AuthorTopic: IO/PO Pricing
Frank
@2014-08-01 12:13:10
Dear All,

I'm working for an FOF manager. Currently one of our managers in the portfolio has delayed updating the NAV calculation for more than 2 weeks. The reason they claimed is that their primary holdings have been IOs and POs, as well as a number of CMO tranches (most of them are of TBA status). Since the MBS market has recently been relatively thin and choppy due to the lowering interest rate and the rising prepayment speed, some of their broker dealers still haven't provided them reliable marks.

Could anyone give me some ideas about the process of the MBS pricing, particularly in the IO/PO, and CMO fields? Thanks.

Warm regards,

Frank

skiloa
@2014-08-07 18:55:27
IOs and POs are just other tranches of a CMO.

IOs are created when there's excess interest between what the bonds are paying out of the trust and what the mortgages are paying into the trust. An IO is a monetization of the excess interest. A PO is where there isn't enough interest being paid into the trust to allow for the bonds to get paid out sufficiently. There's a million different ways that CMOs can be structured and they're usually strcutured in order to fit the appetite of investors at the time of sale (desire for 30 vs 15 yr, ARM vs Fixed, certain WAL and CPR, etc...).

Right now, interest rates have been relatively volatile, especially around the middle of the curve (5yr), so depending on the tranch, it could be difficult to value.

IOs for example, are completely dependent on the interest rate stucture to determine their payoffs. Intuitively, if interest rates rise, the likelihood of prepays goes down and thus the IO becomes more valuable. The opposite is true of the PO as it would like to have its principal to be paid as soon as possible.

Most of the work can be done in Blomberg with inputs of CPR, WAL and Price Paid, you can essentially get a new mark on these. Bloomberg is just a finger in the wind however and your risk management most likely requires several marks from outside firms.
Frank
@2014-08-10 23:56:41
Thanks skiloa,

This makes sense that the CMO valuation is a lot to do with a number of factors, yield curve, prepayment speeds, credit spreads, interest rates, implied vol. etc...., which make the the calculation of CMO tranches difficult especially when the IR is volatile. But how do you determine the prices of them when you trade? purely based on estimation? In the sense that the mechanism between the NAV determination of a CMO portfolio and estimating the price when making transactions is different? Thanks!

Regards,

CFA Discussion Topic: IO/PO Pricing

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