Chapter 12&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

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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 Mortgagerelated 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

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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 Cash Flow from Pass-through securities

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Tranches on the basis of specific rules for coupon and principal payment

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

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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

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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

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Single PSA Rate

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Has protection against only Contraction Risk

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For institutions not overly concerned with some extension risk but greatly concerned with contraction risk

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Schedule of principal repayment

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Single PSA Rate

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Has protection against only Extension Risk

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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 15

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

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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 17

Coupon Rate of the collateral= 7.5%

Tranche

Par Amount

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 Total

Notional Amount

52,566,667

Coupon Rate (%)

7.5

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: Notional Amount for 7.5% IO= (96,000,000*(0.065-0.06))/0.075= 6,433,333 TRANCHE Z: Notional Amount for 7.5% IO= (73,000,000*(0.0675-0.6))/0.075= 2,433,333

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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 19

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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

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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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Synthetic- coupon Pass- throughs 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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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

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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

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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

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Balloon Risk or Extension risk : Failure of borrower to refinance balloon payment

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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

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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. 31

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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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