FIN 2227

Fixed Income Markets & Valuation

LN12.1

Managing Risk in the Mortgage

Sector (CMOs & CDS)
Lecture Note 12

LN12.2

Required Readings
Readings
Textbook: Fabozzi Ch. 12 pp. 248-254; Ch.
32 pp. 754-759; Excel Spreadsheet
Supplemental Articles:
China Becomes Asias Biggest Securitization
Market WSJ
Banks Finalize $1.86 Billion Credit-Swaps
Settlement WSJ

LN12.3

Where we are headed . . .

Collateralized Mortgage Obligations
Credit Default Swaps
CDS and the Mortgage Crisis

LN12.4

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 Obligations: CMOs

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

Mortgage Pool

Tranches

Bondholders

LN12.6

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

LN12.7

CMO: Sequential Pay Example

Lets return to our example from the end of
Lecture 11 :

What if we divided this mortgage pool into 3

tranches?
LN12.8

CMO: Sequential Pay Example

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

LN12.9

CMO: Sequential Pay Example

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

LN12.10

Credit Risk: Primary Mortgage Market

Number of Residential Foreclosures in 2008:
By State

Source: CNN
LN12.11

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
LN12.12

Credit Default Swap:

Example

Example:

Premium
Payments
CDS Buyer

CDS Seller

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

Possible Trigger Events

Bankruptcy
Failure to Pay
Restructuring

LN12.13

Growth of CDS Market

Trillions
$

CDS Notional Outstanding

(Annual)

Sources:
LN12.14

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

LN12.15

For Next Class

Group Presentations (12/7 & 12/9)

LN12.16