In this module we're going to discuss collateralized mortgage obligations or CMOs. CMOs are a class of mortgage backed securities that are created from underlying pools of mortgages or underlying pass-through securities or indeed underlying mortgage backed securities. We're going to see how tranches are created. We're going to see an example of sequential CMO where we've got four tranches, tranche A, tranche B, tranche C and tranche D. And we'll see how these tranches are created and how they've got different risk profiles that might appeal to different investors. In this module we're going to discuss briefly what are called collateralized mortgage obligations or CMOs. CMOs are mortgage-backed securities that have been created by redirecting the cash-flows from other mortgage securities. They are created mainly to mitigate prepayment risk, and create securities that are better suited to potential investors. In practice, CMOs are often created from pass-through's, so we've seen already what pass-through mortgage backed securities are, but they can also be created from other mortgage backed securities, including for example, principal loaning backed securities. Now there are many types of CMOs. They include what are called sequential CMOs, CMOs with accrual bonds, CMOs with floating rate and inverse floating rate tranches and planned amortization class CMOs or PAC CMOs. We're only going to briefly discuss sequential CMOs and I would point out here that the reason we're going through this module is just to give ourselves an idea of how these securities are constructed. To give ourselves another example of securitization. The results of our worksheet, it's the third worksheet in our XL workbook, which shows how a sequential CMO is created and shows how the cashflows for the different tranches in a sequential CMO are created. But I will emphasize here that this material, it's just there to show us how these securities are constructed and to give us an example of these securities. So, don't worry too much about the details, the details aren't particularly important. The basic structure of a sequential CMO is that there are several what are called tranches. Now this word appears very often into the securitization world. We're going to see it again when we discuss credit derivatives and what I call CDOs. So the basic structure of a sequqnetial CMO is that there are several tranches which are ordered in such a way that they are retired sequentially. What do I mean by that? Well, for example, the payment structure of a sequential CMO with tranches a, b, c, and d might be as follows. Number one, periodic coupon interest is disbursed to each tranche on the basis of the amount of principal outstanding in the tranche in the beginning of the period. Number two, all principal payments are disbursed to tranche A until it is paid off entirely. After tranche A has been paid off, all principal payments are dispersed to tranche B, until it is payed off entirely. After tranche B has been paid off, all principal payments are dispersed to tranche C until it is paid off entirely. And then after tranche C has been paid off, all principal payments are dispersed to tranche D, until it is paid off entirely. So let's translate what we're seeing here, what we're seeing here is that there's going to be four tranches, A, B, C, and D. And when we look at the spreadsheet in a few minutes we'll see what we mean by this. On each tranche the interest will be paid to the investors in each tranche in every period. But principal will not be paid to the holders of each tranche. All of the principle payments will go towards paying tranche A investors. And only when tranche A's principle has been paid off entirely will the principle payments from the underlying mortgage pool be used to pay tranche B. And then, only when all of the principle for tranche B has been paid off will the principle payments go towards tranche C. Then only when tranche Cs principal has been paid, will the principal be used to pay tranche D. That's what we mean by retiring sequentially. The advantages of doing this is that we're creating these four new securities, tranche A, B, C and D in such a way that there's more certainty around when these tranches will get their payments. Here's our earlier picture showing the process of securitization. Again, you could imagine that we've got 10,000 mortgages forming a pool of mortgages. These mortgages formed the collateral for our sequential CMO, so there's going to be tranche A, tranche B, tranche C and tranche D. These are all securities, so this is a security an investor can buy tranche a if you like. This is a security, this is a security and this is Is a security. So investors can come along and buy A, B, C, or D. These are four different types of securities. Their all constructed from the underlying 10,000 loans or 10,000 securities. But in order to get a better idea of actually how this sequencial CMO works, its actually much easier to go to our spread sheet and that's what we'll do. So here is our spreadsheet with our sequential pay CMO. The first thing to keep in mind is that this spreadsheet is constructed using the pass through spreadsheet we looked at earlier. So the pass through spreadsheet we looked at in an earlier module, this pass through mortgage, this, this pool of mortgages, of $400 million worth of mortgages, for example. Can be used to actually create a new set of securities and these new sets of