Report CopyRight/DMCA Form For : Ginnie Mae And The Secondary Mortgage Market An Integral
Government Guaranteed Ginnie Mae and the Secondary Mortgage Market an Integral Part of the American Economic Engine Frank J Fabozzi Ph D CFA Adjunct Professor of Finance
Ginnie Mae and the Secondary Mortgage Market,An Integral Part of the American Economic Engine. Frank J Fabozzi Ph D CFA,Adjunct Professor of Finance. School of Management,Yale University,Andrew Kalotay Ph D. Andrew Kalotay Associates Inc,Government Guaranteed. Table of Contents,Introduction 1,Role of the Secondary Mortgage Market and. America s Housing Finance Market 2, Role of Ginnie Mae in the Secondary Mortgage Market 14. Secondary Benefits of the MBS Market,and the Role of Ginnie Mae 16. The Ginnie Mae Operating Model 17,Conclusions 19,Government Guaranteed. Section I Introduction, An important part of the American dream is to own a home To help Americans realize this dream. the U S government has implemented policies that favor the homebuyer For example federal. income tax provisions which in part allow the postponement or elimination of taxes resulting from. capital gains have made homeownership an attractive investment Provisions in the federal income. tax law and non tax legislative initiatives have also made buying a home more affordable the law. allows the interest portion of mortgage payments to be a deductible item thereby reducing the after. tax cost of homeownership Finally federal policies have fostered the development of a strong. housing finance market a market where the availability of credit money to lend results in. favorable lending terms for consumers i e reasonable down payment and flexible consumer. friendly mortgage instruments at highly competitive interest rates. Prior to the Great Depression because of onerous financial requirements that potential homebuyers. faced American homeownership rates were low The terms of a typical mortgage loan required the. borrower make a down payment of about 40 percent and repay the loan within three to five years. Very few Americans today could afford to buy a home under such financial conditions particularly. low and moderate income families who may be first time homebuyers. Today the financial requirements for purchasing a home are nowhere near as strenuous making home. buying within reach of low and moderate income Americans The typical homebuyer will make a. down payment of between 10 percent and 20 percent making it possible to accumulate the necessary. funds in a shorter period of time The term of the mortgage loan can be up to 40 years Because the. term of mortgage loans affects the amount of the monthly mortgage payment specifically the longer. the term of the loan the lower the monthly mortgage payment the homebuyer has the flexibility to. select a mortgage term that will result in a monthly mortgage payment that is within his or her budget. This flexibility increases the affordability of housing to a wider segment of the American population. Finally the interest rate on the mortgage loan can either be fixed for the life of the loan or it can be. adjustable If a potential homebuyer selects a fixed interest rate mortgage the monthly mortgage. payments are known making household budgeting easier But if a potential homebuyer believes that. the prevailing mortgage rate at the time a home is purchased is high and is expected to decline in the. future the homebuyer can obtain an adjustable rate mortgage. Neither the dramatic change in the structure of mortgage designs available from the pre Great. Depression days to today nor the significant pool of funds available to make homeownership possible. came about by accident The obstacle that had to be overcome to develop the world s strongest housing. finance market was to create a vehicle attractive to investors particularly institutional investors i e. pension funds mutual funds central banks insurance companies and depository institutions. anywhere in the world Just how that obstacle was overcome and the role of the Government National. Mortgage Association Ginnie Mae in this process are explained in this paper. The paper is organized as follows in Section II the role of the secondary mortgage market and the. effect of mortgage backed securities MBS on financing housing in America are discussed The role. of Ginnie Mae in the secondary mortgage market through its MBS programs and in particular its. contributions toward financing affordable housing is discussed in Section III The secondary. benefits of the MBS market strengthening the balance sheets of America s lending institutions by. transferring debt to investors and the advantages that a supply of safe sound dependable investment. programs have meant to large numbers of pension funds municipalities individuals and foreign. governments and Ginnie Mae s role are covered in Section IV In Section V we provide an analysis. of the Ginnie Mae business model,Government Guaranteed 1. Section II Role of the Secondary Mortgage Market and. America s Housing Finance Market, Today the mortgage market is the largest sector of