A collateralized mortgage obligation (CMO) is a financial debt vehicle that was first created in June 1983 by
investment banks Salomon Brothers and First
Boston. Legally, a CMO is a special purpose entity that is wholly separate
from the institution(s) that create it. The entity is the legal owner of a set of mortgages, called a pool. Investors in a CMO
buy bonds issued by the entity, and receive payments according to a defined set of rules. The mortgages themselves are called the
collateral, the bonds are called tranches (also
called classes), and the set of rules that dictates how money received from the collateral will be distributed is called the
structure. The legal entity, collateral, and structure are collectively referred to as the deal.
The term collateralized mortgage obligation refers to a specific type of legal entity, but investors frequently refer to deals
issued using other types of entities such as REMICs as CMOs.
Investors in CMOs include banks, hedge funds, insurance companies, pension funds, mutual
funds, government agencies, and most recently central banks. This article focuses primarily on CMO bonds as traded in the United States of America.
Purpose
The most basic way a mortgage loan can be transformed into a bond suitable for purchase by an investor would simply to be to
"split it". For example, a $300,000 30 year mortgage with an interest rate of 6.5% could be split into 300 1000 dollar bonds.
These bonds would have a 30 year amortization, and an interest rate of 6.00% for example (with the remaining .50% going to the
servicing company to send out the monthly bills and perform servicing work). However, this format of bond has various problems
for various investors
- even though the mortgage is 30 years, the borrower could theoretically pay off the loan earlier than 30 years, and will
usually do so when rates have gone down, forcing the investor to have to reinvest his money at lower interest rates, something he
may have not planned for. This is known as prepayment risk.
- A 30 year time frame is a long time for an investor's money to be locked away. Only a small minority of investors would be
interested in locking away their money for this long. Even if the average home owner refinanced their loan every 10 years,
meaning that the average bond would only last 10 years, there is a risk that the borrowers would not refinance, such as during an
extending high interest rate period, this is known as extension risk. In addition, the longer time frame of a bond, the more the
price moves up and down with the changes of interest rates, causing a greater potential penalty or bonus for an investor selling
his bonds early. This is known as interest rate risk.
- Most normal bonds can be thought of as "interest only loans", where the bond issuer borrows a fixed amount and then pays
interest only before returning the principal at the end of a period. On a normal mortgage, interest and principal is paid each
month, causing the amount of interest earned to decrease. This is undesirable to many investors because they are forced to
reinvest the principal.
- On loans not guaranteed by the quasi-governmental agencies Fannie Mae or Freddie Mac, certain investors may not agree with
the risk reward tradeoff of the interest rate earned versus the potential loss of principal due to the borrower not paying.
Salomon Brothers and First Boston created the CMO concept to address these issues. A CMO is essentially a way to create many
different kinds of bonds from the same mortgage loan so as to please many different kinds of investors. For example:
- A group of mortgages could create 4 different classes of bonds. The first group would receive any prepayments before the
second group would, and so on. Thus the first group of bonds would be expected to pay off sooner, but would also have a lower
interest rate. Thus a 30 year mortgage is transformed into bonds of various lengths suitable for various investors with various
goals.
- A group of mortgages could create 4 different classes of bonds. Any losses would go against the first group, before going
against the second group, etc. The first group would have the highest interest rate, while the second would have slightly less,
etc. Thus an investor could choose the bond that is right for the risk they want to take (ie. a conservative bond for an
insurance company, a speculative bond for a hedge fund).
- A group of mortgages could be split into principal-only and interest-only bonds. The "principal-only" bonds would sell at a
discount, and would thus be zero coupon bonds (i.e., bonds that you buy for $800 each and which mature at $1,000, without paying
any cash interest). These bonds would satisfy investors who are worried that mortgage prepayments would force them to re-invest
their money at the exact moment interest rates are lower; countering this, principal only investors in such a scenario would also
be getting their money earlier rather than later, which equates to a higher return on their zero-coupon investment. The
"interest-only" bonds would include only the interest payments of the underlying pool of loans. These kinds of bonds would
dramatically change in value based on interest rate movements, e.g., prepayments mean less interest payments, but higher interest
rates and lower prepayments means these bonds pay more, and for a longer time. These characteristics allow investors to choose
between interest-only (IO) or principal-only (PO) bonds to better manage their sensitivity to interest rates, and can be used
manage and offset the interest rate-related price changes in other investments.
