Purpose
The most basic way a mortgage loan can be transformed into a bond suitable for purchase by an investor would simply be to "split it". For example, a $300,000 30 year mortgage with an interest rate of 6.5% could be split into 300 1000-dollar bonds. These bonds would have a 30-year amortization, and an interest rate of 6.00% for example (with the remaining .50% going to the servicing company to send out the monthly bills and perform servicing work). However, this format of bond has various problems for various investors *Even though the mortgage is 30 years, the borrower could theoretically pay off the loan earlier than 30 years, and will usually do so when rates have gone down, forcing the investor to have to reinvest his money at lower interest rates, something he may have not planned for. This is known as '' prepayment risk''. *A 30-year time frame is a long time for an investor's money to be locked away. Only a small percentage of investors would be interested in locking away their money for this long. Even if the average home owner refinanced their loan every 10 years, meaning that the average bond would only last 10 years, there is a risk that the borrowers would not refinance, such as during an extending high interest rate period, this is known as ''extension risk''. In addition, the longer time frame of a bond, the more the price moves up and down with the changes of interest rates, causing a greater potential penalty or bonus for an investor selling his bonds early. This is known as ''Credit protection
CMOs are most often backed by mortgage loans, which are originated by thrifts (savings and loans), mortgage companies, and the consumer lending units of large commercial banks. Loans meeting certain size and credit criteria can be insured against losses resulting from borrower delinquencies and defaults by any of the Government Sponsored Enterprises (GSEs) ( Freddie Mac, Fannie Mae, or Ginnie Mae). GSE guaranteed loans can serve as collateral for "Agency CMOs", which are subject to interest rate risk but not credit risk. Loans not meeting these criteria are referred to as "Non-Conforming", and can serve as collateral for "private label mortgage bonds", which are also called "whole loan CMOs". Whole loan CMOs are subject to both credit risk and interest rate risk. Issuers of whole loan CMOs generally structure their deals to reduce the credit risk of all certain classes of bonds ("Senior Bonds") by utilizing various forms of credit protection in the structure of the deal.Credit tranching
The most common form of credit protection is called credit tranching. In the simplest case, credit tranching means that any credit losses will be absorbed by the most junior class of bondholders until the principal value of their investment reaches zero. If this occurs, the next class of bonds (more senior) absorb credit losses, and so forth, until finally the senior bonds begin to experience losses. More frequently, a deal is embedded with certain "triggers" related to quantities of delinquencies or defaults in the loans backing the mortgage pool. If a balance of delinquent loans reaches a certain threshold, interest and principal that would be used to pay junior bondholders is instead directed to pay off the principal balance of senior bondholders, shortening the life of the senior bonds.Overcollateralization
In CMOs backed by loans of lower credit quality, such as subprime mortgage loans, the issuer will sell a quantity of bonds whose principal value is less than the value of the underlying pool of mortgages. Because of the excess collateral, investors in the CMO will not experience losses until defaults on the underlying loans reach a certain level. If the "overcollateralization" turns into "undercollateralization" (the assumptions of the default rate were inadequate), then the CMO defaults. CMOs have contributed to the subprime mortgage crisis.Excess spread
Another way to enhance credit protection is to issue bonds that pay a lower interest rate than the underlying mortgages. For example, if the weighted average interest rate of the mortgage pool is 7%, the CMO issuer could choose to issue bonds that pay a 5% coupon. The additional interest, referred to as "excess spread", is placed into a "spread account" until some or all of the bonds in the deal mature. If some of the mortgage loans go delinquent or default, funds from the excess spread account can be used to pay the bondholders. Excess spread is a very effective mechanism for protecting bondholders from defaults that occur late in the life of the deal because by that time the funds in the excess spread account will be sufficient to cover almost any losses.Prepayment tranching
The principal (and associated coupon) stream for CMO collateral can be structured to allocate prepayment risk. Investors in CMOs wish to be protected from prepayment risk as well as credit risk. Prepayment risk is the risk that the term of the security will vary according to differing rates of repayment of principal by borrowers (repayments from refinancings, sales, curtailments, or foreclosures). If principal is prepaid faster than expected (for example, if mortgage rates fall and borrowers refinance), then the overall term of the mortgage collateral will shorten, and the principal returned at par will cause a loss for premium priced collateral. This prepayment risk cannot be removed, but can be reallocated between CMO tranches so that some tranches have some protection against this risk, whereas other tranches will absorb more of this risk. To facilitate this allocation of prepayment risk, CMOs are structured such that prepayments are allocated between bonds using a fixed set of rules. The most common schemes for prepayment tranching are described below.Sequential tranching (or ''by time'')
All of the available principal payments go to the first sequential tranche, until its balance is decremented to zero, then to the second, and so on. There are several reasons that this type of tranching would be done: *The tranches could be expected to mature at very different times and therefore would have different yields that correspond to different points on the yield curve. *The underlying mortgages could have a great deal of uncertainty as to when the principal will actually be received since home owners have the option to make their scheduled payments or to pay their loan off early at any time. The sequential tranches each have much less uncertainty.Parallel tranching