the global debt market far exceeding the market. for U S Treasury securities Table 1 shows the amount of mortgages outstanding from 1994 to 2002. The key to the development of the American housing finance market has been the development of. the American secondary mortgage market today the most robust in the world. To appreciate the important economic role of the secondary mortgage market an understanding of. the basic fixed rate mortgage loan is necessary By understanding the structure of this mortgage loan. and its investment characteristics we can look at the appeal of investing in individual mortgage loans. by investors both retail investors e g individual investors and institutional investors e g. pension funds commercial banks savings loan associations central banks insurance companies. and mutual funds throughout the world,Mortgage Debt Outstanding. 1994 1995 1996 1997 1998 1999 2000 2001 2002, Total Outstanding 4 392 794 4 603 982 4 868 297 5 204 119 5 715 556 6 320 508 6 885 323 7 589 578 7 965 275. By Type of Mortgage, 1 4 Family 3 355 485 3 510 319 3 718 683 3 973 692 4 365 968 4 790 601 5 203 674 5 732 523 6 040 743. Multifamily 271 748 277 002 288 837 302 291 331 602 369 251 406 530 454 715 473 950. Commercial 682 590 732 100 773 643 837 837 921 482 1 057 692 1 166 261 1 286 011 1 330 409. Farm 82 971 84 561 87 134 90 299 96 504 102 964 108 858 116 329 120 173. Commercial Banks 1 012 711 1 090 189 1 145 389 1 245 315 1 336 996 1 495 420 1 660 054 1 789 819 1 875 360. Savings Institutions 596 191 596 763 628 335 631 826 643 955 668 064 722 974 758 236 740 288. Life Insurance Cos 210 904 213 137 208 162 206 840 213 640 230 787 235 941 243 021 245 165. Federal Agency 315 580 308 757 295 192 286 194 291 961 320 054 344 225 376 999 396 091. Mortgage Pools Trusts 1 730 004 1 863 210 2 040 848 2 239 350 2 581 297 2 948 245 3 231 415 3 715 692 3 986 440. Individuals Others 527 404 531 926 550 372 594 594 647 708 657 938 690 714 705 811 721 932. As of June 30 2002,Source Bond Market Association, As noted below the investment characteristics of mortgage loans are unappealing to most investors. The more unappealing the higher the yield premium investors will require to induce them to invest. in mortgage loans The yield premium is the spread investors require over the yield offered on. U S Treasury securities A higher yield premium translates into a higher borrowing cost for. homebuyers thereby reducing the affordability of homeownership. Before we discuss the basic fixed rate mortgage loan it is worthwhile to gain an understanding of. how the mortgage market has developed by looking at the limitations of the early market. Limitations of the Early Mortgage Market, In the first decades of the post World War II period the bulk of mortgage loans was originated and. kept in the portfolios of depository institutions and to a lesser extent portfolios of insurance. companies By 1950 depository institutions held nearly 50 percent of these loans of which S Ls. held 20 percent by the mid 1970s the share of depository institutions had grown to 64 percent of. which S Ls held 37 percent, The supply of funds to the mortgage market was therefore dependent on the ability of depository. institutions particularly S Ls to raise funds and hold the mortgage loans oriented in their loan. portfolio However depository institutions were encouraged by legislation and regulation to. confine deposit seeking and lending activities to their local housing market Under such constraints. a poor allocation of resources that could be committed to the mortgage market developed as some. regions had an excess supply of funds and low rates and others had shortages and high rates. Enter a new participant the mortgage banker Unlike thrift and commercial bankers mortgage. bankers did not provide funds from deposit taking Instead they originated mortgages and sold. them not just to insurance companies but to thrifts in other parts of the country looking for. mortgage investments in essence providing a brokerage function This seemed like an adequate. market bringing mortgage rates throughout the country closer together and reducing the shortage. of mortgage money in high demand regions of the country. The mortgage market operated this way through the late 1960s but it had a major flaw it was. dependent on the availability of funds from thrifts and banks whether local or national However. in the late 1960s an economic period characterized by high and fluctuating inflation and interest. rates disintermediation i e the withdrawing of funds from depository institutions induced by. ceilings on interest rates led to a reduction in funds available to all depository institutions To. counter or at least mitigate this problem the country needed a mortgage market that was not. dependent on deposit taking institutions This could only be accomplished by developing a strong. secondary mortgage market in which financial institutions other than deposit taking institutions and. insurance companies would find it attractive to supply funds. Investment Characteristics of Mortgage Loans, There