Chapter 1 provides a broad overview of the various facets with respect to the valuation of the prepayment speeds within CMO tranches. Collateralized Mortgage Obligations are derivative debt instruments that can be aptly defined as the claim that arises out of cash flows from large pools of home mortgages. The structure of CMO is such that once the principal and interest is received from the mortgage holders, it is distributed to tranches. The principal amount, the coupon rate, the prepayment risk, and the maturity date differ among the tranches (Economy Watch, n.
d. ). CMOs are derivative debt instruments providing both retail and institutional investors the possibility of higher yields with a Standard & Poor AA or AAA ratings. Of concern to these investors is that this instrument is very sensitive since it is exposed to the interest rate risk. Those investing in CMOs must also contend with the possibility of prepayment risk. The housing and financial bubbles in late 2006 and 2007 created a crisis and showed a decline in the demand for CMOs. The specific problem with CMOs is that existing pricing models cannot quantify risk.
This study attempted to determine a standardized valuation model for CMO by taking into consideration the factor of risk. This study focused mainly on the risk factors associated with the valuation methods because the risk at present has evolved as an important factor in the present uncertain environment inclusive of the economic condition of the country (Johnston et al. , 2008). Background of the Problem One of the reasons behind the decline of CMO valuations was the U. S. Subprime crisis, which took place in the middle of the year 2007 and 2008.
This period was marked with a fall in stock markets, collapse of large financial institutions, and decline in returns of the debt instruments. These factors had become a social concern as it affected the society by eroding away its investments in various financial instruments including CMOs. The global financial meltdown affected the livelihoods of a number of people. The subprime crisis arose because of several factors including the enormous securitization due to pooling of various loans by banks into sellable assets which resulted in transferring risky loans onto others.
According to the report of BBC’s former presenter and editor, Evan Davies, the rating agencies were unethically paid to rate these less productive securitized products for personal interests. Banks borrowed large amounts of money to lend out so that they could create more securitization.