Mortgage Back Securities
Vinod Kumar
Example: Sequential-Pay Tranches (0 PSA)
• Each class of bonds would be retired sequentially (sequential-pay CMOs).
Example: From a passthrough pool of $400 mn, WAC =8.125%, WAM=357 months, 4 tranches created
Tranche Par amount $ Coupon rate
A 194.5 mn 7.5%
B 36 mn 7.5%
C 96.5 mn 7.5%
D 73 mn 7.5%
Total 400 mn Same rate
• Payment rules:
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 payments 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 tranche B is paid off completely, disburse principal payments to tranche C
until it is paid off completely. After tranche C is paid off completely, disburse principal payments to
Sequential-Pay Tranches
• Distribution of principal payment (no prepayment): WAM=357 months
1. Tranche A, month 1- 81.
2. Tranche B, month 81 - 100.
3. Tranche C, month 100 - 178.
4. Tranche D, month 178 - 357.
• Avg. Life of the Pool = 240 (please see excel)
• WAM = 357 months
• Thus WAM and average life is not same thing
Advantage of making Tranche
• Considerable variability of the average life for the tranches.
• Prioritizing the distribution of principal in this structure effectively
• Protects the shorter-term tranche A and B against extension risk.
• This protection comes from the three other tranches.
• Tranches C and D provide protection against extension risk for
tranches A and B.
• Protects the shorter-term tranche C and D against contraction risk,
• This protection coming from tranches A and B.
Protection to tranches
• Protection is subject to assumption
• If PAS assumption does not hold, then protection will be affected.
• An assumed PSA speed allows the cash flow to be projected.
• Assuming 165 PSA principal pay-down window for a tranche
• Average life of collateral pool = 8.76 years
• And this is distributed among the tranches
Average Life for the Collateral and the Four Tranches
Other CMOs
• A CMO class may have a different coupon rate from that for underlying collateral.
• Instruments that have varying risk-return characteristics
• It may be more suitable to the needs and expectations of investors, thereby
broadening the appeal of mortgage-backed products to various traditional
fixed-income investors.
Other CMOs: Accrual Bonds
• In some sequential-pay CMO structures, at least one tranche does not receive
current interest.
• The interest for that tranche would accrue and be added to the principal balance.
• Such a bond class is commonly referred to as an accrual tranche, or a Z bond
• Accrued interest in z-bonds are used to speed up the paydown of the principal
balance of earlier bond classes.
• Expected final maturity for tranches A, B, and C has shortened as a result of the
inclusion of tranche Z.
For example in previous example (assuming no prepayments)
• Final payout for tranche A is 64 months rather than 81 months;
• For tranche B it is 77 months rather than 100 months;
• For tranche C it is 112 rather than 178 months.
• Accrual bond has appeal to investors who are also concerned with reinvestment
risk.
Other CMOs: Floating-Rate Tranches
• Remember that the inflow from collateral is a fixed rate
• But, many financial institutions require floating-rate assets, which provide a
better match for their liabilities. (duration risk of floating rate loan is 0)
• Floating-rate tranches can be created from fixed-rate tranches by creating a
floater and an inverse floater.
• Principal balance in Floating-Rate Tranches declines over time as principal
• In a floating-rate note in the corporate bond, principal is unchanged over life of Bond
• Principal payments to the floater are determined by the principal payments from the
tranche from which the floater is created
• To prevent negative coupon rate for inverse floaters, a minimum floor are
placed on the coupon rate in inverse floaters, and to adjust that a maximum cap
is placed on floaters.
Other CMOs: Planned Amortization Class Tranches
• Still significant prepayment risk cause substantial average life variability,
• Potential demand for a CMO product with less uncertainty about the cash flow
increased in the mid-1980s because of 2 trends in corporate bond market.
1. Increased event risk (e.g. leveraged buy-out) faced by investors in corporate bonds.
2. A decline in the number of AAA-rated corporate issues.
• But, Traditional corporate bond buyers sought a structure with both characteristics of
a corporate bond (bullet maturity or a sinking fund) and high credit quality.
• Existing CMOs were satisfying the second condition, but not the first.
