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(d) “Buyer™s Margin Percentage”, with respect to any Transaction as of
any date, a percentage (which may be equal to the Seller™s Margin
Percentage) agreed to by Buyer and Seller or, in the absence of any
such agreement, the percentage obtained by dividing the Market
Value of the Purchased Securities on the Purchase Date by the Pur-
chase Price on the Purchase Date for such Transaction;

(e) “Con¬rmation”, the meaning speci¬ed in Paragraph 3(b) hereof;

(f) “Income”, with respect to any Security at any time, any principal
thereof and all interest, dividends or other distributions thereon;

(g) “Margin De¬cit”, the meaning speci¬ed in Paragraph 4(a) hereof;

(h) “Margin Excess”, the meaning speci¬ed in Paragraph 4(b) hereof;

(i) “Margin Notice Deadline”, the time agreed to by the parties in the
relevant Con¬rmation, Annex I hereto or otherwise as the deadline
for giving notice requiring same-day satisfaction of margin mainte-
nance obligations as provided in Paragraph 4 hereof (or, in the
absence of any such agreement, the deadline for such purposes
established in accordance with market practice);

(j) “Market Value”, with respect to any Securities as of any date, the
price for such Securities on such date obtained from a generally
recognized source agreed to by the parties or the most recent clos-
ing bid quotation from such a source, plus accrued Income to the
extent not included therein (other than any Income credited or
transferred to, or applied to the obligations of, Seller pursuant to
Paragraph 5 hereof) as of such date (unless contrary to market
practice for such Securities);

(k) “Price Differential”, with respect to any Transaction as of any
date, the aggregate amount obtained by daily application of the
Pricing Rate for such Transaction to the Purchase Price for such
Transaction on a 360 day per year basis for the actual number of
143
Repurchase and Reverse Repurchase Agreements



days during the period commencing on (and including) the Pur-
chase Date for such Transaction and ending on (but excluding) the
date of determination (reduced by any amount of such Price Dif-
ferential previously paid by Seller to Buyer with respect to such
Transaction);

(l) “Pricing Rate”, the per annum percentage rate for determination of
the Price Differential;

(m) “Prime Rate”, the prime rate of U.S. commercial banks as pub-
lished in The Wall Street Journal (or, if more than one such rate is
published, the average of such rates);

(n) “Purchase Date”, the date on which Purchased Securities are to be
transferred by Seller to Buyer;

(o) “Purchase Price”, (i) on the Purchase Date, the price at which Pur-
chased Securities are transferred by Seller to Buyer, and (ii) thereaf-
ter, except where Buyer and Seller agree otherwise, such price
increased by the amount of any cash transferred by Buyer to Seller
pursuant to Paragraph 4(b) hereof and decreased by the amount of
any cash transferred by Seller to Buyer pursuant to Paragraph 4(a)
hereof or applied to reduce Seller™s obligations under clause (ii) of
Paragraph 5 hereof;

(p) “Purchased Securities”, the Securities transferred by Seller to Buyer
in a Transaction hereunder, and any Securities substituted therefor
in accordance with Paragraph 9 hereof. The term “Purchased Secu-
rities” with respect to any Transaction at any time also shall
include Additional Purchased Securities delivered pursuant to Para-
graph 4(a) hereof and shall exclude Securities returned pursuant to
Paragraph 4(b) hereof;

(q) “Repurchase Date”, the date on which Seller is to repurchase the
Purchased Securities from Buyer, including any date determined by
application of the provisions of Paragraph 3(c) or 11 hereof;

(r) “Repurchase Price”, the price at which Purchased Securities are to
be transferred from Buyer to Seller upon termination of a Transac-
tion, which will be determined in each case (including Transactions
terminable upon demand) as the sum of the Purchase Price and the
Price Differential as of the date of such determination;
144 THE GLOBAL MONEY MARKETS



(s) “Seller™s Margin Amount”, with respect to any Transaction as of
any date, the amount obtained by application of the Seller™s Mar-
gin Percentage to the Repurchase Price for such Transaction as of
such date;

(t) “Seller™s Margin Percentage”, with respect to any Transaction as of
any date, a percentage (which may be equal to the Buyer™s Margin
Percentage) agreed to by Buyer and Seller or, in the absence of any
such agreement, the percentage obtained by dividing the Market
Value of the Purchased Securities on the Purchase Date by the Pur-
chase Price on the Purchase Date for such Transaction.

4. Margin Maintenance
(a) If at any time the aggregate Market Value of all Purchased Securities
subject to all Transactions in which a particular party hereto is act-
ing as Buyer is less than the aggregate Buyer™s Margin Amount for
all such Transactions (a “Margin De¬cit”), then Buyer may by
notice to Seller require Seller in such Transactions, at Seller™s
option, to transfer to Buyer cash or additional Securities reasonably
acceptable to Buyer (“Additional Purchased Securities”), so that
the cash and aggregate Market Value of the Purchased Securities,
including any such Additional Purchased Securities, will thereupon
equal or exceed such aggregate Buyer™s Margin Amount (decreased
by the amount of any Margin De¬cit as of such date arising from
any Transactions in which such Buyer is acting as Seller).

(b) If at any time the aggregate Market Value of all Purchased Securities
subject to all Transactions in which a particular party hereto is act-
ing as Seller exceeds the aggregate Seller™s Margin Amount for all
such Transactions at such time (a “Margin Excess”), then Seller may
by notice to Buyer require Buyer in such Transactions, at Buyer™s
option, to transfer cash or Purchased Securities to Seller, so that the
aggregate Market Value of the Purchased Securities, after deduction
of any such cash or any Purchased Securities so transferred, will
thereupon not exceed such aggregate Seller™s Margin Amount
(increased by the amount of any Margin Excess as of such date aris-
ing from any Transactions in which such Seller is acting as Buyer).

(c) If any notice is given by Buyer or Seller under subparagraph (a) or
(b) of this Paragraph at or before the Margin Notice Deadline on
any business day, the party receiving such notice shall transfer cash
or Additional Purchased Securities as provided in such subpara-
145
Repurchase and Reverse Repurchase Agreements



graph no later than the close of business in the relevant market on
such day. If any such notice is given after the Margin Notice Dead-
line, the party receiving such notice shall transfer such cash or
Securities no later than the close of business in the relevant market
on the next business day following such notice.

(d) Any cash transferred pursuant to this Paragraph shall be attributed
to such Transactions as shall be agreed upon by Buyer and Seller.

(e) Seller and Buyer may agree, with respect to any or all Transactions
hereunder, that the respective rights of Buyer or Seller (or both)
under subparagraphs (a) and (b) of this Paragraph may be exer-
cised only where a Margin De¬cit or Margin Excess, as the case
may be, exceeds a speci¬ed dollar amount or a speci¬ed percentage
of the Repurchase Prices for such Transactions (which amount or
percentage shall be agreed to by Buyer and Seller prior to entering
into any such Transactions).

(f) Seller and Buyer may agree, with respect to any or all Transactions
hereunder, that the respective rights of Buyer and Seller under sub-
paragraphs (a) and (b) of this Paragraph to require the elimination
of a Margin De¬cit or a Margin Excess, as the case may be, may
be exercised whenever such a Margin De¬cit or Margin Excess
exists with respect to any single Transaction hereunder (calculated
without regard to any other Transaction outstanding under this
Agreement).

8. Segregation of Purchased Securities
To the extent required by applicable law, all Purchased Securities in the
possession of Seller shall be segregated from other securities in its posses-
sion and shall be identi¬ed as subject to this Agreement. Segregation may
be accomplished by appropriate identi¬cation on the books and records
of the holder, including a ¬nancial or securities intermediary or a clear-
ing corporation. All of Seller™s interest in the Purchased Securities shall
pass to Buyer on the Purchase Date and, unless otherwise agreed by
Buyer and Seller, nothing in this Agreement shall preclude Buyer from
engaging in repurchase transactions with the Purchased Securities or oth-
erwise selling, transferring, pledging or hypothecating the Purchased
Securities, but no such transaction shall relieve Buyer of its obligations to
transfer Purchased Securities to Seller pursuant to Paragraph 3, 4 or 11
hereof, or of Buyer™s obligation to credit or pay Income to, or apply
Income to the obligations of, Seller pursuant to Paragraph 5 hereof.
146 THE GLOBAL MONEY MARKETS




Required Disclosure for Transactions in Which the Seller
Retains Custody of the Purchased Securities
Seller is not permitted to substitute other securities for those sub-
ject to this Agreement and therefore must keep Buyer™s securities segre-
gated at all times, unless in this Agreement Buyer grants Seller the
right to substitute other securities. If Buyer grants the right to substi-
tute, this means that Buyer™s securities will likely be commingled with
Seller™s own securities during the trading day. Buyer is advised that,
during any trading day that Buyer™s securities are commingled with
Seller™s securities, they [will]* [may]** be subject to liens granted by
Seller to [its clearing bank]* [third parties]** and may be used by
Seller for deliveries on other securities transactions. Whenever the
securities are commingled, Seller™s ability to resegregate substitute
securities for Buyer will be subject to Seller™s ability to satisfy [the
clearing]* [any]** lien or to obtain substitute securities.
* Language to be used under 17 C.F.R. ß403.4(e) if Seller is a government secu-
rities broker or dealer other than a financial institution.
** Language to be used under 17 C.F.R. ß403.5(d) if Seller is a financial institu-
tion.



