Collateral mortgage obligations, commonly called CMOs, are derivative investments secured by mortgage loans. Credit rating agencies such as Moody’s, Standard & Poor’s, and Fitch assign a credit rating to each CMO based on the credit quality of the underlying mortgages. CMOs purchase mortgages secured by residential, business and commercial real estate. Credit reporting agencies usually assign a higher credit rating to a CMO that holds mortgages made to individuals with high credit ratings. Conversely, credit reporting agencies generally assign a lower credit rating to a CMO backed by subprime mortgages.
Creating a CMO
To create a CMO, business entities such as investment banks purchase mortgages from lenders. The business entities take these individual mortgages and put them together into classes based on the mortgages credit rating. Similar classes are put together to form one bond, which is known as a CMO. The business entities then divide the bond into slices called tranches. These tranches are sold to institutional investors, banks, insurance companies, hedge funds and pension funds.
Types of CMO Tranches
As mortgage holders make their payments, the principal or interest or both are funneled to CMO bond investors based on the type of tranche and class that’s owned. Planned Amortization Class and Targeted Amortization Class tranches pay out principal and interest payments based on amortization schedules. Other CMOs divide the payments they receive into separate principal and interest tranches. Floating Rates tranches tie their interest rate to an interest-rate index, such as the Libor, or the Cost of Funds Index. The interest payments are adjusted upwards or downwards as the target interest rate changes.
Safety of CMO Tranches
CMO tranches are divided into classes identified as A, B or C. Credit reporting agencies assign a credit rating based on the underlying mortgages. Senior Tranches are known as Class A and carry the highest rating from the credit rating agencies. Senior Tranche investors are paid first and the tranches are secured by some type of asset. Junior Tranches are identified as Class B and Class C. Class B tranche investors don’t get paid until Senior Tranche investors are paid. Class C tranche investors get paid last. This tranche pays the highest interest rate of all the tranches.
All CMOs are vulnerable to the same types of risks. A credit risk occurs when CMO bond issuers cannot make their interest payments to their investors. If mortgagees pay off their loans early, the CMO investors lose out on the full principal repayment amount. Conversely, if CMO bonds are bought at a premium and the mortgages are paid off early, the CMO investors loses out on the premium amount. If interest rates increase, the CMO market value falls. Investors who sell their tranche before maturity could receive less than their initial purchase price.
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