CMOs, IOs, POs and Valuation CM O M echanics InterestOnly PrincipalOnly CM O Tranches:PA Cs, TA Cs, Floatersand Inverse Floaters M BS V aluation o M BS Prices o Static V aluation M odels Static Yield Spread Spread to the Y ield Curve o D ynam ic V aluation M odels O ption A djusted Spreads o Introduction to InterestRate M odeling
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CMOs, IOs, POs and Valuation
CMO Mechanics Interest Only Principal Only CMO Tranches: PACs, TACs, Floaters and Inverse Floaters MBS Valuation
o MBS Prices o Static Valuation Models
Static Yield Spread Spread to the Yield Curve
o Dynamic Valuation Models Option Adjusted Spreads
o Introduction to Interest Rate Modeling
CMOs
Introduced by Freddie Mac in June 1983
Created with separate classes or ‘tranches’ where
investors have distinct claims to MBS cash flows
Typically have at least four tranches
Prepayment risk not shared equally
Institutional maturity intermediation
Most have AAA ratings
CMOs
Class A (Fast Pay) Bondholders receive
o Coupon interest
o All scheduled principal payment (amortization)
o All unscheduled principal repayment (prepayments)
o Interest that accrues to Zero Coupon Tranche is
reclassified principal and paid to Class A bondholders
While Class A bondholders are being repaid, Class B and
C bondholders receive coupon interest only.
Zero Coupon bonds accrue interest until other tranches
retired
CMOs
CMO Residuals
Income from securitized mortgages exceed bond
payments and expenses because
o Overcollateralization
o Bond Coupons < Mortgage Interest Rates
Residual typically held by issuer
CMO residual yields typically 300-500bp above other
mortgage derivative products
Loan Amount for One Loan $100,000.00
Annual Interest Rate 8.00%
Loan Term in Years 30
Number of Loans in Pool 1,000
Fees:
Servicing Fee (basis points) 44
Guarantee Fee (basis points) 6
Prepay Rate: % of PSA 100.00%
Computed:
Monthly Payment for One Loan $733.76 Number of Payments 360
Assets Pledged as Security 100,000,000
Debt Issued against Pool 97,000,000
Equity 3,000,000
Residual IRR 13.56%
Tranche Coupon Amount Weight Weighted Average
Rate Issued Coupon
A 6.00% $30,000,000 0.3093 1.86% B 6.50% $25,000,000 0.2577 1.68% C 7.00% $20,000,000 0.2062 1.44% Z 8.00% $22,000,000 0.2268 1.81%
Total $97,000,000 1.0000 6.79%
Prepayment Rate = 100 % of PSA
Residual IRR = 13.56%
Year Number of MBS Cash In MBS Cash
Out Prepayments Fees Tranche A Tranche B Tranche C Tranche Z Residual
In addition to the sequential pay tranches that include a zero-coupon (or accretion) bond, collateralized mortgage obligations typically have one (or more) of the following tranches:
PAC--planned amortization class
TAC--targeted amortization class
Floating rate tranche
Inverse floating rate tranche
CMO TranchesPlanned Amortization Classes
Introduced in 1986 Prepayment "protected" CMO tranche Bond pays scheduled principal payments (irrespective of CFs into
the CMO) for a range of actual prepayment speeds Range of prepay rates: 75% PSA to 240% PSA A companion PAC bond absorbs any cash flow uncertainty
o PAC and companion PAC receive coupon interest, but
o All CMO principal in excess of PAC scheduled go to companion
o All CMO principal below PAC scheduled paid from companion
CMO TranchesTargeted Amortization Classes
CMO pricing speed = prepayment rate that was assumed when the issue was priced
A TAC is a PAC with
o A lower band = CMO pricing speed
o An upper band similar to a PAC upper band Like PACs, TACs repay principal according to a schedule as long
as actual prepayments are within a specified range Unlike PACs, TACs DO NOT protect against WAL extensions
when prepayments are slower than pricing speed Investors tradeoff extension risk for higher yields
CMO TranchesFloaters and Inverse Floaters
Introduced by Shearson Lehman Brothers in 1986 Divide a fixed rate CMO tranche into two tranches with variable
coupons
o Floater rate moves with some index rate
o Inverse floater varies inversely with the index Collateral weighted average coupon = fixed rate coupon Principal payments are the same as they are for the underlying
fixed rate tranche
CMO TranchesFloating Rate Tranche
Floating rate = Index + spread (in basis points) Also have maximums, or caps, on floating rate Typical index rates include
o LIBOR: London Interbank Overnight Rate
o COFI: FHLB 11th District Cost of Funds Index
o CMT: Constant Maturity Treasuries Example:
Floating rate = LIBOR + 65bp with cap of 12%
CMO TranchesInverse Floater
Multiplier Spread) Index ( IFF
C Coupon Floater Inverse , w h e r e C = t h e c o u p o n o n t h e f i x e d r a t e c o l l a t e r a l
I n v e r s e f l o a t e r t r a n c h e s h a v e i n t e r e s t r a t e f l o o r s .
