CMOs, CMBS, and Investment Portfolio Fundamentals

CMO (Collateralized Mortgage Obligation):
- A tranche-based, sliced-up mortgage-backed security.
- Offers varied cash flow profiles to suit different needs.
Pass-Through Mortgage-Backed Security:
- Example: 20-year Freddie Mac (FRLMC) with a 2.5% coupon.
- Weighted Average Maturity (WAM) decreases as the loan ages (inverse relationship).
- Seasoning: How long the security has been outstanding. A shorter seasoning means a newer issue.
- Price volatility is a measure of convexity and duration, estimating price changes with rate fluctuations.

Pass-Through Security:
- Yield: 3.55% (in an unchanged rate environment when the bond was a couple of years old).
- Dollar Price: Approximately 94 and 20/32.
- Price Volatility: -15%.
CMO (made from the above pass-through):
- Lower price volatility (e.g., 5% lower).
- Slightly lower yield.
- Shorter average life.

CMOs offer more options by slicing up mortgage-backed securities.
Enable creation of shorter, more stable securities from longer-term mortgages.
Can strip coupons to lower the dollar price.
Offers diversification, range of coupons, and matches ALM (Asset Liability Management), liquidity, and portfolio needs.

CPR (Constant Prepayment Rate):
- An annualized representation of prepayments, indicating the percentage of unscheduled principal returned annually.
- Example: 9% CPR means 9% of the principal is projected to be paid back unscheduled each year.
- CPR increases (e.g., from 9% to 19%) when rates fall due to more refinance activity.

A pass-through security might yield more (e.g., 3.55%) but carries more interest rate risk and a longer average life compared to a CMO.
Example average life: Pass-through security at 6.29 years (at 9 CPR).
A CMO might have a shorter average life (e.g., 3 years) but offers 40 basis points less yield.

Individual bond analysis is important, but consider the entire portfolio.
If a portfolio contains mostly low-risk, low-average-life bonds and there's an anticipated rate drop, longer-duration bonds might be added to hedge the risk.
Conversely, if a portfolio has high price volatility bonds, shorter, more stable bonds might be added.
Balance sheet context: Lending portfolio, deposit portfolio, and liquidity needs should all be considered.

--- ## Commercial Mortgage-Backed Securities (CMBS)

Agency Space:
- Focus on Fannie Mae, Freddie Mac, or Ginnie Mae for protection and lack of credit risk.
Collateral:
- Backed by multifamily loans (apartment complexes).
Call Protection:
- Prioritize securities with prepayment and call protection.
- Mechanisms: Prepayment penalties, defeasance, or yield maintenance.

Common structure: Fixed-rate, 10-year final maturity with 9.5 years of call protection (10-9.5 structure).
Some structures have varying call protection periods (e.g., 10-7 structure).

If a borrower voluntarily prepays during the prepayment penalty period, they must pay a yield maintenance fee.
This fee compensates investors and can increase if rates fall below the note rate.

Fannie Mae DUS Bond (New Construction Apartment Complex):
- Initial interest-only period.
- Amortization begins afterward.
- May be set on a 20-25 year amortization schedule.
Zero CPY Assumption:
- If the bond is not prepaid, the investor receives the remaining principal at the final balloon maturity.
CPY (Constant Prepayment Yield) Assumption:
- Assumes prepayment occurs as soon as the prepayment penalty drops.

Different CMBS bonds can cater to various portfolio needs.
A bond with concentrated cash flows might be suitable if there is a specific cash flow gap to fill in the portfolio.
Spreads: CMBS may offer better spreads compared to agency or treasury securities.

--- ## Accounting Standards for Securities

Held to Maturity (HTM):
- Positive intent and ability to hold until maturity.
Available for Sale (AFS):
- Default category; flexibility to buy, hold, or sell.
Trading:
- Bought to sell quickly, aiming for short-term gains.

Trading: Unrealized gains/losses are marked to market through current income.
HTM: Held at cost or book value; unrealized gains/losses are not marked to market on financial statements.
AFS: Unrealized gains/losses are included in accumulated other comprehensive income (AOCI), impacting equity capital.
- Large unrealized losses can negatively impact total or tangible equity capital.

Each bond is individually designated as AFS or HTM upon purchase.
Tainting: Selling an HTM bond before maturity can taint the entire portfolio, requiring the rest of HTM bonds to be transferred to AFS.
Transferring from AFS to HTM locks in the unrealized loss at the transfer date, which is then amortized over the remaining life of the security.

Fair value and amortized cost are still reported on Schedule RCD for HTM securities, even though unrealized gains/losses are not recognized in tangible/total equity capital.