Mortgage derivative products include:
* Collateralized Mortgage Obligations (CMOs)
* Real Estate Mortgage Investment Conduits (REMICs)
* Stripped Mortgage Backed Securities (SMBSs) = IOs & POs
CMO fails the average life test one quarter, passes the next, how is it handled? (5.4-8)
1) HTM 2) AFS 3) High-Risk 4) Nonhigh-Risk
A mortgage derivative product that was not a high-risk mortgage security when it was purchased may later fall into the high risk category. If this occurs, the mortgage derivative product must be redesignated as AFS or Trading. If CMO was not high-risk at purchase and subsequently fails, you do not have to move it to AFS if management can demonstrate intent and ability to hold to maturity. Once a security is high risk, it can not be considered nonhigh risk until it passes the test 2 consecutive quarters. Once the security is redesignated non-high risk, it does not have to be retested for another year.
Identify which tests the CMO fails given data for each of the three tests. (5.4-5)
Average Life Test - The mortgage derivative product has an expected weighted average life of greater than 10 years.
Average Life Sensitivity Test -The expected Weighted Average Life of the mortgage derivative product extends by more than 4 years, assuming an immediate and sustained parallel shift in the yield curve of +300 basis points, or shortens by more than 6 years, assuming an immediate and sustained parallel shift in the yield curve of -300 basis points. **
Price Sensitivity Test - The estimated change in price of the mortgage derivative product is more than 17% due to shift in yield curve of +/- 300 basis points. **
** A mortgage derivative product that meets the definition of a high-risk security at any 100 basis point incremental shift (up to 300) in the yield curve will be deemed to be high-risk. Thus, a security that meets the high-risk definition given a 200 basis point increase in interest rates, but does not meet the definition given a 300 basis point increase, will still be deemed to be high-risk.
To be a "high-risk mortgage security" it must fail one of the three tests. (There are exceptions to this)
Definition of high risk mortgage security (5.4-5):
Any mortgage derivative product that at the time of purchase, or at a subsequent testing date, meets any one of the three high risk tests. (Mortgage-backed pass-through securities are not covered by this definition).
A CMO was purchased on 3-15-95. A high-risk test was not performed prior to purchase; however, a test was performed on 4-15-95, indicating that the security was not high-risk. What would you cite in the ROE?
(a) Violation of Part 337
(b) Contravention to the FDIC Statement of Policy on Securities Activities
(c) Comment in the ROE, but don't cite anything on the violations page
(d) No comment is necessary because the security was not high-risk
A high-risk test was performed on a CMO. Based on the following summary of the results, is the security high- risk? (5.4-5)
Average Life Test: 3 years
Average Life Sensitivity Test: +3 years; -1 year
Price Sensitivity Test: 14%
(b) Security is high-risk because it failed the average life test
(c) Security is high-risk because it failed the average life sensitivity test
(d) Security is high-risk because it failed the price sensitivity test.
When is it permissible for a bank to purchase high risk securities?
Bank must demonstrate prior to purchase and quarterly thereafter, that either yield performance or cash flow of the high-risk security is reducing both interest rate risk of designated group of assets or liabilities AND interest rate risk of the bank as a whole.
Definition of residuals. (5.4-2)
A CMO or REMIC residual is a security issued with no amount or a nominal amount of principal and is purchased at a price based on the present value of the estimated cash flows generated by the underlying collateral. The primary source of this cash flow is the coupon differential between the weighted average coupon rate on the underlying collateral and the weighted average coupon rate of all tranches or debt classes. The residual investor also receives any excess cash flows not needed to service the debt of the CMO or REMIC. The cash flows are extremely sensitive to changes in interest rates, and there is a risk that if prepayments occur at a faster rate than anticipated, the investor may lose part of the original investment (as interest rates decline, value decreases).
The investor is paid after holders of other tranches and after trust administrative expenses have been met. Almost always high-risk.
Bank has an IO strip. What happens to the market value if interest rates fall? (5.4-1)
Market value will decrease. (Prepayments will increase, causing interest cash flow received to decrease due to the decrease in the outstanding principal balance).
Bank has an IO strip. What happens if interest rates rise? (5.4-1)
Market value will increase. (Prepayments will decrease, causing the interest cash flow to be received for longer periods of time until total principal is returned).
Bank has a PO strip. What happens if interest rates fall? (5.4-1)
Market value will increase. (Prepayments will increase, causing the investor to receive greater amounts of principal over a shorter period of time until total principal is returned).
Bank has a PO strip. What happens if interest rates rise? (5.4-1)
Market value will decrease. (Prepayments will decrease, causing the investor to receive smaller amounts of principal payments over a longer period of time until total principal is returned).
Interest rates influence the prepayment speed and this affects the values of the IOs and POs. If falling rates, prepayments speed up. This is good for the PO as it will get cash flow sooner; however, it is bad for the IO as underlying mortgages pay off, stopping the interest payments. If rates rise, it is bad for the PO as prepayments slow and principal payments are pushed off into future.
Scenario: The bank purchases a non-high risk security (HTM) but in the 2nd Qtr. it becomes high-risk. In both the 3rd and 4th Qtrs it passes. What is the proper exam procedure? (5.4-8)
a. high-risk
d. AFS
e. trading
Know how to classify a security both before and after 2/10/92.
What are the risks in investing in CMOs?
Price volatility from uncertain cash flows based on prepayment speeds >>>> extremely sensitive to changes in interest rates.
Bank has recently purchased a CMO residual. Interest rates subsequently dropped by 1%. The result? (5.4-2)
1) Residual increased in value and may show a gain
2) Bank will receive more income
Prepayments will increase, reducing the cash flow to residual investors.
Securities - definition of residual
* cash flow after debt service, but before administrative costs
* cash flows after debt services and after administrative costs
Scenario: Portfolio contains an excessive amount of CMOs w/ a lot of depreciation. What should the policy emphasize?