Merrill Lynch has designed a proposal to inject liquidity into CMOs by recreating them as passthroughs.
In a normal, functioning market, CMOs are created out of passthroughs in different ways including modifying the coupons, average lives or cash flows.
"In the past, there was actually a positive arb - the CMOs are sold at a higher price than where the passthrough is bought. That arb is at a very negative price point right now, as CMOs are trading at a lower price relative to passthroughs," said Ari Kavour, managing director and head of CMO/agency hybrid trading at Merrill. However, this is not the first time this has happened. Similar situations occurred in 1994 and 1998, but not to the extent that the dynamic has been playing out in the current environment.
To bring back value to CMO deals, Merrill came up with the idea that the market allow certain REMIC classes or CMOs to be recombined or remade into passthroughs, which are currently trading several points higher than CMOs. These REMIC classes have to be economically identical to the passthroughs.
"We realized that we can combine CMOs and create passthroughs to give back value to our clients," said Brodie Johnson, head of REMIC residual trading at Merrill Lynch.
The first step is to collect the bonds that would be recombined, and one challenge is finding the owners of each bond. Additionally, these CMO deals vary in complexity, some of them have just one or two tranches while some have as many as 70 tranches, which would be impossible to recombine.
This creation of passthroughs from CMOs would have a much bigger impact on the CMO derivative market, where structures have fewer tranches, and where owners might be more willing to sell these securities back to be recombined. Johnson and Kavour believe it would be easy to find the owners of CMOs that have up to three tranches, which amount to about $200 billion of total CMOs outstanding. Examples of recombinations could include: strip inverse IO+ strip floater + strip PO.
There are many options to doing this structure, they said. There are usually several different collateral groups within a given CMO deal, and one of the groups (or a portion of one of the groups) could be taken out and formed into a passthrough.
"This is innovative from a structural point of view," said Johnson. "You are basically taking multiple CMO tranches as assets and issuing as liabilities one instrument that is equivalent to a passthrough."
After collecting the bonds that would be required to make the passthrough and to structure the re-REMIC, the GSEs would have to agree to take the re-REMIC, place it into a trust, then have the trust issue a passthrough certificate with a new pool number.
According to Merrill, all of the three agencies are very much behind the program, with one of them having an existing program that could already accept REMIC tranches. This existing program is quite close to what is needed for the new proposal to work, and is expected to be ready by the end of the month.
The proposed structure is similar to when a simple MBS is created and it goes into a trust and a certificate of participation is issued by one of the GSEs. "It's simply taking a REMIC regular interest and putting it back into a trust that has the cash flow of specifically identifiable pools."
For instance, one has to make sure that the 5.5 coupon that is created is equal to the group of 5.5 coupons used as collateral on the original deal.
After the trust issues passthrough certificates with the new pool number, the Securities Industry and Financial Markets Association (SIFMA) has to decide whether the new pool would be deliverable in the TBA market. This means, among other conditions, that these pools have a re-REMIC cash flow that is identical to a pro-rata portion of the cash flow from the original pools.
SIFMA is currently waiting to have an actual pool that it can confirm has no disclosure, tax or regulatory issues, and to establish that the pool has the appropriate criteria to be TBA deliverable. This sample pool might be ready by late this year or early January.
"This is a win, win for everyone," Johnson said. For instance, if an agency 5.5 security is effectively created for a combined price of 98, and the market price for the passthrough is 99, dealers profit by a point. That profit can then be split with investors as a way of increasing the incentive on both sides of the trade to recombine the CMOs.
"This could reestablish the effective functioning of the CMO market, which is related to the general real estate market," Johnson said. "The lasting effect is that a CMO pricing floor is established, helping investors with their bids."
In the CMO derivative space, most of the clients welcome the proposal since an owner of a floater, for instance, "could get a firm offering for the corresponding inverse floater, giving them the ability to mark their prices higher," Kavour said. "By reversing losses on CMO portfolios, additional capital is restored to lending institutions, increasing their ability to lend to consumers."
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