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5. Collateralized Mortgage Obligations

e. describe types and characteristics of residential mortgage-backed securities, including mortgage pass-through securities and collateralized mortgage obligations, and explain the cash flows and risks for each type;

## f. define prepayment risk and describe the prepayment risk of mortgage-backed securities;

What is a Collateralized Mortgage Obligation (CMO)? 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.

In regards to collateralized mortgage obligations, what is a tranche? 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.

What is a CMO sequential-pay tranche? The first generation of collateralized mortgage obligations (CMOs) was structured so that each tranche would be retired sequentially; such structures are referred to as sequential-pay tranches.

In regards to CMO, what is an accrual bond? An accrual bond receives no periodic interest until the other tranches are retired.

What is a Planned Amortization Class (PAC) bond? A Planned Amortization Class (PAC) bond is a collateralized mortgage obligation (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).

What is an initial PAC collar (planned amortization class)? An initial PAC collar is the upper and lower PSA levels used to construct the principal payment schedule.

For a planned amortization class (PAC) bond, what is an effective collar? The effective collar is a wider range of prepayment speeds over which the life and cash flows of a PAC are predictable.

For a PAC bond, what is a companion bond or support bond? 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. It is exposed to the greatest amount of prepayment risk.

What is an external credit enhancement? External credit enhancements are financial guarantees from third parties.

What are the three most common forms of external credit enhancement? - Monoline insurance companies. They guarantee the timely repayment of bond principal and interest when an issuer defaults. They are so named because they provide services to only one industry. - Letter of credit from a bank - Guarantee by the seller of the assets.

What is an internal credit enhancement? An internal credit enhancement is a tranche design or reserve structure that protects one or all investors against losses from default.

What is a senior subordinated structure? A senior-subordinated structure is a two-tranche structure. The senior tranche gets paid first and the subordinated tranche gets paid only if there are enough funds left after the senior is paid.

What is level of subordination? Level of subordination is the mortgage balance of the subordinated tranche to that of the mortgage balance for the entire deal.

What is a reserve account? A reserve account is used by the sponsor to channel some of the pool’s cash flows into a reserve to be paid out in the case of default or missed payments. Think of a reserve account as a rainy-day fund.

What is over-collateralization? If the amount of the collateral exceeds the amount of the liability of the financial structure, the deal is said to be over-collateralized.