Collateralized Mortgage Obligations

Collateralized Mortgage Obligations (CMOs) are mortgage pass-through securities that provide more predictable and principal payments than GNMA, FNMA, and Freddie Mac pass-through mortgage securities. The CMO pools are separated in tranches, that are classified according to the maturity date of securities and their specific payment rules. The first CMO was issued in 1983. The main innovation in CMOs is that provides investors with a steady income stream within predictable maturity dates.

A CMO is a security debt based on a mortgage pool (like GNMA securities). The borrowers of mortgages make their payments of interest and principal on a monthly basis. However, the returns for principal payments are segmented, and paid in a sequential way to a number of different portions of the investor’s pool. CMOs are created when CMO pools are divided in tranches (or slices) with a range of 3 to 17. In these tranches investors buy bonds with varied maturities.

For example, the classical CMO has 4 tranches. The first three (class A, class B, and class C) pay interests to the assigned coupon rate to bondholders of each tranche. (often referred to as a class Z or a Z-bond class). It is similar to a zero coupon bond in which interests are accrued. The last tranche is always the Z tranche.

The cash flow received are used to pay interests in the first three classes of bonds to later retire bonds from its first tranche at maturity. Every prepayment is applied to the first tranche, class A. Then, when every bond has been retired following prepayments are used in the next tranche, class B. This process continues until class B bonds are retired, and after that continue with bonds class C. Bonds that do not receive payment (interests and principal) until each of the other tranches are cancelled. Subsequent cash flows are listed to pay-off the accrued interest and then the return of principal to retire the Z bonds.

Z bonds are much more complex than bonds A, C, and D in CMOs for many reasons. First, the extension of time to maturity cannot be predicted with certainty (for Z bonds), on the contrary, conventional bonds of tranches A, B, and C have maturities with fixed dates. Second, due that Z bonds are long-term, people who invest in them confront greater risks than if they had short-term securities. For this reason, Z bonds can be very volatile and before buying them you should understand the risks.

Your credit risk varies, depending on the support the CMO pool has. If GNMA or FNMA backs up the CMO pools, then its credit risk is low. The risk much greater to those deprived issuers that are not creditworthy.

Following we give you some characteristics of private CMO pools.:

  • There is a greater certainty for cash flows (trimester and semester) in earlier tranches than for those tranches with longer maturity terms.
  • Earlier tranches have shorter and more predictable maturities and consequently less exposure to interest rate risk..
  • Later tranches have greater prepayment risk than earlier tranches, because they cannot receive any principal payments until the earlier tranches have been paid off.
  • CMO risks are much larger than GNMA risks
  • Depending on the backing of the mortgages CMOs can have little to no credit risk. Some pools are backed by GNMA, FNMA or FHLMC which have no credit risk. Privately backed pools have pool insurance, but they also may have greater credit risks.
  • Minimum investment amouhnts can be as low as $10,000, depending on the brokerage firms selling CMOs.
  • Yields on Z-tranche bonds are higher than yields of GNMA securities, but risk is also much greater for Z-tranche bonds.
  • CMOs are less liquid and might be less marketable than GNMA, FNMA and Freddie Mac securities.
  • Z-tranche bonds can be quite volatile when market risks of interest change.
  • Yields on the earlier tranches tend to be lower than those on GNMA securities.
  • Z-tranche bonds have more complicated tax aspects in that interest is taxed as accrued even though holders do not receive interest payments in the early years (only when the tranches pays out).

Many CMOs have evolved. Specific complexities of each class have increased with CMOs evolution. CMOs offset some problems of the traditional pass-through securities by providing a stream of cash flows for a relatively predictable length of time to maturity (particularly for early tranches).