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CMO
Glossary
Accretion bond: See
“Z-tranche.”
Accrual bond: See
“Z-tranche.”
Accrued interest: Interest
deemed to be earned on a security but not yet paid to the investor.
Active Tranche: A CMO
tranche that is currently paying principal payments to investors.
Amortization:
Liquidation of a debt through installment payments.
Average Life:
On a mortgage security, the average time to receipt of each dollar of
principal, weighted by the amount of each principal prepayment, based
on prepayment assumptions.
Basis Point:
One-one hundredth (1/100 or .01) of one percent. Yield differences
among bonds are stated in basis points.
Beneficial Owner:
One
who
benefits from owning a security, even if the security's title of
ownership is in the name of a broker or bank (“street name”).
Bid:
The price at which a buyer is willing to buy a security.
Bond Equivalent Yield: An
adjustment to a CMO yield which reflects its greater present value,
created because CMOs pay monthly or quarterly interest, as opposed to
semiannual interest payments on most other types of bonds.
Book-entry:
A method of recording and transferring ownership of securities
electronically, thereby eliminating the need for physical certificates.
Call Risk:
For a CMO, the risk that declining interest rates may accelerate
mortgage loan prepayment speeds, causing an investor's principal to be
returned sooner than expected. As a consequence, investors may have to
reinvest their principal at a lower rate of interest.
Cap: The upper limit for the
interest rate on an adjustable-rate loan or security.
Clean CMO: See
“Sequential-pay CMO.”
CMO: (Collateralized
Mortgage Obligation) A multiclass bond
backed by
a pool of mortgage pass-through securities or mortgage loans. See
“REMIC.”
CMT: (Constant Maturity
Treasury) A series of indexes of various maturities (one, three, five,
seven, or ten years) published by the Federal Reserve Board and based
on the average yield of a range of Treasury securities adjusted to a
constant maturity corresponding to that of the index.
COFI: (Cost of Funds
Index)
A bank index reflecting the weighted average interest rate paid by
savings institutions on their sources of funds. There are national and
regional COFI indexes.
Collateral:
Securities or property pledged by a borrower to secure payment of a
loan. If the borrower fails to repay the loan, the lender may take
ownership of the collateral. Collateral for CMOs consists primarily of
mortgage pass-through securities or mortgage loans, although it may
also encompass letters of credit, insurance policies, or other credit
enhancements.
Companion Tranche:
A CMO tranche that absorbs a higher level of the impact of collateral
prepayment variability in order to stabilize the principal payment
schedule for a PAC or TAC tranche in the same offering.
Confirmation:
A document used by securities dealers and banks to state in writing the
terms and execution of a verbal arrangement to buy or sell a security.
Conventional Mortgage Loan:
A mortgage loan granted by a bank or thrift institution that is based
solely on real estate as security and is not insured or guaranteed by a
government agency.
CPR: (Constant
Prepayment
Rate) The percentage of outstanding mortgage loan principal that
prepays in one year, based on the annualization of the Single Monthly
Mortality (SMM), which reflects the outstanding mortgage loan principal
that prepays in one month.
Current Face: The
current
remaining monthly principal on a mortgage security. Current face is
computed by multiplying the original face value of the security by the
current principal balance factor.
CUSIP
number: A unique
nine-digit identification number permanently assigned by the Committee
on Uniform Securities Identification Procedures to each publicly traded
security at the time of issuance. If the security is in physical form,
the CUSIP number is printed on its face.
Delivery Versus Payment: AKA "DVP". A manner in which the buyer's
payment for securities is due at transaction the time of delivery
(usually to a bank acting as agent for the buyer) upon receipt of the
securities. The payment may be made by bank wire, check, or direct
credit to an account.
Extension Risk: For a CMO,
the risk that rising interest rates may slow the anticipated prepayment
speeds, causing investors to find their principal committed longer than
they expected. As a consequence, they may miss the opportunity to earn
a higher rate of interest on their money.
Face Value:
The par value of a security, as distinct from its market value.
Factor: A decimal value
reflecting the proportion of the outstanding principal balance of a
mortgage security, which changes over time, in relation to its original
principal value. The Bond Buyer publishes the “Monthly Factor Report,”
which contains a list of factors for Ginnie Mae, Fannie Mae, and
Freddie Mac securities. Fannie Mae, Freddie Mac, and trustees of
private-label CMOs also publish CMO tranche factors.
Floating-rate CMO: A CMO
tranche which pays an adjustable rate of interest tied to a
representative interest rate index such as the London Interbank Offered
Rate (LIBOR), the Constant Maturity Treasury (CMT), or the Cost of
Funds Index (COFI). Floor: The lower limit
for
the interest rate on an adjustable-rate loan or security.
