All About Collateralized Mortgage Obligations, Known As CMOs
Collateralized Mortgage Obligations (CMOs) sometimes referred to as Real Estate Mortgage Investment Conduits (REMICs), are one of few innovative investment methods available in today’s investment world.
CMOs offer relative safety, regular payments and notable yield advantages over other better known fixed-income securities of comparable credit quality.
A wide variety of CMO securities with different cash flow and expected maturity characteristics have been designed to meet specific investment objectives. While CMOs offer advantages to investors, they also carry certain risks which will be further explained in this document. To determine if CMOs fit within your investment portfolio, you should first understand the distinctive features of these securities.
CMOs were first introduced in 1983. The Tax Reform Act of
1986 allowed CMOs to be issues in the form of REMICs,
creating certain tax and accounting advantages for issuers
and for certain large institutional and foreign investors.
Today, almost all CMOs are issued in REMIC form. Remember
that throughout this CMO explanation, REMICs and CMOs are
interchangeable.
THE BUILDING BLOCKS OF CMOS Mortgage Loans and Mortgage
Pass-Throughs When a CMO is created, it begins with a
mortgage loan extended by a financial institution (such as
a savings and loan, commercial bank or mortgage company) to
finance a borrower’s home or other real estate. The
homeowner usually pays the mortgage loan in monthly
installments composed of both interest and “principal”.
Over the duration of the mortgage loan, the interest
component of payments in the early years gradually declines
as the principal component increases. To obtain funds to
generate more loans, lenders either “pool” groups of loans
with similar characteristics to create securities or sell
the loans to issuers of mortgage securities. The
securities most commonly created from pools of mortgage
loans are “mortgage pass-through securities” (MBS) or
“participation certificates” (PCs). MBS represent a direct
ownership interest in a pool of mortgage loans. As the
homeowners whose loans are in the pool make their mortgage
loan payments, the money is distributed on a pro rata basis
to the holders of the securities. Several factors can
affect the homeowners’ payments.
Typically, the homeowner will “prepay” the mortgage loan by
selling the property, refinancing the mortgage or otherwise
paying off the loan in part or whole. Most mortgage
pass-through securities are based on fixed-rate mortgage
loans with an original maturity of 30 years, but experience
shows that most of these mortgage loans will be paid off
much earlier. While the creation of MBS greatly increased
the secondary market for mortgage loans by pooling them and
selling interests in the pool, the structure of such
securities has inherent limitations. MBSs only appeal to
investors with a certain investment horizon - on average,
10-12 years.
CMOs were developed to offer investors a wider range of
investment time frames and greater cash-flow certainty than
had previously been available with MBS. The CMO issuer
assembles a package of these MBS and uses them as
collateral for a multiclass security offering. The
different classes of securities in a CMO offering are known
as tranches, from the French word for slice. The CMO
structure enables the issuer to direct the principal and
interest cash flow generated by the collateral to the
different tranches in a prescribed manner, as defined in
the offering’s prospectus, to meet different investment
objectives.
THE HIGH CREDIT QUALITY OF CMOS The Government National
Mortgage Association (GNMA, or Ginnie Mae) an agency of the
U.S. government, along with U.S. government-sponsored
enterprises (GSE) such as the Federal National Mortgage
Association (FNMA, or Fannie Mae) or the Federal Home Loan
Mortgage Corporation (FHLMC, or Freddie Mac), guarantee
most MBSs. Ginnie Mae is a government-owned corporation
within the Department of Housing and Urban Development.
Fannie Mae and Freddie Mac have federal charters and are
subject to some oversight by the federal government, but
are publicly owned by stockholders.
Fannie Mae and Freddie Mac issue and guarantee pass-through
securities. Ginnie Mae only adds its guarantee to
privately issued pass-throughs backed by government issued
(FHA and VA) mortgages. Fannie Mae and Freddie Mac have
issues CMOs for quite some time; the Department of Veterans
Affairs (VA) began to issue CMOs in 1992, and Ginnie Mae
initiates its own CMO program which began in 1994.
