COLLATERALIZED MORTGAGE
OBLIGATIONS
Collateralized mortgage obligations (CMOs) offer a unique opportunity for monthly income, relative safety and attractive
yield advantages compared to other similar quality investments. The Federal Home Loan Mortgage Corporation (“Freddie
Mac”) first introduced CMOs in 1983. The Tax Reform Act of 1986 authorized the establishment of Real Estate Mortgage
Investment Conduits (REMICS), creating certain tax and accounting advantages for issuers and for certain large institutional
and foreign investors. For investment purposes, REMIC securities are indistinguishable from CMOs. The CMO market has
grown to more than $1 trillion in size since its inception in 1983 and today accounts for an ever increasing and important
segment of the overall mortgage market.
WHAT IS A CMO?
Collateralized mortgage obligations are mortgage-backed,
investment-grade bonds that separates mortgage pools into
different maturity classes. They are backed by mortgagebacked securities with fixed maturities. CMOs can eliminate
the risks associated with prepayment because each security
is divided into maturity classes that are paid off in order.
However, because you have less prepayment risk and
increased predictability of payments, CMOs offer a lower
yield compared to other mortgage-backed securities.
The maturity classes are called classes or tranches, and they
are differentiated by the type of return. A given class may
provide interest, principal or both.
Because mortgage-backed securities return principal over
a period of time rather than on one specific maturity date,
the return of principal is referred to as the “average life,”
which is the weighted average time to receipt of principal.
In most cases, at the average life, approximately 50 percent
of the principal will have been returned.
THE EVOLUTION OF CMOS
Among the first types of mortgage-backed securities
created were mortgage pass-through securities, which are
now used as collateral for collateral mortgage obligations.
Similar home mortgages meeting the standard criteria of
the issuing government agency are grouped together into
“pools,” and you may purchase an interest in these pools.
As the mortgage holders make monthly payments of principal
and interest, you are entitled to a pro rata portion of the
payments received. Mortgage pass-through securities are
typically considered to have an investment horizon of
approximately 10 to 12 years on average, even though
the mortgages are typically 30-year loans. This shortened
horizon occurs because most mortgage loans are paid off
early due to, among other things, homeowners moving,
prepayments and refinancing. In an effort to attract
investors with investment objectives different than the
typical pass-through security, the CMO was created.
This was achieved by using pools of mortgage pass-through
securities as collateral, which produces monthly cash flow
of principal and interest, and then redirecting the cash
flow to create short-, intermediate- and long-term bonds.
The largest issuers of CMOs are:
• Federal Home Loan Mortgage Corporation (FHLMC—
more commonly referred to as “Freddie Mac”)
• Federal National Mortgage Association (FNMA—more
commonly referred to as “Fannie Mae”)
• Government National Mortgage Association (GNMA—
more commonly referred to as “Ginnie Mae”)
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HOW A CMO WORKS
A typical collateral mortgage obligation has 10 to 20
different tranches, or classes. Each tranch can have a
different coupon, expected average life and cash flow
schedule. This unique structure enables the issuer to
transform a pool of 30-year mortgage pass-through
securities into a series of bonds, each designed to meet
the needs of different investor groups.
The issuer predetermines the order in which the tranches
will be retired. As the cash flow from the underlying
collateral is received each month, the trustee will disburse
the interest and principal to the tranches based on a
predetermined set of rules. Principal and interest will be
directed to some tranches while others will receive interest
only for some period. After the shortest maturity class has
been fully retired, the principal will then be directed to the
next class in line. This type of structure allows investors in
the longer-term tranches to enjoy steady interest income for
several years as the early classes absorb the prepayments.
The yield and average life of each class will fluctuate
depending on changes in current interest rates.
BENEFITS OF CMOS
Collateral mortgage obligations offer excellent credit quality.
FHLMC and FNMA long-term debt has been rated Aa by
Moody’s and AAA by Standard & Poor’s. Although not
explicitly rated by the rating agencies, CMOs are senior to
FHLMC and FNMA long-term debt (meaning it has priority
for repayment in a liquidation) and thus have an implied
AAA rating. This relationship with government agencies
does not guarantee the payment of any premiums.
CMOs are available in a variety of average lives and with
varying sensitivity to changes in prepayment speeds, allowing
you to choose the maturity class that best meets your
investment objectives. They deliver monthly cash flow of
either interest only and ultimately principal, or interest and
principal, until the bond is retired. (Accrual bonds are an
exception; they offer monthly compounding of interest until
a conversion date, when monthly cash flow is paid to you.)
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MINIMUM INVESTMENTS, TRANSACTION COSTS
AND LIQUIDITY
Most collateral mortgage obligation tranches sold to
individual investors are available in $1,000 denominations.
Mortgage securities dealers execute CMO transactions
over the counter. Transactions are done at a net cost, which
includes the dealer spread or profit on the trade. Spreads
on CMOs are generally wider than on Treasuries or agency
debentures, because the Treasury market is generally
broader and more liquid.
Although there is an active secondary market for CMOs,
the degree of liquidity can vary widely. The unique
characteristics of individual CMO tranches place limitations
on the potential liquidity of the product. Accordingly, if
these investments are sold in the secondary market prior to
maturity or a call date, they may be worth less than their
original cost.
TAX CONSIDERATIONS
Interest income on collateral mortgage obligations is subject
to federal, state and local income tax, while Treasury
securities are exempt from state and local income taxes.
CMO payments that represent the return of principal are
not taxable. You should understand all tax issues associated
with CMO investing and should contact a tax advisor prior
to a CMO investment.
QUESTIONS TO ASK WHEN BUYING A CMO
Collateral mortgage obligations can be complex investments,
and you should be sure to understand the terms before you
invest. The anticipated average life, when principal and
interest will be returned and how changes in interest rates
will affect the CMO are all questions you should ask before
investing. Your financial advisor can help you determine
which CMO best suits your needs.
For more information about collateral mortgage
obligations, contact your Piper Jaffray financial advisor.