Collateralized Mortgage Obligations (CMOs)

Collateralized mortgage obligations (CMOs) are collateralized debt obligations (CDOs) consisting of mortgage-backed securities (MBSs) that are separated and issued as different classes of mortgage pass-through securities with different terms, interest rates, and risks. Because mortgages are secured by real estate, CMOs are very safe. In fact, most CMOs are agency CMOs that are guaranteed by the Government National Mortgage Association (Ginnie Mae), the Federal National Mortgage Association (Fannie Mae), or the Federal Home Loan Mortgage Association (Freddie Mac). Most CMOs by private issuers, collectively referred to as non-agency CMOs, achieve a AAA rating through the use of credit enhancements, which increases their credit safety from what they would otherwise be.

First introduced in 1983, the Tax Reform Act of 1986 allowed CMOs to be issued in the form of real estate mortgage investment conduits (REMICs), which are pass-through business entities that confers certain tax advantages, primarily by preventing double taxation. Consequently, almost all CMOs are REMICs.

CMO bonds differ from corporate and government or agency bonds in that payments are made monthly or quarterly instead of semi-annually, the payments may consist of both principal and interest, and, although specific CMO bonds may have stated maturities, the actual lifetime of the bond will depend on prepayment rates, and it could be longer or shorter than the stated maturity date.

CMOs are Mortgage Pass-Through Securities

The value of a CMO is derived from the underlying mortgages on which it is based. A bank offers loans secured by real estate, called mortgages, to people so they can buy homes. Because banks have a reserve requirement stipulated by the Federal Reserve Bank, they cannot lend out more than a certain multiple of what they have on deposit. To get more money to make more loans, the bank may pool some of its mortgages, and issue certificates that represent an ownership interest in that pool, and sell them to institutional investors. These certificates are called mortgage-backed securities, because the certificates represent an ownership interest in the pool of a particular class of mortgages. Or the bank can sell the loans themselves to a 3rd party. The bank makes money on the service fee for originating and servicing the loan.

A CMO issuer will either buy mortgage loans from a bank, or buy MBS certificates, and create different classes of securities called tranches that represent an ownership interest in the mortgages or the MBSs, but these tranches will have different lifetimes, interest rates, risks, and cash-flow certainties that will appeal to a wider variety of investors with different investment objectives.

The market for different tranches of securitized loans arises from the fact that some institutional investors, such as pension funds and insurance companies would only purchase the most highly rated securities, either AA or AAA. However, some institutional investors, such as hedge funds, wanted higher yields and were willing to accept higher risk; hence, commercial banks could offer asset-backed securities that competed with agency bonds, such as those from Fannie Mae or Freddie Mac, by issuing different tranches of a security, thus dividing the interest in the assets in different tranches with yields inversely proportional to the risk.

How do mortgage pass-through securities differ from regular bonds? Most bonds are issued by corporations or government entities. They issue the bonds to use the money for particular purposes, such as paying current expenses, or for specific projects, such as building a school. The bonds pay only interest during the term of the bond, then the principal is repaid when the bond matures or is called.

But a pass-through security, such as a CMO, does not use the money for any particular purpose. A CMO issuer packages a pool of mortgages, and sells the interest in that pool to investors. The CMO ultimately receives the monthly payments of people paying their mortgages, and these payments consist of both principal and interest. After deducting its fees, the CMO issuer passes the payments on to investors according to some prescribed schedule specified in the CMO prospectus. The prospectus describes each tranche and its characteristics. Every tranche receives interest, but different tranches have different priorities and different times in which they receive the principal of the payments. When a tranche receives all of the principal that it is due, it is paid in full and retired. Then the next tranche starts receiving principal payments, and so on.

Prevailing Interest Rates Affect Prepayment Rates which Affect CMO Values.

Besides the particular characteristics of the tranche, the rate of prepayments will affect the profit, risk, and lifetime of any particular CMO tranche. There will always be some prepayments because many people sell their homes before they are paid off, or they prepay to save on interest and to shorten the lifetime of their loans. A certain rate of prepayment is expected, so this is considered.

The price, yield, and market value of a CMO is predicated on a certain prepayment rate. One such model of prepayments, the Standard Prepayment Model, was developed in 1985 by the Bond Market Association. In general, however, if prepayments differ from what was presumed when the CMO was issued, this will potentially affect the profits and lifetimes of the tranches, some more than others, depending on the priority payment of principal for each tranche.

Interest rates have the largest effect on prepayment rates. If interest rates rise, then prepayments will be fewer, and lifetimes of most tranches will lengthen, thus extending the life of the tranche beyond what was expected, called extension risk, because it prevents the investor from re-investing the proceeds for a higher return. If interest rates drop, then prepayments will increase, as homeowners refinance to get a lower interest rate, thereby shortening the life of the tranche. The investor gets less than expected, and may not be able to reinvest for a comparable interest rate and risk, called reinvestment risk.

