Overview
Collateralized Mortgage Obligations (CMOs), a type of mortgage security, are bonds that represent claims to specific cash flows from large pools of home mortgages. There are a wide variety of CMO securities with different cash flow and expected maturity characteristics that have been designed to meet specific investment objectives. These objectives are accomplished via a complicated deal structure whereby streams of principal and interest payments on the underlying mortgages are distributed to the different classes of CMO interest, known as tranches. Each tranche may have different principal balances, coupon rates, prepayment risks and maturity dates. While CMOs offer advantages to investors, they also carry certain risks, some of which are explained in this Disclosure Statement.
Background
The creation of a CMO begins with a mortgage loan extended by a financial institution to finance a borrower’s home or other real estate. The borrower usually pays the mortgage in monthly installments composed of both principal and interest. However, potential investors should be aware that, over the life of the mortgage, the interest component of the payments, which typically comprises a majority of each payment during the early years, gradually declines as the principal component increases.
Several factors can effect homeowners’ payments. Typically, the homeowner will prepay the mortgage by selling the property, refinancing the mortgage, or otherwise paying off the loan in part or in whole. Most mortgage-backed securities are based on fixed-rate mortgages with an original maturity of 30 years, but history shows that most mortgages will be paid off much earlier. While the creation of mortgage-backed securities generally increased the secondary market for mortgage loans by pooling them and selling interests in pool, the structure of such securities has inherent limitations.
Mortgage lenders will either “pool” groups of loans with similar characteristics to create securities or sell the loans to issuers of mortgage securities. These securities are commonly referred to as mortgage-backed securities.
In contrast to the typical mortgage pass-through security, which passes principal and interest cash flows through to investors on a pro rata basis, a CMO aggregates the cash flows from the underlying pool of mortgage assets and reallocates them to two or more classes of securities having different maturities, coupon rates, and cash flow characteristics. The cash flows to each of these classes are prioritized according to a set schedule intended to provide investors with a greater degree of certainty about the maturity of specific classes than they would otherwise have. This increased degree of certainty about the likely maturity of these classes is commonly referred to as “call protection,” primarily because it gives the investor in certain classes a limited degree of protection against prepayment risk. This is achieved by directing all prepayments of principal from the underlying mortgage to the CMO classes with the shortest maturities, thus insulating classes with longer maturities against prepayment risk until the shorter-term classes have been fully paid off.
How CMOs Differ From Other Securities
CMOs differ from corporate bonds and Treasury securities in that corporate and Treasury bonds are issued with stated maturities. The purchase of such a bond is essentially a loan to the issuer of the face amount for a prescribed period of time in return for a specified rate of interest. The investor receives interest payments until the bond is redeemed and the issuer returns the face value to the investor.
With respect to a CMO, the principal is returned over the life of the security, or amortized, rather than repaid in a lump sum at maturity. In addition, CMOs provide monthly or quarterly payments, rather than semi-annual or annual payments, to investors which include varying amount of both principal and interest.
Another difference exists with respect to maturity. As stated above, corporate and Treasury bonds have stated maturities. A mortgage security, however, matures when the investor receives the final principal payment regardless of the fact that it may have a stated maturity based on the last date on which the principal from the collateral could be paid in full. The stated date is theoretical as it assumes that no prepayments of the underlying mortgages will be made. As a result, mortgage securities are often discussed in terms of their “average life” rather than their stated maturity date. The average life is the average time that each principal dollar in the pool is expected to be outstanding, based on certain assumptions about prepayment speed.
Benefits
High Credit Quality. Most mortgage-backed securities are guaranteed by the Government National Mortgage Association (GNMA or Ginnie Mae), an agency of the United States government, or by U.S. government-sponsored enterprises such as the Federal National Mortgage Association (FNMA or Fannie Mae) or the Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac). Securities guaranteed by these entities are generically known as “agency” mortgage securities and, due to the agency guarantees, have enhanced credit quality.
