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Collateralized Mortgage Obligations (CMO)
• Definition
• Structure
• Credit Risk
• Tax Considerations
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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 Mortgage-
related 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
NOTE: Whole loans are usually larger in size than the maximum amount allowed within
GNMA, FNMA and, FHLMC's standards 4
Classified into different Bond classes referred to as tranches
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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
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)
• 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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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
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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
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Schedule of principal repayment
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Schedule of principal repayment
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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
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Principal- only
• All principal are paid to one bond class
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
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Coupon Rate of the collateral= 7.5%
Tranche Par Amount Notional Coupon Rate (%)
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 52,566,667 7.5
Total 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
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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
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
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1. Synthetic- coupon Pass- throughs
2. Interest- only/ Principal only Pass- through Securities
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2. Interest- only / Principal- only securities
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Commercial Mortgage Loans
• Definition
• Indicators of Potential Performance
• Call Protection
• Balloon Mortgage Provisions
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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
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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”
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Call Protection to counter the risk of Prepayment
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Commercial Loans are usually Balloon Loans
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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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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.
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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
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