Fixed Income Types: Collateralized Mortgages

Understanding Collateralized Mortgage Obligations (CMOs)

Collateralized Mortgage Obligations (CMOs) may sound complex, but let's break it down in simple terms for a better grasp. These are securities created from groups of mortgage loans. Imagine it as a way to package and sell pieces of many home loans to different investors. Now, let's dive into the basic details without getting too technical.

What are CMOs?

CMOs are like financial puzzles made from putting together different home loans. Investors buy these puzzles to earn money from the interest and payments people make on their mortgages. CMOs have different parts, called tranches, each with its own level of risk and reward.

How are CMOs Created?

Think of it like making a big potluck dinner. Lenders bring their mortgage loans, and organizers (like banks) mix them together. Then, they divide the potluck into portions (tranches) and invite people (investors) to join the feast by buying a piece. The organizers make money by selling these portions to investors.

Types of Tranches

Tranches are like slices of a cake, but not all slices are the same. There are three main types:

1. Senior Tranches: These are like the first slices of cake, less risky and get paid first.
2. Mezzanine Tranches: Think of these as the middle slices, with moderate risk and reward.
3. Subordinate Tranches: These are the last slices, riskier but might offer more rewards. They get paid last.

Sequential Pay CMO

This is a bit like a line at the grocery store. The "A" tranche goes first, then the "B" tranche, and so on. Each tranche gets paid until it's all done before the next one starts. It's an organized way to share the money from mortgage payments.

Floaters and Inverse Floaters

Some CMOs have parts that act like a seesaw with interest rates. Floaters go up or down based on interest rates, while inverse floaters do the opposite. It's like a see-saw where one side goes up when the other goes down.

Support Tranches and Support Bonds

These are like bodyguards for the tranches. If things go wrong, support tranches take the hit first, protecting the others. Support bonds are like insurance for the bodyguards, helping cover losses and keeping things stable.

Notional Interest-Only (IO) and REMIC

Notional IO is a bit like getting only the interest part of a cookie, not the whole thing. It's a way for investors to earn interest without worrying about the cookie disappearing. REMIC is like a tax helper, making sure everyone gets a fair share without paying taxes twice.

In a Nutshell

CMOs are like financial jigsaw puzzles made from pieces of home loans. Investors buy these puzzles to earn money from people paying their mortgages. Tranches are different slices of the puzzle, each with its own level of risk and reward. It's a way to share the benefits and risks of mortgage payments among different investors. Simple, right?

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