The extent of the agency guarantee depends on the entity making it. Ginnie Mae guarantees the timely payment of principal and interest on all of its mortgage securities, and its guarantee is backed by the full faith and credit of the U.S. Government. Holders of Ginnie Mae mortgage securities are therefore assured to receive payments promptly each month, regardless of whether the underlying homeowners make their payments. They are guaranteed to receive the full return of face-value principal at the original schedule even if the underlying borrowers default of their loans.
Both Fannie Mae and Freddie Mac also guarantee the timely payment of both principal and interest on its mortgage securities whether or not the payments have been collected from the borrowers, but neither carry the additional “full faith and credit” U.S. government guarantee. None of these guarantees however, protect you from market value fluctuations prior to the repayment of principal.
- High Yield. Ginnie Mae guaranteed CMOs typically carry the highest yield of any security that is guaranteed by the full faith and credit of the U.S. Government.
- Liquidity. Ginnie Mae guaranteed CMOs are among the most widely held and traded mortgage backed securities in the world. This allows for a large and active secondary market.
Main Risks
Although it may appear that investments in CMOs do not carry any risk due to the fact that their principal and interest payments are guaranteed by the government/quasi-governmental agencies, it is important for investors to realize that such investments are not free of risk, and for investors to understand the risks associated with CMOs.
You should purchase CMOs only if you understand and are able to bear the associated risks. The risks applicable to your investment depends upon the type of CMO in which you invest. This section highlights certain risks involved.
Interest Rate Risk. Prices of CMOs tend to move inversely with the changes in interest rates. Typically, when interest rates rise, the market prices or value of these securities drops in proportion to the time remaining to the estimated maturity. Conversely, when interest rates fall, the price of CMOs generally rise. There is the potential for capital appreciation or loss if the CMO is sold prior to the time when the principal is fully repaid. Inverse Floaters are especially sensitive to shifts in interest rates. Also, the longer the effective maturity and duration of the security, the more its price is likely to react with interest rates. In addition, investors should be aware that when interest rates fall, the principal on certain mortgage-backed securities may be prepaid resulting in the loss of higher yielding mortgages.
Libor is the most widely used benchmark or reference rate for short term interest rates. Libor stands for the London Interbank Offered Rate and is the rate of interest at which banks borrow funds from other banks, in marketable size, in the London Interbank market.
The level of LIBOR will affect the yields and interest rates on floating rate and inverse floating rate securities. If LIBOR performs differently from your expectations, the yield on your investment may be lower than expected. Lower levels of LIBOR will generally reduce the yield on floating rate securities while higher levels of LIBOR will generally reduce the yield on inverse floating rate securities. An investor should bear in mind that the timing of changes in the level of LIBOR may affect the yield. Generally, the earlier a change, the greater the effect on the yield. It is highly unlikely that LIBOR will remain constant. If LIBOR changes substantially the interest rate paid on Inverse Floaters can change substantially. Rates can potentially go to zero during a sharply rising interest rate environment. This would cause the value of these bonds to drop dramatically if sold prior to the repayment of principal.
Prepayment Risk. Most CMOs have a stated maturity based on the last date on which the principal from the collateral could be paid in full. However, investors must realize that this date is theoretical as it assumes that there will be no prepayments of the underlying mortgages. Therefore, the CMO may be comprised of underlying mortgages having 15 to 30 year maturities but, historically, due to prepayments, the average life of a 15 and 30 year CMO is approximately 5-7 years and 11 years, respectively. Prepayments occur when homeowners refinance their mortgages, sell their homes, or pay off their mortgage loans earlier than the scheduled 15 or 30 years. Prepayments that are passed through to the investor can shorten the life and alter the yield of the security. In addition, if actual prepayment rates are faster or slower than anticipated, the investor who holds the CMO until it is fully paid may recognize a different yield that can be higher or lower than originally estimated.
Extension Risk. This is the possibility that prepayments will be slower than the anticipated rate causing a later than expected return of principal. For example, when interests rates rise, the effective duration of certain mortgage-backed securities may lengthen due to a drop in the prepayments of the underlying mortgages.
Market Risk. Even though Ginnie Maes are backed by the full faith and credit of the United States; they are guaranteed only as to timely payment of interest and principal when held to maturity. The market prices for such securities are not guaranteed and will fluctuate. The guarantee does not protect against prepayment risk or market risk.