CMO TranchesInverse Floater
E x a m p l e : S u p p o s e a $ 3 0 M 6 % f i x e d r a t e c o u p o n C M O t r a n c h e w a s d i v i d e d i n t o a $ 2 0 M f l o a t i n g r a t e b o n d a n d a $ 1 0 M i n v e r s e f l o a t e r . I f t h e c o u p o n o n th e f l o a t i n g r a t e b o n d i s L I B O R + 5 0 b p , w h a t i s t h e c o u p o n o n t h e i n v e r s e f l o a t e r ? M u l t i p l i e r = $ 2 0 M / $ 1 0 M = 2 ; I F F = 1 0 / 3 0 = 1 / 3
LIBOR2 - 17.0
1.00 - LIBOR2 - 18
2 0.50) LIBOR( 3
16 Coupon Floater Inverse
CMO TranchesInverse Floater
Note that the (collateral) weighted coupon is:
trancherate fixed on thecoupon the%,63
18
LIBOR32 0.17
31
31 LIBOR
32
LIBOR)20.17($30M$10M 0.5) LIBOR(
M30$M20$
Valuation
MBS Prices
Stated as a percentage of the face amount (e.g. 102)
Fractions of one percent are expressed in thirty-seconds
(1/32)
Sixty fourths (1/64) are represented with a ‘+’
Valuation
Ginnie Mae 6.5; WAC 7.0%
Price 100-24, Assumed WAM 29-08 Prepayment Speed 125 PSA Yield at Projected Speed 6.42% WAL @ Projected Speed 9.4 Years Yield of WAL (9.4yr) Treasury 4.90% Spread over Treasury 152bp
Valuation
Scenario Analysis for Ginnie Mae 6.5% Pass Through
(Short-Term ) Interest Rate Moves (bp)
-100 0 +100
Prepay rate (PSA) 425 125 112 WAL (years) 3.2 9.4 10.4 Yield 6.19% 6.43% 10.4% WAL Treasury Yield 3.78% 4.90% 5.91% Spread/WAL (bp) 241 142 53 Yield Curve 1 Yr 2 Yr 3 Yr 5 Yr 10 Yr 30 Yr 4.63 4.77 4.78 4.79 4.91 5.35 Source: Salomon Smith Barney
Valuation
Things Influencing MBS Cash Flows
Aging: newer MBSs tend to have slower prepay speeds than seasoned MBSs because households that just moved are unlikely to change homes soon after moving
Burnout: when market interest rates fall below coupon, prepay
speeds accelerate rapidly. After the most financially sophisticated borrowers exit the pool, prepay speeds slow down significantly (burnout)
Seasoning: home buying (selling) has a seasonal component
with more transactions (and prepayments) in the summer months and fewer transactions (and prepayments) in the winter months.
ValuationValuation Models
1. Static yield spread (Spread/WAL): the spread between the MBS bond yield and the yield on the benchmark Treasury.
2. Yield curve spread: discount each monthly cash flow from
the MBS using the yield on the same maturity Treasury plus a constant spread
a. Spread to Treasury zero b. Spread to forward rate
3. Option Adjusted Spread: use Monte Carlo methods to simulate alternative interest rate paths; associate expected prepayments; take average of resulting PVs
ValuationYield Curve Spread
For a given yield curve (or series of zero Treasury rates), rt, the PV
of the MBS cash flows is:
nn
n3
3
32
2
2
1
1
s)r (1CF....
s)r (1CF
s)r (1CF
sr 1CFPV(s)
where CFi is the ith period cash flow, ri is the ith period zero rate,
and s is the spread to the yield curve. The value of s that equates
PV(s) to the market price of the MBS is the Yield Curve Spread.
Valuation
Option Adjusted Spread
The Yield Curve Spread (and the Spread/WAL) ignore
uncertainty in future interest rates (e.g. they use the current
yield on Treasuries to value MBSs)
Future prepayments are going to depend on future interest
rates—these are likely to be different from current rates
In addition, investors’ reinvestment rates will depend on
future interest rates, not on the current yield curve.
Valuation
Option Adjusted Spread
1. Use some interest rate model to generate an interest rate series
2. Attach prepayment behavior to the generated interest rates
3. Compute the expected MBS cash flows for the assumed interest
rate/prepayment behavior.
4. Use the yield curve spread to compute PV(s) for the assumed
interest rate series.
5. Repeat 1-4 one thousand times.
6. The value of s that equates the average PV(s) to the current
ValuationRelationship Between Short and Long Interest Rates
I. Expectations Hypothesis (with certainty)
( 1 + tRN) = [(1 + tR1)(1 + t+1r1)(1 + t+2r1)…(1 + t+N-1r1)]1/N Where R = actual market interest rate r = expected interest rate pre-subscript is the time period for which rates are applicable post-subscript is the maturity of the bond
so tR1 is today’s (period t) one year actual yield (e.g. 2.21%) and t+1r1 is the one-year expected yield one year from today.