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Understanding CMOs and Derivative Securities in the Secondary Market

Learn about Collateralized Mortgage Obligations (CMOs) and derivative securities in the secondary market, including their investment characteristics, risk mitigation strategies, and comparisons with REMICs. Explore how CMOs alleviate prepayment and reinvestment risks, while derivative securities derive their value from underlying securities or financial claims.

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Understanding CMOs and Derivative Securities in the Secondary Market

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  1. CHAPTER TWENTY THE SECONDARY MARKET: CMO’S AND DERIVATIVE SECURITIES

  2. Chapter Objectives • Differentiate between MPTs and MPTBs • CMOs alleviate prepayment risk • Investors rate of return • CMO vs. REMIC

  3. Mortgage Pay-Through Bonds • Hybrid securities • Issued against mortgage pools • Cash flows are passed to security holders • A bond • A debt obligation of the issuer, who retains ownership • Unlike a MPT which represents a undivided equity ownership • Over collateralized like MBBs

  4. Collateralized Mortgage Obligation (CMOs) • Alleviates reinvestment risk • Alleviates prepayment risk • CMOs are debt instruments • Pool of mortgages as collateral • Issuer retains ownership and issues bonds against the pool

  5. Collateralized Mortgage Obligation (CMOs) Continued • All payments flow through • Security holder assumes prepayment risk • Multiple classes of security (maturities) • prioritization established by using tranches- different maturity dates

  6. Derivative Security • Derives its value from another security index, or financial claim • MPTs and CMOs are based on pools of mortgages • Derivatives may be purchased to protect the yield on another portfolio of mortgages or bonds

  7. Investment Characteristics of Mortgage Related Securities

  8. Investment Characteristics of Mortgage Related Securities Continued

  9. Commercial Mortgage-Backed Securities CMBSs • Take the form of MBB, a pass through security or a collateralized mortgage obligation • Default risk is greater • Secured by income properties • Non-recourse loans must look to security to satisfy loan • Shorter maturities • Senior and subordinated tranches

  10. Commercial Mortgage-Backed Securities CMBSs Continued • Prepayment risk mitigated by “lockouts” and prepayment penalties • Extension risk

  11. CMBS General Bond Risk Conditions

  12. CMBSs- Enhancements • Third party guarantees • Surety bonds, LC’s • Advance payment guarantees • Repurchase agreements • Lease assignments • Overcollateralization • Cross default provisions

  13. Real Estate Mortgage Investment Conduits (REMIC’S) • Limited life • Self liquidating • Minimal management • No taxation at the entity level • Qualified mortgages • Foreclosure property only • Assets limited to S-T, passive, or interest bearing assets • Qualified reserve fund

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