Collateralized Mortgage Obligation - Essay Example

This proposed quantitative descriptive research study discusses the various valuation methodologies of prepayment speeds with Collateralized Mortgage Obligations (CMO) tranches and analyzes the way the prevalent valuation methods are useful in current complex economic scenarios. The objective of this study is primarily to examine the applicability of various methods of valuation for pricing the CMOs to determine their validity in the present economic conditions. Chapter 1 provides a broad overview of the various facets concerning the valuation of the prepayment speeds within CMO tranches. Collateralized Mortgage Obligations are derivative debt instruments that can be aptly defined as the claim that arises out of cash flows from large pools of home mortgages. The structure of the CMO is such that once the principal and interest are received from the mortgage holders, it is distributed into tranches. The principal amount, the coupon rate, the prepayment risk, and the maturity date differ among the tranches (Economy Watch, n. d.).

CMOs are derivative debt instruments providing both retail and institutional investors the possibility of higher yields with Standard & Poor AA or AAA ratings. Of concern to these investors is that this instrument is very sensitive since it is exposed to interest rate risk. Those investing in CMOs must also contend with the possibility of prepayment risk. The housing and financial bubbles in late 2006 and 2007 created a crisis and showed a decline in the demand for CMOs. The specific problem with CMOs is that existing pricing models cannot quantify risk. This study attempted to determine a standardized valuation model for CMO by taking into consideration the factor of risk. This study focused mainly on the risk factors associated with the valuation methods because the risk at present has evolved as an important factor in the present uncertain environment inclusive of the economic condition of the country (Johnston et al., 2008).

One of the reasons behind the decline of CMO valuations was the U.S. Subprime crisis, which took place in the middle of 2007 and 2008. This period was marked by a fall in stock markets, the collapse of large financial institutions, and a decline in the returns of debt instruments. These factors had become a social concern as they affected society by eroding its investments in various financial instruments including CMOs. The global financial meltdown affected the livelihoods of several people. The subprime crisis arose because of several factors including the enormous securitization due to the pooling of various loans by banks into sellable assets which resulted in transferring risky loans onto others. According to the report of BBC’s former presenter and editor, Evan Davies, the rating agencies were unethically paid to rate these less productive securitized products for personal interests. Banks borrowed large amounts of money to lend out so that they could create more securitization. For Example, Lehman Brothers bought large numbers of mortgages mixing collateral pools during securitization and sold them to other institutions and investors. Commercial banks took the shape of Investment banks and jumped into the process of selling home loan products, mortgages, etc. without any control and management strategy. The banks increased their exposure to problems (Shah, 2010).

Since 2008, more than 200 banks have failed. The Federal Reserve and other bank regulators embarked on a comprehensive assessment of the capital held by the 19 largest U.S banks and ordered 10 of them to raise a total of $75 billion in extra capital (Treasury’s Supervisory Capital Assessment Program, or “SCAP”, completed in the spring of 2009). One of the reasons behind the great financial turmoil is perceived to be the valuation models of asset-backed securities (ABSs). Increasing credit securitization is responsible for the ill effect on society and the economy (European Central Bank, 2008). These disasters, which may have been avoided or partially avoided, provided us with stress testing or pricing models that enabled us to have a better understanding of the risk exposure. 

The specific problem identified is that the current-pricing models cannot quantify risk (Nadler & Klapper, 2005). Current research in the field of repayment modeling has developed two repayment models, which are commonly used. The ‘rational prepayment survey model’ is a model in which mortgagers pay for the value of the mortgage, which exceeds the remaining principal balance of costs incurred as a result of refinancing plus the principal balance (Bandic, 2009). This approach is resilient to structural changes, which occur in the economic environment, but it does not perform well when evaluating CMO tranches. The other approach is the ‘estimation technique.’ In this approach, the prepayment models that are conducted are developed by using mathematical equations that relate to the environmental assumptions to rates of repayments that can vary from time to time.