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5 Cards in this Set
- Front
- Back
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Collateralized Mortgage Obligation
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Debt instruments like MBBs that are issued using a pool of mortgages for collateral.
The issuer of a CMO offering RETAINS THE OWNERSHIP of the mortgage pool and issues the bonds as debt against the mortgage pool. (unlike a MPT where investors own a individual interest in the entire pool). Like the MPT and MPTB, the CMO is a py-through security in that all amortization and prepayment flow through to investors. The SECURITY HOLDER continues to assume prepayment risk. **However, the CMO modifies how the risk is allocated. The major difference between CMOs and the other mortgage-backed securities is that CMOs are securities issued in multiple classes against the same pool of mortgages. These securities may have a number of maturity classes, such as three, five, or seven years. Such maturities are chosen by the issuer to meet the investment needs of various classes of investors; effectively creating different securities with maturity and payment streams that are vastly different from the underlying mortgage pool. Like both the MBBs and the MPTBs, the difference between assets pledged as security and the amount of the debt issued against the pool constitutes the equity position of the issuer. Can also be referred to as a multiple security class, mortgage pay-through security. By slightly modifying either the method of principal repayment or coupon calculations, investment bankers have created a multitude of unique derivative investment vehicles. |
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Tranches
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Classes with different stated maturity dates.
Mechanism to reduce the prepayment risk (and the coincident reinvestment risk) by the issuer retaining the ownership of the mortgage pool and prioritizing the payment of interest and principal among the various classes, or tranches, of debt securities issued against the pool. Some classes of CMO investors receive cash flows like investors in conventional debt securities, while other investors agree to defer cash flows to later periods. This allocation was designed to appeal to more investor groups than would be willing to invest in MPTs, but who also were wiling to bear some prepayment risk at yields that would be higher than those earned on MBBs. |
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Sequential payout tranche
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when the coupon rate of interest is not paid currently on all tranches
Used to achieve the desired maturity pattern. All current amortization of principal and prepayments from the ENTIRE mortgage pool will also be allocated FIRST to tranche A. Hence, tranche A investors, representing $27 million of the CMO issue, will receive principal on all mortgages in the pool (including prepayments), plus interest that would have been paid to tranche Z until the $27 million tranche is repaid, in addition to a coupon rate of 9.25% on their outstanding investment balance. Their investment balance is reduced by all principal payments from the pool plus the interest not currently paid but accrued on the Z class investment balance. Until tranche A is repaid, tranche B receives "interest only" payments. After class A is repaid, all principal allocations are made to B, and so on. The Z class of security holders receives no interest payments or principal payments while A and B tranches are being repaid. Instead, interest is accrued on the $30 million invested by this class of investors and is compounded at the 11% coupon rate. The accrued interest is then added to the amount owed. After classes A and B are repaid, cash interest payments are made to the Z class, and all principal payments from the pool are then directed towards this class. |
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Overcollateralization in CMOs
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equity invested in the issue by the owner/issuer
required for several reasons. 1. most CMO issues promise payments to investors quarterly or semiannually; we know, however that payments into the mortgage pool occur monthly. Because monthly mortgage payments may be reinvested by the issuer until semiannual payments are due to investors, the issuer promises a minimum rate of interest on these investable funds in addition to promised coupon payments and priority repayment of principal. Hence, in addition to the risk of prepayment, a reinvestment risk exists in the event that market interest rates fall dramatically. In this event, prepayments into the pool would accelerate, thereby repaying all tranches MUCH FASTER than expected. Further the issuer may not be able to earn the promised rate of return on interim cash as interest rates fall (reinvestment risk). In this event, any cash shortfall to CMO investorws will be paid from the $3 million of additional mortgage collateral. The greater the amount of overcollateralization, the more likely the promised coupon rates and rates on interim cash flows will be paid. However, lower risk also implies that the coupon rate and rate on reinvested funds promised to the shorter-term tranches may also be lower. Another important consideration with these securities is whether the CMO issuer is liable beyond the $3 million of equity. Usually issued by a corporation, CMOs are debt instruments that can be made with or without recourse to the issuer. |
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Major investors in CMO securities
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Class A - Thrifts, commercial banks, money market funds, corporations
Class B - Insurance companies, pension funds, trusts, international investors Class Z - Pension funds, trusts, international investors, and hedge funds |