This simply means tranches that pay down '' pro rata''. The coupons on the tranches would be set so that in aggregate the tranches pay the same amount of interest as the underlying mortgages. The tranches could be either fixed rate or floating rate. If they have floating coupons, they would have a formula that make their total interest equal to the collateral interest. For example, with collateral that pays a coupon of 8%, you could have two tranches that each have half of the principal, one being a floater that paysZ bonds
This type of tranche supports other tranches by not receiving an interest payment. The interest payment that would have accrued to the Z tranche is used to pay off the principal of other bonds, and the principal of the Z tranche increases. The Z tranche starts receiving interest and principal payments only after the other tranches in the CMO have been fully paid. This type of tranche is often used to customize sequential tranches, or VADM tranches.Schedule bonds (also called PAC or TAC bonds)
This type of tranching has a bond (often called a PAC or TAC bond) which has even less uncertainty than a sequential bond by receiving prepayments according to a defined schedule. The schedule is maintained by using support bonds (also called companion bonds) that absorb the excess prepayments. *Planned Amortization Class (PAC) bonds have a principal payment rate determined by two different prepayment rates, which together form a band (also called a collar). Early in the life of the CMO, the prepayment at the lowerVery accurately defined maturity (VADM) bonds
Very accurately defined maturity (VADM) bonds are similar to PAC bonds in that they protect against both extension and contraction risk, but their payments are supported in a different way. Instead of a support bond, they are supported by accretion of a Z bond. Because of this, a VADM tranche will receive the scheduled prepayments even if no prepayments are made on the underlying.Non-accelerating senior (NAS)
NAS bonds are designed to protect investors from volatility and negative convexity resulting from prepayments. NAS tranches of bonds are fully protected from prepayments for a specified period, after which time prepayments are allocated to the tranche using a specified step down formula. For example, an NAS bond might be protected from prepayments for five years, and then would receive 10% of the prepayments for the first month, then 20%, and so on. Recently, issuers have added features to accelerate the proportion of prepayments flowing to the NAS class of bond in order to create shorter bonds and reduce extension risk. NAS tranches are usually found in deals that also contain short sequentials, Z-bonds, and credit subordination. A NAS tranche receives principal payments according to a schedule which shows for a given month the share of pro rata principal that must be distributed to the NAS tranche.NASquential
NASquentials were introduced in mid-2005 and represented an innovative structural twist, combining the standard NAS (Non-Accelerated Senior) and Sequential structures. Similar to a sequential structure, the NASquentials are tranched sequentially, however, each tranche has a NAS-like hard lockout date associated with it. Unlike with a NAS, no shifting interest mechanism is employed after the initial lockout date. The resulting bonds offer superior stability versus regular sequentials, and yield pickup versus PACs. The support-like cashflows falling out on the other side of NASquentials are sometimes referred to as RUSquentials (Relatively Unstable Sequentials).Coupon tranching
The coupon stream from the mortgage collateral can also be restructured (analogous to the way the principal stream is structured). This coupon stream allocation is performed after prepayment tranching is complete. If the coupon tranching is done on the collateral without any prepayment tranching, then the resulting tranches are called 'strips'. The benefit is that the resulting CMO tranches can be targeted to very different sets of investors. In general, coupon tranching will produce a pair (or set) of complementary CMO tranches.IO/discount fixed rate pair
A fixed rate CMO tranche can be further restructured into an Interest Only (IO) tranche and a discount coupon fixed rate tranche. An IO pays a coupon only based on a notional principal, it receives no principal payments from amortization or prepayments. Notional principal does not have any cash flows but shadows the principal changes of the original tranche, and it is this principal off which the coupon is calculated. For example, a $100mm PAC tranche off 6% collateral with a 6% coupon ('6 off 6' or '6-squared') can be cut into a $100mm PAC tranche with a 5% coupon (and hence a lower dollar price) called a '5 off 6', and a PAC IO tranche with a notional principal of $16.666667mm and paying a 6% coupon. Note the resulting notional principle of the IO is less than the original principal. Using the example, the IO is created by taking 1% of coupon off the 6% original coupon gives an IO of 1% coupon off $100mm notional principal, but this is by convention 'normalized' to a 6% coupon (as the collateral was originally 6% coupon) by reducing the notional principal to $16.666667mm ($100mm / 6).PO/premium fixed rate pair
Similarly if a fixed rate CMO tranche coupon is desired to be increased, then principal can be removed to form a Principal Only (PO) class and a premium fixed rate tranche. A PO pays no coupon, but receives principal payments from amortization and prepayments. For example, a $100mm sequential (SEQ) tranche off 6% collateral with a 6% coupon ('6 off 6') can be cut into an $92.307692mm SEQ tranche with a 6.5% coupon (and hence a higher dollar price) called a '6.5 off 6', and a SEQ PO tranche with a principal of $7.692308mm and paying a no coupon. The principal of the premium SEQ is calculated as (6 / 6.5) * $100mm, the principal of the PO is calculated as balance from $100mm.IO/PO pair
The simplest coupon tranching is to allocate the coupon stream to an IO, and the principal stream to a PO. This is generally only done on the whole collateral without any prepayment tranching, and generates strip IOs and strip POs. In particular FNMA andPrincipal only (PO)
A principal only (PO) strip may be carved from collateral securities to receive just the principal portion of a payment. Since the IO tranche has negative duration, a PO typically has more effective duration than its collateral. One may think of this in two ways: 1. The increased effective duration must balance the matching IO's negative effective duration to equal the collateral's effective duration, or 2. Bonds with lower coupons usually have higher effective durations, and a PO has noSee also
References
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Works cited
* {{Structured finance Structured finance Mortgage Fixed-income securities Mortgage-backed security