Collateralized Mortgage Obligation Valuation Methods - Dissertation Example

Download file to see previous pages 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 are received from the mortgage holders it is distributed into tranches. The principal amount, the coupon rate, the prepayment risk, and the maturity date differ among the tranches (Economy Watch, n. d.).

CMOS is derivative debt instrument providing both retail and institutional investors the possibility of higher yields with Standard & Poor's AA or AAA ratings. Of concern to these investors is that this instrument is very sensitive since it is exposed to 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 will thus undertake to determine a standardized valuation model for CMO by taking into consideration the factor of risk. This study will focus mainly on risk factors associated with 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 years 2007 and 2008. This period was marked by a fall in stock markets, the collapse of large financial institutions, and a decline in the returns of debt instruments. These factors had become a social concern as they affected 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 bank pooling their various loans into sellable assets and thus 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 a large amount of money to lend out so that they could create more securitization. For Example, Lehman Brothers bought large numbers of mortgages, and mixed collateral pools during securitization, and sold them to other institutions and investors. ...Download file to see next pages Read More