Liquidity Risk. When there is no active trading market for specific types of securities, it can become more difficult to sell the securities at or near their perceived value. In such a market, the value of such securities may fall dramatically. In particular, Inverse Floaters have lower liquidity and prices may be adversely affected as much as 15 to 25 percent or more.
Price Volatility. The value of your investment in a CMO is based on the market price of the CMO. These prices change daily due to economic and other events that generally affect the markets, as well as those that affect particular regions, countries, industries, companies or governments. These price movements, sometimes called volatility, may be greater or less depending on the types of CMOs owned. CMOs regardless of their high credit quality, experience price volatility, especially in response to interest rate changes. As a result of price volatility, there is a risk that you may lose money by investing in CMOs.
Types of CMOs
Two types of classes that have evolved within the CMO structure are planned amortization classes (“PACs”) and targeted amortization classes (“TACs”).
A PAC bond is one of several possible classes of bonds within a CMO structure designed to increase the investor’s protection from prepayment risk. PAC bonds are distinguished from other CMO classes by the fixed and stable cash flows that they receive over a range of prepayment scenarios (called the “protected range”). Over this range, PAC bonds have a set schedule of principal payments that must be met before principal can be paid to the other classes of securities in the CMO issue. These other classes are referred to as PAC support classes or companion bonds. Therefore, within this range of prepayment possibilities, investors are provided call protection against unexpected prepayments in addition to protection against an extended life expectancy due to slower than expected prepayments. This protection allows investors to more accurately predict the average life of the asset and may reduce the price volatility that would have been assumed if the underlying mortgage pass-through securities had been purchased.
Any deviations in the actual prepayments from the expected prepayment schedule are absorbed by the associated PAC support bonds. Thus, prepayment risk is shifted from the PAC bond to the associated PAC support bonds within a particular CMO issue. As a result, PAC support bonds generally will have more volatile cash flows than comparable, conventional CMO classes. The degree of protection provided by the PAC depends upon the size of the protected range which in turn is determined by the proportion of PAC classes relative to the entire CMO.
Some PACs have a feature, which diverts principal payments from PAC support bonds to cover any previous shortfall in scheduled principal payments. As a result, these PAC bonds have a senior claim to the PAC support bonds not only with respect to the scheduled principal payments during the protected range for each period but also to the coverage of any previous shortfalls.
A TAC bond is a derivative of the PAC bond and, like PACs, is designed to provide the investor with call protection and have a priority in receiving principal payments under certain circumstances. Instead of being protected against prepayments over a range of scenarios as are PACs, TACs are insulated from effects of prepayments only in one direction. As a result, any rise in prepayments will result in the additional cashflows being directed to the other classes in the CMO structure. As a result, the associated TAC support bonds are adversely affected by the protection granted the TAC bond from increases in prepayments.
Inverse Floaters
Another type of CMO is an inverse floater which is a CMO tranche that pays an adjustable rate of interest that moves in the opposite direction from movements in representative interest rates indexes such as the London Interbank Offered Rate (LIBOR), the constant Maturity Treasury (CMT) or the Cost of Funds Index (COFI). When interest rates go up, the coupon on these bonds will go down. A one point rise in interest rates could result in as much as a four point or more decline in coupon rate. The relationship between interest rates and the coupon rate is called the lever. You should always be aware of the lever of your particular bonds. In cases where short term rates rise sharply the coupon rates will decline sharply and consequently the value of your bonds can decline dramatically.
Please be advised that there are other types of CMOs that may be more suitable for your investment objectives.
Minimum Investments and Transaction Costs
The minimum investment for a CMO varies according to the structure of the offering and the type of CMO being purchased. Transaction costs are determined by your representative but may not exceed 4.5 %.
Taxation
Investors should be aware that interest income on CMOs is subject to federal, state and local income tax. The principal portion of the monthly payment may or may not be taxable. Investors should have a comprehensive understanding of all tax related matters associated with investing in CMOs and should contact their tax advisor, prior to any CMO investment, to determine their tax liability.
Questions You Should Ask Before Investing in CMOs
- Is the CMO agency issued or private labeled?