Credit Protection
CMOs are most often backed by mortgage loans, which are originated by thrifts, mortgage
companies, and the consumer lending units of large commercial banks. Loans meeting certain size and credit criteria can be
insured against losses resulting from borrower delinquencies and defaults by any of the Government Sponsored Enterprises (GSEs)
(Freddie Mac, Fannie Mae, or Ginnie
Mae). GSE guaranteed loans can serve as collateral for "Agency CMOs", which are subject to interest rate risk but not
credit risk. Loans not meeting these criteria are referred to as "Non-Conforming", and can serve as collateral "private label
mortgage bonds", which are also called "whole loan CMOs". Whole loan CMOs are subject to both credit risk and interest rate risk.
Issuers of whole loan CMOs generally structure their deals to reduce the credit risk of all certain classes of bonds ("Senior
Bonds") by utilizing various forms of credit protection in the structure of the deal.
Credit Tranching
The most common form of credit protection is called Credit Tranching. In the simplest case, credit tranching means that any
credit losses will be absorbed by the most junior class of bondholders until the principal value of their investment reaches
zero. If this occurs, the next class of bonds absorb credit, and so forth, until finally the senior bonds begin to experience
losses. More frequently, a deal is embedded with certain "triggers" related to quantities of delinquencies or defaults in the
loans backing the mortgage pool. If a balance of delinquent loans reaches a certain threshold, interest and principal that would
be used to pay junior bondholders is instead directed to pay off the principal balance of senior bondholders, shortening the life
of the senior bonds.
Overcollateralization
In CMOs backed by loans of lower credit quality, such as subprime mortgage loans,
the issuer will sell a quantity of bonds whose principal value is less than the value of the underlying pool of mortgages.
Because of the excess collateral, investors in the CMO will not experience losses until defaults on the underlying loans reach a
certain level.
Excess Spread
Another way to enhance credit protection is to issue bonds that pay a lower interest rate than the underlying mortgages. For
example, if the weighted average interest rate of the mortgage pool is 7%, the CMO issuer could choose to issue bonds that pay a
5% coupon. The additional interest, referred to as "excess spread", is placed into a "spread account" until some or all of the
bonds in the deal mature. If some of the mortgage loans go delinquent or default, funds from the excess spread account can be
used to pay the bondholders. Excess spread is a very effective mechanism for protecting bondholders from defaults that occur late
in the life of the deal because by that time the funds in the excess spread account will be sufficient to cover almost any
losses.
Prepayment Tranching
Investors in CMOs wish to be protected from interest rate risk as well as credit risk. To facilitate this, CMOs are structured
such that prepayments are allocated between bonds using a fixed set of rules. The most common schemes for prepayment tranching
are described below.
Sequential Tranching (or by time)
All of the available principal payments go to the first sequential tranche, until its balance is decremented to zero, then to
the second, and so on. There are several reasons that this type of tranching would be done:
- The tranches could be expected to mature at very different times and therefore would have different Yields that correspond to different points on the Yield Curve.
- The underlying mortgages could have a great deal of uncertainty as to when the principal will actually be received since home
owners have the option to make their scheduled payments or to pay their loan off early at any time. The sequential tranches each
have much less uncertainty.
Parallel Tranching
This simply means tranches that pay down pro
rata. The coupons on the tranches would be set so that in aggregate the tranches pay the same amount of interest as the
underlying mortgages. The tranches could be either fixed rate, or floating rate. If they have floating coupons, they would have
formulae that make their total interest equal to the collateral interest. For example, with collateral that pays a coupon of 8%,
you could have two tranches that each have half of the principal, one being a floater that pays LIBOR with a cap of 16%, the other being an inverse floater that pays a coupon of 16%
minus LIBOR.
- A special case of parallel tranching is known as the IO/PO split. IO and PO refer to Interest Only and Principal Only. In
this case, one tranche would have a coupon of zero (meaning that it would get no interest at all) and the other would get all of
the interest. These bonds could be used to speculate on prepayments. A principal only bond
would be sold at a deep discount (a much lower price than the underlying mortgage) and would rise in price rapidly if many of the
underlying mortgages were prepaid. The interest only bond would be very profitable if few of the mortgages prepaid, but could get
very little money if many mortgages prepaid.
