a.
The mere creation of a CMO cannot eliminate prepayment risk; it can only
transfer the various forms of this risk among different classes of bondholders.
CMOs strip the principal and coupon payments of the underlying mortgages
and create tranches of bondholders that are paid with different priorities.
Although prepayment risk doesn’t completely disappear for those bondholders
in lower-priority tranches, it is diminished significantly while, at the same time,
increasing significantly for bondholders in other tranches.
b. Many CMOs have been designed in response to a specific market demand.
Institutional investors gave rise to PAC bonds. Companies hoping to match
liabilities better with assets gave rise to CMO tranches featuring floaters and
inverse floaters. Investors wanting to avoid reinvestment risk were supplied
with accrual bonds. CMOs are almost like the Build-A-Bear of the securities
market. Many innovations were made to customize the features of the security
to a particular group of people.
Because the CMOs are made of pass-through securities, the risks inherent in both assets are
exactly the same. CMOs redistribute the total risk of pass-through securities to different
investors who are willing take on different risks. Although some investors in the CMO space
take positions speculatively, they are exposed to greater risk than an investor who simply
purchases pass-through securities. However, the total risk of the CMO is the sum total of
those risks faced by each investor in the CMO. Everything evens out.
The inclusion of an accrual tranche in a CMO structure decreases the average lives of all
sequential-pay structures in the CMO besides the accrual tranche itself, which experiences an
increase to its life.
The accrual bond appeals to investors who are concerned with reinvestment risk. Because
there are no coupon payments to reinvest, reinvestment risk is eliminated until all the other
tranches are paid off.
The average life of the inverse floater would depend on the relative weights of the floater and
inverse floater in the CMO. If the two are equally weighted, the average life of the inverse
floater would also be 5 years. The weighted average life of the floater and inverse floater
equal the average life of the tranche from which they are both made.
The Planned Amortization Class of bondholders is given a schedule of guaranteed minimum
payments to protect against extension and contraction risks. These payments on the schedule
are determined by calculating what principle payments are over a given prepayment range
stated in PSA.
A support bond absorbs prepayment risk for the PAC tranche. Because the PAC tranche is
guaranteed a certain schedule of payments that must be satisfied, the cash flows required to
do so must come from other support or companion bonds within the CMO.
PAC bonds were created by the securities market to appeal to institutional investors who were
reluctant to invest in mortgage-backed securities due to substantial prepayment risk and
variability in average mortalities. PAC bonds significantly diminish this uncertainty in cash
flows and open an opportunity for institutional investors to invest.
