Exotic Security Classes, Balloon Payments, and Prepayment Penalty

This quote (from an article I referenced in my last post) caught my eye:

"CRL also found that more than two thirds of the subprime loans it looked at contained prepayment penalties. By charging borrowers up to six months of mortgage payments to retire mortgages, prepayment penalties lock borrowers into onerous loans by making it very expensive to refinance out of them and into a lower-rate fixed."

Prepayment penalties are a result of a CDO market making every attempt to minimize risk. Let's look at a couple of exotic securities available: IOs (interest only) and POs (principle only). Consider the following example: Bank 'A' created $100 million worth of mortgages. The mortgages are for 8 years at 8% with a balloon payment at the end. The bank takes those debt obligations, pools them together, and sells them to an intermediary who creates different asset classes depending on the cash flow expected from the borrower. The two equations below outline the yearly payment plan for two different asset classes. The top equation is the payment schedule for the investor who buys an IO security; the majority of their return comes from the interest paid by the borrower. The bottom equation is the payment schedule for the investor who buys a PO security; the majority of their return comes from the principle payment in the form of the balloon payment at the end of eight years.

You may have noticed that 43.5 and 55.7 is 99.2, not 100. In the example, the intermediary takes 0.8 as payment for administering the asset classes.
Prepayment penalties on mortgages are meant to reduce the risk. In our example, when borrowers refinance, the owners of the PO security class get their return without having to wait out the eight years, but the IO class is left with a bad investment as less interest is paid, causing a declining return on capital. Conversely, when the borrowers extend their loan, the IO class reaps the rewards as they continue to collect interest, while the PO class is forced to wait for their return.
What happens when the borrower defaults on the mortgage? A portion of the security becomes worthless. When there are record defaults, these securities will have big problems.
There's much more default risk undertaken by the PO class as 87 percent of their return depends on the balloon payment. There's default risk with the IO class as well, but that risk diminishes with each successive year.
There are some hedge funds that are heavily invested in these types of securities. The companies operating them will be the ones that suffer tremendously as foreclosure rates increase further, and they will. The beginning of the great mortgage reset has just begun and with more subprime mortgages being issued, the problem will continue.
At the beginning of this post, I referenced a CNN Money article that described a subprime mortgage market who hadn't learned their lesson. The lesson won't be learned until we reform the CDO market. Much like the illegal drug industry, as long as there is demand for these types of exotic investments, there will be a supply of exotic mortgages.