Suppose that a savings and loan association has decided to invest in mortgage-backed securities and is considering the following two securities: (i) a Freddie Mac pass-through security with a WAM of 340 months or (ii) a PAC tranche of a Freddie Mac

Question

CMO issue with an average life of two years. Which mortgage-backed security would probably be better from an asset/liability perspective?

Answer 1

Below we first describe the two choices in order to establish asset/liability possibilities.

The first choice is a pass-through security. The cash flow of a mortgage pass-through security depends on the cash flow of the underlying mortgages. A weighted average maturity (WAM) is found by weighting the remaining number of months to maturity for each mortgage loan in the pool by the amount of the mortgage outstanding. Freddie Mac issues a pass-through called a participation certificate (PC). In 1990, Freddie Mac introduced its Gold PC, which has stronger guarantees than other PCs it issues and will be the only type of PC issued in the future. Specifically, non-Gold PCs that have been issued are modified pass-throughs. This type of pass-through guarantees both interest and principal payments, but it guarantees only the timely payment of interest. The scheduled principal is passed through as it is collected, with a guarantee that the scheduled payment will be made no later than a specified date. The Freddie Mac
pass-through still entails prepayment risk and uncertainty in cash flows that can be alleviated by creating CMOs.

A CMO is the second choice. A CMO is a security backed by a pool of pass-throughs, whole loans, or stripped mortgage-backed securities. CMOs are structured so that there are several classes of bondholders with varying stated maturities. When there is more than one class of bondholders with the same level of credit priority, the structure is called a pay-through structure, as opposed to a pass-through structure in which there is only one class of bondholders at a given level of credit priority. The bond classes created are commonly referred to as tranches. The principal payments from the underlying collateral are used to retire the tranches on a priority basis according to terms specified in the prospectus. Despite the redistribution of prepayment risk with sequential-pay and accrual CMOs, there is still considerable prepayment risk. That is, there is still considerable average life variability for a given tranche. This problem has been mitigated by the creation of a planned amortization class (PAC) tranche. This type of CMO tranche reduces average life variability. The bonds included in a CMO structure that provide the better protection for PAC tranches are the support or companion tranches. There are various ways in which greater prepayment protection can be provided for some or all of the PAC bonds within a CMO structure. These include a lockout and a reverse PAC structure.

From the above description, we see that both types are backed by the same mortgages and should share in the same credit risk. Thus, the savings and loan association can focus on matching assets and liabilities. There is a significant difference in terms of maturity between the two types. Thus, the savings and loan will choose the Freddie Mac pass-through security with a WAM of 340 months if their liabilities are closer to 340 than two years. The savings and loan will choose the PAC tranche of a Freddie Mac CMO issue with an average life of two years if their liabilities are closer to 24 months than 340 months.