11. Events of Default
In the event that (i) Seller fails to transfer or Buyer fails to purchase Pur-
chased Securities upon the applicable Purchase Date, (ii) Seller fails to
repurchase or Buyer fails to transfer Purchased Securities upon the appli-
cable Repurchase Date, (iii) Seller or Buyer fails to comply with Para-
graph 4 hereof, (iv) Buyer fails, after one business day™s notice, to comply
with Paragraph 5 hereof, (v) an Act of Insolvency occurs with respect to
Seller or Buyer, (vi) any representation made by Seller or Buyer shall have
been incorrect or untrue in any material respect when made or repeated
or deemed to have been made or repeated, or (vii) Seller or Buyer shall
admit to the other its inability to, or its intention not to, perform any of
its obligations hereunder (each an “Event of Default”):

(a) The nondefaulting party may, at its option (which option shall be
deemed to have been exercised immediately upon the occurrence of
an Act of Insolvency), declare an Event of Default to have occurred
hereunder and, upon the exercise or deemed exercise of such
option, the Repurchase Date for each Transaction hereunder shall,
if it has not already occurred, be deemed immediately to occur
(except that, in the event that the Purchase Date for any Transac-
147
Repurchase and Reverse Repurchase Agreements



tion has not yet occurred as of the date of such exercise or deemed
exercise, such Transaction shall be deemed immediately canceled).
The nondefaulting party shall (except upon the occurrence of an
Act of Insolvency) give notice to the defaulting party of the exercise
of such option as promptly as practicable.

(b) In all Transactions in which the defaulting party is acting as Seller,
if the nondefaulting party exercises or is deemed to have exercised
the option referred to in subparagraph (a) of this Paragraph, (i) the
defaulting party™s obligations in such Transactions to repurchase
all Purchased Securities, at the Repurchase Price therefor on the
Repurchase Date determined in accordance with subparagraph (a)
of this Paragraph, shall thereupon become immediately due and
payable, (ii) all Income paid after such exercise or deemed exercise
shall be retained by the nondefaulting party and applied to the
aggregate unpaid Repurchase Prices and any other amounts owing
by the defaulting party hereunder, and (iii) the defaulting party
shall immediately deliver to the nondefaulting party any Purchased
Securities subject to such Transactions then in the defaulting
party™s possession or control.

(c) In all Transactions in which the defaulting party is acting as Buyer,
upon tender by the nondefaulting party of payment of the aggre-
gate Repurchase Prices for all such Transactions, all right, title and
interest in and entitlement to all Purchased Securities subject to
such Transactions shall be deemed transferred to the nondefaulting
party, and the defaulting party shall deliver all such Purchased
Securities to the nondefaulting party.

(d) If the nondefaulting party exercises or is deemed to have exercised
the option referred to in subparagraph (a) of this Paragraph, the
nondefaulting party, without prior notice to the defaulting party,
may:

(i) as to Transactions in which the defaulting party is acting as
Seller, (A) immediately sell, in a recognized market (or other-
wise in a commercially reasonable manner) at such price or
prices as the nondefaulting party may reasonably deem satisfac-
tory, any or all Purchased Securities subject to such Transac-
tions and apply the proceeds thereof to the aggregate unpaid
Repurchase Prices and any other amounts owing by the default-
ing party hereunder or (B) in its sole discretion elect, in lieu of
selling all or a portion of such Purchased Securities, to give the
148 THE GLOBAL MONEY MARKETS



defaulting party credit for such Purchased Securities in an
amount equal to the price therefor on such date, obtained from
a generally recognized source or the most recent closing bid
quotation from such a source, against the aggregate unpaid
Repurchase Prices and any other amounts owing by the default-
ing party hereunder; and

(ii) as to Transactions in which the defaulting party is acting as
Buyer, (A) immediately purchase, in a recognized market (or
otherwise in a commercially reasonable manner) at such price
or prices as the nondefaulting party may reasonably deem satis-
factory, securities (“Replacement Securities”) of the same class
and amount as any Purchased Securities that are not delivered
by the defaulting party to the nondefaulting party as required
hereunder or (B) in its sole discretion elect, in lieu of purchasing
Replacement Securities, to be deemed to have purchased
Replacement Securities at the price therefor on such date,
obtained from a generally recognized source or the most recent
closing offer quotation from such a source.

Unless otherwise provided in Annex I, the parties acknowledge and
agree that (1) the Securities subject to any Transaction hereunder
are instruments traded in a recognized market, (2) in the absence of
a generally recognized source for prices or bid or offer quotations
for any Security, the nondefaulting party may establish the source
therefor in its sole discretion and (3) all prices, bids and offers shall
be determined together with accrued Income (except to the extent
contrary to market practice with respect to the relevant Securities).

(e) As to Transactions in which the defaulting party is acting as Buyer,
the defaulting party shall be liable to the nondefaulting party for
any excess of the price paid (or deemed paid) by the nondefaulting
party for Replacement Securities over the Repurchase Price for the
Purchased Securities replaced thereby and for any amounts payable
by the defaulting party under Paragraph 5 hereof or otherwise
hereunder.

(f) For purposes of this Paragraph 11, the Repurchase Price for each
Transaction hereunder in respect of which the defaulting party is
acting as Buyer shall not increase above the amount of such Repur-
chase Price for such Transaction determined as of the date of the
exercise or deemed exercise by the nondefaulting party of the
option referred to in subparagraph (a) of this Paragraph.
149
Repurchase and Reverse Repurchase Agreements



(g) The defaulting party shall be liable to the nondefaulting party for (i)
the amount of all reasonable legal or other expenses incurred by
the nondefaulting party in connection with or as a result of an
Event of Default, (ii) damages in an amount equal to the cost
(including all fees, expenses and commissions) of entering into
replacement transactions and entering into or terminating hedge
transactions in connection with or as a result of an Event of
Default, and (iii) any other loss, damage, cost or expense directly
arising or resulting from the occurrence of an Event of Default in
respect of a Transaction.

(h) To the extent permitted by applicable law, the defaulting party
shall be liable to the nondefaulting party for interest on any
amounts owing by the defaulting party hereunder, from the date
the defaulting party becomes liable for such amounts hereunder
until such amounts are (i) paid in full by the defaulting party or
(ii) satis¬ed in full by the exercise of the nondefaulting party™s
rights hereunder. Interest on any sum payable by the defaulting
party to the nondefaulting party under this Paragraph 11(h) shall
be at a rate equal to the greater of the Pricing Rate for the relevant
Transaction or the Prime Rate.

(i) The nondefaulting party shall have, in addition to its rights hereun-
der, any rights otherwise available to it under any other agreement
or applicable law.

19. Intent
(a) The parties recognize that each Transaction is a “repurchase agree-
ment” as that term is de¬ned in Section 101 of Title 11 of the
United States Code, as amended (except insofar as the type of Secu-
rities subject to such Transaction or the term of such Transaction
would render such de¬nition inapplicable), and a “securities con-
tract” as that term is de¬ned in Section 741 of Title 11 of the
United States Code, as amended (except insofar as the type of
assets subject to such Transaction would render such de¬nition
inapplicable).

(b) It is understood that either party™s right to liquidate Securities deliv-
ered to it in connection with Transactions hereunder or to exercise
any other remedies pursuant to Paragraph 11 hereof is a contrac-
tual right to liquidate such Transaction as described in Sections
555 and 559 of Title 11 of the United States Code, as amended.
150 THE GLOBAL MONEY MARKETS



(c) The parties agree and acknowledge that if a party hereto is an
“insured depository institution,” as such term is de¬ned in the Fed-
eral Deposit Insurance Act, as amended (“FDIA”), then each
Transaction hereunder is a “quali¬ed ¬nancial contract,” as that
term is de¬ned in FDIA and any rules, orders or policy statements
thereunder (except insofar as the type of assets subject to such
Transaction would render such de¬nition inapplicable).

