Collateralized mortgage obligation
A collateralized mortgage obligation (CMO) is a type of complex debt security that
repackages and directs the payments of principal and interest from a collateral pool to
different types and maturities of securities, thereby meeting investor needs.[1] CMOs
were first created in 1983 by the investment banks Salomon Brothers and First Boston
for the U.S. mortgage liquidity provider Freddie Mac. (The Salomon Brothers team was
led by Gordon Taylor. The First Boston team was led by Dexter Senft[2]).
Legally, a CMO is a debt security issued by an abstraction - a special purpose entity and is not a debt owed by the institution creating and operating the entity. 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 they receive payments from the income generated by the
mortgages according to a defined set of rules. With regard to terminology, the
mortgages themselves are termed collateral, 'classes' refers to groups of mortgages
issued to borrowers of roughly similar credit worthiness, tranches are specified fractions
or slices, metaphorically speaking, of a pool of mortgages and the income they produce
that are combined into an individual security, while the structure is the set of rules that
dictates how the income received from the collateral will be distributed. The legal entity,
collateral, and structure are collectively referred to as the deal. Unlike traditional
mortgage pass-through securities, CMOs feature different payment streams and risks,
depending on investor preferences.[1] For tax purposes, CMOs are generally structured as
Real Estate Mortgage Investment Conduits, which avoid the potential for "doubletaxation."[3]
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.
The term "collateralized mortgage obligation" technically refers to a security issued by
specific type of legal entity dealing in residential mortgages, but investors also
frequently refer to deals put together using other types of entities such as real estate
mortgage investment conduits as CMOs.
Purpose
The most basic way a mortgage loan can be transformed into a bond suitable for
purchase by an investor would simply 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 percentage 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
borrower 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
are 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.
This is known as reinvestment risk.
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. The latter event is known as default risk.
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 (i.e. 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 (e.g., 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 to manage and offset the interest rate-related
price changes in other investments.[4]
Whenever a group of mortgages is split into different classes of bonds, the risk does not
disappear. Rather, it is reallocated among the different classes. Some classes receive less
risk of a particular type; other classes more risk of that type. How much the risk is
reduced or increased for each class depends on how the classes are structured.
Credit protection
CMOs are most often backed by mortgage loans, which are originated by thrifts
(savings and loans), 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 for "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 losses, 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.
If the "overcollateralization" turns into "undercollateralization" (the assumptions of the
default rate were inadequate), then the CMO defaults. CMOs have contributed to the
subprime mortgage crisis.
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
The principal (and associated coupon) stream for CMO collateral can be structured to
allocate prepayment risk. Investors in CMOs wish to be protected from prepayment risk
as well as credit risk. Prepayment risk is the risk that the term of the security will vary
according to differing rates of repayment of principal by borrowers (repayments from
refinancings, sales, curtailments, or foreclosures). If principal is prepaid faster than
expected (for example, if mortgage rates fall and borrowers refinance), then the overall
term of the mortgage collateral will shorten, and the principal returned at par will cause
a loss for premium priced collateral. This prepayment risk cannot be removed, but can
be reallocated between CMO tranches so that some tranches have some protection
against this risk, whereas other tranches will absorb more of this risk. To facilitate this
allocation of prepayment risk, 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 a formula 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. The schedule of
principal payments is created by using just a single PSA.
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. A
NAS tranche receives principal payments according to a schedule which shows for a
given month the share of pro rata principal that must be distributed to the NAS tranche.
NASquential
NASquentials were introduced in mid-2005 and represented an innovative structural
twist, combining the standard NAS (Non-Accelerated Senior) and Sequential structures.
Similar 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).
Coupon tranching
The coupon stream from the mortgage collateral can also be restructured (analogous to
the way the principal stream is structured). This coupon stream allocation is performed
after prepayment tranching is complete. If the coupon tranching is done on the
collateral without any prepayment tranching, then the resulting tranches are called
'strips'. The benefit is that the resulting CMO tranches can be targeted to very different
sets of investors. In general, coupon tranching will produce a pair (or set) of
complementary CMO tranches.
