FIN 2227Fixed Income Markets & Valuation

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Managing Risk in the Mortgage Sector (CMOs & CDS)

Lecture Note 12

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Required Readings

• Readings– Textbook: Fabozzi Ch. 12 pp. 248-254; Ch.

32 pp. 754-759; Excel Spreadsheet – Supplemental Articles:• China Becomes Asia’s Biggest Securitization

Market – WSJ• Banks Finalize $1.86 Billion Credit-Swaps

Settlement – WSJ

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Where we are headed . . .

• Collateralized Mortgage Obligations• Credit Default Swaps• CDS and the Mortgage Crisis

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Prepayment Risk• Recall from Lecture 11: – Two Types of Prepayment Risk:• Contraction Risk• Extension Risk

• So how can we reduce exposure to prepayment risk for certain groups of investors?– Structured products!• Transfer exposure to investors who are better

suited (or willing) to bear that risk LN12.5

• Collateralized Mortgage Obligation (CMO):– CFs of the underlying pool are redirected to several

classes of bondholders with varying maturities and priority of payment• These bond classes are referred to as tranches

– “Tranche” comes from the French “to slice”

Tranche B

Tranche C

Tranche A

Mortgage Pool Tranches Bondholders

Collateralized Mortgage Obligations: CMOs

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CMO: Payment Structure• Sequential-Pay Payment Structure

– Principal payments are paid sequentially on a priority basis to individual tranches

– Periodic interest payments are made to each tranche based on the amount of outstanding principal balance that remains in that tranche at the beginning of each month

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CMO: Sequential Pay Example

• Let’s return to our example from the end of Lecture 11 :

• What if we divided this mortgage pool into 3 tranches?

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• Cash Flows to Tranches A, B, and C (Months 1-4):

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CMO: Sequential Pay Example

• Cash Flows to Tranches A, B, and C (Months 115-118):

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CMO: Sequential Pay Example

Credit Risk: Primary Mortgage Market

Source: CNN

Number of Residential Foreclosures in 2008: By State

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Credit Default Swap (CDS)• Credit Default Swap (CDS):

– Contract designed to provide insurance against the risk of default by a particular bond issuer– Buyer of CDS receives credit protection (insurance) in the

case of default on the underlying entity– Seller of the swap guarantees the credit worthiness of this

entity

• CDS can be written on:– Corporate debt issuers– Sovereign debt issuers– Municipal bond issuers– Tranches of asset backed securities

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Credit Default Swap: Example

• Example:

• Possible Trigger Events– Bankruptcy– Failure to Pay– Restructuring

CDS Buyer CDS Seller

Premium Payments

Payoff

only if trigger event occurs (e.g., default)

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Growth of CDS MarketTr

illio

ns

$

CDS Notional Outstanding (Annual)

Sources:

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CDS and the Mortgage Crisis

• Important differences from buying insurance:– In case of CDS, buyer of protection does not need to own

the underlying issuer or security and thereby does not have to suffer loss from default of underlying issuer or security

– CDS contracts could be traded between institutions on both ends (“insurer” and “insured”)

• Use of CDS spiraled out of control as investors used them as speculative bets that mortgages were going to default

• “Financial Weapons of Mass Destruction”– Warren Buffet

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For Next Class…

• Group Presentations (12/7 & 12/9)

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