(d) It is understood that this Agreement constitutes a “netting con-
tract” as de¬ned in and subject to Title IV of the Federal Deposit
Insurance Corporation Improvement Act of 1991 (“FDICIA”) and
each payment entitlement and payment obligation under any
Transaction hereunder shall constitute a “covered contractual pay-
ment entitlement” or “covered contractual payment obligation”,
respectively, as de¬ned in and subject to FDI-CIA (except insofar as
one or both of the parties is not a “¬nancial institution” as that
term is de¬ned in FDICIA).
9
CHAPTER

Short-Term Mortgage-Backed
Securities



n asset-backed security (ABS) is a security supported by a pool of
A loans or receivables. That is, the cash ¬‚ow to pay the holders of the
security comes from the cash ¬‚ow of the underlying loans or receivables.
A mortgage-backed security (MBS) refers to an ABS created by pooling
mortgage loans on real estate property. While technically the MBS mar-
ket is part of the ABS market, in the United States, the two markets are
viewed as being separate. There are many short-term ¬xed-rate products
and ¬‚oating-rate products in this market that fall into the money market
area. In this chapter we discuss mortgage-backed securities and in the
next we focus on asset-backed securities.



MORTGAGE LOANS
While any type of mortgage loans”residential or commercial”can be
used as collateral for an MBS, most are backed by residential mort-
gages. We begin our coverage of MBS products with a description of the
raw product”the mortgage loan.

Mortgage Designs
There are many types of mortgage designs. By a mortgage design we
mean the speci¬cation of the interest rate (¬xed or ¬‚oating), the term of
the mortgage, and the manner in which the principal is repaid. We sum-
marize the major mortgage designs below.



151
152 THE GLOBAL MONEY MARKETS



Fixed-Rate, Level-Payment, Fully Amortized Mortgage
The basic idea behind the design of the ¬xed-rate, level payment, fully
amortized mortgage is that the borrower pays interest and repays prin-
cipal in equal installments over an agreed-upon period of time, called
the maturity or term of the mortgage. The frequency of payment is typi-
cally monthly. Each monthly mortgage payment for this mortgage
design is due on the ¬rst of each month and consists of:

1. interest of ¹ ‚‚‚th of the annual interest rate times the amount of the out-
standing mortgage balance at the beginning of the previous month, and
2. a repayment of a portion of the outstanding mortgage balance (princi-
pal).

The difference between the monthly mortgage payment and the por-
tion of the payment that represents interest equals the amount that is
applied to reduce the outstanding mortgage balance. The portion of the
monthly mortgage payment applied to interest declines each month and
the portion applied to reducing the mortgage balance increases each
month. The reason for this is that as the mortgage balance is reduced
with each monthly mortgage payment, the interest on the mortgage bal-
ance declines. Since the monthly mortgage payment is ¬xed, an increas-
ingly larger portion of the monthly payment is applied to reduce the
outstanding principal in each subsequent month. The monthly mortgage
payment is designed so that after the last scheduled monthly payment of
the loan is made, the amount of the outstanding mortgage balance is
zero (i.e., the mortgage is fully repaid or amortized).
The cash ¬‚ow from this mortgage loan, as well as all mortgage designs,
is not simply the interest payment and the scheduled principal repayments.
There are two additional factors”servicing fees and prepayments.
Every mortgage loan must be serviced. The servicing fee is a portion
of the mortgage rate. If the mortgage rate is 8.125% and the servicing
fee is 50 basis points, then the investor receives interest of 7.625%. The
interest rate that the investor receives is said to be the net interest or net
coupon. The servicing fee is commonly called the servicing spread. The
dollar amount of the servicing fee declines over time as the mortgage
amortizes. This is true for not only the mortgage design that we have
just described, but for all mortgage designs.
The second modi¬cation to the cash ¬‚ow is that the borrower typi-
cally has the right to pay off any portion of the mortgage balance prior
to the scheduled due date typically without a penalty. Payments made in
excess of the scheduled principal repayments are called prepayments.
When less than the entire amount of the outstanding mortgage balance
153
Short-Term Mortgage-Backed Securities



is prepaid in a month, this type of prepayment is called a curtailment
because it shortens or curtails the life of the loan. The effect of prepay-
ments is that the amount and timing of the cash ¬‚ows from a mortgage
loan are not known with certainty. This risk is referred to as prepay-
ment risk. This is true for all mortgage loans, not just ¬xed-rate, level-
payment, fully amortized mortgages.

Balloon Mortgages
In a balloon mortgage, the borrower is given long-term ¬nancing by the
lender but at speci¬ed future dates the mortgage rate is renegotiated.
Thus, the lender is providing long-term funds for what is effectively a
short-term borrowing, how short depending on the frequency of the
renegotiation period. Effectively it is a short-term balloon loan in which
the lender agrees to provide ¬nancing for the remainder of the term of
the mortgage if certain conditions are met. The balloon payment is the
original amount borrowed less the amount amortized. Thus, in a bal-
loon mortgage, the actual maturity is shorter than the stated maturity.

Adjustable-Rate Mortgages
As the name implies, an adjustable-rate mortgage (ARM) has an adjustable
or ¬‚oating coupon instead of a ¬xed one. The coupon adjusts periodi-
cally”monthly, semiannually, or annually. Some ARMs even have coupons
that adjust every three years or ¬ve years. The coupon formula for an
ARM is speci¬ed in terms of a reference rate plus a quoted margin.
At origination, the mortgage usually has an initial rate for an initial
period (teaser period) which is slightly below the rate speci¬ed by the
coupon formula. This is called a “teaser rate” and makes it easier for
¬rst time home buyers to qualify for the loan. At the end of the teaser
period, the loan rate is reset based on the coupon formula. Once the
loan comes out of its teaser period and resets based on the coupon for-
mula, it is said to be fully indexed.
To protect the homeowner from interest rate shock, there are caps
imposed on the coupon adjustment level. There are periodic caps and life-
time caps. The periodic cap limits the amount of coupon reset upward from
one reset date to another. The lifetime cap is the maximum absolute level
for the coupon rate that the loan can reset to for the life of the mortgage.
Two categories of reference rates have been used in ARMs: (1) market
determined rates and (2) calculated cost of funds for thrifts. The most
common market determined rates used are the 1-year, 3-year or 5-year
CMT and 3-month or 6-month London interbank offered rate (LIBOR).
The most popular cost of funds for thrift index used is the Eleventh Fed-
eral Home Loan Bank Board District Cost of Funds Index (COFI).
154 THE GLOBAL MONEY MARKETS



MORTGAGE PASSTHROUGH SECURITIES
A mortgage passthrough is an MBS where the cash ¬‚ows from the
underlying pool of mortgage loans is distributed to the security holders
on a pro rata basis. That is, if there are X certi¬cates issued against a
pool of mortgage loans, then a certi¬cate holder is entitled to 1/X of the
cash ¬‚ow from the pool of mortgage loans. The cash ¬‚ow for the certi¬-
cate holder depends on the cash ¬‚ow of the underlying mortgages:
monthly mortgage payments representing interest, the scheduled repay-
ment of principal, and any prepayments.
Payments are made to security holders each month. Neither the
amount nor the timing, however, of the cash ¬‚ows from the pool of
mortgages are identical to that of the cash ¬‚ows passed through to
investors. The monthly cash ¬‚ows for a passthrough are less than the
monthly cash ¬‚ows of the underlying mortgages by an amount equal to
the servicing fee and other fees. The other fees are those charged by the
issuer or guarantor of the passthrough for guaranteeing the issue. The
coupon rate on a passthrough, called the “passthrough coupon rate,” is
less than the mortgage rate on the underlying pool of mortgage loans by
an amount equal to the servicing fee and guarantee fee.
Not all of the mortgages that are included in a pool of mortgages that
are securitized have the same mortgage rate and the same maturity. Con-
sequently, when describing a passthrough security, a weighted average
coupon rate and a weighted average maturity are determined. A weighted
average coupon rate, or WAC, is found by weighting the mortgage rate of
each mortgage loan in the pool by the amount of the mortgage balance
outstanding. A weighted average maturity, or WAM, is found by weight-
ing the remaining number of months to maturity for each mortgage loan
in the pool by the amount of the mortgage balance outstanding.

