IO and PO CMOs

<body onLoad="MM_checkPlugin('Shockwave Flash','','http://www.riskglossary.com/default_nofl.htm',false);return document.MM_returnValue" stylesrc="../_private/template.htm" bgcolor="#FFFFFF" link="#669933" vlink="#000000" alink="#000000"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table1"> <tr> <td width="740"> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" height="37" id="table2"> <tr> <td height="35" width="100%"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" id="table3"> <tr> <td width="100%" align="left" valign="top"> <p class="header_gold">IO and PO CMOs</td> <td width="45" align="right" valign="bottom"> <map name="FPMap6"> <area href="http://www.contingencyanalysis.com" shape="rect" coords="1, 0, 44, 11" target="_top"> </map> <img border="0" src="../images/home.gif" usemap="#FPMap6" width="45" height="12"></td> </tr> </table> </td> </tr> <tr> <td width="100%" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td width="0%" valign="top" bgcolor="#FFFFCC"> <table border="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="0" cellspacing="1" id="table4"> <tr> <td width="0%" align="left" valign="top"> <p class="header2_black">Explained:<br> <img border="0" src="../images/blank_1x100.gif" width="100" height="1"></td> <td width="100%" align="left" valign="top"><p class="word_list"> <a href="#Interest only">interest only CMO bond</a><p class="word_list"> <a href="#principal only">principal only CMO bond</a><br> <img border="0" src="../images/blank_1x160.gif" width="160" height="1"></td> </tr> </table> </td> </tr> </table> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="165" align="left" id="table5"> <tr> <td width="160"> </td> <td width="11"> </td> </tr> <tr> <td width="160"> <script type="text/javascript"></script> <script type="text/javascript" src="http://pagead2.googlesyndication.com/pagead/show_ads.js"> </script> </td> <td width="11"> </td> </tr> </table> <p class="body"><b><a name="Interest only">Interest only</a></b> (IO) and <b> <a name="principal only">principal only</a></b> (PO) <a href="../articles/collateralized_mortgage_obligation.htm">CMO</a> <a href="../articles/coupon_bond.htm">bonds</a> are obtained by stripping the interest cash flows from the <a href="../articles/par_value.htm">principal</a> cash flows of mortgage collateral. The interest cash flows form one bond, which is the IO. The principal cash flows form a second bond, which is the PO. This is illustrated in Exhibit 1.</p> <div align="center"> <center> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="350" cellpadding="0" id="table6"> <tr> <td> <p class="exhibit_header"><span class="exhibit_header">IO and PO CMO Structure</span><br> <span class="exhibit_subheader">Exhibit 1</span></td> </tr> <tr> <td bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td><img border="0" src="../images/ex1_io_and_po.gif" width="350" height="160"></td> </tr> <tr> <td> <p class="exhibit_legend">With an IO and PO CMO structure, all interest cash flows go to the IO. All principal cash flows go to the PO.</td> </tr> </table> </center> </div> <p><a href="../articles/mortgage_backed_security.htm">Prepayment risk</a> tends to be extreme for IO's and PO's, with one benefiting when the other suffers. This is because </p> <p class="body"><img border="0" src="../images/bullet.gif" width="20" height="10">Total payments to a PO are fixed—all that is uncertain is the timing of those payments. Prepayments are desirable because the holder of the PO receives the money earlier.<p class="body"> <img border="0" src="../images/bullet.gif" width="20" height="10">Total payments to an IO are not fixed. Prepayments are undesirable because they reduce future interest payments.<p>Because prepayments are sensitive to interest rates, the value of a PO tends to rise (often dramatically) with declining interest rates. The value of an IO responds in the opposite manner. POs tend to have very high <a href="../articles/duration_and_convexity.htm">durations</a>. IOs tend to have significantly negative durations.</p> <table border="0" cellpadding="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" id="table7"> <tr> <td height="30" valign="bottom" colspan="2"> <p class="header2_black">Related Internal Links</td> </tr> <tr> <td colspan="2" bgcolor="#CC9966" height="2"> <img border="0" src="../images/blank_2x2.gif" width="2" height="2"></td> </tr> <tr> <td bgcolor="#FFFFCC" colspan="2"> <table border="0" cellspacing="0" style="border-collapse: collapse" bordercolor="#111111" width="100%" cellpadding="6" id="table8"> <tr> <td width="100%"> <p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/collateralized_mortgage_obligation.htm">collateralized mortgage obligation</a> A type of MBS with cash flows segregated into bonds offering different maturity and risk characteristics.<p class="explanatory_text"> <img border="0" src="../images/bullet_link_glossary.gif" width="26" height="15"><a href="../articles/mortgage_backed_security.htm">mortgage-backed security</a> Securitized interest in a pool of mortgages. 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