Free Delivery : Securities industry procedure whereby delivery of
securities sold is made to the buying customer's bank without requiring
immediate payment; thus a credit agreement of sorts. Antithesis of
delivery vs. payment.
Hedge:
A commitment or investment made with the intention of minimizing the
impact of adverse movements in interest rates or securities prices and
offsetting potential losses. Inverse
floater: A CMO
tranche that pays an adjustable rate of interest that moves in the
opposite direction from movements in a representative interest rate
index such as the London Interbank Offered Rate (LIBOR), the Constant
Maturity Treasury (CMT), or the Cost of Funds Index (COFI).
IO (interest-only)
security:
In the case of a CMO, an IO tranche is created deliberately to pay
investors only interest and not principal. IO securities are priced at
a deep discount to the “notional” amount of principal used to calculate
the amount of interest due. Issue date:
The date on which a security is deemed to be issued or originated.
Issuer:
An entity which issues and is obligated to pay amounts due on
securities.
Jump Z-tranche: A
Z-tranche that may start receiving principal payments before prior
tranches are retired if market forces create a “triggering” event, such
as a drop in Treasury yields to a defined level, or a prepayment
experience that differs from assumptions by a specific margin. “Sticky”
jump Z-tranches maintain their changed payment priority until they are
retired. “Non-sticky” jump Z-tranches maintain their priority only
temporarily for as long as the triggering event is present. Although
jump Z-tranches are no longer issued, some still trade in the secondary
market.
LIBOR: (London Interbank
Offered Rate) The interest rate banks charge each other for short-term
Eurodollar loans ranging from overnight to five years in maturity.
Lockout: The period of time
before a CMO investor will begin receiving principal payments.
Maturity Date:
The date on which the principal amount of a security is due and payable.
Mortgage A legal instrument
that creates a lien upon real estate securing the payment of a specific
debt.
Mortgage loan: A loan
secured by a mortgage. Mortgage
pass-through
security:
A security representing a direct interest in a pool of mortgage loans.
The pass-through issuer or servicer collects the payments on the loans
in the pool and “passes through” the principal and interest to the
security holders on a pro rata basis. Mortgage pass-through securities
are also known as mortgage-backed securities (MBS) and participation
certificates (PC). Negative convexity: A
characteristic of CMOs and other callable or prepayable securities that
causes investors to have their principal returned sooner than expected
in a declining interest rate environment or later than expected in a
rising interest rate environment. In the former scenario, investors may
have to reinvest their funds at lower rates (“call risk”); in the
latter, they may miss an opportunity to earn higher rates (“extension
risk”).
Offer: The price at
which a
seller will sell a security.
Original
face: The face
value or original principal amount of a security on its issue date.
PAC (planned amortization
class) tranche: A CMO tranche that uses a mechanism similar to a
sinking fund to determine a fixed principal payment schedule that will
apply over a range of prepayment assumptions. The effect of the
prepayment variability that is removed from a PAC bond is transferred
to a companion tranche.
Par: A price equal
to the
original face amount of a security, as distinct from its market value.
On a debt security, the par or face value is the amount the investor
has been promised to receive from the issuer at maturity.
Payment date: The date that
principal and interest payments are paid to the record owner of a
security. P&I (principal and
interest): The term used to refer to regularly scheduled payments or
prepayments of principal and of interest on mortgage securities.
Plain-vanilla CMO:
See “Sequential-pay CMO.”
PO
(principal-only)
security:
In the case of a CMO, a PO tranche is created deliberately to pay
investors principal only and not interest. PO securities are priced at
a deep discount from their face value.
Pool:
A collection of
mortgage loans assembled by an originator or master servicer as the
basis for a security. In the case of Ginnie Mae, Fannie Mae, or Freddie
Mac mortgage pass-through securities, pools are identified by a number
assigned by the issuing agency.
Prepayment:
The unscheduled partial or complete payment of the principal amount
outstanding on a mortgage loan or other debt before it is due.
Price: The dollar amount to
be paid for a security, which may also be stated as a percentage of its
face value or par in the case of debt securities.
Principal:
With mortgage securities, the amount of debt outstanding on the
underlying mortgage loans.
Private label:
The term used to describe a mortgage security whose issuer is an entity
other than a U.S. government agency or U.S. government-sponsored
enterprise. Such issuers may be subsidiaries of investment banks,
financial institutions, or home builders.
Ratings:
Designations used by investors' services to give relative indications
of credit quality.
Record date: The date for
determining the owner entitled to the next scheduled payment of
principal or interest on a mortgage security.