securities give us the sequential pay CMO. So up here what we have is the following, we have a total of $400 million, that's from the underlying pass through on the other worksheet. We've split this $400 million into different notions, $194.5 million for tranche A, $36 million for tranche B, $96.5 million for transche C and $73 million for tranche D. We're going to assume that the underlying coupon rate for all four charges is 7.5% and of course, this is the same 7.5% that we saw on the pass through. The underlying pass through had a pass through rate of 7.5%. So, that gives us these four new securities. So we've got four new securities, each of them have different principle amounts but the sum of the four principal amounts must be equal to 400 million dollars, the sum of the principal of the underlying pass through security. We then have our months, again, just to show us all the payments on one screen, I've assumed that we're only going to have 17 payments, or 17 months. in reality, you can have many more months than this, up to maybe 240 or 360, as I said earlier. we start off with our balances for each if the tranche, so tranche A balance is 194.5 to begin with, tranche B is 36, which is what we have up here, tranche C is 96.5, which is what we have here, and tranche D is 73.0. Now, what we do is, we follow the instructions on the, on the and two slides ago, which tells us how interest and principle are paid on each of these trenches. So notice that the principle is decreasing on trench eight, for the first nine months until there is no interest or no principle remaining. It is only at that point that the principle in trench B starts to be repaid. Notice that the principle on trans B remains 36 on every period until the principle on trans A has been repaid and only at that point does the principle on trans B start being repaid. Likewise the principle on trans C remains 96.5 until such time as the principle on trans B has been repaid entirely, only then is tranche C paid down. Likewise, on Tranche D it starts off with a principal of 73 and it remains 73 until the principal on all the previous Tranches has been paid down and only after that point is the principal on Tranche D paid. Notice these principal payments by the way Are the principle payments that are calculated from the underlying passthrough on the previous worksheet. If you look at the formula, you'll see that it refers to the passthrough worksheet. Passthrough here is the worksheet here. So the principle payments are computed from the underlying passthrough and they are here. So, 22.533 That is the principal payment that appears over here. So what we're doing here is constructing a mortgage-backed-security, or CMO, with different tranches, so an investor could invest in tranche a or another investor could invest in tranche b, and so on. And they're going to get the schedule of cash flows. one thing to notice here as well is we've actually calculated the average life of each tranche . So you can see how the average life is calculated by looking at this formula. Not surprisingly, the average life in years of tranche A, is less than tranche B, is less than trance C, and is less than trance D. So for trans A, it's 0.4 years, for trans B it's 0.8 years, trans C it's 1.04 years, trans D it's 1.33 years. And of course that's understood by the fact that the principle in trans B gets payed, and so on. So what we've succeeded in doing here, is taking the underlying pass through and instead of just leaving it as a pass 3 mortgage backed security, we constructed a more complicated mortgage backed security, where the underlying charges have very dis, different risk profiles. Some investors might like a, a security with a shorter average life, other investors might prefer a security with a longer average life. And so they might prefer trans d to trans a. And why are we doing all of this? Well it goes back to that comment we made in an earlier module about securitization. The economic, or big picture goal behind securitization is the idea of spreading the risk. An investor may not want to invest in the pass through security. They may not like an average life of .76 years, however, that same investor may like a security with an average life of 0.4 and so they may be willing to buy this tranche, even though they would not buy the underlying pass-through. Likewise, there may be another investor who does not like the pass-through security, but they do like tranche D, with the longer average life. So by constructing new securities with very different risk profiles out of the same underlined pool of loans, you can actually potentially appeal to more investors. And therefore share the risk among investors who want to hold different types of risks. This prepayment multiplier by the way is the same prepayment multiplier of the underlying pass through. Remember, it's the underlying pass through security which is actually creating the cash flows that feed into the four trenches of the CMO. Finally, in practice you would actually have many more periods here, it wouldn't just be 17 periods, it would be maybe 240 and if I change it 240 here, it will also change appropriately over here. So now you can get a better sense. So in this case with a 240 period Sequential CMO, the average life of tranche A is four years, the average life of tranche C is 11.93 years, and so on. And the, these tranches will have there, therefore have very different risk profiles.
