The prepayment risk seen in mortgage pass-through securities can be reduced by distributing the cash flows of these mortgage products to different classes or tranches through a process called structuring.
Collateralized mortgage obligation (CMO) is one such security created based on this principle of structuring where the cash flows (interest and principal) are redistributed to different tranches based on a set of rules. The different classes of bondholders in a CMO have different exposures to prepayment risk. The collateral for a CMO is a pool of mortgage pass-through securities and not a pool of mortgage loans.
Advantages of a CMO
Following are the key benefits of a CMO:
The most common types of CMO tranches are sequential-pay tranches, planned amortization class (PAC) tranches, support tranches, and floating-rate tranches.
Sequential-Pay CMO Structures
Each class/tranche of bond in this CMO structure is retired sequentially. Let us consider a CMO with four tranches. Note that this example is for simplicity. The coupon rate usually varies by tranche.
|Tranche||Par amount(US $)||Coupon rate (%)|
The prepayment risk is mitigated in this CMO by following these interest and principal repayment rules:
For payment of monthly coupon interest: Disburse monthly coupon interest to each tranche on the basis of the amount of principal outstanding for each tranche at the beginning of the month.
For disbursement of principal payments:
Disburse principal payments to tranche A until it is completely paid off.
After tranche A is completely paid off, disburse principal payments to tranche B until it is completely paid off.
After tranche B is completely paid off, disburse principal payments to tranche C until it is completely paid off.
After tranche C is completely paid off, disburse principal payments to tranche D until it is completely paid off.
The table below shows the average life of the collateral and different tranches at various prepayment rates. For instance, at a prepayment rate of 165 PSA, the average life of the collateral is 8.6 years, while it is 3.4 years and 19.8 years for tranches A and D respectively. At higher levels of prepayment, the average life of tranche A falls to 1.6 years and to 7 years for tranche D.
|PSA||Collateral||Tranche A||Tranche B||Tranche C||Tranche D|
CMO Structures Including Planned Amortization Class and Support Tranches
In a CMO with a sequential pay-structure, there was a great variability in average life/prepayment risk based on the prepayment rate. This is partly overcome with a CMO structure called the planned amortization class (PAC) tranches. PAC tranches offer great predictability as long as the prepayment rate is within a specified band over the collateral’s life. PACs offer protection against both extension risk and contraction risk.
Two PSA prepayment rates must be specified to create a PAC tranche. The two prepayment speeds used to create a PAC bond is called the PAC collar. The lower and upper PSA prepayment assumptions are called the “initial PAC collar”, or the “initial PAC bond”.
The greater certainty of the cash flow for the PAC tranches comes at the expense of the non-PAC tranches (called support tranches). The support tranches provide protection against both contraction and extension risk by absorbing excess principal paid or forgoing principal payment, if the collateral payments are slow.
The table below illustrates the life of PAC and support tranches at various prepayment rates. As you can see, for a prepayment rate between 100 PSA and 250 PSA, the average life of the PAC tranche is 7.7 years. Whereas, the average life of support tranche varies from 20 years to 3.3 years. The prepayment speeds of 100 PSA and 250 PSA create the initial PAC collar.
|PSA||Life of PAC||Life of Support|
The support tranches defer principal payments to the PAC tranches if the collateral prepayments are slow; support tranches do not receive any principal until the PAC tranches receive their scheduled principal repayment.
Support tranches absorb any principal prepayments in excess of the scheduled principal repayments that are made. This rule reduces the contraction risk of the PAC tranches. If the support tranches are paid off quickly because of faster-than-expected prepayments, they no longer provide any protection for the PAC tranches.
For example, a mortgage pass-through security has a greater average life variability than a PAC tranche, but lesser than that of a support tranche. The bond classes in a CMO can either be riskier or less risky than a mortgage pass-through security.
Unlike agency residential mortgage-backed securities (RMBS), non-agency RMBS is not backed by the government or a by a GSE; so, credit risk is a major concern for investors. For agency RMBS, when the principal will be repaid (prepayment risk) was a major concern. For non-agency RMBS, if and when (credit risk + prepayment risk) the principal will be paid is a concern.
Based on the credit quality of the mortgage loans in the pool, the securities can be classified into two:
The two complementary mechanisms required in structuring a non-agency RMBS are:
Two factors to consider when forecasting the future cash flows of a non-agency RMBS:
In order to obtain a favorable credit rating and to ensure some protection against losses in the pool, non-agency RMBS and non-mortgage ABS often require one or more credit enhancements.