IO/discount fixed rate pair
A fixed rate CMO tranche can be further restructured into an Interest Only (IO) tranche
and a discount coupon fixed rate tranche. An IO pays a coupon only based on a notional
principal, it receives no principal payments from amortization or prepayments. Notional
principal does not have any cash flows but shadows the principal changes of the original
tranche, and it is this principal off which the coupon is calculated. For example, a
$100mm PAC tranche off 6% collateral with a 6% coupon ('6 off 6' or '6-squared') can
be cut into a $100mm PAC tranche with a 5% coupon (and hence a lower dollar price)
called a '5 off 6', and a PAC IO tranche with a notional principal of $16.666667mm and
paying a 6% coupon. Note the resulting notional principle of the IO is less than the
original principal. Using the example, the IO is created by taking 1% of coupon off the
6% original coupon gives an IO of 1% coupon off $100mm notional principal, but this
is by convention 'normalized' to a 6% coupon (as the collateral was originally 6%
coupon) by reducing the notional principal to $16.666667mm ($100mm / 6).
PO/premium fixed rate pair
Similarly if a fixed rate CMO tranche coupon is desired to be increased, then principal
can be removed to form a Principal Only (PO) class and a premium fixed rate tranche. A
PO pays no coupon, but receives principal payments from amortization and
prepayments. For example, a $100mm sequential (SEQ) tranche off 6% collateral with a
6% coupon ('6 off 6') can be cut into an $92.307692mm SEQ tranche with a 6.5%
coupon (and hence a higher dollar price) called a '6.5 off 6', and a SEQ PO tranche with
a principal of $7.692308mm and paying a no coupon. The principal of the premium
SEQ is calculated as (6 / 6.5) * $100mm, the principal of the PO is calculated as balance
from $100mm.
IO/PO pair
The simplest coupon tranching is to allocate the coupon stream to an IO, and the
principal stream to a PO. This is generally only done on the whole collateral without
any prepayment tranching, and generates strip IOs and strip POs. In particular FNMA
and FHLMC both have extensive strip IO/PO programs (aka Trusts IO/PO or SMBS)
which generate very large, liquid strip IO/PO deals at regular intervals.
Floater/inverse pair[edit]
The construction of CMO Floaters is the most effective means of getting additional
market liquidity for CMOs. CMO floaters have a coupon that moves in line with a given
index (usually 1 month LIBOR) plus a spread, and is thus seen as a relatively safe
investment even though the term of the security may change. One feature of CMO
floaters that is somewhat unusual is that they have a coupon cap, usually set well out of
the money (e.g. 8% when LIBOR is 5%) In creating a CMO floater, a CMO Inverse is
generated. The CMO inverse is a more complicated instrument to hedge and analyse,
and is usually sold to sophisticated investors.
The construction of a floater/inverse can be seen in two stages. The first stage is to
synthetically raise the effective coupon to the target floater cap, in the same way as done
for the PO/Premium fixed rate pair. As an example using $100mm 6% collateral,
targeting an 8% cap, we generate $25mm of PO and $75mm of '8 off 6'. The next stage
is to cut up the premium coupon into a floater and inverse coupon, where the floater is a
linear function of the index, with unit slope and a given offset or spread. In the example,
the 8% coupon of the '8 off 6' is cut into a floater coupon of:
(indicating a 0.40%, or 40bps, spread in this example)
The inverse formula is simply the difference of the original premium fixed rate coupon
less the floater formula. In the example:
The floater coupon is allocated to the premium fixed rate tranche principal, in the
example the $75mm '8 off 6', giving the floater tranche of '$75mm 8% cap + 40bps
LIBOR SEQ floater'. The floater will pay LIBOR + 0.40% each month on an original
balance of $75mm, subject to a coupon cap of 8%.
The inverse coupon is to be allocated to the PO principal, but has been generated of the
notional principal of the premium fixed rate tranche (in the example the PO principal is
$25mm but the inverse coupon is notionalized off $75mm). Therefore, the inverse
coupon is 're-notionalized' to the smaller principal amount, in the example this is done
by multiplying the coupon by ($75mm /$25mm) = 3. Therefore, the resulting coupon is:
In the example the inverse generated is a '$25mm 3 times levered 7.6 strike LIBOR
SEQ inverse'.
Other structures
Other structures include Inverse IOs, TTIBs, Digital TTIBs/Superfloaters, and
'mountain' bonds. A special class of IO/POs generated in non-agency deals are WAC
IOs and WAC POs, which are used to build a fixed pass through rate on a deal.
Attributes of IOs and POs
Interest only (IO)
An interest only (IO) strip may be carved from 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.) IOs have investor demand due to their negative duration
acting as a hedge against conventional securities in a portfolio, their generally positive
carry (net cashflow), and their implicit leverage (low dollar price versus potential price
action).
Principal only (PO)
A principal only (PO) strip may be carved from collateral securities to receive just the
principal portion of a payment. 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.) POs have investor demand as hedges against IO type streams
(e.g. mortgage servicing).
