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Fixed Income Types: Collateralized Mortgages

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Collateralized Mortgage Obligations (CMO) Structure, Tranches, and Risk Considerations

Collateralized Mortgage Obligations (CMOs) are structured securities created from pools of mortgage loans. CMOs offer investors various tranches with different risk and return profiles, allowing for customization based on investor preferences. In this section, we will explore the detailed aspects of CMOs, including their creation, sequential pay structure, average life, tranches, floaters, inverse floaters, support tranches, support bonds, notional interest-only (IO), and Real Estate Mortgage Investment Conduits (REMIC).

Creation of CMOs

CMOs are created to redistribute the cash flows from underlying mortgage loans into different securities to meet investor preferences and risk profiles. The process of creating a CMO involves the following steps:

  1. Mortgage Pool Creation: A mortgage pool is formed by combining a group of individual mortgage loans with similar characteristics, such as loan type, interest rate, and maturity.
  2. Structuring the CMO: The mortgage pool is divided into multiple tranches, each representing a different portion of the cash flows generated by the underlying mortgage loans. Each tranche has unique characteristics, risks, and potential returns.
  3. Sale and Distribution: The CMO tranches are sold to investors, who receive cash flows based on the tranche's structure and priority in the payment hierarchy.

Sequential Pay CMO

A sequential pay CMO is a type of CMO structure where cash flows from the underlying mortgage loans are distributed in a specific order. The priority of payment is determined by the tranche's position in the sequential payment structure. Tranches are typically named based on their priority, such as "A," "B," "C," and so on.

Example: In a sequential pay CMO, the "A" tranche receives cash flows first, followed by the "B" tranche, and so on. Each tranche receives principal and interest payments until it is completely paid off before the next tranche begins to receive payments.

Average Life and Collateral Difference

The average life of a sequential pay CMO tranche can differ from the collateral from which it is created. This is primarily due to the impact of prepayments. Prepayments accelerate the return of principal to investors, shortening the average life of the tranche compared to the original collateral.

Example: If the underlying mortgage loans experience higher prepayment rates, the average life of the sequential pay CMO tranche will be shorter than the average life of the mortgage loans in the collateral pool.

Tranches and Impact on CMO Structure

CMOs consist of different tranches that offer varying risk and return profiles. Each tranche has a unique structure and priority in receiving cash flows. The key tranches found in CMOs include:

  1. Senior Tranches: Senior tranches have the highest payment priority and are considered the least risky. They typically receive interest and principal payments before subordinate tranches.
  2. Mezzanine Tranches: Mezzanine tranches fall between senior and subordinate tranches in terms of payment priority. They offer intermediate risk and return characteristics.
  3. Subordinate Tranches: Subordinate tranches have the lowest payment priority and are considered riskier than senior and mezzanine tranches. They may offer higher potential returns but are more exposed to credit and prepayment risks.

Floaters and Inverse Floaters

CMOs may include floating-rate tranches, known as floaters, and inverse floating-rate tranches, known as inverse floaters. These tranches have unique cash flow characteristics tied to changes in interest rates:

  1. Floaters: Floaters pay interest that adjusts periodically based on a reference rate, such as LIBOR. The interest payments increase or decrease in response to changes in the reference rate.
  2. Inverse Floaters: Inverse floaters pay interest that moves inversely to changes in the reference rate. As the reference rate decreases, the interest payments on inverse floaters increase, and vice versa.

Support Tranches and Prepayment Risk for Investors

Support tranches in a CMO provide credit enhancement and absorb losses before other tranches. They help protect higher-priority tranches from default and prepayment risks. However, support tranches also face higher credit risk and may experience losses if the collateral performs poorly.

Support Bonds

Support bonds are issued to finance the support tranches in a CMO structure. These bonds provide additional credit enhancement to the CMO by absorbing losses and protecting higher-rated tranches. The cash flows from support bonds are used to cover losses in lower-rated tranches, reducing default risk for higher-rated tranches.

Notional Interest-Only (IO)

Notional IO is a derivative instrument created from the interest component of mortgage pass-through securities. Investors in notional IO receive the interest payments from the underlying mortgage pool but do not receive any principal payments. Notional IO can be structured as a separate tranche or a stand-alone security.

Real Estate Mortgage Investment Conduits (REMIC)

REMIC is a tax designation used for CMOs to ensure favorable tax treatment. REMICs allow the pass-through of income and losses from the underlying mortgage loans to investors without double taxation at the entity level.

Conclusion

Collateralized Mortgage Obligations (CMOs) offer investors various tranches with different risk and return profiles derived from pools of mortgage loans. Understanding the creation process, sequential pay structure, tranches, floaters, inverse floaters, support tranches, support bonds, notional IO, and REMIC status is essential for investors participating in the CMO market. A comprehensive understanding of CMOs empowers investors to evaluate risks and opportunities in this segment of the debt and money markets.

This article takes inspiration from a lesson found in FIN 4243 at the University of Florida.