Definition
A Collateralized Mortgage Obligation (CMO) is a type of mortgage-backed security (MBS) that consolidates many mortgages to create multiple tranches, or classes, that distribute risk and returns differently. These tranches have varying interest rates and maturities, tailored to meet diverse investor needs. CMOs originated to manage the cash flow and prepayment risks inherent in traditional mortgage-backed securities by partitioning the risk, making them appealing to a broader range of investors.
Examples
- Sequential-Pay Tranches: A basic form where principal repayments are directed to one tranche until it is completely paid off, and then to the next.
- Planned Amortization Class (PAC) Tranches: Designed to have stable cash flows and are protected from prepayment risks to an extent compared to other tranches.
- Support/Companion Tranches: Absorb excess prepayments before other tranches either resulting in more volatility but a higher yield.
Frequently Asked Questions
What differentiates CMOs from traditional mortgage-backed securities (MBS)?
CMOs offer multiple tranches with different risk, return, and maturity profiles, managing risks such as prepayment more effectively compared to traditional MBS at a given fee structure.
What are the main types of CMO tranches?
The primary types include sequential pay, planned amortization class (PAC), targeted amortization class (TAC), and support/companion tranches. Each type handles interest, principal payments, and prepayments differently.
Who typically invests in CMOs?
CMOs attract institutional investors like pension funds, insurance companies, and banks looking for steady income and tailored risk profiles, as well as sophisticated individual investors.
Are CMOs risk-free?
No, CMOs carry various risks, including credit risk, interest rate risk, and prepayment risk. Each tranche has a different balance of these risks, which investors need to consider.
How do prepayments affect CMOs?
Prepayments accelerate the return of principal investments, affecting the yield and maturities of the tranches. While some tranches (e.g., PAC) are more protected against prepayments, others (e.g., support tranches) absorb the brunt of variability.
Related Terms
- Tranche: A segment of a CMO offering distinct risk and return characteristics.
- Prepayment Risk: The risk associated with the early repayment of mortgage loans within a MBS or CMO.
- Mortgage-Backed Securities (MBS): Bonds backed by a pool of mortgage loans.
- Planned Amortization Class (PAC): Tranches structured to mitigate prepayment risks providing more predictable payouts.
- Credit Risk: Risk of borrower default affecting mortgage-backed securities.
Online Resources
- Securities Industry and Financial Markets Association (SIFMA) - Provides information on various security markets including CMOs.
- U.S. Securities and Exchange Commission - Offers reports, guidelines, and detailed explanations of investment products including MBS and CMOs.
- Investopedia on CMOs - Extensive articles and tutorials about CMOs and related mortgage securities.
References
- Fabozzi, Frank J. “Bond Markets, Analysis, and Strategies.” Pearson, 2015.
- Chance, Don M., and Brooks, Robert. “An Introduction to Derivatives and Risk Management.” South-Western College Publishing, 2013.
- “Mortgage-Backed Securities: Investment Characteristics and Risk.” Federal Deposit Insurance Corporation (FDIC), financial report, 2018.
Suggested Books for Further Study
- “Mortgage-Backed Securities: Products, Structuring, and Analytical Techniques” by Frank J. Fabozzi
- “The Handbook of Mortgage-Backed Securities” by Frank J. Fabozzi
- “Investing in Mortgage-Backed and Asset-Backed Securities” by Glenn Schultz and Frank J. Fabozzi