Securities guaranteed or guaranteed and issues by these
entities are known generically as “agency” mortgage
securities. The agency guarantees enhance their credit
quality for investors. In addition, the mortgages backing
Fannie Mae and Freddie Mac mortgage securities must meet
strict quality criteria. Those backing GNMA pass-throughs
are underwritten in accordance with the rules and
regulations of the FHA and the VA, which insure them
against default.
The extent of the agency guarantee depends on the entity
making it. Ginnie Mae, for example, guarantees the timely
payment of principal and interest on all of its mortgage
securities, and its guarantee is backed by the “full faith
and credit” of the U.S. government. Holders of Ginnie Mae
mortgage securities are therefore assured of receiving
payments promptly each month, regardless of whether the
underlying homeowners make their payments. They are
guaranteed to receive the full return of face-value
principal even if the underlying borrowers default on their
loans. Mortgage securities issued by the VA carry the same
full faith and credit U.S. government guarantees.
Fannie Mae guarantees timely payment of both principal and
interest on its mortgage securities whether or not the
payments have been collected from the borrowers. Freddie
Mac also guarantees timely payment of both principal and
interest on its Gold PCs and CMOs. Some older series of
Freddie Mac PCs guarantee timely payment of interest, but
only the eventual payment of principal. Although neither
Fannie Mae or Freddie Mac securities carry the additional
full faith and credit U.S. government guarantee, the credit
markets consider the credit on these securities to be
equivalent to that of securities rated triple-A or better.
Some private institutions, such as subsidiaries of
investment bank, financial institutions and home-builders,
also issue mortgage securities. When issuing CMOs, they
often use agency mortgage pass-through securities as
collateral; however, their collateral may include different
or specialized types of mortgage loans and/or pools,
letters of credit and other types of credit enhancements.
These private-labeled CMOs are the sole obligation of their
issuer. To the extent that private-label CMOs use agency
mortgage pass-through securities as collateral, their
agency collateral carries the respective agency’s
guarantees. Private-label CMOs are assigned credit ratings
by independent credit agencies based on their structure,
issuer, collateral and any guarantees or outside factors.
Many carry the highest AAA credit rating.
As an additional investor protection, the CMO issuer
typically segregates the CMO collateral or deposits it in
the care of the trustee, who holds it for the exclusive
benefit of the CMO bondholders.
A DIFFERENT SORT OF BOND Prepayment Rates and Average Lives
Although CMOs entitle investors to payments of principal
and interest, they differ from corporate bonds and Treasury
securities in significant ways. Corporate and Treasury
bonds are issued with stated maturities. The purchase of a
bond from an investor is essentially a loan to the issuer
in the amount of the principal, or face amount, of the bond
for a prescribed period of time in return for a specified
annual rate of interest. The bondholder receives interest,
generally in semiannual payments, until the bond is
redeemed.
When the bond matures, or is called by the issuer, the
issuer returns face value of the bond to the investor in a
single principal payment. With a CMO, the ultimate borrower
is the homeowner who takes who takes on a mortgage loan.
Because the homeowner’s monthly payments include both
interest and principal, the mortgage security investor’s
principal is returned over the life of the security, or
amortized rather than repaid in a single lump sum at
maturity.
CMOs provide monthly or quarterly payments to investors
which include varying amounts of both principal and
interest. As the principal is repaid (or prepaid), the
interest payments become smaller because they are based on
a lower amount of outstanding principal. A mortgage
security “matures” when the investor receives the final
principal payment. Most CMO tranches have a stated
maturity based on the last date on which the principal from
the collateral could be paid in full. This date is
theoretical, because it assumes no prepayments on the
underlying mortgage loans. Mortgage securities are more
often discussed in terms of their average life rather than
their stated maturity date. Technically, the average life
is defined on the average time to receipt of each dollar of
principal, weighted by the amount of each principal payment.
In simpler terms, the average life is the average time that
the principal dollar in the pool is expected to be
outstanding, based on certain assumptions about prepayment
speeds.
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