: Pay- through securities

• More than one class of bondholders with the same level of credit priority

NOTE: Whole loans are usually larger in size than the maximum amount allowed within

GNMA, FNMA and, FHLMC's standards 4

Classified into different Bond classes referred to as tranches

Principal payments from the underlying collateral are used to

retire the tranches on a priority basis according to terms specified

in the prospectus

Interest Payment is periodic coupon interest on the amount of

outstanding principal at the beginning of each period

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Sequential- Pay CMOs• Each class of bond retire sequentially

• Periodic interest to all tranches with first tranche receiving all principal payments (expected and prepays)

• principal pay-down window – time period between beginning and ending of principal payments for specific tranche

Accrual Bonds• At least one tranche does not receive current interest per month but the

interest is added to the principal balance (the bond is similar to zero coupon

bond

• The interest is used to speed up the pay down of the principal balance of the

earlier bond classes

Cash Flow from

Pass-through securities

Tranches on the basis of specific rules

for coupon and principal payment

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Floating Rate Tranches (Combination of Floaters & Inverse Floaters):

• Partitioning between the floater and inverse floater is driven by the demand of the investors

• Coupon Rate on Floater = LIBOR+ pre-determined rate (fixed)

• Coupon Rate on Inverse Floater= K-L*(one-month LIBOR)

K= Cap or maximum coupon rate for the Inverse Floater

L= Coupon Leverage

• The higher the coupon leverage, the more the inverse floater’s coupon rate changes for a given change in one- month LIBOR Low leverage (0.5 to 2.1)

Medium- leverage (more than 2.1 but lesser than 4.5)

Higher Leverage (higher than 4.5)

Objective of issue: • Matches their liability schedule to the prepayment schedule

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LIBOR is never negative hence the Coupon Rate of

Floating Rate Bond cannot be negative

If there are no restrictions on the inverse floater rate

then there is a possibility of negative coupon rate

• For example:

CAP= 28.5% and Coupon Leverage= 3

If the LIBOR becomes 10% then the coupon rate would become as

follows:

28.5%- 3*10%= 28.5%- 30% = - 1.5%

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PAC Bonds

• Low Contraction and Extension Risk

• Allows greater certainty of timing of CFs

Support/ Companion Bonds

• Forego the scheduled principal repayment

• Do not receive any principal until the PAC bonds receive the

scheduled principal payment that are made

• If paid off due to faster-than-expected pre payments then there

is no longer any protection on PAC bonds

Busted – Term used to denote the break of a PAC schedule

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Determination of Monthly schedule of Principal Repayments

• Minimum (Low Collar)and Maximum (Upper Collar) Prepayment

speeds are assumed till the outstanding principal balance is paid

off

• Minimum Principal payment is determined

Average Life of PAC Bonds varies with the nature of the bond

• For Superior Bonds the effective collar is higher as compared to

the support bonds

Note:

Initial collar is the range of two speeds used to create a PAC bond

Effective collar is the range of PSA in which the average life remains stable

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PAC buyers prefer tight windows

Institutional investors prefer a window which matches

its liability schedule

Investor demand drives the PAC windows that the

issuers will create which in turn is driven by investor

liability schedules

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Lockout PAC Structure

• Issue fewer PAC bonds relative to support bonds

• No principal payments to a PAC bond class in the earlier years

in order to create more Support bonds

Reverse PAC Structure• Any excess principal payments to be made to the longer PAC bonds

after all support bonds are paid off is called a Reverse PAC Structure

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Schedule of principal repayment

Single PSA Rate

Has protection against only Contraction Risk

For institutions not overly concerned with some

extension risk but greatly concerned with contraction

risk

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Schedule of principal repayment

Single PSA Rate

Has protection against only Extension Risk

For institutions not overly concerned with some

contraction risk but greatly concerned with extension

risk

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The interest accrued on accrual bonds are used to pay off the principal and interest of the VADM bonds

Provides protection against extension risk even if prepayments slow down because the interest accrued on Z bond will be sufficient to pay off the scheduled principal and interest on VADM bond

The maximum final maturity can be determined with a high degree of certainty

If prepayments are high resulting in the supporting bond being paid off faster a VADM bond can shorten

Compared with PACs they have greater absolute protection against extension risk

Structures that include these bonds have do not have much significance of contraction risk

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Principal- only• All principal are paid to one bond class

Interest- only• All interest payment are done to another bond class

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In practice the coupon rate of each tranche is different depending

upon the term structure and the average life of the tranche

In earlier CMO deals the excess interest between the coupon rate

on the tranches and coupon rate on the collateral was paid to an

equity class referred to as the CMO Residual

Now a tranche is created which receives the excess coupon

interest known as Notional Interest- only class or Structured IO

Notional Amount for 7.5% IO= (Tranche par value*excess

interest)/0.075

Excess interest= collateral coupon rate- tranche coupon rate

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Tranche Par Amount Notional

Amount

Coupon Rate (%)