- Do I have a prospectus, prospectus supplement, or offering circular available for the CMO?
- Am I buying this CMO as an original issue or in the secondary market?
- If it is from the secondary market, how have the prepayments compared to the assumptions?
- If it is from the secondary market, how much of the underlying principal remains or what is its current factor?
- What is the CMOs estimated average life, final maturity, and yield?
- How does the estimated average life compare to my investment timeframes?
- What is the estimated first principal payment date?
- Is the tranche a SEQ (sequential pay), TAC, PAC, or companion tranche?
- How will my estimated yield and average life of this CMO if interest rates move in either direction by 100, 200, or 300 basis points?
- Am I paying a price at a premium of at a discount to par?
- Is there an active secondary market for this CMO?
- Given my investment objectives, is this CMO an appropriate investment?
- Are there any non-credit related risks of losing my principal investment in this CMO?
Terminology
Below is an overview of some frequently used terms that may be helpful to know
when investing in CMOs:
Accrued Interest. Interest deemed to be earned on a security, but not yet paid to
the investor.
Amortization. Liquidation of a debt through installment payments.
Average Life. On a mortgage security, the average life to receipt of each dollar of
principal, weighted by the amount of each principal prepayment, based on prepayment
assumptions.
Bid. The price at which a buyer is willing to buy a security.
Bond Equivalent Yield. Due to the fact that most CMOs pay interest monthly,
rather than semi-annually, CMO yields are not directly comparable to bond yields. The
bond equivalent yield restates the CMO yield to allow a meaningful comparison.
Book-entry. A method of recording and transferring ownership of securities
electronically, thereby eliminating the need for physical certificates.
Call Risk. For a CMO, the risk that declining interest rates may accelerate
mortgage prepayment speeds, causing an investor’s principal to be returned sooner than
expected. As a consequence, investors may have to reinvest their principal at a lower rate
of interest.
Cap. The upper limit for the interest rate on an adjustable-rate loan or security.
CMO (Collateralized Mortgage Obligation). A multiclass bond backed by a
pool of mortgage pass-through securities of mortgage loans.
Collateral. Securities or property pledged by a borrower to secure payment of a
loan. If the borrower fails to repay the loan, the lender may take ownership of the
collateral. Collateral for CMOs consists primarily of mortgage pass-through securities or
mortgage loans, although it may also encompass letters of credit, insurance policies, or
other credit enhancements.
Companion Tranche. A CMO tranche that absorbs a higher level of the impact
of collateral prepayment variability in order to stabilize the principal payment schedule
for a PAC or TAC tranche in the same offering.
Confirmation. A document used by securities dealers and banks to state in
writing the terms and execution of a verbal arrangement to buy or sell a security.
CPR (Constant Prepayment Rate). The percentage of outstanding mortgage
loan principal that prepays in one year, based on the annualization of the of the Single
Monthly Mortality (SMM), which reflects the outstanding mortgage loan principal that
prepays in one month.
Current Face. The current remaining monthly principal on a mortgage security.
Current face is computed by multiplying the original face value of the security by the
current principal balance factor.
CUSIP number. A unique nine-digit identification number permanently
assigned by the Committee on Uniform Securities Identification Procedures to each
publicly traded security at the time of issuance. If the security is in physical form the
CUSIP number is printed on its face.
Estimated Average Life. The average amount of time until the principal on the
underlying mortgages is paid. The average life is estimated using the prepayment rate,
issue date, and coupon.
Extension Risk. For a CMO, the risk that rising interest rates may slow the
anticipated prepayment rates, causing investors to find their principal committed longer
than they expected. As a consequence, they may miss the opportunity to earn a higher
rate of interest on their money.
Face Value. The par value of a security, as distinguished from its market value.
Factor. A decimal value reflecting the proportion of the outstanding principal
balance of a mortgage security, which changes over time, in relation to its original
principal value.
Floating-rate CMO. A CMO tranche which pays an adjustable rate of interest
tied to a representative interest rate index such as LIBOR (London Interbank Offered
Rate).
Inverse floater. A CMO tranche that pays an adjustable rate of interest that
moves in the opposite direction from movements in a representative interest rate index.
