Fixed Income Research Commentary Collateralized Mortgage Obligations: An Introduction to Sequentials, PACs, TACs, and VADMs

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1 April 1, 2010 Ruben Hovhannisyan Vice President U.S. Fixed Income Fixed Income Research Commentary An Introduction to Sequentials, PACs, TACs, and VADMs The Evolution of Mortgage Securities The U.S. mortgage market is the largest and perhaps most diverse sector of the fixed income landscape. Mortgage securities are segmented according to whether they are guaranteed by an agency or an instrumentality of the Federal government (so-called agency mortgages) or whether their credit enhancement is a function of the underlying collateral (the mortgage loans themselves) in combination with various forms of structural credit enhancement built into the actual bonds. The most basic form of claim in the mortgage market is the pass-through. Essentially, an underwriter (typically a Wall Street firm) buys some number of mortgage loans from an originator (a bank or mortgage broker) and places them into a bankrupt-remote trust, generally a so-called REMIC (a real-estate mortgage investment conduit) 1. The homeowners make their monthly payments to their respective mortgage servicer who then remits the monies (principal and interest) to the REMIC. The cash is then distributed to the mortgage pass-through note holders in a pro rata manner. Hence, the pass-through in and of itself is simply a mechanism by which "shares" in a pool of mortgages can be securitized and distributed. The mortgage market, a financial innovation of the late 1970s, was designed to solve one of the problems brought on by the combination of Regulation T (which prevented banks and S&Ls from paying more than 5 1/4% on deposits) and various laws which restricted interstate banking activity. The mortgage market became a mechanism by which prospective homeowners in fast growth states (think Sunbelt states in the in the late 1970s) could gain access to savers from slow growth states (think Snowbelt from the same era). In essence, the advent of mortgage securitization expanded the pool of available mortgage lenders beyond the state level to the nation as a whole and, now, worldwide. To improve mortgage product distribution, Wall Street further developed the mortgage market with the creation of the Collateralized Mortgage Obligation (CMO). The CMO became a means by which the principal and interest payments coming off the mortgage pools could be redistributed in a variety of cash flow packages. Initially, these packages took the form of the "sequential pay" CMO, which over time was expanded to include a very wide variety of structures and cash flows designed to suit the individual preferences of investors (and to enhance the profitability of the Wall Street underwriters). Although there can seem to be an overwhelming number of CMO variations, these variations all ultimately derive from the rules governing payment of principal and a complimentary set of rules specifying payment of interest. 1 In the case of agency MBS, the originator packages the loans and swaps them for MBS pass-throughs with an agency (Government Sponsored Enterprise), which charges a guarantee fee to ensure timely interest and principal payments. The originator then sells the pass-throughs to Wall Street firms.

2 As it relates to the modalities of principal payment structures, the basic menu as to how a CMO can pay is as follows: Pass-through/Pro-rata Sequential Planned Amortization Class (PAC) Targeted Amortization Class (TAC) Companion Very Accurately Defined Maturity (VADM) Interest-Only Principal-Only The menu of options for paying interest is as follows: Fixed rate Floating rate Inverse Floating rate Interest-Only TTIB (Two-tiered Indexed bond) Principal-Only Accrual (pay-in-kind, known as Z bonds) Super Floaters The scope of this brief is to provide an overview of that group of CMOs referred to as sequentials, PACs, TACs and VADMs. As a general rule, these CMO types are those which present a relatively stable cash flow profile, even as prepayments fluctuate. In so doing, Wall Street is servicing the demand for lower volatility mortgage assets. Of course, it goes almost without saying that the presence of prepayment-protected CMOs forces into existence those CMOs that exhibit an exaggerated response to fluctuating prepayments. In effect, the CMO marketplace is a mechanism by which some investor (the buyer of a PAC) is able to express his preference for more stability by sacrificing yield. Conversely, other investors (buyers of companion tranches) can receive higher yield by accepting the relatively elevated prepayment risk of their CMO holdings. Sequential Plain Vanilla CMOs The sequential CMO is perhaps the simplest to describe in terms of structure. A pool of say 30-year mortgage passthroughs is placed into a REMIC trust. Assume the entire pool is carved up into a sequential CMO. In that event, the claims priority on the cash flows initially resembles: A basic way to understand the CMO market is simply to recognize that the CMO is a mechanism for repackaging and re-arranging cash flows generated by pools of mortgage pass-throughs. Significantly, the structuring desks can mix and match the aforementioned principal payment structures with the various interest payment structures. It is via these combinations that the seeming menagerie of CMO bonds proliferates. For instance, a sequential-pay bond can be either a fixed rate or floating rate sequential. Alternatively, a fixed rate pass-through may be used to create an inverse IO and a floating rate bond. Principal A Pool of Mortgage Pass-Throughs B Interest C Z VADM 2

