Mortgage-Backed Securities: Products, Structuring, and Analytical Techniques

CHAPTER 6

Fundamental MBS Structuring Techniques: Divisions of Principal

Directing principal cash flows to different tranches within a deal is a primary method of creating bonds to meet the varying needs of different investor classes. Viewing a collateralized mortgage obligation (CMO) deal as a cash flow allocation mechanism, as described in the previous chapter, means that the allocation of principal is accomplished by the creation of a set of payment rules. The rules specify how cash flows are allocated for each month’s payments and will vary depending on what type of bond is being created. For example, a deal’s pay rules may state that a bond in the structure receives all principal paid by the collateral until the bond is fully paid; at that point, principal is directed to a different tranche. In this and the following chapter, we describe fundamental structuring techniques used in agency CMO deals, in which no credit enhancement is necessary due to the agency guaranty at the pool level. In both chapters, payment rules are shown for each structuring example, in order to demonstrate how different structuring techniques allocate principal and interest cash flows.

It is important to remember that a deal represents a “closed universe” of principal. A deal with a principal face value of $400 million means that the total amount of principal available to be paid is $400 million—not a penny more. At faster prepayment speeds, for example, principal cash flows are paid to the investor ...