The interest rate paid on CMOs will be less than the underlying mortgages because the CMO issuer will deduct a service fee for creating the CMO, and for collecting and distributing the payments to investors.

The yield and yield to maturity of a CMO bond is calculated like a regular bond, except that the time to maturity is uncertain and variable. If the time until the final principal payment is sooner than expected, then the yield to maturity will be greater for a bond bought at a discount, and less for a bond bought at a premium. The shorter the time, the greater the yield to maturity, but lifetimes longer than anticipated will reduce the yield to maturity.

CMO Tranche — An Overview

Tranches are different classes of bonds of the CMO with different maturity terms. Interest is paid on all tranches when the CMO is first issued, but principal payments are paid according to a schedule outlined in the CMO prospectus. The lockout period for each tranche is the time frame during which the tranche receives only interest payments. For each tranche, there is a estimated date for the first payment and last payment of principal—this duration is known as a window. During the window, the tranche becomes the active tranche, and receives both principal and interest, and any prepayments. If the prepayment rate is greater or less than expected, then the lifetime of the tranche will vary accordingly, changing the date for the last payment of principal of the active tranche, and the first payment of principal for the next active tranche. After the tranche receives the last payment of principal, it is retired. The bond has matured. Then the next tranche becomes active, and starts receiving principal payments, and so on, until all tranches are retired.

However, CMOs have evolved from this basic model.

Types of CMOs

Sequential Pay Tranches

In the simplest CMO, known as sequential pay CMO, but may also be called a clean, or plain vanilla offering, tranches are paid sequentially with no overlap. All tranches receive interest payments, but the 1st tranche receives all principal payments until it is retired. Then the 2nd tranche starts receiving principal payments, and so on, until the last tranche is paid off. Typical lifetimes:

  1. 1st tranche: 2-3 years;
  2. 2nd tranche: 5-7 years;
  3. 3rd tranche: 10-12 years.

Planned Amortization Class (PAC) Tranches

PAC tranches account for more than 50% of newly issued CMOs. In a PAC CMO, there is a main tranche, known as the PAC tranche, and a companion or support tranche. The main purpose of a PAC tranche is to give investors in the PAC tranche a more certain cash flow. The PAC tranche receives priority for receiving payments of principal and interest that gives investors in the PAC tranche a steadier income. If prepayments differ from what was expected, then the support tranche gets the variable portion of the payments. While income to the support tranche is more variable, it is also higher yielding. Estimates of the yield, average life, and lockout periods of the PAC tranche is more certain.

If there is little prepayment of principal, most of the money initially goes to the PAC tranche. With more prepayments, the PAC tranche still receives the scheduled amount, but the companion tranche receives anything over that.

Some CMOs have more than one PAC tranche with different levels of priorities. A Type I PAC receives the highest priority, and has the most stable and predictable income. Type II and Type III PACs have lesser priorities, and income is stable over a narrower range of deviations from the expected prepayment schedule.

Targeted Amortization Class (TAC) Tranches

TACs are like PACs, but principal payment is specified for only 1 prepayment rate. If prepayment rates are higher or lower, then the principal payment to the TAC holders will be higher or lower accordingly. If PAC tranches are also a part of the CMO, then TAC tranche payments will be more variable, but less so than for companion tranches.

Companion Tranches

All CMOs that have PAC or TAC tranches will have a companion tranche to absorb variable prepayment rates. Because companion tranches receives the most variable payment, the term of a companion tranche can vary widely. Falling interest rates will cause more prepayments, and thus, more payments to the companion tranche, resulting in a shorter lifetime; rising rates will slow prepayments, and increase the term for the companion tranche. For this variable payment schedule and accompanying risks, companion tranches generally pay the highest yield.

Z-Tranches (also known as Z-Bonds, Accretion Bonds, or Accrual Bonds)

Z-tranches pay no interest until the lockout period ends. A Z-tranche is credited accrued interest and the face amount of the bond increases at the stated coupon rate on each payment date. A Z-tranche is usually the last tranche of a sequential or PAC CMO, and often have terms of 18 to 22 years. Only after the other bonds of the CMO have been retired, do Z-tranche bondholders start receiving payments of interest and principal. However, taxes must be paid on the accrued interest when it is credited, even though the money is not yet actually received. The market value and terms of Z-tranches varies widely.

Principal-Only (PO) Securities

These securities can be created directly from mortgage pass-through securities, or they can be tranches in a CMO. POs are paid only with principal payments. The investor buys the bond at a deep discount from face value, which is returned through scheduled payments and prepayments. Note that higher prepayment rates will result in a shorter term for the bond, thus paying the face value in a shorter term, effectively increasing its yield. When interest rates rise, prepayments decline, and the term of the bond is increased, lowering its effective yield. Sometimes a companion tranche will be issued as a PO bond, called a super PO.

