Tara StanleyEmily Kenyon

CMOs OverviewWhat is a CMO?HistoryAssociated RiskAdvantages of CMOsTypes of CMOsRole in Current Economy

What is a CMO?Collateralized Mortgage Obligation

1.Mortgages are pooled2.The ‘pool’ is split into various tranches with

varying degrees of risk, cash flows, and time frames.

3.Investors purchase securities4.Mortgages are used as collateral for

mortgage pass-through securities

History of CMOsOriginated as a mortgage pass-through securityGovernment-sponsored enterprises were created to

attract investors & create a liquid secondary market.Fannie Mae, Ginnie Mae, & Freddie Mac were

responsible for purchasing mortgages and issuing mortgage backed securities

1970 Ginnie Mae issued the first bonds backed by pools of mortgages to free up funds for more home loans

1977 The first private mortgage backed securities are sold

1983 Freddie Mac issues the first collateralized mortgage obligation, which allows investors to pick their level of risk

Risk of Mortgage Pass-Through SecuritiesPrepayment Risk

Unknown probability that the borrower will pay off the loan sooner than expected.

Extension RiskInterest Rates increase therefore decreasing

the probability of prepaymentContraction Risk

Interest Rates decrease therefore increasing the probability of prepayment

Advantages of CMOsReduce Prepayment riskAttract a wide variety of investors by offering

various tranchesRegular monthly or quarterly paymentsGuaranteed by the financial institution that

issues the investment.Fannie Mae & Freddie Mac insure payment

when borrower defaultsGinnie Mae insures “full faith and credit” to

investors

Types of CMOsSequential-PayAccrual Tranche or Z-BondPlanned Amortization ClassTargeted Amortization ClassPrincipal-OnlyInterest-Only

Sequential-Pay CMO•Tranches mature in chronological order

•Tranche 1 receives principal and interest payments while Tranche 2 & 3 receive interest only until Tranche 1 hits maturity•After Tranche 1 is paid in full, Tranche 2 receives principal and interest payments while Tranche 3 continues to receive interest only payments•Finally, Tranche 3 begins to receive principal and interest payments once Tranche 2 is complete

•Attracts a variety of investors by offering different levels of risk and investment periods

Accrual Tranches or Z-BondsSimilar to a Sequential-Pay CMOInstead of the last Tranche receiving interest

payments while the other Tranches are paid, the interest is accrued

The accrued interest is then used to help pay off the principal in the preceding tranches

Once preceding tranches have matured, the last tranche receives principal and all accrued interest

Eliminates Reinvestment Risk

Planned Amortization Class (PAC)Most popular CMO issued today Make up 50% of all first time issued CMOsCreates a schedule of fixed principal paymentsIf prepayment occurs, investor receives fixed

payment while additional funds are applied to a companion tranche

Guarantee cash flow at given intervalsProtected against Contraction & Extension RiskMinimal Risk = Lower Rates

Targeted Amortization Class (TAC)Similar to Planned Amortization ClassOffered at a fixed rate versus a fixed payment

Minimal RiskExcess cash flow is distributed to companion

trancheCompanion tranches offer higher rates

No telling how fast or slow the tranche will mature

Principal-Only & Interest-OnlyPrincipal-Only

Receives only principal paymentsBought at discount Vulnerable to Interest Rate Changes

Decrease in interest rates create an increase in prepayment

Interest-OnlyReceives only interest paymentsVulnerable to Interest Rate Changes

Increase in interest rates create a decrease in prepayment

CMOs in the Current EconomyHow have CMOs contributed to the current

economic meltdown?What can be done to prevent future

problems?

How have CMOs contributed to the current economic meltdown?Subprime Lending

Borrowers who do not qualify for prime loansPredatory Lending

Targets individuals with a limited understanding of financial transactions

Offers subprime loans to individuals who qualify for prime loans

How have CMOs contributed to the current economic meltdown?Conflicts of Interest

Lack of training or licensing for mortgage brokersBrokers paid by both the borrowers and loan

originators Some brokers received a ‘yield-spread premium’ for

charging a higher interest rate than the borrower qualified for

Companies rating CMOs Paid by company offering security, not buyers of securities Chastised by SEC

Failed to protect investors Inadequate staffing Not tracking performance after giving initial rating

How have CMOs contributed to the current economic meltdown?Fraud

Fraud for Profit Collusion between industry insiders

Fraud for Property Material misrepresentation on loan application

How have CMOs contributed to the current economic meltdown?Lack of ethical behavior in the origination of

mortgages led to higher possibility of default for mortgages underlying the CMO

Collapse in housing prices End of 2-3 year fixed rate for Adjustable Rate

Mortgages (ARMs) meant many could not make their new mortgage payment

How have CMOs contributed to the current economic meltdown?Once considered as safe as treasury bonds

with a higher returnOften invested in by institutions who could

only invest in the highest grade securitiesDowngrades from investment quality to junk

rocked financial markets

What can be done to prevent future problems?Licensing & training for mortgage brokersMake all parties bear default riskEliminate conflicts of interest

Questions?

Question #1

What does CMO stand for?

AnswerCollateralized Mortgage Obligation

Question #2What is the most popular type of CMO?

AnswerPlanned Amortization Class (PAC)

Question #3What are 2 advantages of CMOs?

AnswerReduce Prepayment riskAttract a wide variety of investors by offering

various tranchesRegular monthly or quarterly paymentsGuaranteed by the financial institution that

issues the investment.

Question #4True or False?

CMOs eliminate prepayment risk?

AnswerFalse

They only reduce prepayment risk by spreading it among tranches.

Question #5This type of CMO pays tranches in chronological order and was the first type of CMO offered

AnswerSequential-Pay

Question #6When interest rates rise creating less prepayment, this risk is called?

AnswerExtension Risk

Question #7What year was the first CMO offered?

Answer1983