Question

Sequential Pay security

This question is based on the following CMO:

-100 residential loans, average starting loan balance $250,000

-10 year FRMs with annual payments, WAC 4.25%

-Assume 0 prepayment

Now, suppose than instead the CMO was structured as a sequential pay security. There is $5,000,000 of principal allotted to the A Tranche, which has a coupon rate of 3.00%, $7,500,000 of principal allotted to the B Tranche, which has a coupon rate of 3.75%, $10,500,000 of principal allotted to the Z (accrual) Tranche, which has a coupon rate of 4.25%. The issuer (residual) will receive cash flows after payment rules to other classes are satisfied.

The payment rules are as follows:

Priority payments will be made to the A tranche and the A class will be first to receive their promised coupon payment.

The B class will receive interest payments only until the A class is repaid. In addition to interest, A will receive priority payments toward principal in the amount of sum of principal repayment by the pool and the interest accrued to Z in that period. After A is repaid, B then will receive priority payments of amortization and accrued interest according the same rules as A. The Z class will accrue interest until both A and B are repaid. Z will receive current interest and principal payments at that time according to the same rules as A and B. All cash flows from the pool that are not designated by the above rules will go to the residual class in that period.

CFs to pool:

Time (in years)	Start Balance	Payment	Interest	Principal	End Balance
1	$25,000,000.00	$3,120,753.04	1,062,500.00	$2,058,253.04	$22,941,746.96
2	22,941,746.96	$3,120,753.04	975,024.25	$2,145,728.80	$20,796,018.16
3	20,796,018.16	$3,120,753.04	883,830.77	$2,236,922.27	$18,559,095.89
4	18,559,095.89	$3,120,753.04	788,761.58	$2,331,991.47	$16,227,104.42
5	16,227,104.42	$3,120,753.04	689,651.94	$2,431,101.11	$13,796,003.31
6	13,796,003.31	$3,120,753.04	586,330.14	$2,534,422.90	$11,261,580.41
7	11,261,580.41	$3,120,753.04	478,617.17	$2,642,135.88	$8,619,444.53
8	8,619,444.53	$3,120,753.04	366,326.39	$2,754,426.65	$5,865,017.88
9	5,865,017.88	$3,120,753.04	249,263.26	$2,871,489.78	$2,993,528.10
10	2,993,528.10	$3,120,753.04	127,224.94	$2,993,528.10	$0.00

What is the IRR to the residual class, given the information in the chart below?

Cash flows to residual class:

T=0 ????

T=1 ????

T=2 153,693.71

T=3 121,922.76

T=4 108,313.21

T=5 94,125.26

T=6 85,000.00

T=7 85,000.00

T=8 85,000.00

T=9 85,000.00

T=10 2,085,000.00

State your answer as a percentage rounded to two decimal places. For example, three and a half would be 3.50.

Answer 1

The principal amount for the issuer is (25million - 5 million (A Tranche) - 7.5 million (B Tranche) - 10.5 million (Z tranche) = 2 million

We will now calculate the cash flow in Period 1 for the issuer (residual class):

Period 1: Interest applicable for A tranche = 5million * 3% = 150000; Interest on B Tranche = 281250 ; Interest on Z Tranche (accrued & paid only after A & B have been satisfied) = 446250. Since the total interest payment in Period 1 is $ 1062500 - all the tranches A, B & Z can be paid their due interest. The residual left will (1062500-150000-281250-446250) = 185000

The principal to be repaid to Tranche A = 2058253.04

All the other tranches are paid principal only after Tranche A has been fully repaid.

Hence Period 1 cash flows for residual class = 185000

Now we can calculate the IRR since we have Period 0 cash flow (-2000000) and Period 1 cash flows (185000)

IRR = 5.68%