Collateralized Mortgage Obligations (CMO)

As mentioned earlier, traditional lenders package home mortgages and pass them onto intermediary companies. These companies then sell the obligations to investors, who receive payments of principal and interest from the package of homeowners. This is why these investments are sometimes referred to as pass-through securities.

There are two ways CMOs cn address the risk of repayment/ prepayment: planned amortization class (PAC) tranches, and targeted amortization class (TAC) tranches.

Moneyzine Editor

Investors in collateralized mortgage obligations are exposed to several risks, including:

• Repayment: unlike traditional bonds, homeowners will pay down the outstanding balance of their loan over time. As this happens, the size of the investor's stake in the security will decline, forcing the buyer of the CMO to find alternative investments.

• Prepayment: homeowners also have the right to prepay their mortgages. This frequently occurs when interest rates drop and homeowner's refinance their loans or when a homeowner sells their home.

• Default: as demonstrated during the 2008 / 2009 recession, the sub-prime mortgage market saw a dramatic rise in the default rate on home loans. For example, the Mortgage Bankers Association reported the delinquency rate for loans rose to 9.64% in the third quarter of 2009.

Prepayment / Repayment

From a risk standpoint, both repayment and prepayment will always be present in collateralized mortgage obligations because they're based on traditional lending practices. Homeowners and businesses will be paying down the principal of their loans each month, and this process slowly lowers the size of the investment. Prepayment occurs as homeowners move from one residence to another and pay off their mortgages when they sell their homes. Prepayment can also accelerate when interest rates fall and mortgage holders subsequently refinance their homes. Therefore, CMOs are subject to interest rate risk, which manifests itself as an increase in refinancing activity.

Amortization Tranches

There are two ways CMOs can address the risk of repayment / prepayment: planned amortization class (PAC) tranches, and targeted amortization class (TAC) tranches.

• Planned Amortization Class: use a companion tranche (discussed later) to combat prepayments that occur faster or slower than anticipated. Inflows and outflows of funds from the companion tranche are used to even out payments to investors. PAC tranches are useful in reducing the risk of prepayment.

• Targeted Amortization Class: also improve investor cash flow by establishing a companion tranche to replenish funds as repayment of mortgage principal occurs over time. TACs are established using a schedule that assumes a fixed rate of repayment. If the rate of prepayment is higher or lower than the assumed rate of repayment, then holders of TAC bonds may receive more or less principal than planned.

Companion Tranches

Also-known-as support bonds, a companion tranche will accompany any collateralized mortgage obligation that has a PAC or TAC tranche. The purpose of the companion tranche is to even-out any variability in prepayment patterns. Once principal payments have been directed to the PAC or TAC according to schedule, all excess or shortfall flowing from, and to, the PAC or TAC is then directed to the companion tranche. If interest rates rise, then the predicted rate of prepayment will likely be less than planned. Rising interest rates will extend the life of the companion tranche. If interest rates decline, then the predicted rate of prepayment will likely be greater than planned. Therefore, falling interest rates will shorten the life of the companion tranche. Since a companion tranche carries a greater risk of prepayment than the PAC or TAC tranche it supports, it will also offer investors the opportunity to realize a higher return on their investment. In summary, investors enjoy a greater return from the companion fund, but they will also have to look for an alternative investment sooner than the investor in the PAC or TAC.

Default

The risk of default was of particular concern for investors during the subprime mortgage crisis that accompanied the Great Recession of 2008 / 2009. Collateralized mortgage obligations are often backed by commercial or home mortgages, which were originally written by savings and loans, mortgage companies, and other traditional lenders. If a loan meets certain credit criteria, then Government sponsored Enterprises (such as Freddie Mac, Ginnie Mae, and Fannie Mae) will guarantee payment on the loan. These are often referred to as conforming loans, and when packaged in a CMO, they eliminate credit risk. When CMOs are packaged with non-conforming loans, they are often referred to as whole-loan CMOs. These security issues continue to carry the risk of individual loan default.

Default or Credit Tranching

Non-conforming loans will often require borrowers to pay a premium over existing interest rates. The higher rate of interest on these loans makes them more desirable to investors if credit risk can be mitigated. One way to lower the risk of these issues is to create different classes, or tranches, based on the creditworthiness of the borrowers. Junior class bondholders will absorb losses until their investment no longer has any value. This process continues through each class of bondholder, and ends with investors holding senior debt. The approach provides investors willing to take greater risks with greater rewards. A second way to lower the risk of default is by reducing the interest payments to bondholders. For example, if the average interest rate in a pool of mortgages is 6.5%, the issuer of the bond could choose to pay a 5.0% rate of interest to bondholders. The excess interest payments collected on the loans are then directed to a "spread" account. If borrowers default on their loans, the money in the spread account can be used to repay the lost principal. Finally, credit risk can also be mitigated through over-collateralization. In simple terms, the issuer of the bonds will sell them at a discount to the value of the pool of mortgages. For example, $110 million in mortgages could be sold as $100 million in bonds. While this approach will lower the interest payments to bondholders, the excess collateral insulates the bondholder from losses until they reach a given threshold. In this example, $10 million of loans can go into default until the bond's principal is reduced.