IO (Interest Only) Security. In the case of a CMO, an IO tranche is created
deliberately to pay investors only interest and not principal. IO securities are priced at a
deep discount to the “notional” amount of principal used to calculate the amount of
interest due.
Issue date. The date on which a security is deemed to be issued or originated.
Issuer. An entity which issues and is obligated to pay amounts due on
securities.
LIBOR (London Interbank Offered Rate). The interest rate banks charge each
other for short-term Euro-dollar loans ranging from overnight to five years in maturity.
Mortgage pass-through security. A security representing a direct interest in a
pool of mortgage loans. The pass-through issuer or servicer collects the payments on the
loans in the pool and “pass through” the principal and interest to the security holders on a
pro rata basis. Mortgage pass-through securities are also known as mortgage-backed
securities (MBS) and participation certificates (PC).
Offer. The price at which a seller will sell a security.
Original face. The face value or original principal amount of a security on its
issue date.
PAC tranche. A CMO tranche that uses a mechanism similar to a sinking fund
to determine a fixed principal payment schedule that will apply over a range of
prepayment assumptions. The effect of the prepayment variability that is removed from a
PAC bond is transferred to a companion tranche.
Payment date. The date that principal and interest payments are paid to the
record owner of a security.
PO (Principal Only) Security. In the case of a CMO, a PO tranche is created
deliberately to pay investors principal only and not interest. PO securities are priced at a
deep discount form their face value.
Pool. A collection of mortgage loans assembled by an originator or master
servicer as the basis for a security.
Prepayment. The unscheduled partial or complete payment of the principal
amount outstanding on a mortgage or other debt before it is due.
Prepayment Models. Prepayment models have been developed based upon
historical mortgage payments. They are used in projecting the prepayment rate of a
particular mortgage pool by comparing the pool to its prepayment model. The standard
prepayment model used is the Bond Market Association Prepayment Model.
Price. The dollar amount to be paid for a security, which may also be stated as
a percentage of its face value or par in the case of debt securities.
Principal. With mortgage securities, the amount of debt outstanding on the
underlying mortgage loan.
Record date. The date for determining the owner entitled tot eh next scheduled
payment of principal or interest on a mortgage security.
REMIC. Real Estate Mortgage Investment Conduit. As a result of a change in
the 1986 Tax Reform Act, most CMOs are today issued in REMIC form to create certain
tax advantages for the issuer. The term “REMIC” and “CMO” are now used
interchangeably.
Sequential- pay CMO. The most basic type of CMO, in which all tranches
receive regular interest payments, but principal payments are directed initially only to the
first tranche until it is completely retired, then to the second tranche and so on.
Settlement date. The date agreed upon by the parties to a transaction for the
delivery of securities and payment of funds.
Sinking fund. Money set aside on a regular basis, sometimes from current
earnings, for the specific purpose of redeeming debt.
SMM (Single Monthly Mortality). The percentage of outstanding mortgage loan
principal that prepays in one month.
TAC tranche. Targeted amortization class tranche. A TAC tranche uses a
mechanism similar to a sinking fund to determine a fixed principal payment schedule
based of an assumed prepayment rate. The effect of prepayment variability that is
removed from the TAC tranche is transferred to a companion tranche.
Tranche. A class of bonds in a CMO offering which shares the same
characteristics. “Tranche” is the French word for “slice”.
Weighted Average Coupon (WAC). The weighted average interest rate of the
underlying mortgage loans or pools that serve as collateral for a security, weighted by the
size of the principal loan balances.
Weighted Average Loan Age (WALA). The weighted average number of months
since the date of the loan origination of the mortgages in a mortgage pass-through
security pool issued by Freddie Mac, weighted by the size of the principal loan balances.
Weighted Average Maturity (WAM). The weighted average number on months
to the final payment of each loan backing a mortgage security, weighted by the size of the
principal loan balances.
Window. In a CMO bond, the period of time between the expected first
payment of principal and the expected last payment of principal.
Yield. The annual percentage rate of return earned on a security, as computed in
accordance with standard industry practices. Yield is a function of a security’s purchase
price and interest rate.