A collateralized mortgage obligation (CMO) is a type of mortgage-backed security (MBS). Unlike a mortgage pass-through, in which all investors participate proportionately in the net cash flows from the mortgage collateral, with a CMO, different bond classes are issued, which participate in different components, called tranches, of the net cash flows. A CMO is any one of those bonds. The tranches are structured to each have their own risk characteristics and maturity range. In this way, investors can select a bond offering the characteristics which most closely meet their needs. Collateral for the securitization may represent a pool of mortgages, but it is often a mortgage pass-through. Many arrangements are possible. One of the simplest is a sequential pay structure comprising three or four tranches that mature sequentially. All tranches participate in interest payments from the mortgage collateral, but initially, only the first tranch receives principal payments. It receives all principal payments until it is retired. Next, all principal payments are paid to the second tranch until it is retired, and so on. This process is illustrated for a three-tranch sequential pay structure in Exhibit 1:
CMOs entail the same prepayment risk as mortgage pass-throughs. The prepayment risk of a specific bond depends upon how that tranch is structured and on the underlying collateral. Many different structures are used in practice, including stable PAC bonds or risky IOs and POs. There are floaters and inverse floaters. There are also Z-bonds, which are analogous to zero-coupon bonds. The first CMO was created for Freddie Mac in 1983 by Salomon Brothers and First Boston. With Freddie Mac guaranteeing the payment of principal and interest on the underlying mortgages, the instrument posed essentially no credit risk. This became the norm with CMOs for many years, with collateral comprising mortgages guaranteed by Fannie Mae, Freddie Mac, or Ginnie Mae, all of which had, explicitly or implicitly, the full backing of the US Treasury. Investors took prepayment risk, for which they were compensated with higher yields, but no credit risk. The CMO market boomed, with "vanilla" structures, such as PAC bonds, routinely held in fixed income portfolios. Soon, investment banks started issuing their own "private label" CMOs with underlying mortgages that were not guaranteed by Fannie, Freddie or Ginnie. Those "nonconforming" mortgages added credit risk to the familiar CMO model. At first, the investment banks addressed that credit risk by purchasing credit insurance, over-collateralizing or by other means. Once private label CMOs were broadly accepted in the market, the investment banks started passing more of the credit risk on to investors. Not only did this make CMOs staggeringly complex, with the interrelated uncertainties of prepayment and default, but it opened the door to a variety of abuses. Such abuses, exploited on a staggering scale by mortgage originators, investment banks and rating agencies, lead to the financial crisis of 2008.
|
||||||||||||||||||||||||||||||||||||||||||||||
