Collateralized mortgage obligation

Collateralized Mortgage Obligation

A Collateralized Mortgage Obligation (CMO) is a type of mortgage-backed security (MBS) that creates separate pools of pass-through rates for different classes of bondholders with varying maturities, called tranches. The payments from the underlying mortgages are used to pay off the CMO bonds in a prescribed order, based on the tranche structure.

Structure

CMOs are structured by dividing the pool of mortgage loans into different tranches, each with its own level of risk, return, and maturity. The tranches are typically categorized as follows:

• Senior tranches: These have the highest credit quality and are the first to receive principal and interest payments.
• Mezzanine tranches: These have a moderate level of risk and return.
• Equity tranches: These are the riskiest and are the last to receive payments, often absorbing any losses first.

Types of Tranches

• Sequential-Pay Tranches: Payments are made to one tranche at a time until it is fully paid off.
• Planned Amortization Class (PAC) Tranches: These tranches have a set schedule of principal payments, providing more predictable cash flows.
• Targeted Amortization Class (TAC) Tranches: Similar to PAC tranches but with a single target principal payment schedule.
• Support or Companion Tranches: These absorb excess or shortfall in payments to protect PAC and TAC tranches.

Risks

CMOs carry several types of risks, including:

• Prepayment Risk: The risk that the underlying mortgages will be paid off earlier than expected, affecting the cash flow.
• Extension Risk: The risk that the underlying mortgages will be paid off slower than expected, extending the duration of the investment.
• Credit Risk: The risk of default on the underlying mortgages.

History

CMOs were first introduced in the early 1980s by investment banks to provide more predictable cash flows to investors compared to traditional MBS. They became popular due to their ability to meet the needs of different types of investors with varying risk appetites.

Regulation

CMOs are subject to regulation by various financial authorities, including the Securities and Exchange Commission (SEC) in the United States. They must comply with specific disclosure requirements to ensure transparency for investors.

Related Pages

• Mortgage-backed security
• Tranche
• Prepayment risk
• Credit risk
• Investment bank
• Securities and Exchange Commission