Z bonds
This type of tranche supports other tranches by not receiving an interest payment. The interest payment that would have
accrued to the Z tranche is used to pay off the principal of other bonds, and the principal of the Z tranche increases. The Z
tranche starts receiving interest and principal payments only after the other tranches in the CMO have been fully paid. This type
of tranche is often used to customize sequential tranches, or VADM tranches.
Schedule bonds (also called PAC or TAC bonds)
This type of tranching has a bond (often called a PAC or TAC bond) which has even less uncertainty than a sequential bond by
receiving prepayments according to a defined schedule. The schedule is maintained by using support bonds (also called companion
bonds) that absorb the excess prepayments.
- Planned Amortization Class (PAC) bonds have a principal payment rate determined by two different prepayment rates, which
together form a band (also called a collar). Early in the life of the CMO, the prepayment at the lower PSA will yield a lower
prepayment. Later in the life, the principal in the higher PSA will have declined enough that it will yield a lower prepayment.
The PAC tranche will receive whichever rate is lower, so it will change prepayment at one PSA for the first part of its life,
then switch to the other rate. The ability to stay on this schedule is maintained by a support bond, which absorbs excess
prepayments, and will receive less prepayments to prevent extension of average life. However, the PAC is only protected from
extension to the amount that prepayments are made on the underlying MBSs. When the principal of that bond is exhausted, the CMO
is referred to as a "busted PAC", or "busted collar".
- Target Amortization Class (TAC) bonds are similar to PAC bonds, but they do not provide protection against extension of
average life.
Very Accurately Defined Maturity (VADM) bonds
Very Accurately Defined Maturity (VADM) bonds are similar to PAC bonds in that they protect against both extension and
contraction risk, but their payments are supported in a different way. Instead of a support bond, they are supported by accretion
of a Z bond. Because of this, a VADM tranche will receive the scheduled prepayments even if no prepayments are made on the
underlying.
Non-Accelerating Senior (NAS)
NAS bonds are designed to protect investors from volatility and negative convexity resulting from prepayments. NAS tranches of
bonds are fully protected from prepayments for a specified period, after which time prepayments are allocated to the tranche
using a specified step down formula. For example, an NAS bond might be protected from prepayments for five years, and then would
receive 10% of the prepayments for the first month, then 20%, and so on. Recently, issuers have added features to accelerate the
proportion of prepayments flowing to the NAS class of bond in order to create shorter bonds and reduce extension risk. NAS
tranches are usually found in deals that also contain short sequentials, Z-bonds, and credit subordination.
NASquential
NASquentials were introduced in mid 2005 and represented an innovative structural twist, combining the standard NAS
(Non-Accelerated Senior) and Sequential structures. Similarly to a sequential structure, the NASquentials are tranched
sequentially, however, each tranche has a NAS-like hard lockout date associated with it. Unlike with a NAS, no shifting interest
mechanism is employed after the initial lockout date. The resulting bonds offer superior stability versus regular sequentials,
and yield pickup versus PACs. The support-like cashflows falling out on the other side of NASquentials are sometimes referred to
as RUSquentials (Relatively Unstable Sequentials).
Interest Rate Risk Tranching
Interest Only
An interest only (IO) strip may be carved off of collateral securities to receive just the interest portion of a payment. Once
an underlying debt is paid off, that debt's future stream of interest is terminated. Therefore, IO securities are highly
sensitive to prepayments and/or interest rates and bear more risk. (These securities usually have a negative effective duration.)
Creating an IO often leads to either the creation of a matching PO or a coupon cutdown bond where the coupon cutdown bond's
coupon is less than the underlying collateral's coupon.
Principal Only
A principal only (PO) strip may be carved off of collateral securities to receive just the principal portion of a payment.
These securities usually have a matching IO that was formed in their creation. A PO typically has more effective duration than
its collateral. (One may think of this in two ways: 1. The increased effective duration must balance the matching IO's negative
effective duration to equal the collateral's effective duration, or 2. Bonds with lower coupons usually have higher effective
durations and a PO has no [zero] coupon.)
See also
References
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Bond market |
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| Types of bonds by issuer |
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| Types of bonds by payout |
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| Derivatives |
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| Pricing |
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| Yield analysis |
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| Credit and spread analysis |
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| Interest rate models |
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