CFA Level 1 - Fixed Income Investments
GSEs issue two forms of debt: debentures are notes or bonds with typical maturities of one to 20 years, while discount notes are short-term papers with maturities ranging from overnight to 360 days.Fannie Mae and Freddie Mac, as noted above, provide credit and support for the housing sector. In doing so, they issue securities that are backed by the mortgage loans that they purchase.
The loans act as collateral for the bonds and they come in three forms:
Mortgage pass through securities are created when one or more bondholders form a pool (or collection) of mortgages and sell shares or certificates in the pool. The cash flows depend on the payments of the mortgage and opens the investor to prepayment risk. The monthly cash flows include net interest, scheduled principal payments and any principal prepayments.
2.Collateralized Mortgage Obligations (CMOs)
CMOs are a derivative securities. They help an investor pick the type of cash flows he wants to be exposed to based on how the pool of mortgages are sliced up into tranches. The tranches offer investors different payment rules and par values. For example Tranche A might receive all principal payments until the balance is zero then the payments would flow to Tranche B and so on.
3.Stripped Mortgage-Backed Securities
For CFA exam purposes, just know that the name exists in case they want three examples of Freddie or Fannie.
Motivation Behind CMO Creation
The motivation behind creating a CMO is to spread the risk of prepayment among different classes of bonds. A CMO has several tranches that splits the mortgage pool into different layers. These layers have different par values and prepayment speeds. This aids investors in helping them manage the risk exposures they want in this arena.