Payments from a CMO

[ChadWOB]

Hi David,

When calculating the expected payment to investors of a CMO, given;

The $MV of the CMO, time period (months), pass-through coupon and the weighted average coupons of the underlying ---which coupon figure should be used to calculate the payment?

My notes on this are unclear to me. I used the pass through coupon to compute the payment, but got a practice question wrong since it used the WAC instead.

I thought that if the WAC of the underlying was higher than the pass through coupon this just served as a sort of credit enhancement for the CMO, since it is taking in more than it is paying out?

 

[David Harper CFA FRM]

Hi Chad,

Yes, I agree. Is question mine, if so, can you point to it, so i can check it?
If you have Excel, maybe my replication of his Table 8-3 will help: https://www.dropbox.com/s/wo8g717oko81d0b/Veronesi_Table8_3.xlsx
(although for exam purposes, I'd be careful about too much time on this, could be a time trap and unproven testability)

I'll use Veronesi's terminology:

• The mortgage pool, on the asset side, gives the structure its cash inflows. That's WAC, i.e., "Coupon, C(t)" in Veronesi.
• The securities/notes, on the liabilities side, are outflows to investors. That's "total cash flow" which includes "pass-through interest" to investors; aka, "security coupon rate"
• As you say, WAC (inflow) should be greater than pass-through coupon rate (outflow to investors). In Veronesi (see XLS), 6.5% WAC > 6.0% r(PT,12).
• The total cash outflow to investors (notes on liability side) equal sum of: the pass-through coupon (return on capital) + scheduled & prepaid principal (return of capital).

Thanks,

 

[ChadWOB]

No this wasn't one of yours. It was a Schweser question on one of their mock exams. Their material is rife with errors.

Thank you for clearing this up! For what its worth, you've been a great resource for me (am I'm sure many others on this forum) in preparing for this exam. I will certainly spread the word to others pursuing the FRM and/or CFA.

When I'm done with the FRM (fingers crossed) I'm going to look into your CFP material (since only Schweser was available when I did this one a few years back) as a possible resource for my colleagues pursuing the CFP.

 

[David Harper CFA FRM]

Chad,

Thank you, we really appreciate the generous feedback! The issue of errors holds great interest for me; e.g., I trained under a mentor (or two) who cherished quality. So I do value it. But, at the same time, any witness of this forum over the last few weeks, especially while i posted my mock exam questions in near real-time, can see that I make plenty of errors, too. (in fact, we have a customer or two who is currently dissatisfied with our error rate). I do (candidly) think we separate ourselves from the others, and sadly from GARP too, in our follow-up. I think everybody understands that everybody makes some errors, but there is a big difference in how you deal with that knowledge in terms of your process. So, i think it becomes a question about (i) whether there exists a sincere intent to understand the concept details and (ii) whether there is a process to deal with errors conditional on the knowledge that errors will be committed. Thanks!