are many types of mortgage designs available to homebuyers in the United States In general. they are classified as either fixed rate or adjustable rate mortgages Regardless of the type of design. they have three features unattractive to investors credit risk liquidity risk and prepayment risk. Credit risk is the risk that the homebuyer will fail to make contractual payments set forth in the. mortgage loan agreement Liquidity risk is the risk that an individual mortgage loan will not be able. to be sold in the market at its true value We will see the role that Ginnie Mae and mortgage backed. securities play in eliminating credit risk and reducing liquidity risk in Section III. Prepayment risk arises because the homebuyer typically has the right to prepay a mortgage loan in. whole or in part prior to the scheduled principal repayment date From the perspective of the. homebuyer an attractive feature of the mortgage designs in the United States is the availability of. long term funds at fixed interest rates However long term fixed rate mortgage designs investment. characteristics do not appeal to institutional investors seeking to match asset cash flows to that of. their liabilities To understand why we must understand the investment characteristics of the long. term fixed rate mortgage design,Government Guaranteed 3. While there are various fixed rate long term mortgage designs our discussion will focus on the most. common design one where the mortgage payments are level for the term of the mortgage That. is the homebuyer makes equal monthly installments over the term of the mortgage This mortgage. design is also the one most frequently used as collateral for a Ginnie Mae MBS. Each monthly mortgage payment for a level payment fixed rate mortgage loan consists of the. interest of 1 12 of the fixed annual interest rate multiplied by the amount of the outstanding. mortgage balance at the beginning of the previous month and. a repayment of a portion of the outstanding mortgage principal balance. The difference between the monthly mortgage payment and the portion of the payment that. represents interest is equal to the amount that is applied to reduce the outstanding mortgage balance. Figure 1 shows the portion of the monthly mortgage payment that represents interest and principal. repayment i e amortization over the life of a 100 000 7 percent 30 year mortgage Notice that. the portion of the monthly mortgage payment applied to interest declines each month and the. portion applied to reducing the outstanding mortgage balance increases The reason for this is that. as the outstanding mortgage balance is reduced with each monthly mortgage payment the interest. on the outstanding mortgage balance declines Since the monthly mortgage payment is fixed an. increasingly larger portion of the monthly mortgage payment is applied to reduce the principal in. each subsequent month The monthly mortgage payment is computed so that after the last scheduled. monthly mortgage payment is made the amount of the outstanding mortgage balance is zero i e. the mortgage is fully repaid This can be seen in Figure 2. Interest and Principal Components of the Life,of a 7 30 Year 100 000 Mortgage Loan. Outstanding Mortgage Balance over the Life,of a 7 30 Year 100 000 Mortgage Loan. The description of this mortgage design assumes that the homebuyer does not pay off any portion. of the outstanding mortgage balance prior to the scheduled due date But homebuyers often do pay. all or part of the outstanding mortgage balance prior to the scheduled date Payments made in excess. of the scheduled principal repayments are called prepayments. Prepayments occur for many reasons The major concern from the perspective of an investor is a. homebuyer refinancing the mortgage loan to take advantage of a decline in the mortgage rate. available in the market relative to the rate on the loan An investor who invests in a mortgage loan. therefore cannot predict the cash flow from that loan This risk the cash flow uncertainty due to. prepayments is what results in prepayment risk Figure 3 shows how the mortgage balance. outstanding differs depending on the rate of prepayment for a pool of mortgage loans Figure 4. shows how the principal and interest is allocated for the same pool of mortgage loans based on. different prepayment rates,Government Guaranteed 5. Outstanding Principal Balance with Varying Levels of Prepayment. 1 000 000 7 Fixed Rate Pool,As prepayments increase duration and. convexity decreases,100 000 3 Year, 1 12 23 34 45 56 67 78 89 100 111 122 133 144 155 166 177 188 199 210 221 232 243 254 265 276 287 298 309 320 331 342 353. Monthly Principal and Interest Payment with Varying Levels of Prepayment. 1 000 000 7 Fixed Rate Pool,Principle and Interest Payment. Constant payment,under no prepayment,8 000 assumption. Prepayments Increasing,Results in cash received sooner. 