Empower Federal Credit Union is a mortgage originator that has recently decided to pool 5,000 of its mortgages into a portfolio. The average value of each mortgage in the pool is $200,000, and the average interest rate is 4.25%. The credit union plans to sell the mortgages to Bank of America Corporation (NYSE: BAC), but it will continue to service the mortgages for a small fee (0.25% per year).
The cash flows from the assets will be allocated to tranches. The investment bank plans to create a mortgage-backed security (MBS) with only three tranches: a senior tranche, a mezzanine tranche, and an equity tranche. The principal from the portfolio of mortgages will be allocated as follows: 80% will go to the senior tranche (rated ‘AA’ and earning 2.60%), 10% will go to the mezzanine tranche (rated ‘BBB’ and earning 3.50%), and the remainder will go to the equity tranche (rated ‘CCC’ and earning 9.75%). The investment bank plans to keep any remaining cash flow as its share for the administration of the securitization process.
Additionally, Bank of America plans to create a collateralized mortgage obligation (CMO) from the mezzanine tranche of the MBS. The principal assigned to the senior, mezzanine, and equity tranches of the CMO is in the proportions of 70%, 23%, and 7%, respectively; the credit ratings and coupon rates for the CMO tranches are the same as for the MBS. All of this information is represented in the diagram below.
How much does the investment bank generate in fees for creating the MBS, expressed as a dollar amount? How much is this when expressed as a percentage of the principal underlying the MBS?
How much does the investment bank generate in fees for creating the CMO, expressed as a dollar amount? How much is this when expressed as a percentage of the principal underlying the CMO?
Suppose that the economy experiences a real estate crisis, prices drop, and many of the original borrowers (14% of them) decide to default on their mortgages and abandon their homes. In dollar terms, how much would the loss of principal be for investors in the senior tranche of the CMO?