Collateralized mortgage obligations (CMOs)

Collateralized mortgage obligations (CMOs) are not products of federal agencies, but they are closely tied to them. In the previous section, we learned how the mortgage agencies (Ginnie Mae, Fannie Mae, Freddie Mac) obtain mortgages from private lending institutions and package them as pass through certificates. Two unique risks exist with these securities - prepayment and extension risk. CMOs were created to reduce these risks and the uncertainties of mortgage-backed securities.

When investing in a pass through certificate, investors may be in for a short or long ride. If interest rates fall, homeowners pay off their mortgages early typically due to refinancing. In this scenario, pass through certificates have shorter maturities and investors receive their principal faster. An expected 15-year maturity on a pass through certificate could turn to a 5-year maturity. On top of that, the investor likely reinvests their money back into the market at lower rates of return (interest rates fell). This is prepayment risk.

If interest rates rise, homeowners extend their mortgages for longer periods of time. Why consider paying off or refinancing a low interest rate mortgage? In this scenario, pass through certificates have longer maturities and investors receive their principal slower. An expected 15-year maturity on a pass through certificate could turn to a 25-year maturity. On top of that, the investor is stuck in a lower yielding pass through certificate for longer. This is extension risk.

CMOs were created to reduce these risks by removing some uncertainty for investors in mortgage-backed securities. Unlike pass through certificates, CMOs do not pass through principal payments on a pro-rata basis.

CMOs are basically “sliced up” pass through certificates. Let’s take a look at a visual representation of a pass through certificate:

As you can see, homeowners make their monthly interest and principal payments to the mortgage agency (Ginnie Mae, Fannie Mae, or Freddie Mac), then the agency “passes through” those payments to investors. If there was a large influx of principal payments due to large levels of refinancing, each investor receives their pro-rata amount. If there were only three investors, each would receive an equal third of the payments coming their way.

CMOs are created by financial institutions that typically purchase pass through certificates from mortgage agencies and repackage them. Essentially, the pass through certificate is “sliced up” into tranches.

A simple version of a CMO looks like this:

These are known as plain vanilla CMO tranches. Interest is still split up on a pro-rata basis (each investor receives their proportionate amount of interest), while principal is only allocated to the investor owning the first tranche. This is known as sequential allocation. While a CMO structure like this is still subject to prepayment and extension risk, investors know where they stand based on the tranche they invest in. A front-end tranche receives all principal immediately and is the first investor to receive all of their principal back.

Tranches are chosen depending on how long the investor wants to receive payments and the level of risk they want to absorb. Front-end tranches have shorter maturities, less risk, and lower yields. Back-end tranches have longer maturities, more risk, and higher yields. In the real world, CMOs sometimes have thousands of tranches to choose from.

Eventually, the investor owning the first tranche receives their entire principal value back. Once this occurs, their CMO matures and they’re out of the mix. Interest continues to be paid to the remaining two tranches on a pro-rata basis, but the principal now goes down the sequence and is paid to the second tranche.

Eventually, the second tranche receives all principal back and is retired. The principal is now diverted to the last tranche, where the final investor receives every dollar of interest and principal.

Choosing the right tranche is a tough process for investors. While payment speed is unknown and dependent on many economic factors (interest rates, the real estate market, etc.), there are sources investors can utilize to forecast principal payment speed. Formerly known as the Public Securities Association, the Securities Industry and Financial Markets Association (SIFMA) predicts future principal payment speeds. While you don’t need to know the specifics, investors utilize SIFMA’s prepayment speed assumption (PSA) tool to predict how quickly their tranches will be retired.

Tools utilized to determine prepayment speeds are complicated and difficult to understand. Thankfully, the Series 7 generally does not test on the specifics. Knowing some investors use SIFMA’s PSA tool to determine how quickly their tranche will be paid off is likely going to answer any questions relating to this topic

Plain vanilla tranches aren’t the only types of tranches you could see on the exam. Planned amortization class (PAC) CMOs utilize other tranches called companion classes to accept extra principal when prepayment risk occurs or to go some time without principal payments if extension risk occurs. It looks like this:

While it looks similar to a plain vanilla structure, imagine we’re looking at a small set of tranches within a larger tranche. In this scenario, each investor receives interest and principal simultaneously. However, the front-end companion class, which is another investor, receives any “extra” principal that wasn’t anticipated. By accepting the extra principal, the companion class reduces prepayment risk for the PAC. Companion classes are riskier investments because of their role (to protect the PAC).

