Collateralized mortgage obligations are securities issued against a pool of mortgage pass-through securities for which the cash flows have been allocated to different classes (tranches), each having a different claim against the cash flows of the pool.
As previously mentioned, some institutional investors are concerned with extension risk and other with contraction risk. The mere creation of a CMO cannot eliminate prepayment risk; it can only distribute the various forms of this risk among different classes of bondholders. The technique of redistributing the coupon interest and principal from the underlying collateral to different classes (so that a CMO results in instruments that have varying convexity characteristics more suitable to the needs and expectations of different investors) broadens the appeal of mortgage-backed products to various traditional fixed-income investors.
A tranche is a slice of the cash flows generated by a mortgage pool. The claim of each tranche is governed by a specific formula. A CMO distributes prepayment risk among tranches so as to create products that provide better matching of assets and liabilities for institutional investors.
There are many types of CMO structures; three are discussed here.
The first generation of CMOs was structured so that each tranche would be retired sequentially; such structures are referred to as sequential-pay tranches.
In a "plain vanilla" CMO structure, there may be four tranches: A, B, C and Z. The first three tranches, with tranche A representing the shortest-maturity bond, receive periodic interest payments from the underlying collateral. Tranche Z is an accrual bond that receives no periodic interest until the other three tranches are retired.
There is some protection provided against prepayment risk for each tranche. For example, prioritizing the distribution of principal effectively protects tranche A against extension risk (the protection coming from tranches B, C and D). Similarly, tranches C and D are protected against contraction risk.
Note that tranche Z (the accrual tranche) appeals to investors who are concerned with reinvest risk. Since there are no coupon payments to reinvest, reinvestment risk is eliminated until all the other tranches are paid off.
Planned Amortization Class Tranches
A Planned Amortization Class (PAC) bond is a CMO product that was created to have a similar cash flow structure to a sinking fund corporate bond within a specified range of prepayment rates (i.e., the cash flow pattern to the bond holder is known). The cash flow for PAC bonds is more predictable because there is a principal repayment schedule that must be satisfied. PAC bondholders, therefore, have priority over all other classes in the CMO issue in receiving principal payments from the underlying collateral in order to satisfy the repayment schedule.
The greater certainty regarding the cash flow for PAC bonds comes at the expense, of course, of the non-PAC classes, called the companion or support classes.
The upper and lower PSA levels used to construct the principal payment schedule are called the initial PAC collar. A key consideration is that prepayment protection is ensured as long as companion bonds are not fully paid off. Consequently, the degree of prepayment protection changes over time as actually prepayments occur. For example, if prepayments over the first few years are at the lower end of the initial PAC collar, there will be more companion bonds remaining, which will result in greater prepayment protection for the PAC bonds. A new collar can be calculated, which will allow PAC bondholders to realize their original principal payment schedule as long as prepayments are within the collar. This new collar is called the effective collar. The effective collar is a wider range of prepayment speeds over which the life and cash flows of a PAC are predictable. An effective collar is necessary because the capacity of the support tranche to absorb prepayments is gradually diminished over the life of the security.
A companion bond or a support bond absorbs the surplus or shortfall cash flows from a pool, allowing PAC bond to have a much more predictable series of cash flows. The support tranche is exposed to both contraction and extension risks. By definition, it is exposed to the greatest amount of prepayment risk.
All non-agency asset-backed securities are credit-enhanced.
External credit enhancements are financial guarantees from third parties. The most common forms are:
A guarantee does not completely remove the risk of default. Rather, it partially isolates it. Many factors can force an insured bond to default.
An internal credit enhancement is a tranche design or reserve structure that protects one or all investors against losses from default.
The level of protection provided by the subordinated tranche changes over time due to prepayments. Prepayments change how much of the remaining pool is allocated to each of the two tranches. If the subordinated tranche gets prepaid early because of fast prepayment, the level of protection for the senior tranche declines. To guard against this problem, prepayments are allocated between the two tranches so that the percentage of the mortgage balance of the subordinated tranche to that of the mortgage balance for the entire deal, known as the level of subordination, is maintained at an acceptable level.
A commonly used shifting interest percentage schedule is as follows:
A structure can have more than one subordinated tranche.
| danlan2: Sequential pay tranches|
planned amortization class
|danlan2: Three forms of credit enhancement: Monoline insurance companies, letter of credit from a bank, seller guarantee.|
|danlan2: Internal credit enhancement: reserve account, collateralized, senior-subordinated structure,|
|actiger: The key to this LOS is the shifting interest in the senior-subordinated structure.|
|bodduna: where is accrual tranche?|
|joywind: What is the difference between PAC tranche in MBS and senior tranche here? Is Senior-Subordinated Structure means to protect against credit risk or prepayment risk?|
|joywind: if there is no shifting interest percentage schedule, how the prepayment will be received by those two tranches?|
| joywind: follow the last post: |
what I understand is that prepayment will all go to senior tranche if there is no schedule exist. then with the shifting int. percentage schedule, senior tranche actually trade in some contraction risk with credit risk, this is also what Fabozzi's book is saying. But I think the existence of the schedule made the subordinated tranche get paid earlier, therefore reducing the protection can be provided... And this is absolutely opposite from what says above? Anyone tell me where am I wrong? THANKS!!!
|olympria: joywind, I see what you are saying. I think senior tranches PREFER prepayment (i.e., they want to avoid extension risk).|
|JCarney: joywind, Senior Tranches get paid before the subordinated tranches. Subordinated tranches receive payment only after the Senior tranche has been paid. Senior tranche holders want to minimize credit risk.|