What is Collateralized Mortgage Obligations?

Collateralized Mortgage Obligation (CMO) is a type of mortgage-backed investment wherein a number of mortgages are pooled in together and sold as investment securities. Cash inflow occurs when the borrowers repay their loans which are then paid out to the CMO investors.

How do CMOs Work?

Collateralized Mortgage Obligation is divided into various risk categories known as tranches. These multiple classes are meant for investors with different risk appetites and return expectations. They have different maturity dates and are ranked according to the priority of payments i.e. some tranches are paid off before others. As a result, each tranche behaves as separate security with different outstanding principal and coupons.

The riskiest tranche will be the first one to bear the brunt of losses arising from default and in turn, will be rewarded by the highest coupon rate among all. In the event of prepayments, the least risky class receives its share first and will have the lowest rates of return. Structuring the CMOS like this doesn’t eliminate or lower risk. Instead, the risk gets distributed among investors as per their risk profiles.

Types of Tranching in CMO

#1 – Credit Tranching

This is the most prevalent form of tranching aiming towards credit protection. The structure consists of senior and junior tranches. Junior tranches absorb any losses resulting from default of borrowers before it can be passed on to the senior tranches. Whatever cash flow is available is first made available to the senior tranches. This kind of structure is also referred to as the “waterfall structure”. Generally, a threshold trigger is also defined where after a certain level of delinquency the losses start getting transferred to the senior tranches as well.

#2 – Overcollateralization

This refers to a situation of credit enhancement where the principal value of CMOs issued is far less than the total value of underlying mortgages. This renders the CMOS over collateralized where do not experience losses until the value of mortgages falls below the principal of CMOs leading to under collateralization. This condition is common in the case of subprime loans.

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#3 – Excess spread

The term excess spread refers to the difference between the coupon rate of the issued CMOs and the weighted average interest rate of all the mortgages in the pool. Maintaining excess spread provides a cushion for any losses that might occur in the future. This margin is stored in a spread account and is used to maintain timely payments in case of default and non-payment.

#4 – Prepayment Tranching

Prepayment tranching is a mode of providing a level of protection against prepayment risk. Prepayment of mortgages in the pool shortens the life span of CMOs as the principal is paid before maturity and any future interest payments disappear. Prepayment tranching re-allocates the prepayment risk over a number of tranches. This can be approached in a number of ways:

Time Tranching – All the principal payments available at one time are used to pay off the first tranche. Any next prepayments go to the next tranche in the sequence. This way, different tranches mature at different times.
Parallel Tranching – This occurs when the coupon rates of all tranches eventually equal the interest rates of the mortgages in the pool. The tranches may have fixed or floating rates but it all comes down to match the mortgage rates.
Z Bonds/ Accrual Bonds – This refers to a CMO which has a “Z” tranche. This tranche is often the last tranche and does not receive any interest payments at first. All the interest accruing for this tranche goes to pay off the principal of other tranches. After other tranches are paid off, this tranche starts receiving its due payments.
Schedule Bonds and Companion Bonds – Schedule bonds receive prepayments as per a pre-defined schedule and any excess is absorbed by the support bonds also known as companion bonds.

#5 – Coupon Tranching

This type of tranching is approached by re-allocating the coupons of the mortgages and is mostly done after prepayment tranching is achieved. Coupon tranching produces two main types of tranches:

Interest-only tranche (IO) – This tranche only receives the interest calculated over a notional principal. No principal payments are made. Hence, it does not face any prepayment risk.
Principal only tranche (PO) – This tranche is only set to receive the principal payment and no interest and hence it becomes more vulnerable to prepayments.

Advantages

Tranching allows investors to earn profits more suited to their risk profiles and investment return expectations.
CMOs benefit the financial institutions by allowing them to issue securities that are structured in a way where they do not have to worry about making payments to all investors at once. Some receive payments before the others and those who don’t have signed up for it.
Investors have access to a varied set of mortgage loans under one roof.

Disadvantages

Prepayment risk- Prepayments shorten the life span of a CMO and any future payments cease to exist.
Interest rate risk- Prepayments are most common when market interest rates fall since the homeowners look for refinancing options to reduce their borrowing costs.
Market risk- Overall economic condition also impacts the functioning of a CMO.
Liquidity risk- Mortgage loans aren’t liquid. If an investor looks to get out of one position, it isn’t very easy.

Limitations

The performance of a CMO is largely dependent on the quality of underlying loans. If the underlying mortgages are subprime, the probability of default is much greater.

Conclusion

CMOS are complex financial structures that are governed by the different terms associated with the mortgages in the pool. As such, it isn’t very easy to assess the risks and returns associated. Sometimes investors get so blinded by the income that is supposed to come that they forget to assess the quality of the underlying.

The Subprime Mortgage Crisis was a result of this ignorance. This led to increased monitoring by the regulatory bodies. CMOs are good investment options but like everything else, they need to be assessed for any possible risks and losses before investment decisions are taken.

Collateralized Mortgage Obligations