Agency Mortgage Passthrough Securities
There are three government agencies that issue passthrough securities:
Government National Mortgage Association, Federal National Mortgage
Association, and Federal Home Loan Mortgage Corporation. The ¬rst is
a federally related government agency. The last two are government spon-
sored enterprises. There are also MBS issued by nonagencies. We will
postpone discussion of nonagency MBS until later in this chapter.
The Government National Mortgage Association (nicknamed “Gin-
nie Mae”) passthroughs are guaranteed by the full faith and credit of
the U.S. government. For this reason, Ginnie Mae passthroughs are
viewed as risk-free in terms of default risk, just like Treasury securities.
The security guaranteed by Ginnie Mae is called a mortgage-backed
155
Short-Term Mortgage-Backed Securities



security (MBS). All Ginnie Mae MBS are guaranteed with respect to the
timely payment of interest and principal, meaning the interest and prin-
cipal will be paid when due, even if any of the borrowers fail to make
their monthly mortgage payments.
Only mortgage loans insured or guaranteed by either the Federal
Housing Administration, the Veterans Administration, or the Rural
Housing Service can be included in a mortgage pool guaranteed by Gin-
nie Mae. The maximum loan size is set by Congress, based on the maxi-
mum amount that the FHA, VA, or RHS may guarantee. The maximum
for a given loan varies with the region of the country and type of resi-
dential property.
The passthroughs issued by the Federal National Mortgage Associa-
tion (nicknamed “Fannie Mae”) are called mortgage-backed securities
(MBSs). Although a guarantee of Fannie Mae is not a guarantee by the
U.S. government, most market participants view Fannie Mae MBSs as
similar, although not identical, in credit worthiness to Ginnie Mae
passthroughs. All Fannie Mae MBSs carry its guarantee of timely pay-
ment of both interest and principal.
The Federal Home Loan Mortgage Corporation (nicknamed “Freddie
Mac”) is a government sponsored enterprise that issues a passthrough
security that is called a participation certi¬cate (PC). As with Fannie Mae
MBS, a guarantee of Freddie Mac is not a guarantee by the U.S. govern-
ment, but most market participants view Freddie Mac PCs as similar,
although not identical, in credit worthiness to Ginnie Mae passthroughs.
Freddie Mac has issued PCs with different types of guarantee. The old
PCs issued by Freddie Mac guarantee the timely payment of interest; the
scheduled principal is passed through as it is collected, with Freddie Mac
only guaranteeing that the scheduled payment will be made no later than
one year after it is due. Today, Freddie Mac issues PCs under its “Gold
Program” in which both the timely payment of interest and principal are
guaranteed.

Price Quotes and Trading Procedures
Passthroughs are quoted in the same manner as U.S. Treasury coupon
securities. A quote of 94-05 means 94 and µ ‚‚‚nds of par value, or
94.15625% of par value. The price that the buyer pays the seller is the
agreed upon sale price plus accrued interest. Given the par value, the
dollar price (excluding accrued interest) is affected by the amount of the
mortgage pool balance outstanding. The pool factor indicates the per-
centage of the initial mortgage balance still outstanding. So, a pool fac-
tor of 90 means that 90% of the original mortgage pool balance is
outstanding. The pool factor is reported by the agency each month.
156 THE GLOBAL MONEY MARKETS



The dollar price paid for just the principal is found as follows given
the agreed upon price, par value, and the month™s pool factor provided
by the agency:

Price = Par value — Pool factor

For example, if the parties agree to a price of 92 for $1 million par
value for a passthrough with a pool factor of 85, then the dollar price
paid by the buyer in addition to accrued interest is:

0.92 — $1,000,000 — 0.85 = $782,000

Many trades occur while a pool is still unspeci¬ed, and therefore no
pool information is known at the time of the trade. This kind of trade is
known as a “TBA” (to be announced) trade. In a TBA trade for a ¬xed-
rate passthrough, the two parties agree on the agency type, the agency
program, the coupon rate, the face value, the price, and the settlement
date. The actual pools underlying the agency passthrough are not speci-
¬ed in a TBA trade. However, this information is provided by the seller
to the buyer before delivery. In contrast to a TBA trade, there are speci-
¬ed pool trades wherein the actual pool numbers to be delivered are
speci¬ed.

Prepayment Conventions and Cash Flows
To value a security it is necessary to project its cash ¬‚ows. The dif¬culty
for an MBS is that the cash ¬‚ows are unknown because of prepayments.
The only way to project cash ¬‚ows is to make some assumption about
the prepayment rate over the life of the underlying mortgage pool. The
prepayment rate is sometimes referred to as the prepayment speed, or
simply speed. Two conventions have been used as a benchmark for pre-
payment rates”conditional prepayment rate and Public Securities Asso-
ciation prepayment benchmark.

Conditional Prepayment Rate
One convention for describing the pattern of prepayments and the cash
¬‚ows of a passthrough assumes that some fraction of the remaining
principal in the pool is prepaid each month for the remaining term of
the mortgage. The prepayment rate assumed for a pool, called the con-
ditional prepayment rate (CPR), is based on the characteristics of the
pool (including its historical prepayment experience) and the current
and expected future economic environment.
157
Short-Term Mortgage-Backed Securities



The CPR is an annual prepayment rate. To estimate monthly pre-
payments, the CPR must be converted into a monthly prepayment rate,
commonly referred to as the single-monthly mortality rate (SMM). The
following formula is used to determine the SMM for a given CPR:

SMM = 1 ’ (1 ’ CPR)¹ ‚‚‚

Suppose that the CPR used to estimate prepayments is 6%. The cor-
responding SMM is:

SMM = 1 ’ (1 ’ 0.06)¹ ‚‚‚
= 1 ’ (0.94)0.08333 = 0.005143

An SMM of w% means that approximately w% of the remaining
mortgage balance at the beginning of the month, less the scheduled prin-
cipal payment, will prepay that month. That is,

Prepayment for month t
= SMM — (Beginning mortgage balance for month t
’ Scheduled principal payment for month t)

For example, suppose that an investor owns a passthrough in which
the remaining mortgage balance at the beginning of some month is $290
million. Assuming that the SMM is 0.5143% and the scheduled princi-
pal payment is $3 million, the estimated prepayment for the month is:

0.005143 — ($290,000,000 ’ $3,000,000) = $1,476,041

PSA Prepayment Benchmark
The Public Securities Association (PSA) prepayment benchmark is
expressed as a monthly series of CPRs. The PSA benchmark assumes
that prepayment rates are low for newly originated mortgages and then
will speed up as the mortgages become seasoned.
The PSA prepayment benchmark assumes the following prepayment
rates for 30-year mortgages: (1) a CPR of 0.2% for the ¬rst month,
increased by 0.2% per year per month for the next 30 months when it
reaches 6% per year, and
(2) a 6% CPR for the remaining years. This benchmark is referred
to as “100% PSA” or simply “100 PSA.” Slower or faster speeds are
then referred to as some percentage of 100 PSA. For example, 50 PSA
means one-half the CPR of the PSA benchmark prepayment rate; 150
PSA means 1.5 times the CPR of the PSA benchmark prepayment rate;
158 THE GLOBAL MONEY MARKETS



300 PSA means three times the CPR of the benchmark prepayment rate.
A prepayment rate of 0 PSA means that no prepayments are assumed.
It is important to understand that the PSA benchmark is commonly
referred to as a prepayment model, suggesting that it can be used to esti-
mate prepayments. Characterization of this benchmark as a prepayment
model is incorrect. It is simply a market convention describing what the
PSA believes the pattern will be for prepayments.
It is worthwhile to see a monthly cash ¬‚ow for a hypothetical
passthrough given a PSA assumption since we can use the information
in our discussion of collateralized mortgage obligations in the next sec-
tion. Exhibit 9.1 shows the cash ¬‚ow for selected months assuming 165
PSA for a passthrough security in which the underlying loans are
assumed to be ¬xed-rate, level-payment, fully amortized mortgages with
a WAC of 8.125%. It is assumed that the passthrough rate is 7.5% with
a WAM of 357 months. The cash ¬‚ow in Exhibit 9.1 is broken down
into three components: (1) interest (based on the passthrough rate), (2)
the regularly scheduled principal repayment, and (3) prepayments based
on 165 PSA.
Since the WAM is 357 months, the underlying mortgage pool is sea-
soned an average of three months. Therefore, the CPR for month 27 is
1.65 times 6%.

