Question

Briefly describe the differences between a pass-through security and a CDO/CMO. Imagine an investor purchased a relatively risky tranche ("slice") of a CDO/CMO. Describe how participating in the CDS market for that security could change the investors potential risks and payoffs.

Answer 1

Pass through Security vs CDO/CMO-

Pass through is a security that group of securities that is backed by asset(s). Each security in this group is a representative of a number of debts, such as 100s of loans etc. There is a investment bank or a servicing entity, which collects a fees and passes the remaining interest on to the investors . Thus, if you are invested in a pass through security, you will get an interest every month. When an investor invests in these security, he essentially takes the risk of default as well as the risk if the loan is repaid early. eg. Mortagage based secutiry

Risk of Default: If many parties with debts default, the secuity will loose value

Refinancing and fast repayments: If interest rates fall, there might be refinancing done, leading to losses to investors.

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Comparison with CMO: In a Collateralized Mortagage obligation, the pool of mortagages are taken together and are sold to the investor(s). These obligations are organized into tranches by the level of risk the investor has to bear and the maturity. The principal and interest is distributed among the investors.

The problem here is, that there are complex debt obligations involved in CMO. Which may lead to investors choosing the tranche that provides a higher return. The investors here may not be able to assess the health of the debt obligations and if they may be paid or not.

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Compaison with CDO: CMO uses mortagages. However, CDO may have a lot of loans such as car loans, corporate loans, etc.

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Participation in Credit Default Swaps:

A CDS is an instrument that transfers credit risk of bonds to another party that is willing to take it. It is similar to an insurance as it protects the buyer of the instrument from negative credit event.

The seller, in return takes the risk and takes the fee for owning the risk just like in an insurance. The seller has to pay only in case of a negative credit event (default, credit downgrade etc).

Impact on Risk and Payouts: The investor's credit risk is reduced by buying a CDS. The risk is transferred to the seller, who takes a fee to assume the risk.

In case of a negative credit event, the buyer will profit as the seller will have to deliver the interest as well as principal of the liability.

If there is no such event, the regular payouts for the buyer will get reduced by the payment amount that he has given to the seller (as a fees for owning the risk).

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