Collateralized mortgage obligation
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A collateralized mortgage obligation (CMO) is a type of financial debt security that was first created in June 1983 by investment banks Salomon Brothers and First Boston. A CMO deal can be thought of as having a set of collateral, a set of tranches (also called classes), and a set of rules that dictate how money coming in from the collateral will be distributed to the tranches. The collateral is most often a pool of home mortgages. Investors purchase certificates of a tranche.
This article focuses primarily on CMO bonds as traded in the United States of America.
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[edit] Principal payments
Every time some principal payments are made on the underlying mortgages, that principal is paid to some (or all) of the tranches. In most CMO transactions, the total balance of the tranches is equal to the total balance of the collateral, and they remain equal, as each time the balance of the collateral changes (because of the principal payments on the underlying mortgages) the total balance of the tranches is also changed. The tranches typically separate the original bond (referred to as the collateral) cash flows in time or by interest and principal.
[edit] Tranches
The tranches can be made in several ways.
[edit] Credit Tranching
Many CMO bonds are backed by collateral, which is issued and guaranteed by the "Federal Agencies" (Freddie Mac, Fannie Mae, or Ginnie Mae). Those that are not are called "whole loan CMOs". Whole loan CMOs are subjected to the risk of the home owners not paying the entire principal balance on their loans (in other words defaulting on their mortgages). This is often handled by designating some of the tranches (called "B" pieces) to have any losses passed on to them. When a mortgage default causes a loss, the balance of one of the B pieces is reduced by the amount of the loss.
[edit] Sequential Tranching (or by time)
All of the available principal payments go to the first sequential tranche, until its balance is decremented to zero, then to the second, and so on. There are several reasons that this type of tranching would be done:
- The tranches could be expected to mature at very different times and therefore would have different Yields that correspond to different points on the Yield Curve.
- The underlying mortgages could have a great deal of uncertainty as to when the principal will actually be received since home owners have the option to make their scheduled payments or to pay their loan off early at any time. The sequential tranches each have much less uncertainty.
[edit] Parallel Tranching
This simply means tranches that pay down pro rata. The coupons on the tranches would be set so that in aggregate the tranches pay the same amount of interest as the underlying mortgages. The tranches could be either fixed rate, or floating rate. If they have floating coupons, they would have formulas that make their total interest equal to the collateral interest. For example, with collateral that pays a coupon of 8%, you could have two tranches that each have half of the principal, one being a floater that pays LIBOR with a cap of 16%, the other being an inverse floater that pays a coupon of 16% minus LIBOR.
- A special case of parallel tranching is known as the IO/PO split. IO and PO refer to Interest Only and Principal Only. In this case, one tranche would have a coupon of zero (meaning that it would get no interest at all) and the other would get all of the interest. These bonds could be used to speculate on prepayments. A principal only bond would be sold at a deep discount (a much lower price than the underlying mortgage) and would rise in price rapidly if many of the underlying mortgages were prepaid. The interest only bond would be very profitable if few of the mortgages prepaid, but could get very little money if many mortgages prepaid.
[edit] Z bonds
This type of tranche supports other tranches by not receiving an interest payment. The interest payment that would have accrued to the Z tranche is used to pay off the principal of other bonds, and the principal of the Z tranche increases. The Z tranche starts receiving interest and principal payments only after the other tranches in the CMO have been fully paid. This type of tranche is often used to customize sequential tranches, or VADM tranches.
[edit] Schedule bonds (also called PAC or TAC bonds)
This type of tranching has a bond (often called a PAC or TAC bond) which has even less uncertainty than a sequential bond by receiving prepayments according to a defined schedule. The schedule is maintained by using support bonds (also called companion bonds) that absorb the excess prepayments.
- Planned Amortization Class (PAC) bonds have a principal payment rate determined by two different prepayment rates, which together form a band (also called a collar). Early in the life of the CMO, the prepayment at the lower PSA will yield a lower prepayment. Later in the life, the principal in the higher PSA will have declined enough that it will yield a lower prepayment. The PAC tranche will receive whichever rate is lower, so it will change prepayment at one PSA for the first part of its life, then switch to the other rate. The ability to stay on this schedule is maintained by a support bond, which absorbs excess prepayments, and will receive less prepayments to prevent extension of average life. However, the PAC is only protected from extension to the amount that prepayments are made on the underlying MBSs. When the principal of that bond is exhausted, the CMO is referred to as a "busted PAC", or "busted collar".
- Target Amortization Class (TAC) bonds are similar to PAC bonds, but they do not provide protection against extension of average life.
[edit] Very Accurately Defined Maturity (VADM) bonds
Very Accurately Defined Maturity (VADM) bonds are similar to PAC bonds in that they protect against both extension and contraction risk, but their payments are supported in a different way. Instead of a support bond, they are supported by accretion of a Z bond. Because of this, a VADM tranche will receive the scheduled prepayments even if no prepayments are made on the underlying.
- Non-Accelerating Senior bonds are designed to protect investors from volatility and negative convexity resulting from prepayments. NAS traunches of bonds are fully protected from prepayments for a specified period, after which time prepayments are allocated to the traunche using a specified step down formula. For example, an NAS bond might be protected from prepayments for five years, and then would receive 10% of the prepayments for the first month, then 20%, and so on. Recently, issuers have added features to accelerate the proportion of prepayments flowing to the NAS class of bond in order to create shorter bonds and reduce extension risk. NAS traunches are usually found in deals that also contain short sequentials, Z-bonds, and credit subordination.
The process of dividing an mortgage-backed securities into CMO tranches is referred to as structuring.