Interest-Only (IO) Securities

Any CMO that has principal-only tranches will also have interest-only tranches. An IO security has a notional principal, which is the principal used to calculate the interest amount, but it has no par value. IO cash flows decline as the notional principal is paid down. However, the value of IOs increases when interest rates increase, because prepayments decrease, thus they can be used as a hedge against interest rate risk. However, it is possible, especially if interest rates are dropping, that the investor may actually receive less money back than initially invested because prepayments will increase, and diminish interest income.

Buy IOs when interest rates are rising; buy POs when interest rates are declining.

IOs are particularly risky investments. It makes sense to buy these only if interest rates are rising, or if they are expected to rise. However, prepayments are not only influenced by interest rates. People pay off their mortgages because they sold their house, or they got extra cash which they want to invest tax-free and risk-free by prepaying their mortgage. Thus, it is possible to lose with an IO, or get diminished returns, regardless of future interest rate changes. Buying a PO when rates are declining is a good investment because it will likely be paid off quickly. This money can then be re-invested. Because POs are bought at a discount, the return is the same regardless of how long it takes to get your money back, so the sooner you get it back, the higher the effective yield. Longer terms will tie up your money longer, delaying any re-investment, or use of your money.

Floating-Rate Tranches — Superfloaters and Inverse Floaters

These tranches have interest rates tied to an interest-rate index, such as the London Interbank Offered Rate (LIBOR), the Cost of Funds Index (COFI), or the Constant Maturity Treasury (CMT), but with a specified upper limit, and sometimes a lower limit as well. They can be structured as a PAC, TAC, companion, or sequential tranches, and are often used to hedge interest-rate risks.

Superfloaters are tranches that have a specified formula for interest that is tied to an interest-rate index and moves more than 1 basis point (1/100 of 1%) up or down with each basis point movement of the index. The interest rate of inverse floaters moves in the opposite direction of interest rates.

Thus, it makes sense to buy superfloaters when interest rates are expected to rise, and inverse floaters if they are expected to fall. Although all floating-rate tranches are subject to prepayment risk, the risk is greater for inverse floaters because prepayments usually increase when interest rates are declining.

Residual-Interest Tranche

These tranches collect any remaining money after all other tranches have been retired, and they are taxed differently. Non-REMIC CMOs have residuals that are sold as a trust certificate or a partnership interest.

Cleanup Call Provisions

Servicers manage the cash flow of almost all mortgage-backed securities as well as many other asset-backed securities, such as auto ABS. Servicers collect and process the payments from the loan pool and pay the investors. They also attempt to collect from delinquent borrowers. Servicers are paid a fixed fee that ranges from 0.5% to 2.0% of the pool's remaining collateral balance.

Therefore, when the balance on a CMO issue falls below about 10% of the original balance, the cost to service the CMO becomes greater than the servicing fee. Hence, all non-agency CMOs and some agency CMOs are issued with a cleanup call provision, which gives the servicer the right, but not the obligation, to call all remaining tranches by paying the remaining balances. This, in effect, shortens the average life of the bottom tranches, which are usually the last to be paid in full.

Buying and Selling CMO Bonds

The minimum investment for most CMOs is $1,000, which is also the usual minimum investment for CMO mutual funds and unit trusts.

In the primary market, where the investor buys a CMO bond from the issuer, it could take up to a month to settle because it takes time to start collecting and distributing the money. Once payments begin, then payments will be monthly, typically on the 15th or 25th of the month after the record date.

The secondary market is provided by dealers that trade in CMOs in the over-the-counter market. The dealers make a profit through a markup included in the selling price. As with most securities, the greater the liquidity, the lower the dealer markup, and vice versa. Transactions settle in 3 business days.

Like corporate bonds, the interest earned or accrued, and any principal received above the purchase price is taxable.

In the News, 7/2007

Collateralized Debt Obligations are being Downgraded

The credit ratings of certain collateralized debt obligations (CDO) will soon be downgraded in light of the increasing delinquency rate of subprime mortgages. About 40% of CDOs consists of residential mortgage-backed securities (RMBS), and ¾ of that consists of subprime loans and home-equity loans, which have a lower lien status. Predictions are being made that CDOs will experience significant losses if home prices continue to depreciate, which was expected to continue at least until 2008, but did not actually reach bottom until 2012.

Much of the subprime trouble was caused by mortgage fraud and falsifications in credit reports, which helped to fuel the increase in home prices. Thus, credit scores, loan-to-value ratios, and ownership status have become less reliable as indicators of creditworthiness, so S&P, which rates much of the CDO issues, is changing its methodology. One change is that higher-rated tranches will need greater credit enhancements to prevent being downgraded if lower tranches in the same issue are downgraded.

A CDO issue divides its RMBSs into different tranches, or classes, with different risk profiles. Lower credit-rated mortgages compose the lower tranches, which gives a higher credit quality to the upper tranches. However, all tranches must be sold, or the CDO cannot be issued. Thus, the lower credit ratings of the lower tranches may decrease the number of CDOs that can be sold, which, in turn, will decrease the number of mortgages that can be sold, which will increase mortgage rates for all borrowers.