BUS424 (Ch 12, 14, 15, 16) 1

CMO, Stripped MBS, CMBS, ABS, CDO

1. Collateralized Mortgage Obligations – ch12

2. Stripped Mortgage-backed Securities – ch 12

3. Commercial MBS – Ch14

4. ABS -- Ch15

5. Collateralized debt obligations -- Ch16

BUS424 (Ch 12, 14, 15, 16) 2

CMOs

Bond classes created by redirecting the cash flows of mortgage-related products so as to mitigate prepayment risk.

Pay-through structure: there are more than one class of bondholders with the same level of credit priority

Tranches: different bond classes

BUS424 (Ch 12, 14, 15, 16) 3

Materials Covered under CMOs

Sequential-Pay Tranches (basic)

Accrual Tranche

Floater and Inverse Floater

Planned Amortization Class versus Support Class

BUS424 (Ch 12, 14, 15, 16) 4

Sequential-Pay Tranches

The collateral for the hypothetical CMO is a hypothetical pass-through with total par value of $400 million and the following characteristics :

(1) The pass-through coupon rate is 7.5%

(2) WAC=8.125%

(3) WAM=357 month

(4) 165PSA

(page 277):

BUS424 (Ch 12, 14, 15, 16) 5

FJF-01Tranche Par Amount Coupon Rate(%) A 194,500,000 7.5 B 36,500,000 7.5 C 96,500,000 7.5 D 73,000,000 7.5 ?1. For payment of periodic coupon interest: Disburse periodic coupon interest to

each tranche on the basis of the amount of principal outstanding at the beginning of the period

2. For disbursement of principal payments: Disburse principal prepayments to tranche A until it is paid off completely. After tranche A is paid off completely, disburse principal payments to tranche B until it is paid off completely. After … After tranche C is paid off completely, disburse principal payments to tranche D until it is paid off completely.

BUS424 (Ch 12, 14, 15, 16) 6

Cash flow from Pass through (page 279)

In month 1: total payment=$709,923;

Interest=$250,000

In month 81: total payment=

BUS424 (Ch 12, 14, 15, 16) 7

Cash flow from the CMO

Exhibit 12-2 – split the principal; CMO specifies the order of principal payment

The principal pay-down window

Average lives for the collateral and four tranches of the CMO – page 281 (ex 12-3).

BUS424 (Ch 12, 14, 15, 16) 8

Accrual Bond

One tranches (or more) does (do) not receive current interest. This is an accrual tranche, or Z bond.

BUS424 (Ch 12, 14, 15, 16) 9

FJF-02Tranche Par Amount Coupon Rate(%)

A 194,500,000 7.5

B 36,500,000 7.5

C 96,500,000 7.5

Z 73,000,000 7.5

?

1. For payment of periodic coupon interest

2. For disbursement of principal payments

3. Solution: see Exhibit 5 – page 283.

BUS424 (Ch 12, 14, 15, 16) 10

FJF-03: Floating-rate TranchesTranche Par Amount Coupon Rate(%)

A 194,500,000 7.5

B 36,500,000 7.5

FL 72,375,000 1-month LIBOR + 0.50

IFL 24,125,000 28.5-3*(1-month LIBOR)

Z 73,000,000 7.5

?

1. For payment of periodic coupon interest

2. For disbursement of principal payments

BUS424 (Ch 12, 14, 15, 16) 11

Planned Amortization Class (PAC)

Exhibit 12-8

Tranche Par Amount Coupon rate (%)

P $243,800,000 7.5

S 156,200,000 7.5

400,000,000

For payment of periodic coupon interest

For disbursement of principal payments

BUS424 (Ch 12, 14, 15, 16) 12

Principal Payments under PAC

Disburse principal payments to tranche P based on its schedule of principal repayments. Tranche P has priority with respect to current and future principal payments to satisfy the schedule. Any excess principal payments in a month over the amount necessary to satisfy the schedule for tranche P are paid to tranche S. When tranche S is paid off completely, all principal payments are to be made to

tranche P regardless of the schedule.

BUS424 (Ch 12, 14, 15, 16) 13

Support Bonds

Bodyguards for the PAC bondholders

Can be partitioned into classes, I.e, bodyguards have ranks and titles, too.

BUS424 (Ch 12, 14, 15, 16) 14

Objective

To eliminate the contraction risk and the extension risk

Contraction risk: when interest rate goes down

Extension risk: when interest rate goes up

BUS424 (Ch 12, 14, 15, 16) 15

Series of PAC Bonds

• Combination of PAC and sequential-pay CMO• Page 290• At different prepayment rate, the average lives of

6 PAC bonds are different (ex 12-11).– What do you see from there?

BUS424 (Ch 12, 14, 15, 16) 16

TACOne-side prepayment protection.

Has a single PSA rate from which the schedule of principal repayment is protected

Typically protected when prepayment is high, thus avoid contraction risk.

BUS424 (Ch 12, 14, 15, 16) 17

Credit Risk and Tax Treatment of CMOs

Agency CMOs

Nonagency CMOs

Interest and principal payments are not taxable.

BUS424 (Ch 12, 14, 15, 16) 18

Stripped Mortgage-Backed Securities

Principal-only (PO) securitieswhen current mortgage rate < coupon rate, prepayment speeds up. price goes up

when current mortgage rate > coupon rate, price drops.

Interest-only (IO) securitiescurrent mortgage rate < coupon rate, mixed

Exhibit 12-145(page 297)

CMO strips: one class in CMO structure could be PO or IO.