The back-end companion class comes into play when extension risk occurs and homeowners are not prepaying their mortgages as fast as predicted:

As you can see, the front-end companion class and the PAC get paid while the back-end companion class goes without receiving principal. The back-end tranche’s role is to withstand extension risk by going without principal if extensions occur. This system ensures the PAC receives as much forecasted principal as possible. PACs are tranches that utilize companion classes to reduce prepayment and extension risk.

Targeted amortization class (TAC) CMOs are similar to PACs, but only use one companion class and only protect against prepayment risk.

This time, there’s only a front-end companion class that protects the TAC against prepayment risk. If more than the expected principal is paid by homeowners, the companion class absorbs it. This helps make the TAC’s principal more predictable when prepayment risk occurs. The TAC does not have a companion class on the back end, making TACs susceptible to extension risk. If less principal than expected is paid, the TAC is affected like a normal plain vanilla CMO.

Sometimes financial firms break up plain vanilla tranches into separate streams of income. Principal-only (PO) CMOs represent only the principal portion that comes in. These CMOs do not pay interest but are sold at a discount to par (similar to a zero coupon bond). PO tranche investors realize the greatest return the sooner they receive the investment’s face (par) value back. For example, assume an investor purchases a $1,000 face value PO tranche for $800. The $200 discount represents the return of the investment. If the tranche is retired in 5 years, the investor realizes a 5% annualized return. If the tranche is retired in 10 years, the investor realizes a 2.5% annualized return. The faster the PO tranche matures, the greater the return. On the other hand, the slower the PO tranche matures, the lower the return. Therefore, PO tranche investors hope for mortgages to be prepaid early, while they experience losses if mortgages extend (extension risk).

Interest-only (IO) CMOs represent only the interest portion of a plain vanilla CMO. IO tranches are also sold at discounts, but they begin collecting interest immediately. The longer the investor receives interest payments, the more valuable the investment. Therefore, IO tranche investors hope for mortgages to be extended, while they experience losses if prepayments occur.

A tricky aspect of IO tranches is their response to interest rate changes. Every debt security we’ve discussed so far has a market price that moves inversely to interest rate changes (interest rates up, prices down, and vice versa). IO tranches are the exact opposite. When interest rates rise, so do IO tranche market prices. Think about it - when interest rates rise, fewer homeowners pay off their mortgages early. This leads to mortgages lasting longer and more interest being paid. Remember, IO tranches are more valuable when they receive more interest payments. When interest rates fall, prepayments rise, leading to mortgages being paid off earlier. With earlier prepayments, less interest is paid, leading to lower IO tranche values.

The last type of CMO to discuss is the Z-tranche CMO. These tranches do not receive any payment until all other tranches have matured. Once this occurs, principal and interest begin flowing to the Z-tranche. Similar to long-term zero coupon bonds, Z-tranches are the most volatile type of CMO. When interest rates fluctuate, the value of these CMOs can change drastically.

All these CMOs have common characteristics. Like bonds, they are typically issued in $1,000 denominations. Like pass through certificates, they are fully taxable (federal, state, and local) securities. The more complex the CMO, the more likely it’s subject to liquidity risk. Also, the more complicated the setup, the less likely it’s suitable for the typical retail investor. It’s important for investors to understand the risks and benefits of the securities they invest in, and many small investors have difficulty understanding the details of CMOs.

While complex CMOs may be unsuitable for many retail investors, they are typically AAA (or highly) rated because of the product they’re based on. Remember, CMOs are “sliced up” pass through certificates, which are created by the federal mortgage agencies that have federal backing (indirect or direct). Even if homeowners stop making their mortgage payments, the agencies step in and make it on their behalf. You can assume typical CMOs are fairly low risk.

Private label CMOs are CMOs that are not created with federal agency pass through certificates. Instead of repackaging a safe agency security, these CMOs are created by the inventories of private financial firms without government backing, leading to significant amounts of risk. If homeowners stop making their mortgage payments, investors can experience significant losses. The quality of the private label CMO is dependent on the firm that creates it.