Collateralized mortgage obligation
A collateralized mortgage obligation 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.
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 Lewis Ranieri and the First Boston team by Laurence D. Fink, although Dexter Senft also later received an industry award for his contribution).
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. For tax purposes, CMOs are generally structured as Real Estate Mortgage Investment Conduits, which avoid the potential for "double-taxation".
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.
The term "collateralized mortgage obligation" technically refers to a security issued by a 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. 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.
- A group of mortgages could create four 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 four 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.
- 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. 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 or principal-only 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.
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 . 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 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", then the CMO defaults. CMOs have contributed to the subprime mortgage crisis.