2 000 2 Year, 1 12 23 34 45 56 67 78 89 100 111 122 133 144 155 166 177 188 199 210 221 232 243 254 265 276 287 298 309 320 331 342 353. To understand prepayment risk suppose an investor acquires a mortgage with a 9 percent mortgage. rate Consider what will happen to prepayments if mortgage rates decline to say 5 percent There. will be two adverse consequences First the price of a fixed income instrument that is not. prepayable will rise But in the case of a fixed rate mortgage loan the rise in price will not be as large. as that of a fixed rate instrument that is not prepayable because a decline in interest rates increases. the homebuyer s incentive to prepay the mortgage loan and refinance it at a lower rate This results. in the same adverse consequence faced by holders of callable corporate and municipal bonds As in. the case of those instruments the upside price potential of a fixed rate mortgage loan is truncated. because of prepayments Investors refer to this property as negative convexity This should not. be surprising because a mortgage loan effectively grants the homebuyer the right to call the loan at. par value The second adverse consequence of a prepayment attributable to a decline in interest rates. is that the unscheduled principal repayment must be reinvested at a lower rate These two adverse. consequences when prevailing mortgage rates decline below the rate on the mortgage loan are. referred to as contraction risk, Now look at what happens if mortgage rates rise to 11 percent The price of a fixed rate mortgage. loan like the price of any fixed rate instrument that is not prepayable will decline But the fixed. rate mortgage loan will decline more because the higher rate in the market will tend to slow down. the rate of prepayment in effect increasing the amount invested at the mortgage rate which is lower. than the prevailing market rate Prepayments would be expected to slow down because homebuyers. will not refinance or partially prepay their mortgages when mortgage rates are higher than the loan s. rate of 9 percent Of course this is just the time when investors want prepayments to speed up so. that they can reinvest the prepayments at the higher market interest rate This adverse consequence. of rising mortgage rates is called extension risk, Prepayment risk therefore encompasses contraction risk and extension risk Even in the absence of. credit risk and liquidity risk prepayment risk makes long term fixed rate mortgage loans. unattractive for certain financial institutions from an asset liability perspective The following. reasons detail why two particular institutional investors depository institutions and pension. funds would find long term fixed rate mortgage loans unattractive even if credit risk and liquidity. risk could be eliminated, 1 Depository institutions i e commercial banks savings and loan associations savings banks. and credit unions seek to lock in a spread over their cost of funds For example if the funding. cost of a depository institution is 5 percent per annum and the return on an asset in its portfolio. is 7 percent per annum the spread is 2 percent 200 basis points. Depository institutions raise funds on a short term basis If they invest in long term fixed rate. mortgage loans they will be mismatched because of the characteristics of these assets When. interest rates and mortgage rates rise a depository institution s spread over its funding cost will. decrease because the return on its investment the mortgage loan would be unchanged but its. borrowing cost would increase For example suppose a depository institution invests in a long. term fixed rate mortgage loan with a 7 percent rate and can obtain an initial funding cost of 5. percent by issuing a one year certificate of deposit Suppose further that five years later interest. rates rise such that to be competitive the depository institution must pay 6 7 percent on one year. certificates of deposit The spread on the mortgage loan has thus declined from 200 basis points. to 30 basis points 7 percent minus 6 7 percent If in the next year interest rates rise further such. that the cost of a one year certificate of deposit exceeds 7 percent the spread on the mortgage. loan becomes negative In addition to the reduction in the spread due to a rise in interest rates. Government Guaranteed 7, the long term fixed rate mortgage loan may be outstanding longer than anticipated when the loan. was acquired because prepayments would be expected to slow down Clearly depository. institutions are exposed to extension risk when they invest in long term fixed rate mortgage loans. 