Collateralized Mortgage Obligations
(CMOs)
History and Application
Michael Wallace
BA543-1
Agenda
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What is a CMO?
History
Risk
Example – (Sequential-Pay CMO)
Types of CMOs
Conclusion
What is a CMO?
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Pools of securitized mortgages whose cash flows
have been dedicated to two or more types of bond
classes designed to better meet investor needs.
Derivative mortgage securities
What is a CMO?
Loan # 1
Loan # 2
Monthly Cash Flow
Interest
Scheduled principal payments
Prepayments
Pass-through: Pooled
mortgage loans
Interest
Scheduled principal payments
Prepayments
Tranche A
Loan # 3
Rule for distribution of
cash flow (i.e. Pro rata
basis)
Tranche B
Interest
Scheduled principal payments
Prepayments
Tranche A
Loan # 4
Tranche B
Interest
Scheduled principal payments
Prepayments
Tranche C
Tranche D
CMO
Tranche C
Tranche D
Who issues CMOs?
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Agencies (i.e. Freddie Mac, Ginnie Mae..etc)
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Non-agency (i.e. Countrywide)
Private-label
 Whole-loan
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History
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The first CMO was issued in 1983 by Freddie Mac
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Sears/Dean Witter, Reynolds attempted CMO issuance
in 1984
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Volatility of interest rates in previous decade => high
prepayment risk
IRS ruling made CMOs uncompetitive
Tax Reform Act of 1986
 Creation of the Real Estate Mortgage Investment
Conduit (REMICs)
 Required accrual-based accounting for investors
Characteristics
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Maturity – Matures when investor receives final
principal payment
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Yield
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Weighted average maturity (WAM)
Assumed prepayment rates
Tranches
Interest
 Principal – “active” tranche
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The Three Relationships
•Prices and Rates
Interest Rates
CMO Prices
CMO Prices
Interest Rates
•Prices and Time
CMO Life
CMO Life
CMO Prices
CMO Prices
•Prepayments and Time
Interest Rates
Prepayment
Prepayment
Interest Rates
Risk
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Why not invest directly in mortgages?
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Exposure: credit risk, liquidity risk, price risk,
prepayment risk
Types of Risk
Price Risk
 Return Risk
 Prepayment (“Call”) Risk
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Prepayment Risk
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Contraction Risk-Decline in mortgage rates that
effectively shortens the life of a pass-through
security
Extension Risk-Increase in mortgage rate that
effectively lengthen the life of a pass-through
security
Prepayment Speed Assumptions
(PSA) Model
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Created by the Bond Market
Association
Based on Constant Prepayment
Rate (CPR)
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Annualized amount of outstanding
principal prepaid each month (SMM)
Ex. 100% PSA => 0.2%CPR in
first month, 0.4% CPR in second
month, and increases until rate
reaches 6%
200
300
400
100
500
0
600
PSA
Example Sequential-Pay CMO
Classes of CMOs
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Sequential-Pay
Planned Amortization – PAC & Companion Tranches
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Type I PAC – 100% to 300% PSA
Target Amortization
Companion Tranches – Higher yield, greater uncertainty
Z-Tranches
Principal-Only (PO)
Interest-Only (IO)
Floating-Rate – tied to interest rate index (i.e. LIBOR)
Residuals
Conclusion
CMO Issuance
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20
02
20
00
19
98
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19
96
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High credit rating (AAA)
Low minimum cost to buy
into ($1,000)
Competitive yield
Flexibility to meet investor
needs (maturity)
Ability to receive monthly
cash flow
Hedging against prepayment
risk
Liquidity
19
94
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BILLIONS
19
92
Why invest in CMOs?
19
90
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900
800
700
600
500
400
300
200
100
0
Questions?