• Innovation: PAC Bonds
• Prepayments are within a specified range, cash flow pattern is known.
• PAC bonds have protection against both extension risk and contraction risk
• To support PAC bonds, there must be some non PAC Class.
Non-PAC Class: Support Bonds
• Because PAC bonds have protection against both extension risk and contraction risk,
they are said to provide two-sided prepayment protection.
• Greater certainty of the cash flow for the PAC bonds comes at the expense of the
non-PAC classes, called support or companion bonds.
• It is these bonds that absorb the prepayment risk. Consequently, non-PAC class are
exposed to the greatest level of prepayment risk.
Support Bonds: non-PAC Class
• Support bond typically is divided into different bond classes including
sequential-pay, floater and inverse floater, and accrual bond.
• Support bond can even be partitioned so as to create PAC bonds.
• In a structure with a PAC bond is called a PAC I bond or level I PAC bond ;
• Support bond with a PAC schedule of principal is called PAC II bond or
level II PAC bond
• PAC II bonds have greater prepayment protection than other support bond
classes, but less than PAC I bonds.
Example
Monthly Principal Payment for $400 Million 7.5% Coupon
Pass-Through with an 8.125% WAC and a 357 WAM Assuming
Prepayment Rates of 90 PSA and 300 PSA
Example
• A CMO structure created from the $400 million, 7.5% coupon pass-through
with a WAC of 8.125% and a WAM of 357 months.
• Only two bond classes are in this structure: a 7.5% coupon PAC bond created
assuming 90 to 300 PSA with a par value of $243.8 million, and
• A support bond with a par value of $156.2 million (400 mn - 243.8 mn).
• Two speeds used to create a PAC bond are called the initial PAC collars (or initial PAC
bands); in this case, 90 PSA is the lower collar and 300 PSA is the upper collar.
• The range between which the PAC have stable average life is called effective collar.
Average Life for PAC Bond
Multiple PAC
• Once the support Band exhaust the PAC bonds are now a normal Bond.
• The shorter the PAC (as % of total tranche principal), the more protection it has
against faster prepayments
Effective Collar (initial collar is 90-300 PSA)
• Average life is stable even beyond the upper and lower collar
Planned Amortization Class Window
• Length of time over which scheduled principal repayments are made is referred
to as the window.
• Who prefers PAC bonds?
• PAC buyers appear to prefer tight windows,
• Institutional investors facing a liability schedule are generally better off with
a window that more closely matches the liabilities.
• Investor demand dictates the PAC windows that issuers will create.
• Investor demand in turn is governed by the nature of investor liabilities.
Protection in PAC
• Total prepayment risk of the passthrough pool is same
• Through redistribution:
• Some reduce their prepayment risk
• Other investors accepts higher prepayment risk
• Creation of a mortgage-backed security cannot make prepayment risk
disappear. This is true for both a pass-through and a CMO
• Once support band is paid off (schedule is busted), the PAC structure is now
effectively a sequential-pay structure
Agency Stripped MBS
• Distribution of interest or principal were not equal (no pro rata basis).
• There are three types of SMBS:
1. Synthetic-coupon pass-throughs
• Two securities with a synthetic coupon rate that was different from that of the
underlying pass-through security from which they were created
For example suppose that $1 billion of pass-throughs with a 6% coupon rate are used
to create two securities
a) A-1 receives 75% of the interest and 50% of the principal
b) A-2 receives 25% of the interest and 50% of the principal
The synthetic coupon rate for the two securities is then
c) Synthetic coupon for A-1: $45 million/$500 million = 9%
d) Synthetic coupon for A-2: $15 million/$500 million = 3%
2. Interest-only/principal-only securities
3. CMO strips
• Notional Interest only
PO and IO
• Reason: Prepayment decreases when interest rate goes up
Asset Backed Securities & CDO
• Asset Backed security
• Collateralized DEBT obligation
• Collateral is other than mortgage loan (auto loan, car loan, or low rated bonds)
• CMO is issued by agency and private both; CDO by Private body
• Issued by SPE (special purpose entity)
• Complex structure than CMO
• Rating agencies have role in CDO, but not in CMO
• Rating augmentation
• Cash flows from a CDO
• Create tranche where cash flow will be distributed like waterfall (waterfall provision)
• Can create higher grade security from a low grade bonds (support is equity tranche).
