3. The Pretty Lake Bank Corp. has placed $100 million of GNMA-guaranteed securi- ties in a trust account off the balance sheet. A CMO with four tranches has just been issued by Pretty Lake using the GNMAs as collateral. Each tranche has a face value of $25 million and makes monthly payments. The annual coupon rates are 4.5 percent for Tranche A, 5 percent for Tranche B, 5.5 percent for Tranche C, and 6 percent for Tranche D.

a. Which tranche has the shortest maturity, and which tranche has the most prepay- ment protection?

b. Every month principal and interest are paid on the outstanding mortgages, and some mortgages are paid in full. These payments are passed through to Pretty Lake, and the trustee uses the funds to pay coupons to CMO bondholders. What are the coupon payments owed for each tranche for the first month?

c. If scheduled mortgage payments and early prepayments bring in $5 million, how much will be used to retire the principal of CMO bondholders and which tranche will be affected?

cl. Why does Tranche D have a higher expected return?