There is little standardization in CMO Residual contracts. Their terms are defined soley by contract, with tax law being about the only limitation.
The Mortgage Residual is something like buying the rights to one third of the rents from an apartment building for the next thirty years - but only in months when it doesn't rain. You can look at historic weather patterns and say statistically what you are buying, but in actual fact you don't know what you bought until it's all over.
Imagine we begin with a standard CMO, but the market for these is limited and this can affect the pricing. Most pension and insurance investors want a fixed duration product, just like an ordinary bond. So Bear-Stearns takes a standard CMO and, by contract, slices out a synthetic bond which:
pays a lower interest rate than the CMO;
has a fixed duration of less than the CMO;
has no pre-payment risk.
This synthetic bond tranche can be sold to a pension fund for almost as much as the underlying CMO.
The Mortgage Residual gets the following:
all interest above the portion carved out the the synthetic bond;
all interest paid beyond the life of the synthetic bond;
all pre-payments of capital; an obligation to pay off the synthetic bond on maturity;
an obligation to make up interest on the synthetic bond should pre-payments of the CMO diminish the interest paid by the CMO below the requirements of the synthetic bond.
The buyer of the Mortgage Residual makes an up-front payment and pledges securities as a guarantee of performance. Frequently a zero coupon bond, with a maturity similar to the synthetic bond, is purchased which greatly reduces the need for pledged securities.
Pre-payments from the CMO generally reduce the need for securities pledged, and all pledged securities are released after maturity of the synthetic bond.
Generally, if interest rates rise, the Mortgage Residual will greatly increase in value. The mortgages will tend not to be repaid and the CMO will have a maturity far longer than the Synthetic Bond. This means the owner of the Mortgage Residual will reap huge "bonus" interest and principal payments after the maturity of the Synthetic Bond.
On the other hand, if interest rates decline the Mortgage Residual will greatly decline in value - possibly even eating into the pledged securities. The mortgages will tend to be paid off early so the Synthetic Bond now outlives the CMO. The Residual owner must continue to make interest payments for the life of the Synthetic Bond at the high fixed rate, even though rates have fallen. And of course there will be nothing, no big bonanza, after the life of the Synthetic Bond.
Who would buy the Mortgage Residual? Since the value of the security moves opposite to bonds, it is attractive to a holder of long-term bonds who wants the income but wants to hedge against fluctuations in principal value. If interest rates declined the Residuals would become a worthless, then as rates decline further the Residuals become a black hole sucking in pledged capital. But since they own lots of long-term bonds, there are off-setting gains in value on those bonds.
But let's say some REIT were to buy these securities while owning short-term bonds. Obviously a sharp decline in interest rates can wipe out the value of the REIT overnight. If the product were designed poorly the owner of the Synthetic Bond would look to Bear-Stearns for payment once the REIT goes out of business.
This entire business exists because there is a big market for standard bonds and a much smaller market for the CMOs with their unpredictable payment rate. |
