STEP 1:

Which of the following types of securities are backed by conventional mortgages that are insured through private insurance companies?

Government National Mortgage Association (Ginnie Mae) mortgage-backed securities

Federal Home Loan Mortgage Association (Freddie Mac) participation certificates

Private-label pass-through securities

Federal National Mortgage Association (Fannie Mae) mortgage-backed securities

STEP 2:

Suppose an investment bank is trying to sell BBB rated mortgage-backed securities, with an 8% yield, to two classes of investors: (1) pension fund managers and (2) hedge fund managers. However, neither class of investors wants to purchase the securities. Pension fund managers think the securities are too risky for their low-risk portfolios, and hedge fund managers are willing to take the risk on the securities, but they feel that the yield is too low for their portfolios.

What is one way that the investment bank could sell the securities to both classes of investors?

Increase the yield on the securities to 12%

Sell the securities as participation certificates

Sell the securities as collateralized mortgage obligations

Decrease the yield on the securities to 5%

STEP 3:

In order to sell the mortgage-backed securities to the pension fund managers (who require low-risk securities) and hedge fund managers (who require high-yield securities), the investment bank decides it will need to turn the MBSs into collateralized mortgage obligations that are segmented into three tranches. The first tranche investors get paid before the investors in the remaining two tranches, the second tranche investors get paid after the first tranche investors and before the third tranche investors, and the third tranche investors get paid after the investors in the other two tranches.

The following tables outline the payment order, yields, and ratings of each of the tranches within three CMOs that the investment bank could create.

CMO 1

Tranche	Payment Order	Yield	Rating
1	First	6%	BB
2	Second	12%	CC
3	Third	13%	DDD

CMO 2

Tranche	Payment Order	Yield	Rating
1	First	2%	AAA
2	Second	11%	BB
3	Third	16%	CC

CMO 3

Tranche	Payment Order	Yield	Rating
1	First	2%	A
2	Second	6%	BB
3	Third	7%	B

A.) Which CMO would be most appealing to pension fund managers?

CMO 1

CMO 2

CMO 3

B.) Which tranche in that CMO would be most appealing to pension fund managers?

Tranche 1

Tranche 2

Tranche 3

C.) Which CMO would be most appealing to hedge fund managers?

CMO 1

CMO 2

CMO 3

D.) Which tranche in that CMO would be most appealing to hedge fund managers?

Tranche 1

Tranche 2

Tranche 3

E.) Based on your answers to the previous questions, which CMO should the investment manager create so that both classes of investors will purchase the securities?

CMO 1

CMO 2

CMO 3