BUS424 (Ch 12, 14, 15, 16) 19

Commercial Mortgage-Backed Securities(ch14)

Commercial mortgage loans are for income-generating properties, including

• Multifamily properties (apartment buildings)• Office building• Industrial properties• Shopping centers• Hotel• Health care facilities

BUS424 (Ch 12, 14, 15, 16) 20

Characteristics of Commercial Mortgage Loans

Commercial mortgage loans are non-recourse loans – lenders can only look to the income-producing property backing the loan for interest and principal repayments.

Performance• Debt-to-service coverage ratio – page 331• Loan-to-value ratio – page 331Prevent from prepayment – page 332

BUS424 (Ch 12, 14, 15, 16) 21

CMBS

A commercial mortgage-backed security is a security backed by one or more commercial mortgage loans. It can be issued by agency or none agency backed.

• Single borrower/multi-property deals• Multi-borrower deals

BUS424 (Ch 12, 14, 15, 16) 22

Asset-backed Securities –

Chapter 15• Securities created by pooling loans other than first-lien mortgage loans are referred to as asset-backed securities.

• 4 biggest sectors

• Credit card receivables

• Auto loans

• Home-equity loans

• Manufactured housing loans

BUS424 (Ch 12, 14, 15, 16) 23

Creation of an ABS1. Granting a loan

– Underwriting standards– Originator of a loan

2. Securitization process– Special purpose vehicle (SPV): the ABS issuer

—Legal implication: rating of ABS will be independent of the originator (page 356)

– Conduit: the party who buys the loans and sell them to SPV.

3. Credit enhancements– External – bond insurance (page 358)– Internal

BUS424 (Ch 12, 14, 15, 16) 24

Roles of SPV

1. The potential for reducing funding costs (page 358)

2. To diversify funding sources

3. To accelerate earnings for financial reporting purposes

4. For regulated entities, potential relief from capital requirements.

BUS424 (Ch 12, 14, 15, 16) 25

Credit Enhancement of ABS

External credit enhancement

Guaranty from third party like bond insurance

Internal credit enhancement

Cash flow waterfall (or simply waterfall)

-- cash flow to senior bondholders first, then to lower priority classes.

BUS424 (Ch 12, 14, 15, 16) 26

Collateral Type and Securitization Structure

Amortizing assets

Nonamortizing assets -- page 362

Amortization schedule

Amortization period – page 363

BUS424 (Ch 12, 14, 15, 16) 27

Credit Risks with ABS

Asset risk

Structure risk

-- make sure if the collateral’s cash flows match the payments that must be made to satisfy the issuer’s obligtions.

Third-party providers

-- Page 365

BUS424 (Ch 12, 14, 15, 16) 28

Credit Card Receivable-Backed Securities

This is an example of ABS -- Page 366.

Credit card issuers have receivables• financing charges collected, fees and

principals.

IBs use the future cash flows from credit card receivables as collaterals to issue ABS or CDOs

BUS424 (Ch 12, 14, 15, 16) 29

Collateralized Debt Obligations (chapter 16, page 382)

A security backed by a diversified pool of one or more of the following types of debt obligations

• U.S. domestic investment-grade and high-yield corporate bonds

• U.S. domestic bank loans• Emerging market bonds• Special situation loans and distressed debt• Foreign bank loans• Asset-backed securities• Residential and commercial mortgage-back securities

BUS424 (Ch 12, 14, 15, 16) 30

Structure of A CDO – page 385Collateral managersCollateral Collateral assetsThe funds to purchase collateral assets come from the

issuance of debt obligations.

Structure of debt obligationsSenior tranchesMezzanine tranchesSubordinate/equity tranches

BUS424 (Ch 12, 14, 15, 16) 31

Categories of CDOs

Arbitrage transactionswhen the motivation of the sponsor is to earn the spread between the yield offered on the collateral and the payments made to the various tranches

Balance sheet transactionswhen the motivation is to remove debt instruments (primarily loans) from its balance sheet, typically financial institutions such as banks seeking to reduce their capital requirement specified by bank regulators

BUS424 (Ch 12, 14, 15, 16) 32

Cash vs Synthetic Structures

Synthetic CDO structures involve the use of credit derivatives.

BUS424 (Ch 12, 14, 15, 16) 33

Arbitrage Transactions

Tranche Par Value Coupon Value Coupon Rate

Senior $80,000,000 Floating LIBOR+70 basis points

Mezzanine $10,000,000 Fixed Treasury rate + 200 basis point

Subordinate/Equity $10,000,000

Create an arbitrage CDO is whether a structure can offer a competitive return for the subordinate/equity tranche as below:

BUS424 (Ch 12, 14, 15, 16) 34

AssumptionsThe collateral of the CDO:• bonds that all mature in 10 years• The coupon rate for every bond is a fixed rate• The fixed rate at the time of purchase of cash bond is the 10 year

treasury plus 400 basis points

To finance the senior tranche, • collateral manager enters into an interest-rate swap with another party

with a notional principal of $80 million in which it agrees to do the following:

• Pay a fixed rate each year equal to the 10-year Treasury rate plus 100 basis points

• Receive LIBOR

BUS424 (Ch 12, 14, 15, 16) 35

Cash flowsAssuming the 10-year rate at the time the CDO is issued is 7%.• Interest received from collatoral:• Interest to senior tranche:• Interest to mezzanine tranche:• Interest to swap counterpart: • Interest received from swap counter partAs a result,• Total interest received:• Total interest paid:• Net interest

BUS424 (Ch 12, 14, 15, 16) 36

Synthetic CDOs

In a synthetic CDO, the collateral absorbs the economic risk associated with specified assets but does not have legal ownership of those assets

Requires the use of CDS

BUS424 (Ch 12, 14, 15, 16) 37

Exercises (Ch12)

Problem 13: should be something close to 7.26 years

Problem 14: (a) support bond; (b) PAC bond

Problem 20: (a) 8.67%, (b) no effect , (c) more stable cash flows and lower variability