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ADM 3351 Lecture Notes - Lecture 12: Government National Mortgage Association, Reinvestment Risk, Credit Risk

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pearmoose523
5 Dec 2017
School
University of Ottawa
Department
Administration
Course
ADM 3351
Professor
Chen Guo

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Document Summary

In this chapter we discuss two derivative mortgage-backed securities products: collateralized mortgage obligations. These securities derive their cash flow from underlying mortgage collateral such as pass-throughs or a pool of whole loans. Collateralized mortgage obligations (cmos) are bond classes created by redirecting the cash flows of mortgage-related products so as to mitigate prepayment risk. The mere creation of a cmo cannot eliminate prepayment risk; it can only transfer the various forms of this risk among different classes of bondholders. A cmo is a security backed by a pool of pass-throughs, whole loans, or stripped mortgage-backed securities. Cmos are structured so that there are several classes of bondholders with varying stated maturities. The bond classes created are commonly referred to as tranches. The first cmo was created in 1983 and was structured so that each class of bond would be retired sequentially. Such structures are referred to as sequential-pay cmos.

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Related Questions

Mortgage markets have developed significantly since the early 1970s through the creation of secondary market instruments in the form of mortgage pass-throughs, collateralized mortgage obligations (CMOs), and REMICs. These collectively have been generally referred to as mortgage backed securities (MBS). In many ways, these instruments carry the characteristics of their underlying assets -- individual mortgages.

a. Why is the cash flow of a mortgage, or a MBS, uncertain in the sense that the investor in the mortgage has granted the borrower a call option to prepay the mortgage? Compare a mortgage cash flow with a Treasury coupon bearing bond paying interest semi-annually and a payment of principal at maturity.

b. What does this call option depend upon and why?

c. The cash flow for a mortgage pass-through typically is based on some prepayment speed benchmark. Why is the assumed prepayment speed necessary to price the MBS?

d. Suppose a bank has decided to invest in a MBS and is considering the following two securities: a Freddie Mac pass-through with a WAM of 340 months and an average life of 7 years or a PAC tranche of a Freddie Mac CMO issue with an average life of 2 years. In terms of prepayment risk, contraction risk and extension risk, which MBS would probably be best for the bank’s asset/liability management perspective when it is known that liabilities generally have a duration less than 1 year and that assets have durations in the 2-year to 7-year range?