2 There are various types of pension plans in the United States One type is a defined benefit plan. in which the sponsor agrees to make payments to beneficiaries after their retirement The. obligations of a pension sponsor are its liabilities Consider a pension sponsor that wants to. satisfy long term liabilities by locking in prevailing interest rates It would seem that a long term. fixed rate mortgage loan would be a natural candidate for purchase because both the liability and. the asset are long term However this is not the case Buying a long term fixed rate mortgage. loan exposes the pension fund to the risk that prepayments will speed up and the maturity of the. investment will shorten considerably Prepayments speed up when interest rates decline thereby. forcing reinvestment of prepayments at a lower interest rate In this case the pension fund is. exposed to contraction risk, We can see that some institutional investors are concerned with extension risk and others with. contraction risk when they invest in a long term fixed rate mortgage loan. As will be seen it is possible to create mortgage backed securities that alter the cash flow of a pool. of long term fixed rate mortgage loans so as to reduce the contraction risk and extension risk for. institutional investors,Mortgage Backed Securities. Given that residential mortgage debt is the largest debt market in the world and given the highly. undesirable investment property of long term fixed rate mortgage loans for U S and non U S. institutional investors even in the absence of credit and liquidity risk the challenge is to create a. more appealing investment product This can be done by taking the individual mortgage and using. it to create various mortgage backed security products The two major products are pass through. securities and different types of bonds created from collateralized mortgage obligations. 1 Pass Through Securities, A pass through security is created when one or more holders of mortgage loans form a. collection pool of mortgage loans and sell shares or participation certificates in the pool A pool. may consist of several thousand or only a few mortgage loans When a mortgage loan is. included in a pool of mortgages that is used as collateral for a mortgage backed security the. mortgage loan is said to be securitized Every month a certificate holder is entitled to a pro. rata share of the cash flow generated by the pool of mortgage loans. The first mortgage backed pass through security was created by Ginnie Mae in 1968 Ginnie Mae. has continually issued pass throughs since 1970 for the fiscal year ending September 30 2002. Ginnie Mae securitized 174 9 billion Because Ginnie Mae MBS are backed by the full faith and. credit of the United States government investors need not be concerned with credit risk. Investors prefer investing in a fraction of a pool of mortgage loans to investing in a single. mortgage loan just as investors prefer to hold a diversified portfolio of stocks rather than an. individual stock Individual mortgage loans expose an investor to unique or unsystematic risk. and systematic risk The risks are that the homeowner will prepay the mortgage loan when. interest rates decline and or that the borrower may default on the loan. Unsystematic prepayment risk is the risk of an adverse change in the speed at which. prepayments are made that is not attributable to a change in mortgage interest rates Systematic. prepayment risk is an unfavorable change in prepayments attributable to a change in mortgage. interest rates Systematic risk in the case of default rates represents widespread default rates. perhaps because of severe economic recession Investing in a diversified pool of mortgage loans. in the form of a pass through security reduces most unsystematic risk leaving only systematic. risk Another important advantage of a pass through security is that it is considerably more. liquid than an individual mortgage loan or an unsecuritized pool of mortgage loans. By reducing liquidity risk and eliminating credit risk Ginnie Mae made investing in the. mortgage sector of the fixed income securities market attractive to investors The creators of. broad based bond market indexes Lehman Brothers Salomon Smith Barney and Merrill. Lynch fostered the demand for pass through securities because these securities constituted the. mortgage sector of the broad based bond market indexes Thus even though an asset manager. does not have an exposure to liabilities but manages a portfolio whose benchmark is a broad. based bond market index that asset manager would effectively be required to invest in the. mortgage market or face the risk of being mismatched against its benchmark. Table 2 shows the total outstanding volume of agency mortgage backed securities from 1980 to. 2002 The agencies include Ginnie Mae Fannie Mae and Freddie Mac Also shown in Table 2 is. the outstanding volume of agency mortgage backed securities relative to U S Treasury securities. As of 2002 agency mortgage backed securities were almost equal to the amount of U S Treasury. securities outstanding If U S Treasury bills are eliminated the amount of agency mortgage backed. securities outstanding well exceeds U S Treasury notes and bonds outstanding. Outstanding Volume of Agency MBS,Treasury as,of US Treasury. Securities,GNMA FNMA FHLMC Total Outstanding,1980 93 9 17 110 9. 1981 105 8 0 7 19 9 126 4,1982 118 9 14 4 43 176 3. 1983 159 8 25 1 59 4 244 3,1984 180 36 2 73 2 289 4 23 20. 1985 212 1 55 105 372 1 25 88,1986 262 7 97 2 174 5 534 4 33 01. 1987 315 8 140 216 3 672 1 38 97,1988 340 5 178 3 231 1 749 9 41 17. 1989 369 9 228 2 278 2 876 3 45 04,1990 403 6 299 8 321 1 024 40 46 65. 1991 425 3 372 363 2 1 160 50 46 95,1992 419 5 445 409 2 1 273 70 46 25. 