Asset Backed Securities & CDO
• CDO market:
• Securitization of the asset pool allows investors to acquire the fixed-income instruments
that perfectly fit their risk-return demands.
• Custom-tailored securities allow for more efficient risk allocation among the market
players.
• Arbitrage opportunity
• Parts can be sold at higher price than full.
• Hedge funds are typical equity tranche investors.
What would an SPV’s balance sheet look like?
• Assets of the SPV are represented by loans it buys (invests in) from Western Asset.
• Liabilities of the SVP are the bonds (tranches) it issues to fund the loan investment.
• Expected return on SPV’s assets: 360 /400*7.53% +40/400*8.50%=7.627%
Assets Liabilities
Security $ mn Coupon Coupon Security $ mn Coupon Coupon
B+ LIBOR + AAA (A-1) 238 Float LIBOR + 0.23%
360 Float
(leveraged loans) 2.35% AAA (A-2) 60 Float LIBOR + 0.34%
B AA 18 Float LIBOR + 0.45%
40 Fixed 8.50%
(high-yield bonds) A 24 Float LIBOR + 1.00%
BBB 32 Float LIBOR + 2.75%
Equity 28
Total 400 Total 400
Libor = 5.18%
• What is expected rate of return for equity investor?
Advantage of CDO?
• Issuer or Asset manager
• Asset manager gets an opportunity to sell rather illiquid investments
• Originators can eliminate risky assets from its balance sheet to reduce capital
requirements
• Capital adequacy ratio requirement for banks is addressed
• In addition, in the presence of the arbitrage (demand imbalance between AAA- and B-)
• Parts are more valuable than aggregate;
• More demand for part and less demand for aggregate (some investor face legal
restrictions and can buy only investment grades; some are good in accepting and
managing risk)
• Investors
• CDO investors invest in financial products that are highly customized to their taste and
portfolio demands.
• CDOs allow investors to diversify more effectively in a pool of loans on their own terms
(tranche). They also allow investors to participate indirectly in the attractive markets
(e.g., real estate).
Collateralized debt obligation (CDO)
• CMO vs CDO: Name suggests the difference
1. Pool of mortgage security (CMO) vs. pool of debt, loan & ABS
2. Prepayment risk and default risk in the two POOLs are different
• CMO: Prepayment risk high, default risk low. Mainly to redistribute repayment risk.
• CDO: prepayment risk low, default risk can be higher. To redistribute default risk.
• Some steps can be taken to reduce default risk in CDO
• If all risks are low, then there is no point of pooling and repackaging, repackaging is
basically intended to redistribute a risk.
• Both CMO & CDO are pooling the fixed income securities, and then repackage the cashflow
in the POOL to issue various kind of securities
i.e. tranche (securities with different maturity, coupon rate, and risk)
• Both are having some obligation on issuer, and not simply pass-through to investors, therefore
both face some additional regulation
• Issuer bear little risk in aggregate. In total, it is a passthrough for issuer.
• Issuer bears the obligation for CMO/CDO investors, but then pass-on this risk taken on
the equity tranche.
CMO vs CDO
CMO CDO
A pool of mortgage loans. Pool of automobile loans, credit card loans,
falls under the MBS category. commercial loans, and even some tranches from
a CMO; falls under ABS category
Investment similar to a bond that is made up of a bundle of Structured from senior to junior with some
home loans oversight from rating agencies who assign grade
ratings just like a single-issue bond, e.g. AAA,
AA+, AA, etc.
Still subject to some prepayment risk for investors Default risk is more serious
CMOs can be issued by private parties or backed by quasi- CDOs are private-labelled
government lending agencies
Investor can choose how much reinvestment risk he is investor can choose Safety of investment. Each
willing to take in a CMO CDO has a balance sheet just like a company
Easier to understand Complex securities
CMO market also suffered in 2007 crisis, but recovered. CDO market was hit harder.
Global CDO Issuance
CDO/CMO Structure an example
