Credit Instruments

Primers and articles related to credit instruments

Edited 2 time(s). Last edit at 03/19/2007 01:43PM by regli.

Financial alphabet soup as complex as ABCDS

http://theaustralian.news.com.au/story/0,20867,20988166-36375,00.html

* The sector is so rich in abbreviations it leaves seasoned financiers, as well as investors, scratching their heads, writes Gillian Tett
* December 30, 2006

WHEN bright sparks at Dutch bank ABN Amro recently invented an innovative debt product, it triggered a wave of Star Wars jokes. For the eggheads christened their brainchild - which has taken credit markets by storm this winter - a CPDO. It stands for constant proportion debt obligation but, with a name like that, some bankers quip, it might be a new friend for R2D2 and C3PO, the robots from the films.
Welcome to the world of complex finance, a sector now so rich in abbreviations it leaves even seasoned financiers, as well as investors, scratching their heads.

A couple of decades ago, when new financial products hit the markets, banks gave them names. A host of new words have crept into the investment bible over the years, such as "options", "swaps" and "puts".

These days, it seems, bankers cannot be bothered to name their creations. Instead, the trend is to wrap financial products in sets of initials almost as unwieldy as the products themselves.

Thus the credit markets are full of CDOs (collateralised debt obligations), ABSs (asset backed securities), CDSs (credit default swaps), LCDSs (loan CDSs) and even the ABCDS (a CDS of an ABS). Then there are CLOs (collateralised loan obligations), ECOs (equity collateralised obligations) and the recently arrived CDO2 and CDO3 (CDOs of CDOs of CDOs).

A longer-standing abbreviation is the CMBS (commercial mortgage backed securities) or its cousin the RMBS (residential mortgage backed securities), not to mention REITs (for real estate investment trusts). This month, Bank of America produced the ALDO (adjustable liabilities debt obligation), which is designed to compete with the CPDO.

Bankers, however, sometimes call these "reverse CPPIs" (standing for constant proportion portfolio insurances) just to be more confusing still. Some investors blame the "alphabet soup" on the fact that many bankers in complex finance have been trained in science and mathematics. Others suspect that bankers are just making life complicated to exude an aura of mystery - and justify fat fees.

Another factor driving the trend is broader acceleration of the global financial innovation cycle. Low interest rates have left investors scrambling to find new ways to earn returns - and banks are responding by inventing products at such a furious pace they barely have time to think up names.

"There is greater investor demand for products using derivatives - that drives the alphabet soup," says Bob Pickel, head of the International Swaps and Derivatives Association (best known as the ISDA).

The soup is expected to thicken in 2007. Satyajit Das, a former derivatives trader who is now a consultant, says he is tempted to produce a spoof product called an unspecified fund obligation - or UFO.

What are CMOs

http://www.lasallecmos.com/default.asp

The following is a presentation about Collateralized Mortgage Obligations (CMOs). CMOs are complex securities and are not suitable for all investors. The average life and yield of a CMO will fluctuate depending on the actual prepayment experience of the underlying mortgages and changes in current interest rates. This information is designed to help you understand how CMOs react to different market conditions. If CMOs are sold in the secondary market prior to maturity, the proceeds received may be more or less than the original amount invested.

Collateralized Mortgage Obligations (CMOs) offer a unique opportunity for monthly income, relative safety, and attractive yield advantages compared to other similar quality investments. The Federal Home Loan Mortgage Corporation (more commonly known as “Freddie Mac”) first introduced CMOs in 1983. The Tax Reform Act of 1986 authorized the establishment of Real Estate Mortgage Investment Conduits (REMICS), creating certain tax and accounting advantages for issuers and for certain large institutional and foreign investors. For investment purposes, REMIC securities are indistinguishable from CMOs. The CMO market has grown to over $1 trillion in size since its inception in 1983 and today accounts for an ever increasing and important segment of the overall mortgage market.

One of the first types of mortgage-backed securities created were mortgage pass-through securities. These securities are now also used as collateral for CMO issues. To create these pass-through securities, similar home mortgages meeting the standard criteria of the issuing Government Agency are grouped together into “pools”. Investors are then able to purchase an interest in these pass-through securities. As the mortgage holders make monthly payments of principal and interest, the pass-through security holder is entitled to a pro rata portion of the payments received. The mutual advantage of this process is that it makes funds available for home mortgages at attractive rates, while at the same time creating high quality securities for investors. Mortgage pass-through securities are typically considered to have an investment horizon of approximately 10-12 years on average, even though the mortgages are typically 30-year loans. This shortened horizon occurs because most mortgage loans are paid off early due to, among other things, homeowners moving, prepayments and in the event of lower interest rates, refinancing. In an effort to attract clients with investment objectives shorter or longer than the typical pass-through security, the CMO was created. This was achieved by using pools of mortgage pass-throughs as collateral, which produces monthly cash flow of principal and interest, and then redirecting the cash flow to create short, intermediate and long-term bonds.

Edited 1 time(s). Last edit at 03/19/2007 05:29PM by regli.

Under the current credit environment, are there still opportunites to leverage CMO instruments? I see a lot of I.O strips being sold at a few cents or less on the dollar.  The P+I instruments cost more, and still have decent underwriting guidelines if originated over the last few months (depending upon the instrument of course).

With the wide array of risk in the general category of CMOs, what advice do you have for me as I seek for leveraging opportunites for my clients and myself.

Thanks!