1993 414 1 495 5 440 1 1 349 70 45 15,1994 450 9 530 3 460 7 1 441 90 46 13. 1995 472 3 583 515 1 1 570 40 47 48,1996 506 2 650 7 554 3 1 711 20 49 46. 1997 536 8 709 6 579 4 1 825 80 52 82,1998 537 4 834 5 646 5 2 018 40 60 15. 1999 582 960 9 749 1 2 292 00 69 86,2000 610 5 1 057 80 822 3 2 490 60 83 95. 2001 589 5 1 290 40 948 4 2 828 30 95 31,2002 536 2 1 538 30 1 082 10 3 156 60 98 49. Source Bond Market Association,Government Guaranteed 9. Even after reducing liquidity risk and eliminating credit risk there was still one risk to deal with. when the pool of mortgage loans are long term fixed rate mortgage loans prepayment risk. contraction and extension risk This problem still existed despite the pooling of mortgage loans. 2 Collateralized Mortgage Obligations Multi class Securities. As explained earlier when investing in pass through securities in which the underlying pools are. comprised of long term fixed rate mortgage loans some institutional investors are concerned. with extension risk while others must deal with contraction risk These issues were mitigated for. certain institutional investors by 1 pooling pass through securities and 2 redirecting the cash. flows of a pool of pass through securities to different bond classes called tranches to create. securities with different exposure to prepayment risk These securities would therefore have. different risk return patterns than the pass through securities from which they were created. When the cash flow of pass through securities are redistributed to different bond classes the. resulting securities are called collateralized mortgage obligations CMO or multi class securities. The creation of a CMO cannot eliminate prepayment risk it can only distribute the various. forms of this risk among different classes of bondholders The CMO s major financial. innovation is that the bond classes created are more appealing to global bond investors because. 1 certain bond classes more closely satisfy the asset liability needs of investors and 2 certain. bond classes are more efficient for investors seeking to take an aggressive position in the. mortgage market by taking advantage of anticipated movements in interest rates and. prepayments The bottom line is that the bond classes created in a CMO broadened the appeal. of mortgage backed products to traditional fixed income investors. CMOs issued by Ginnie Mae Fannie Mae and Freddie Mac are referred to as agency CMOs. CMOs not issued by one of these three entities are referred to as non agency CMOs Table 3. shows the amount outstanding of agency CMOs and the issuance volume from 1987 to 2002. 3a Outstanding Volume Outstanding Volume and Issuance. of Agency CMOs,GNMA FNMA FHLMC Total,1987 0 9 0 9,1988 11 6 10 9 22 5. 1989 47 6 47 6 95 2,1990 104 3 83 4 187 7,1991 193 3 143 336 3. 1992 276 9 217 494,1993 323 4 264 1 587 6,1994 315 263 7 578 7. 1995 294 247 540 9,1996 283 4 237 6 521,1997 17 5 328 6 233 6 579 7. 1998 29 311 4 260 3 600 8,1999 52 5 293 6 316 1 662 1. 2000 63 2 291 8 309 1 664 1,2001 81 7 346 1 373 5 801 3. 2002 105 346 7 474 3 926,Source Bond Market Association. Table 3 cont d, 3b Issuance of Agency Outstanding Volume and Issuance. of Agency CMOs,GNMA FNMA FHLMC Total,1987 0 9 0 9,1988 11 2 13 24 2. 1989 37 6 39 8 77 3,1990 60 9 40 5 101 4,1991 101 8 72 173 8. 1992 154 8 131 3 286 1,1993 168 143 3 311 3,1994 3 1 56 3 73 1 132 6. 1995 1 9 8 2 15 4 25 4,1996 9 5 26 6 34 1 70 2,1997 7 9 74 8 84 4 167. 1998 13 6 76 3 135 2 225 1,1999 29 6 50 6 119 6 199 7. 2000 18 6 33 6 48 2 100 4,2001 46 3 192 4 123 5 362 2. 2002 65 3 143 9 331 7 540 9,Source Bond Market Association. While there are many different types of bond classes that have been created within a CMO structure. we will look briefly at four sequential pay bond classes accrual bond classes floating rate inverse. floating rate bond classes and planned amortization class bonds1. Sequential pay bond classes The first CMO created in 1983 was structured so that each bond class. would be retired sequentially For example suppose that a CMO had four bond classes A B C and. D The rules for the distribution of the cash flow to each bond class each month would be as follows. with respect to the interest received from the collateral interest is paid to each bond class based on. the par value outstanding in the previous month The distribution of all principal both the regularly. scheduled principal payment and prepayments would be made as follows. principal is distributed to bond class A until the par value for that bond class is fully paid off. after bond class A is paid off principal is distributed to bond class B until the par value for that. bond class is fully paid off, after bond class B is paid off principal is distributed to bond class C until the par value for that. bond class is fully paid off and, after bond class C is paid off principal is distributed to bond class D until the par value for that. bond class is fully paid off, For a more detailed discussion of these bond classes see Frank J Fabozzi and Chuck Ramsey Collateralized Mortgage. Obligations Structures and Analysis New Jersey John Wiley Sons 1999.