3 Beginning with the first tranche of a vanilla deal, each bond receives all the principal payments until it is completely paid down; then the next tranche begins to receive principal until it is completely paid down. Obviously, fast prepayments on sequential structures will shorten the average lives of the individual bonds. However, plain vanilla CMOs have some degree of protection against prepayments because every preceding tranche has to be paid off in-full before prepayments begin to affect sequentials situated further back in the deal structure. The average lives of sequential bonds are generally stable, but can be greatly influenced by the presence of Z-bonds in the deal structure. Z-bonds are accrual structures which receive no interest (only payment-in-kind) until their principal begins to pay down. Interest accrued on a Z-bond is deferred and added to the principal of the Z-bond ( Z accretion ), while the interest cash flows are applied to VADM bonds. The presence of a long sequential Z-bond adds stability to the earlier sequential tranches. Sequential bonds are ordinarily priced on the basis of some spread over that Treasury whose maturity corresponds to the tranche s expected average life. In upwardly sloped yield curve environments, Wall Street underwriters prefer to use faster rather than slower prepayment assumptions. In so doing, all tranches are assumed to have shorter average lives and get priced off lower yielding (higher priced) parts of the Treasury curve. Generally, sequential spreads will be wider than protected classes (like PACs), but narrower than more volatile average life bonds (like companions). Planned Amortization Class (PAC) Bonds Planned Amortization Class (PAC) bonds were launched in 1986 to present the capital markets with a mortgage security with a better defined trajectory of cash flows versus that of a sequential payer. The payment rules for the PAC are such that the cash flow schedule is guaranteed as long as prepayment speeds 2 stay within a stated range called the PAC band. The PAC band specifies the low and high future prepayment rates within which the bond s payments remain exactly defined. As such, a PAC is said to offer call protection (i.e. protection against the risk of the shortening of the bond s average life due to elevated prepayment rates) as well as extension protection (i.e. protection from the bond lengthening its average life due to slower prepayments). Scheduled principal payments to PAC bonds are protected from prepayment risk by surrounding classes of securities known as the companion bonds or support classes. The companion tranches around the PAC absorb excess cash flow in times of high prepayments, and release principal in times of low prepayments. Because the companion bonds around the PAC serve as a principal buffer, the PAC itself has added stability. Conversely, the effect of principal prepayments on the average life and cash flow of the companion bonds becomes exaggerated. Once again, stability of cash flow in one part of the capital structure of a CMO can only be enhanced at the expense of another part of the CMO, hence the inverse stability relationship between a PAC and its corresponding companion bond. Prepayment Speed 6 CPR 10 CPR 15 CPR 18 CPR 20 CPR Avg Life 1.68 yrs 1.14 yrs 1.14 yrs 1.14 yrs 1.07 yrs PAC bond exhibits stable characteristics when prepayments 2 remain within the PAC band range. 2 Prepayment speeds that form the PAC band generally follow PSA convention, which assumes that prepayment rate starts at zero, gradually increases in the first 30 months, and stays constant thereafter. 3