Average Life Measure
Because an MBS is an amortizing security, market participants do not
talk in terms of an issue™s maturity. Instead, the average life of an MBS
is computed. The average life is the average time to receipt of principal
payments (scheduled principal payments and projected prepayments).
Speci¬cally, the average life is found by ¬rst calculating:

1 — (Projected principal received in month 1)
2 — (Projected principal received in month 2)
3 — (Projected principal received in month 3)
...
+ T — (Projected principal received in month T)
Weighted monthly average of principal received

where T is the last month that principal is expected to be received.
Then the average life is found as follows:

Weighted monthly average of principal received
Average life = ---------------------------------------------------------------------------------------------------------------------------
12 ( Total principal to be received )
159
Short-Term Mortgage-Backed Securities



EXHIBIT 9.1 Monthly Cash Flow for a $400 Million Passthrough with a 7.5%
Passthrough Rate, a WAC of 8.125%, and a WAM of 357 Months Assuming 165 PSA

(1) (2) (3) (4) (5) (6) (7) (8) (9)

Outstanding Mortgage Net Scheduled Total Cash
Month Balance SMM Payment Interest Principal Prepayment Principal Flow

1 $400,000,000 0.00111 $2,975,868 $2,500,000 $267,535 $442,389 $709,923 $3,209,923
2 399,290,077 0.00139 2,972,575 2,495,563 269,048 552,847 821,896 3,317,459
3 398,468,181 0.00167 2,968,456 2,490,426 270,495 663,065 933,560 3,423,986
4 397,534,621 0.00195 2,963,513 2,484,591 271,873 772,949 1,044,822 3,529,413
5 396,489,799 0.00223 2,957,747 2,478,061 273,181 882,405 1,155,586 3,633,647
6 395,334,213 0.00251 2,951,160 2,470,839 274,418 991,341 1,265,759 3,736,598
7 394,068,454 0.00279 2,943,755 2,462,928 275,583 1,099,664 1,375,246 3,838,174
8 392,693,208 0.00308 2,935,534 2,454,333 276,674 1,207,280 1,483,954 3,938,287
9 391,209,254 0.00336 2,926,503 2,445,058 277,690 1,314,099 1,591,789 4,036,847
10 389,617,464 0.00365 2,916,666 2,435,109 278,631 1,420,029 1,698,659 4,133,769
11 387,918,805 0.00393 2,906,028 2,424,493 279,494 1,524,979 1,804,473 4,228,965

24 356,711,789 0.00775 2,698,575 2,229,449 283,338 2,761,139 3,044,477 5,273,926
25 353,667,312 0.00805 2,677,670 2,210,421 283,047 2,843,593 3,126,640 5,337,061
26 350,540,672 0.00835 2,656,123 2,190,879 282,671 2,923,885 3,206,556 5,397,435
27 347,334,116 0.00865 2,633,950 2,170,838 282,209 3,001,955 3,284,164 5,455,002
28 344,049,952 0.00865 2,611,167 2,150,312 281,662 2,973,553 3,255,215 5,405,527
29 340,794,737 0.00865 2,588,581 2,129,967 281,116 2,945,400 3,226,516 5,356,483
30 337,568,221 0.00865 2,566,190 2,109,801 280,572 2,917,496 3,198,067 5,307,869

100 170,142,350 0.00865 1,396,958 1,063,390 244,953 1,469,591 1,714,544 2,777,933
101 168,427,806 0.00865 1,384,875 1,052,674 244,478 1,454,765 1,699,243 2,751,916
102 166,728,563 0.00865 1,372,896 1,042,054 244,004 1,440,071 1,684,075 2,726,128
103 165,044,489 0.00865 1,361,020 1,031,528 243,531 1,425,508 1,669,039 2,700,567

200 56,746,664 0.00865 585,990 354,667 201,767 489,106 690,874 1,045,540
201 56,055,790 0.00865 580,921 350,349 201,377 483,134 684,510 1,034,859
202 55,371,280 0.00865 575,896 346,070 200,986 477,216 678,202 1,024,273
203 54,693,077 0.00865 570,915 341,832 200,597 471,353 671,950 1,013,782

300 11,758,141 0.00865 245,808 73,488 166,196 100,269 266,465 339,953
301 11,491,677 0.00865 243,682 71,823 165,874 97,967 263,841 335,664
302 11,227,836 0.00865 241,574 70,174 165,552 95,687 261,240 331,414
303 10,966,596 0.00865 239,485 68,541 165,232 93,430 258,662 327,203

353 760,027 0.00865 155,107 4,750 149,961 5,277 155,238 159,988
354 604,789 0.00865 153,765 3,780 149,670 3,937 153,607 157,387
355 451,182 0.00865 152,435 2,820 149,380 2,611 151,991 154,811
356 299,191 0.00865 151,117 1,870 149,091 1,298 150,389 152,259
357 148,802 0.00865 149,809 930 148,802 0 148,802 149,732

Note: Since the WAM is 357 months, the underlying mortgage pool is seasoned an
average of three months. Therefore, the CPR for month 27 is 1.65 — 6%.
160 THE GLOBAL MONEY MARKETS



The average life of a passthrough depends on the prepayment
assumption. To see this, the average life is shown below for different
PSA prepayment speeds for the passthrough we used to illustrate the
cash ¬‚ows for 165 PSA in Exhibit 9.1:

PSA speed 50 100 165 200 300 400 500 600 700
Average life 15.11 11.66 8.76 7.68 5.63 4.44 3.68 3.16 2.78

Closer Look at Prepayment Risk:
Contraction Risk and Extension Risk
Just like the owner of any security that contains an embedded option,
investors in passthrough securities do not know what their cash ¬‚ows
will be because of prepayments”the borrower™s option to alter the mort-
gage™s cash ¬‚ows. As we noted earlier, this risk is called prepayment risk.
To understand the signi¬cance of prepayment risk, suppose an investor
buys an 8.5% coupon Ginnie Mae at a time when mortgage rates are
8.5%. Let™s consider what will happen to prepayments if mortgage rates
decline to, say, 6.5%. There will be two adverse consequences. First, a
basic property of ¬xed-income securities is that the price of an option-
free bond increases at an increasing rate as interest rates decline. How-
ever, for a passthrough security with an embedded prepayment option,
the rise in price will not be as large as that of an option-free bond because
a drop in interest rates will give the borrower an incentive to prepay the
loan and re¬nance at a lower rate. In other words, the borrower is alter-
ing the mortgage™s ¬‚ows (i.e., exercising the prepayment option) when
this action enhances his/her economic value. Thus, the upside price
potential of a passthrough security is truncated because of prepayments
in a manner similar to that of a callable bond. The second adverse conse-
quence is that the cash ¬‚ows must be reinvested at a lower rate. These
two adverse consequences when mortgage rates decline are referred to as
contraction risk. In essence, contraction risk is all the consequences
resulting from borrowers prepaying at a faster rate than anticipated.
Now let™s look at what happens if mortgage rates rise to 10.5%.
The price of the passthrough, like the price of any bond, will decline.
But again it will decline more because the higher rates will tend to slow
down the rate of prepayment, in effect increasing the amount invested at
the coupon rate, which is lower than the market rate. Prepayments will
slow down because homeowners will not re¬nance or partially prepay
their mortgages when mortgage rates are higher than the contract rate
of 8.5%. Of course, this is just the time when investors want prepay-
ments to speed up so that they can reinvest the prepayments at the
higher market interest rate. This adverse consequence of rising mortgage
161
Short-Term Mortgage-Backed Securities



rates is called extension risk and results from borrowers prepaying at a
slower rate than anticipated.
Therefore, prepayment risk encompasses contraction risk and
extension risk. Prepayment risk makes passthrough securities unattrac-
tive for certain individuals and ¬nancial institutions to hold for pur-
poses of accomplishing their investment objectives. Some individuals
and institutional investors such as cash managers and managers of
short-duration portfolios are concerned with extension risk and others
with contraction risk when they purchase a passthrough security. Is it
possible to alter the cash ¬‚ows of a mortgage passthrough security so as
to reduce the contraction risk or extension risk for institutional inves-
tors? This can be done as we will see in the next section.



COLLATERALIZED MORTGAGE OBLIGATIONS
Now we will see how mortgage passthroughs securities backed by ¬xed-
rate mortgage loans with a long WAM can be used to create a structure
called a collateralized mortgage obligation (CMO). Two types of bond
classes that can be created within the structure is a ¬‚oating-rate bond
class and a ¬xed-rate bond class with a short average life.
We will discuss CMOs issued by the three agencies that issue mort-
gage passthrough securities and CMOs issued by private entities. CMOs
are also referred to as “paythroughs” or “multi-class passthroughs.”
Because they are created so as to comply with a provision in the tax law
called the Real Estate Mortgage Investment Conduit, or REMIC, they
are also referred to as “REMICs.” Throughout this chapter we refer to
these structures as simply CMOs. We will see similar paythrough or
multi-class passthrough structures when we cover other asset-backed
security structures in the next chapter.

