The Bulldawg Mortgage Company is issuing a CMO with three tranches. The A tranche will consist of $40.5 million principal with a coupon of 8.25 percent. The B tranche will be issued with a coupon of 9.0 percent and a principal of $22.5 million. The Z tranche will carry a coupon of 11.0 percent with a principal of $45 million. The mortgages backing the security issue were originated at a fixed rate of 10.5% with a maturity and amortization of 10 years (annual payments). The issue will be overcollateralized by $4.5 million[1], and the issuer (Bulldawg) will receive all net cash flows after priority payments are made to each class of securities.[2]Tranche A, B and Z will receive their coupon interest each year. Principal from the mortgage payments will go first to pay down the principal balance of the A tranche. Once the A bond is entirely paid off, the mortgage principal payments will pay down the balance of the B bond. Once the B bond is entirely paid off, mortgage principal payments will bay down the balance of the Z bond. Mortgage defaults losses will be absorbed by the residual cash flows, then the Z tranche, then the B tranche, then the A tranche.

1. Why do you think the A tranche has a coupon rate well below the contract rate on the mortgages?

2. What will the maturity (in years) of each tranche be assuming no prepayment of the mortgages in the pool?

Tranche Maturity

Tranche A:

Tranche B:

Tranche Z:

3. If class A, B, and Z investors demand an 8 percent, 9.5 percent, and 9.75 percent yield to maturity, respectively, at the time of issue, what price should Bulldawg Mortgage Company ask for each security?

Tranche Price

Tranche A:

Tranche B:

Tranche Z:

4. Calculate the residual cash flows to Bulldawg. Assuming that Bulldawg sold the A, B, and Z tranches at the prices in question (3), what rate of return (IRR) will Bulldawg earn on its investment? (hint: Bulldawgs initial investment is going to be the amount they disbursed on the mortgages minus what they sold the bonds for).

5. Now assume that mortgages in the underlying pool prepay at the rate of 10 percent per year. (hint: in years 1-9, additional principal will be paid equal to 10% of beginning loan balance). What will the maturity of each tranche be?

Tranche Maturity

Tranche A:

Tranche B:

Tranche Z:

6. Assume the investors pay the prices from part (3) for each tranche [e.g., assuming no prepayment], but the underlying pool of mortgage prepay at the rate of 10 percent per year.
   1. What are the realized yields to each of the tranches?

Tranche Realized yield (IRR)

Tranche A:

Tranche B:

Tranche Z:

2. Calculate the residual cash flows to Bulldawg. Assuming that Bulldawg sold the A, B, and Z tranches at the prices in question (3), what rate of return (IRR) will Bulldawg earn on its investment? (hint: Bulldawgs initial investment is going to be the amount they disbursed on the mortgages minus what they sold the bonds for).

7. Comparing the yields used to compute prices in part (3), and the realized yields calculated in part (6), did any of the tranches (or Bulldawg) do worse (in terms off IRR) due to the prepayments? (Put Betteror Worse for each investment below).

Tranche Better or worse IRR with prepay

Tranche A:

Tranche B:

Tranche Z:

Bulldawg Resdidual

8. Many have proposed that lenders should keep more skin in the game. These proposals generally require that the lender cannot sell off the residual cash flow stream to someone else (if they sold off all the tranches and the residual cash flows, theyd have no skin in the game). The intuition of these proposals is that if lenders hold a piece of the securitization, their incentives will be better aligned with investors in the securities, and theyll wont originate bad loans (e.g., high prepayment or default risk). Based on your answers from (6) and (7), do you think these proposals make sense?

[1] This is a form or credit protection for the investors in the CMO tranches. Overcollateralization means that the total principal balance of the loans at origination is greater than the par value of the bonds in the CMO. Basically, the sum of the outstanding loan balances at origination is $4.5 million greater than the par value of the CMO tranches.

[2] These residual cash flows could actually be sold off to another entity, usually in the form of another mortgage bond.