Problem 7 [10 points] Contents of a CMO security offering with sequential annual pay tranches coupon rate Mortgage Pool: 3/1 10 ARM Mortgages $75,000,000 Initial rate: 10% ARM rates in year 4-5: 12% 5 year maturity Total assets $75,000,000 Liabilities Class A Bonds Class B Bonds Class Z Bonds Total bonds Equity contribution by issuer Total debt and equity 8.0% 9.5% 11.0% amount issued $31,000,000 $15,000,000 $27,000,000 $73,000,000 $2,000,000 $75,000,000 Rules of cash distributions to A, B and Z: interest is paid currently on tranches A and B, but it is not paid on tranche Z until principal on the other tranches is repaid. For tranche Z, interest will be accured and accumulated into the investment balance. In addition, to ensure that the maturity of tranche A securities is kept relatively short, the interest accrued to tranche Z and all current amortization of principal and prepayments from the entire mortgage pool will be allocated to tranche A, and then to tranche B. Questions 1. [4 points] Suppose that there are no prepayment and no default, what are the cash flows for Class A, Class B and Class Z bonds? What is the IRR for the issuer? 2. [4 points] Suppose that there are 10% prepayment and no default, what are the cash flows for Class A, Class B and Class Z bonds? What is the IRR for the issuer? 3. [2 points] Please briefly discuss your findings. Problem 7 [10 points] Contents of a CMO security offering with sequential annual pay tranches coupon rate Mortgage Pool: 3/1 10 ARM Mortgages $75,000,000 Initial rate: 10% ARM rates in year 4-5: 12% 5 year maturity Total assets $75,000,000 Liabilities Class A Bonds Class B Bonds Class Z Bonds Total bonds Equity contribution by issuer Total debt and equity 8.0% 9.5% 11.0% amount issued $31,000,000 $15,000,000 $27,000,000 $73,000,000 $2,000,000 $75,000,000 Rules of cash distributions to A, B and Z: interest is paid currently on tranches A and B, but it is not paid on tranche Z until principal on the other tranches is repaid. For tranche Z, interest will be accured and accumulated into the investment balance. In addition, to ensure that the maturity of tranche A securities is kept relatively short, the interest accrued to tranche Z and all current amortization of principal and prepayments from the entire mortgage pool will be allocated to tranche A, and then to tranche B. Questions 1. [4 points] Suppose that there are no prepayment and no default, what are the cash flows for Class A, Class B and Class Z bonds? What is the IRR for the issuer? 2. [4 points] Suppose that there are 10% prepayment and no default, what are the cash flows for Class A, Class B and Class Z bonds? What is the IRR for the issuer? 3. [2 points] Please briefly discuss your findings