Basic Principles of a CMO
By investing in a mortgage passthrough security an investor is exposed to
prepayment risk. Furthermore, as explained earlier, prepayment risk can
be divided into extension risk and contraction risk. Some investors are
concerned with extension risk and others with contraction risk when they
invest in a passthrough. An investor may be willing to accept one form of
prepayment risk but seek to avoid the other. For example, a cash manager
seeks a short-term security and is concerned with extension risk. A portfo-
lio manager who seeks a long-term security, and wants to avoid reinvest-
ing unexpected principal prepayments due to re¬nancing of mortgages
should interest rates drop, is concerned with contraction risk.
162 THE GLOBAL MONEY MARKETS



By redirecting how the cash ¬‚ows of passthrough securities are paid
to different bond classes that are created, securities can be created that
have different exposure to prepayment risk. When the cash ¬‚ows of
mortgage-related products are redistributed to different bond classes,
the resulting securities are called CMOs. Simply put, CMOs set forth
rules for dividing up cash ¬‚ows among bond classes.
The basic principle is that redirecting cash ¬‚ows (interest and prin-
cipal) to different bond classes, called tranches, mitigates different
forms of prepayment risk. It is never possible to eliminate prepayment
risk. If one tranche in a CMO structure has less prepayment risk than
the mortgage passthrough securities that are collateral for the structure,
then another tranche in the same structure has greater prepayment risk
than the collateral.

Agency Collateralized Mortgage Obligations
Issuers of CMOs are the same three entities that issue agency passthrough
securities: Freddie Mac, Fannie Mae, and Ginnie Mae. However, Freddie
Mac and Fannie Mae have used Ginnie Mae passthroughs as collateral
for their own CMOs. CMOs issued by any of these entities are referred to
as agency CMOs.
When an agency CMO is created it is structured so that even under
the worst circumstances regarding prepayments, the interest and princi-
pal payments from the collateral will be suf¬cient to meet the interest
obligation of each tranche and pay off the par value of each tranche.
Defaults are ignored because the agency that has issued the passthroughs
used as collateral is expected to make up any de¬ciency. Thus, the credit
risk of agency CMOs is minimal. However, the guarantee of a govern-
ment sponsored enterprise does not carry the full faith and credit of the
U.S. government. Fannie Mae and Freddie Mac CMOs created from
Ginnie Mae passthroughs effectively carry the full faith and credit of the
U.S. government.

Types of Bond Classes
There have been a good number of products created in the CMO market
that would be acceptable investments for short-term investors. But there
are also a good number that short-term investors should avoid given the
typical interest rate exposure a short-term investor seeks.

Sequential-Pay Tranches
The ¬rst CMO was structured so that each tranche would be retired
sequentially. Such structures are referred to as sequential-pay CMOs. To
illustrate a sequential-pay CMO, we will use a hypothetical deal that we
163
Short-Term Mortgage-Backed Securities



will refer to as Deal 1. The collateral for Deal 1 is a hypothetical
passthrough with a total par value of $400 million and the following
characteristics: (1) the passthrough coupon rate is 7.5%, (2) the WAC is
8.125%, and (3) the WAM is 357 months. This is the same passthrough
that we used in Exhibit 9.1 to describe the cash ¬‚ows of a passthrough
based on an assumed 165 PSA prepayment speed.
From this $400 million of collateral, four tranches are created. Their
characteristics are summarized in Exhibit 9.2. The total par value of the
four tranches is equal to the par value of the collateral (i.e., the
passthrough security). In this simple structure, the coupon rate is the
same for each tranche and also the same as the collateral™s coupon rate.
There is no reason why this must be so, and, in fact, typically the coupon
rate varies by tranche. Speci¬cally, if the yield curve is upward-sloping,
the coupon rates of the tranches will usually increase with average life.
Now remember that a CMO is created by redistributing the cash
¬‚ow”interest and principal”to the different tranches based on a set of
payment rules. The payment rules at the bottom of Exhibit 9.2 set forth
how the monthly cash ¬‚ow from the passthrough (i.e., collateral) is to be
distributed among the four tranches. There are separate rules for the pay-
ment of the coupon interest and the payment of principal, the principal
being the total of the regularly scheduled principal payment and any pre-
payments.


EXHIBIT 9.2 Deal 1: A Hypothetical Four-Tranche Sequential-Pay Structure

Tranche Par Amount Coupon Rate (%)

A $194,500,000 7.5
B 36,000,000 7.5
C 96,500,000 7.5
D 73,000,000 7.5
Total $400,000,000

Payment rules:
1. For payment of periodic coupon interest: Disburse periodic coupon interest to
each tranche on the basis of the amount of principal outstanding at the beginning of
the period.
2. For disbursement of principal payments: Disburse principal payments to tranche
A until it is completely paid off. After tranche A is completely paid off, disburse prin-
cipal payments to tranche B until it is completely paid off. After tranche B is com-
pletely paid off, disburse principal payments to tranche C until it is completely paid
off. After tranche C is completely paid off, disburse principal payments to tranche D
until it is completely paid off.
164 THE GLOBAL MONEY MARKETS



In Deal 1, each tranche receives periodic coupon interest payments
based on the amount of the outstanding balance. The disbursement of
the principal, however, is made in a special way. A tranche is not enti-
tled to receive principal until the entire principal of the tranche before it
has been paid off. More speci¬cally, tranche A receives all the principal
payments until the entire principal amount owed to that tranche,
$194,500,000, is paid off; then tranche B begins to receive principal and
continues to do so until it is paid the entire $36,000,000. Tranche C
then receives principal, and when it is paid off, tranche D starts receiv-
ing principal payments.
While the payment rules for the disbursement of the principal pay-
ments are known, the precise amount of the principal in each period is
not. This will depend on the cash ¬‚ow, and therefore principal pay-
ments, of the collateral, which depends on the actual prepayment rate of
the collateral. An assumed PSA speed allows the monthly cash ¬‚ow to
be projected. Exhibit 9.1 shows the monthly cash ¬‚ow (interest, regu-
larly scheduled principal repayment, and prepayments) assuming 165
PSA. Assuming that the collateral does prepay at 165 PSA, the cash
¬‚ows available to all four tranches of Deal 1 will be precisely the cash
¬‚ows shown in Exhibit 9.1.
To demonstrate how the payment rules for Deal 1 work, Exhibit 9.3
shows the cash ¬‚ow for selected months assuming the collateral prepays
at 165 PSA. For each tranche, the exhibit shows: (1) the balance at the
end of the month, (2) the principal paid down (regularly scheduled prin-
cipal repayment plus prepayments), and (3) interest. In month 1, the
cash ¬‚ow for the collateral consists of a principal payment of $709,923
and interest of $2.5 million (0.075 times $400 million divided by 12).
The interest payment is distributed to the four tranches based on the
amount of the par value outstanding. So, for example, tranche A
receives $1,215,625 (0.075 times $194,500,000 divided by 12) of the
$2.5 million. The principal, however, is all distributed to tranche A.
Therefore, the cash ¬‚ow for tranche A in month 1 is $1,925,548. The
principal balance at the end of month 1 for tranche A is $193,790,076
(the original principal balance of $194,500,000 less the principal pay-
ment of $709,923). No principal payment is distributed to the three
other tranches because there is still a principal balance outstanding for
tranche A. This will be true for months 2 through 80.
After month 81, the principal balance will be zero for tranche A.
For the collateral the cash ¬‚ow in month 81 is $3,318,521, consisting of
a principal payment of $2,032,196 and interest of $1,286,325. At the
beginning of month 81 (end of month 80), the principal balance for
tranche A is $311,926. Therefore, $311,926 of the $2,032,196 of the
principal payment from the collateral will be disbursed to tranche A.
165
Short-Term Mortgage-Backed Securities



After this payment is made, no additional principal payments are made
to this tranche as the principal balance is zero. The remaining principal
payment from the collateral, $1,720,271, is disbursed to tranche B.
According to the assumed prepayment speed of 165 PSA, tranche B then
begins receiving principal payments in month 81.