REMIC:
Real Estate Mortgage Investment Conduit. As a result of a change in the
1986 Tax Reform Act, most CMOs are today issued in REMIC form to create
certain tax advantages for the issuer. The terms “REMIC” and “CMO” are
now used interchangeably.
Residual:
In a CMO, the residual is that tranche which collects any cash flow
from the collateral that remains after obligations to the other
tranches have been met.
Scenario Analysis:
Examining
the likely performance of an investment under a wide range of possible
interest rate environments.
Sequential-pay
CMO:
The most basic type of CMO, in which all tranches receive regular
interest payments, but principal payments are directed initially only
to the first tranche until it is completely retired. Once the first
tranche is retired, the principal payments are applied to the second
tranche until it is fully retired, and so on. Servicing
Collection
and
pooling
of principal, interest, and escrow payments on mortgage loans
and mortgage pools, as well as certain operational procedures such as
accounting, bookkeeping, insurance, tax records, loan payment
follow-up, delinquency loan follow-up, and loan analysis. The party
providing the servicing receives a servicing fee.
Servicing Fee:
The amount retained by the mortgage servicer from monthly interest
payments made on a mortgage loan.
Settlement Date:
The date agreed upon by the parties to a transaction for the delivery
of securities and payment of funds.
Sinking Fund:
Money set aside on a regular basis, sometimes from current earnings,
for the specific purpose of redeeming debt.
SMM (Single Monthly
Mortality):
The percentage of outstanding mortgage loan principal that prepays in
one month.
Standard Prepayment Model of
The Bond Market Association: A model based on historical mortgage
prepayment rates that is used to estimate prepayment rates on mortgage
securities. The Association's model is based on the Constant Prepayment
Rate (CPR), which annualizes the Single Monthly Mortality (SMM), or the
amount of outstanding principal that is prepaid in a month. Projected
and historical prepayment rates are often expressed as “percentage of
PSA” (Prepayment Speed Assumptions). A prepayment rate of 100% PSA
implies annualized prepayment rates of 0.2% CPR in the first month,
0.4% CPR in the second month, 0.6% CPR in the third month, and 0.2%
increases in every month thereafter until the thirtieth month, when the
rate reaches 6%. From the thirtieth month until the mortgage loan
reaches maturity, 100% PSA equals 6% CPR. Super
PO
A
principal-only
security structured as a companion bond.
Superfloater:
A
floating-rate CMO tranche whose rate is based on a formulaic
relationship to a representative interest rate index.
Support Tranche:
See “Companion tranche.”
T+3:The settlement date for securities transactions such as a stock
sale. It refers to the obligation in the brokerage business to settle
securities trades by the third day following the trade date. The
settlement occurs when the seller receives the sales price (the
broker's commission) and the buyer receives the shares.
TAC tranche:
Targeted
amortization class tranche. A TAC tranche uses a mechanism similar to a
sinking fund to determine a fixed principal payment schedule based on
an assumed prepayment rate. The effect of prepayment variability that
is removed from the TAC tranche is transferred to a companion tranche.
Toggle Tranche:
See “Jump Z-tranche.” Tranche: A class of
bonds in
a CMO offering which shares the same characteristics. “Tranche” is the
French word for “slice.”
Transfer agent:
A party appointed to maintain records of securities owners, to cancel
and issue certificates, and to address issues arising from lost,
destroyed, or stolen certificates. Trustee:
An
individual
or
institution that holds assets for the benefit of another.
Weighted Average Coupon
(WAC):
The weighted average interest rate of the underlying mortgage loans or
pools that serve as collateral for a security, weighted by the size of
the principal loan balances.
Weighted Average Loan Age
(WALA):
The weighted average number of months since the date of the loan
origination of the mortgages in a mortgage pass-through security pool
issued by Freddie Mac, weighted by the size of the principal loan
balances.
Weighted Average Maturity
(WAM):
The weighted average number of months to the final payment of each loan
backing a mortgage security, weighted by the size of the principal loan
balances. Also known as weighted average remaining maturity (WARM) and
weighted average remaining term (WART).
Window:
In a CMO bond, the period of time between the expected first payment of
principal and the expected last payment of principal.
Yield:
The annual percentage rate of return earned on a security, as computed
in accordance with standard industry practices. Yield is a function of
a security's purchase price and interest rate.
Z-tranche:
Often the last tranche in a CMO, the Z-tranche receives no cash
payments for an extended period of time until the previous tranches are
retired. While the other tranches are outstanding, the Z-tranche
receives credit for periodic interest payments that increase its face
value but are not paid out. When the other tranches are retired, the
Z-tranche begins to receive cash payments that include both principal
and continuing interest.
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