A 194,500,000 6.00

B 36,000,000 6.50

C 96,500,000 7.00

Z 73,000,000 7.25

IO 52,566,667 7.5

Total 400,000,000

TRANCHE A:

Notional Amount for 7.5% IO= (194,500,000* (0.075-0.06))/0.075= 38,900,000

TRANCHE B:

Notional Amount for 7.5% IO= (36,000,000*(0.07-0.06))/0.075= 4,800,000

TRANCHE C:


TRANCHE Z:


Coupon Rate of the collateral= 7.5%

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Bonds providing prepayment protection to PAC tranches

Exposed to greatest level of prepayment risk

Support bonds are classified into different bond classes

• Sequential- pay support bond

• Floaters

• Inverse Floaters

• Accrual support bond

Support bonds that are pack bonds can be created (PAC II

Bonds) with a PAC schedule of repayment

PAC II Bonds have greater prepayment protection than the

support bond classes without the schedule of principal

repayments but lesser Prepayment Protection than PAC I

Bonds

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CMOS can be considered to be a business entity• Assets are the collateral (Pass- through or pool of mortgage loans)

• Liabilities are the payments due to the CMO Bond Classes

• Liability obligation : the Par value and the periodic interest payment

that is owed to each class of bond

Agency CMOs: Issued by Freddie Mac, Fannie Mae or Ginnie

Mae

Non- Agency CMOs: Issued by a private entity

• Private Label CMOs: The underlying pool of pass throughs are

guaranteed by an agency

• Whole Loan CMOs: Pool of unsecuritized mortgage loans

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A provision of Tax Reforms, 1986 called Real Estate

Mortgage Investment Conduit (REMIC) specifies the

requirements that an issuer must fulfill so that the legal

entity created to issue a CMO is not taxable

Not all CMOs are REMICs

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1. Synthetic- coupon Pass- throughs

2. Interest- only/ Principal only Pass- through Securities

1. Synthetic – coupon Pass- throughs

Unequal distribution of coupon and principal results in a synthetic

coupon rate that is different from that of the underlying collateral

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2. Interest- only / Principal- only securities

• Principal- only securities

With a fall in the mortgage rates the principal prepayments become faster leading to a rise in the cash flows which are discounted by a lower interest rate and hence the price of a PO rises

With an increase in the mortgage rates the principal prepayments become slower leading to a deterioration in the cash flows which are then discounted by a higher interest rate and hence the price of PO falls

• Interest- only securities

With a fall in the mortgage rates the outstanding balance of principal prepayments fall and hence the interest amount will fall leading to a fall in the price of IO

With a rise in the mortgage rates the outstanding balance of principal prepayments rise and hence the high interest amount will rise leading to a rise in the price of IO

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Commercial Mortgage Loans

• Definition

• Indicators of Potential Performance

• Call Protection

• Balloon Mortgage Provisions

Commercial Mortgage Backed-Securities (CMBS)

• Types of Deals

• Servicer

• Analysis of The Collateral

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Commercial Mortgages loans are for income

producing properties

Includes:

• Multi-family Properties

• Office Buildings

• Shopping Centers

• Hotels

• Health Care Facilities

• Industrial Properties

Commercial Loans are Non-Recourse loans

Potential Performance Measures

• Debt Service Coverage Ratio

NOI/Debt Service

Higher the Ratio better it is

• Loan-to-Value

Expected cash flows are plotted

Discounting rate referred as “Capitalization Rate”

Analysts are skeptical about estimates of market value and resulting

LTV’s reported for properties

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Call Protection to counter the risk of Prepayment

Call protection Methods Prepayment Lockouts

Defeasance

Prepayment Penalty

Yield Maintenance Charge

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Commercial Loans are usually Balloon Loans

Balloon Risk or Extension risk :

Failure of borrower to refinance balloon payment

Measures to counter the Balloon Risk

• Internal Tail

• External Tail

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Single Borrower/Multi Property Deals

• Features

Cross Collateralization

Cross Default feature

• In case of retiring of a property

Retirement should be greater then Asset value

DSC should be maintained

Multi Borrower Deals

• Fusion conduit Deal (for property greater then$ 50 mn)

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A servicer is required to perform key functions like

collecting monthly loan payments, maintaining escrow

for taxes & insurance, preparing reports for trustee etc.

Types of Servicers:

• Sub- Servicer

• Master Servicer

• Special Servicer

Notes:

Banc of America commercial mortgage series 2001-1, GMAC is

the master servicer. Lenner Partners is the special servicer in

above series.

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CMBS are non-recourse in nature hence proper

evaluation should be done

Key checks

Performance Indicators of Property

Property Type

Geographical Distribution of Properties

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Key Factors to be considered

Number and Quality of tenants

Physical Attributes of Building

Business Location

Strength and nature of Local Economy

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Economy & Finance

Chapters12&13