EXHIBIT 9.3 Monthly Cash Flow for Selected Months for Deal 1 Assuming 165 PSA

Tranche A Tranche B

Month Balance Principal Interest Balance Principal Interest

1 194,500,000 709,923 1,215,625 36,000,000 0 225,000
2 193,790,077 821,896 1,211,188 36,000,000 0 225,000
3 192,968,181 933,560 1,206,051 36,000,000 0 225,000
4 192,034,621 1,044,822 1,200,216 36,000,000 0 225,000
5 190,989,799 1,155,586 1,193,686 36,000,000 0 225,000
6 189,834,213 1,265,759 1,186,464 36,000,000 0 225,000
7 188,568,454 1,375,246 1,178,553 36,000,000 0 225,000
8 187,193,208 1,483,954 1,169,958 36,000,000 0 225,000
9 185,709,254 1,591,789 1,160,683 36,000,000 0 225,000
10 184,117,464 1,698,659 1,150,734 36,000,000 0 225,000
11 182,418,805 1,804,473 1,140,118 36,000,000 0 225,000
12 180,614,332 1,909,139 1,128,840 36,000,000 0 225,000

75 12,893,479 2,143,974 80,584 36,000,000 0 225,000
76 10,749,504 2,124,935 67,184 36,000,000 0 225,000
77 8,624,569 2,106,062 53,904 36,000,000 0 225,000
78 6,518,507 2,087,353 40,741 36,000,000 0 225,000
79 4,431,154 2,068,807 27,695 36,000,000 0 225,000
80 2,362,347 2,050,422 14,765 36,000,000 0 225,000
81 311,926 311,926 1,950 36,000,000 1,720,271 225,000
82 0 0 0 34,279,729 2,014,130 214,248
83 0 0 0 32,265,599 1,996,221 201,660
84 0 0 0 30,269,378 1,978,468 189,184
85 0 0 0 28,290,911 1,960,869 176,818

95 0 0 0 9,449,331 1,793,089 59,058
96 0 0 0 7,656,242 1,777,104 47,852
97 0 0 0 5,879,138 1,761,258 36,745
98 0 0 0 4,117,880 1,745,550 25,737
99 0 0 0 2,372,329 1,729,979 14,827
100 0 0 0 642,350 642,350 4,015
101 0 0 0 0 0 0
102 0 0 0 0 0 0
103 0 0 0 0 0 0
104 0 0 0 0 0 0
105 0 0 0 0 0 0
166 THE GLOBAL MONEY MARKETS



EXHIBIT 9.3 (Concluded)
Tranche C Tranche D

Month Balance Principal Interest Balance Principal Interest

1 96,500,000 0 603,125 73,000,000 0 456,250
2 96,500,000 0 603,125 73,000,000 0 456,250
3 96,500,000 0 603,125 73,000,000 0 456,250
4 96,500,000 0 603,125 73,000,000 0 456,250
5 96,500,000 0 603,125 73,000,000 0 456,250
6 96,500,000 0 603,125 73,000,000 0 456,250
7 96,500,000 0 603,125 73,000,000 0 456,250
8 96,500,000 0 603,125 73,000,000 0 456,250
9 96,500,000 0 603,125 73,000,000 0 456,250
10 96,500,000 0 603,125 73,000,000 0 456,250
11 96,500,000 0 603,125 73,000,000 0 456,250
12 96,500,000 0 603,125 73,000,000 0 456,250

95 96,500,000 0 603,125 73,000,000 0 456,250
96 96,500,000 0 603,125 73,000,000 0 456,250
97 96,500,000 0 603,125 73,000,000 0 456,250
98 96,500,000 0 603,125 73,000,000 0 456,250
99 96,500,000 0 603,125 73,000,000 0 456,250
100 96,500,000 1,072,194 603,125 73,000,000 0 456,250
101 95,427,806 1,699,243 596,424 73,000,000 0 456,250
102 93,728,563 1,684,075 585,804 73,000,000 0 456,250
103 92,044,489 1,669,039 575,278 73,000,000 0 456,250
104 90,375,450 1,654,134 564,847 73,000,000 0 456,250
105 88,721,315 1,639,359 554,508 73,000,000 0 456,250

175 3,260,287 869,602 20,377 73,000,000 0 456,250
176 2,390,685 861,673 14,942 73,000,000 0 456,250
177 1,529,013 853,813 9,556 73,000,000 0 456,250
178 675,199 675,199 4,220 73,000,000 170,824 456,250
179 0 0 0 72,829,176 838,300 455,182
180 0 0 0 71,990,876 830,646 449,943
181 0 0 0 71,160,230 823,058 444,751
182 0 0 0 70,337,173 815,536 439,607
183 0 0 0 69,521,637 808,081 434,510
184 0 0 0 68,713,556 800,690 429,460
185 0 0 0 67,912,866 793,365 424,455

350 0 0 0 1,235,674 160,220 7,723
351 0 0 0 1,075,454 158,544 6,722
352 0 0 0 916,910 156,883 5,731
353 0 0 0 760,027 155,238 4,750
354 0 0 0 604,789 153,607 3,780
355 0 0 0 451,182 151,991 2,820
356 0 0 0 299,191 150,389 1,870
357 0 0 0 148,802 148,802 930
167
Short-Term Mortgage-Backed Securities



EXHIBIT 9.4 Average Life for the Collateral and the Four Tranches of Deal 1

Average life for
Prepayment
speed (PSA) Collateral Tranche A Tranche B Tranche C Tranche D

50 15.11 7.48 15.98 21.02 27.24
100 11.66 4.90 10.86 15.78 24.58
165 8.76 3.48 7.49 11.19 20.27
200 7.68 3.05 6.42 9.60 18.11
300 5.63 2.32 4.64 6.81 13.36
400 4.44 1.94 3.70 5.31 10.34
500 3.68 1.69 3.12 4.38 8.35
600 3.16 1.51 2.74 3.75 6.96
700 2.78 1.38 2.47 3.30 5.95


Exhibit 9.3 shows that tranche B is fully paid off by month 100,
when tranche C begins to receive principal payments. Tranche C is not
fully paid off until month 178, at which time tranche D begins receiving
the remaining principal payments. The maturity (i.e., the time until the
principal is fully paid off) for these four tranches assuming 165 PSA is
81 months for tranche A, 100 months for tranche B, 178 months for
tranche C, and 357 months for tranche D.
The principal pay down window for a tranche is the time period
between the beginning and the ending of the principal payments to that
tranche. So, for example, for tranche A, the principal pay down window
would be month 1 to month 81 assuming 165 PSA. For tranche B it is
from month 81 to month 100. In con¬rmation of trades involving
CMOs, the principal pay down window is speci¬ed in terms of the ini-
tial month that principal is expected to be received based on an assumed
PSA speed to the ¬nal month that principal is expected to be received.
Let™s look at what has been accomplished by creating the CMO. First,
earlier we saw that the average life of the passthrough is 8.76 years,
assuming a prepayment speed of 165 PSA. Exhibit 9.4 reports the average
life of the collateral and the four tranches assuming different prepayment
speeds. Notice that the four tranches have average lives that are both
shorter and longer than the collateral, thereby attracting investors who
have a preference for an average life different from that of the collateral.
There is still a major problem: there is considerable variability of
the average life for the tranches. We™ll see how this can be tackled later
on. However, there is some protection provided for each tranche against
prepayment risk. This is because prioritizing the distribution of princi-
pal (i.e., establishing the payment rules for principal) effectively protects
168 THE GLOBAL MONEY MARKETS



the shorter-term tranche A in this structure against extension risk. This
protection must come from somewhere”it comes from the three other
tranches. Similarly, tranches C and D provide protection against exten-
sion risk for tranche B. At the same time, tranches C and D bene¬t
because they are provided protection against contraction risk, the pro-
tection coming from tranches A and B.

Accrual Tranches
In Deal 1, the payment rules for interest provide for all tranches to be
paid interest each month. In many sequential-pay CMO structures, at
least one tranche does not receive current interest. Instead, the interest
for that tranche would accrue and be added to the principal balance.
Such a bond class is commonly referred to as an accrual tranche or a Z
bond (because the bond is similar to a zero-coupon bond). The interest
that would have been paid to the accrual tranche is then used to speed
up pay down of the principal balance of earlier tranches.
To see this, consider Deal 2, a hypothetical CMO structure with the
same collateral as Deal 1 and with four tranches, each with a coupon
rate of 7.5%. The difference is in the last tranche, Z, which is an accrual
tranche. The structure for Deal 2 is shown in Exhibit 9.5.