4 The degree of call or extension protection offered by PAC bonds depends upon the width of the band, which is largely dependent on the size of the support classes. The higher the percentage of companion bonds within the CMO structure, the more stable the PAC bonds will be. PAC bands delimit the range of prepayment speeds in which principal cash flow is guaranteed. Outside the bands, PAC bond average lives may shorten or extend significantly depending on the structure of the CMO. When a PAC bond is subjected to prepayment rates outside those of the band for a sustained period or if prepayments are within the band, but are not stable month to month, the PAC may, at some point, become broken. A broken PAC no longer possesses the desirable traits of a well-defined cash flow profile. Although breaking a PAC s schedule will generally have an unfavorable effect on the valuation of a PAC bond, the net effect will also be impacted by the bond s coupon level relative to the prevailing market yields. Breaking the lower band of a PAC which pays a premium coupon will have a net positive effect on the yield of the bond as the holders of the bond will enjoy higher coupon rates for a longer time horizon. Similarly, breaking the upper band of a discount coupon PAC will result in the earlier receipt of principal and, consequently, will have a positive impact on the yield of the PAC bond, although the bond may be paid off sooner than originally anticipated. In response to the very high level of prepayment instabilities which the mortgage markets have witnessed over the past twenty years, Wall Street has invented the Super-PAC. The Super-PAC works in conjunction with one or more subordinate PACs in order to create a bond which has a broader measure of protection than a regular PAC. A Super-PAC is meant to be highly resistant to becoming broken. Of course, the subordinate PACs have a correspondingly lower degree of prepayment protection versus that of a regular PAC, and are more readily broken than a normal PAC. Another variety of PAC is the so-called PAC II. The PAC II actually has some characteristics of companion (support) bonds; hence, the name is a bit misleading. Suffice it to say that a PAC II provides some principal payment stability within a much narrower range of prepayments than is typical for a regular PAC (i.e. a so-called PAC I). Targeted Amortization Class (TAC) Bonds Unlike PAC bonds which offer both call and extension protection, TACs offer only one-sided protection, against call risk only. When rates fall and prepayments rise, the principal cash flow to the TAC will remain fairly stable. When rates rise and prepayments slow, TACs will ordinarily extend (sometimes dramatically) their average life. In this sense, a TAC bond has characteristics similar to that of a companion bond. Indeed, a TAC is often used as a companion class to a PAC bond. TACs are able to adhere to their principal payment schedules because of still other companion bonds that absorb excess cash flow when prepayments are high. High prepayments cause the companion bonds which support the TAC to be paid off before the TAC is fully paid down. Once all the companion bonds are retired, the TAC receives all the principal cash flow from the remaining collateral. This cash flow may not be enough to meet the TAC s initial principal payment schedule. Hence, the TAC may receive cash flows beyond its original maturity date. TACs are priced at some spread over the Treasury curve. Generally speaking, TAC spreads will be wider than PAC bonds of similar average life, reflecting the lesser stability of the TAC. 4

5 Very Accurately Defined Maturity (VADM) Bonds Very Accurately Defined Maturity (VADM) bonds represent yet another structure designed to protect investors from extension risk caused by rising interest rates. The first VADM bonds were created in the 1990s in response to government regulation which required banks and thrifts to invest a fraction of their assets in high-quality, short-term securities guaranteed not to extend beyond a certain date. Wall Street was quick to meet the new demand by designing VADM bonds, which derive all their cash flows from the interest accrued to (but not paid to) a Z-bond. Given that Z-bonds will continue accruing interest even under zero prepayments scenarios, there is virtually no event that may cause an extension of a VADM bond. Conversely, even if interest rates fall sharply and prepayments skyrocket, VADM bonds still cushion against call risk. This (limited) protection against call risk is predicated on the fundamental cash flow characteristics of underlying Z-bonds, which are usually the last tranche in a CMO structure to receive principal. Conclusion Sequentials, PACs, TACs and VADMs represent the most basic CMO types and the ones with generally more stable average life and duration profiles. The stability of these CMO structures is achieved through pairing these bonds with one or more CMO tranches with more volatile prepayment response profiles, such as companions or Z-bonds, which act as buffers and absorb some of the impact from interest rate and prepayment rate volatility. An overview of some of these more volatile CMO types as well as mortgage derivative securities (e.g. IOs, POs, inverse floaters, etc.) will follow in subsequent briefs. This publication is for information purposes only. While the information and statistical data contained herein are based on sources believed to be reliable, we do not represent that it is accurate and should not be relied on as such or be the basis for an investment decision. Any opinions expressed are current only as of the time made and are subject to change without notice. TCW assumes no duty to update any such statements. Copyright TCW 2010 METWEST IS A WHOLLY-OWNED SUBSIDIARY OF THE TCW GROUP, INC. 865 South Figueroa Street Los Angeles, California DFIrsch117 4/7/10