EXHIBIT 9.5 Deal 2: A Hypothetical Four-Tranche Sequential-Pay Structure
with an Accrual Bond Class

Tranche Par Amount Coupon rate (%)

A $194,500,000 7.5
B 36,000,000 7.5
C 96,500,000 7.5
Z (Accrual) 73,000,000 7.5
Total $400,000,000

Payment rules:
1. For payment of periodic coupon interest: Disburse periodic coupon interest to
tranches A, B, and C on the basis of the amount of principal outstanding at the be-
ginning of the period. For tranche Z, accrue the interest based on the principal plus
accrued interest in the previous period. The interest for tranche Z is to be paid to the
earlier tranches as a principal paydown.
2. For disbursement of principal payments: Disburse principal payments to tranche
A until it is completely paid off. After tranche A is completely paid off, disburse prin-
cipal payments to tranche B until it is completely paid off. After tranche B is com-
pletely paid off, disburse principal payments to tranche C until it is completely paid
off. After tranche C is completely paid off, disburse principal payments to tranche Z
until the original principal balance plus accrued interest is completely paid off.
169
Short-Term Mortgage-Backed Securities



It can be shown that the expected ¬nal maturity for tranches A, B,
and C will shorten as a result of the inclusion of tranche Z. The ¬nal
payout for tranche A is 64 months rather than 81 months; for tranche B
it is 77 months rather than 100 months; and for tranche C it is 112
months rather than 178 months. The average lives for tranches A, B,
and C are shorter in Deal 2 compared to Deal 1 because of the inclusion
of the accrual tranche. For example, at 165 PSA, the average lives are as
follows:

Structure Tranche A Tranche B Tranche C

Deal 1 3.48 7.49 11.19
Deal 2 2.90 5.86 7.87


The reason for the shortening of the non-accrual tranches is that the
interest that would be paid to the accrual tranche is being allocated to
the other tranches. Tranche Z in Deal 2 will have a longer average life
than tranche D in Deal 1. These shorter term average life tranches are
more attractive to cash managers than the deal without an accrual
tranche.

Floating-Rate Tranches
Now let™s see how a ¬‚oating-rate tranche can be created from a ¬xed-
rate tranche. This is done by creating a ¬‚oater and an inverse ¬‚oater. We
will illustrate the creation of a ¬‚oater and an inverse ¬‚oater tranche
using the hypothetical CMO structure Deal 2, which is a four tranche
sequential-pay structure with an accrual tranche. We can select any of
the tranches from which to create a ¬‚oater tranche and an inverse
¬‚oater tranche. In fact, we can create these two securities for more than
one of the four tranches or for only a portion of one tranche.
In this case, we created a ¬‚oater and an inverse ¬‚oater from tranche
C. The par value for this tranche is $96.5 million, and we create two
tranches that have a combined par value of $96.5 million. We refer to
this CMO structure with a ¬‚oater and an inverse ¬‚oater as Deal 3. It has
¬ve tranches, designated A, B, FL, IFL, and Z, where FL is the ¬‚oating-
rate tranche and IFL is the inverse ¬‚oating-rate tranche. Exhibit 9.6
describes Deal 3. Any reference rate can be used to create a ¬‚oater and
the corresponding inverse ¬‚oater. The reference rate selected for setting
the coupon rate for FL and IFL in Deal 3 is 1-month LIBOR. The princi-
pal paydown for the ¬‚oater and inverse ¬‚oater is proportionate to the
amount of the principal paydown of tranche C.
170 THE GLOBAL MONEY MARKETS



EXHIBIT 9.6 Deal 3: A Hypothetical Five-Tranche Sequential-Pay Structure with
Floater, Inverse Floater, and Accrual Tranches

Tranche Par amount Coupon rate

A $194,500,000 7.50%
B 36,000,000 7.50%
FL 72,375,000 1-mo. LIBOR + 0.50
28.50 ’ 3 — (1-mo. LIBOR)
IFL 24,125,000
Z (Accrual) 73,000,000 7.50%
Total $400,000,000

Payment rules:
1. For payment of periodic coupon interest: Disburse periodic coupon interest to
tranches A, B, FL, and IFL on the basis of the amount of principal outstanding at the
beginning of the period. For tranche Z, accrue the interest based on the principal plus
accrued interest in the previous period. The interest for tranche Z is to be paid to the
earlier tranches as a principal paydown. The maximum coupon rate for FL is 10%;
the minimum coupon rate for IFL is 0%.
2. For disbursement of principal payments: Disburse principal payments to tranche
A until it is completely paid off. After tranche A is completely paid off, disburse prin-
cipal payments to tranche B until it is completely paid off. After tranche B is com-
pletely paid off, disburse principal payments to tranches FL and IFL until they are
completely paid off. The principal payments between tranches FL and IFL should be
made in the following way: 75% to tranche FL and 25% to tranche IFL. After
tranches FL and IFL are completely paid off, disburse principal payments to tranche
Z until the original principal balance plus accrued interest is completely paid off.

The amount of the par value of the ¬‚oater tranche will be some por-
tion of the $96.5 million. There are an in¬nite number of ways to cut up
the $96.5 million between the ¬‚oater and inverse ¬‚oater, and ¬nal parti-
tioning will be driven by the demands of investors. In Deal 3, we made the
¬‚oater from $72,375,000 or 75% of the $96.5 million. Therefore, for
every $100 of principal received in a month, the ¬‚oater receives $75 and
the inverse ¬‚oater receives $25. The coupon rate on the ¬‚oater is set at 1-
month LIBOR plus 50 basis points. So, for example, if LIBOR is 3.75% at
the coupon reset date, the coupon rate on the ¬‚oater is 3.75% + 0.5%, or
4.25%. There is a cap on the coupon rate for the ¬‚oater (discussed later).
Unlike the ¬‚oaters discussed in Chapter 7 whose principal is
unchanged over the life of the instrument, the ¬‚oater™s principal balance
declines over time as principal repayments are made. The principal pay-
ments to the ¬‚oater are determined by the principal payments from the
tranche from which the ¬‚oater is created. In Deal 3, this is tranche C.
Since the ¬‚oater™s par value is $72,375,000 of the $96.5 million, the
balance is the inverse ¬‚oater. Assuming that 1-month LIBOR is the ref-
171
Short-Term Mortgage-Backed Securities



erence rate, the coupon reset formula for an inverse ¬‚oater takes the fol-
lowing form:
K ’ L — (1-month LIBOR)

In Deal 3, K is set at 28.50% and L at 3. Thus, if 1-month LIBOR is
3.75%, the coupon rate for the month is:
28.50% ’ 3 — (3.75%) = 17.25%

K is the cap or maximum coupon rate for the inverse ¬‚oater. In Deal
3, the cap for the inverse ¬‚oater is 28.50%.
The L or multiple in the coupon reset formula for the inverse ¬‚oater
is called the “coupon leverage.” The higher the coupon leverage, the
more the inverse ¬‚oater™s coupon rate changes for a given change in 1-
month LIBOR. For example, a coupon leverage of 3 means that a 1-
basis point change in 1-month LIBOR will change the coupon rate on
the inverse ¬‚oater by 3 basis points.
Because 1-month LIBOR is always positive, the coupon rate paid to
the ¬‚oating-rate tranche cannot be negative. If there are no restrictions
placed on the coupon rate for the inverse ¬‚oater, however, it is possible
for the coupon rate for that tranche to be negative. To prevent this, a
¬‚oor, or minimum, is placed on the coupon rate. In many structures, the
¬‚oor is set at zero. Once a ¬‚oor is set for the inverse ¬‚oater, a cap is
imposed on the ¬‚oater. In Deal 3, a ¬‚oor of zero is set for the inverse
¬‚oater. The ¬‚oor results in a cap for the ¬‚oater of 10%.
As noted in Chapter 7, inverse ¬‚oaters have substantial price volatil-
ity, a point that was unfortunately not recognized by some cash or
short-duration managers who purchased them in anticipation of a
decline in interest rates.

Planned Amortization Class Tranches
A planned amortization class (PAC) bond is one in which a schedule of
principal payments is set forth in the prospectus. The PAC bondholders
have priority over all other bond classes in the structure with respect to
the receipt of the scheduled principal payments. While there is no assur-
ance that the principal payments will be actually realized so as to satisfy
the schedule, a PAC bond is structured so that if prepayment speeds are
within a certain range of prepayment speeds, the collateral will generate
suf¬cient principal to meet the schedule of principal payments.1
1
For an explanation of how a PAC schedule is created, see Chapter 6 in Frank J.
Fabozzi and Chuck Ramsey, Collateralized Mortgage Obligations: Structures and
Analysis (New Hope, PA: Frank J. Fabozzi Associates, 1999).
172 THE GLOBAL MONEY MARKETS



EXHIBIT 9.7 Deal 4: Structure with One PAC Bond and One Support Bond

Tranche Par amount Coupon rate (%)

P (PAC) $243,800,000 7.5
S (Support) 156,200,000 7.5
Total $400,000,000

Payment rules:
1. For payment of periodic coupon interest: Disburse periodic coupon interest to
each tranche on the basis of the amount of principal outstanding at the beginning of

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