Definition
A collateralized mortgage obligation (CMO) is a mortgage‑backed security (a bond backed by mortgage loans) that divides a pool of residential mortgages into separate slices called tranches. Each tranche has its own priority for receiving principal and interest, a different expected maturity, and a different risk profile. CMOs pass cash flows from borrowers (monthly principal and interest payments) to investors according to the contract that created the tranches.
Key terms (defined on first use)
– Tranche: a slice or class of the overall security with a specific claim on cash
– Principal: the portion of each mortgage payment that reduces the outstanding loan balance. In CMOs, principal payments from the mortgage pool are distributed to tranches according to the contract’s priority rules.
– Interest: the portion of each mortgage payment that compensates the lender for borrowing. Interest from the mortgage pool is usually passed through to all tranches, though some structured tranches may receive only principal or only interest.
– Prepayment: early repayment of mortgage principal by borrowers (through refinancing, sale, or extra payments). Prepayments shorten the expected life of a tranche and change cash‑flow timing.
– Prepayment speed measures:
– CPR (Conditional Prepayment Rate): the annualized percentage of the outstanding principal that is expected to prepay in a year.
– SMM (Single Monthly Mortality): the monthly equivalent of CPR. Conversion: SMM = 1 − (1 − CPR)^(1/12). Example: CPR = 12% ⇒ SMM ≈ 1 − 0.88^(1/12) ≈ 1.06% per month.
– PSA (Public Securities Association) benchmark: a standard seasoning curve (100% PSA equals a rising CPR up to 6% per year in the first 30 months, then 6% thereafter). Investors often quote multiples of PSA (e.g., 150% PSA).
– Weighted Average Life (WAL): the average time until principal is repaid, weighted by the amount of principal returned in each period. Formula:
WAL = (Σ t * Principal_t) / Total Principal
where t is time in years and Principal_t is principal repaid in period t. WAL changes with prepayment assumptions and is often more informative for CMOs than yield‑to‑maturity.
– Credit enhancement: mechanisms that reduce default risk for senior tranches (examples: subordination, reserve funds, overcollateralization). CMOs backed by agency securities (Ginnie Mae, Fannie Mae, Freddie Mac) carry explicit or implicit government backing; private‑label CMOs depend on credit support and ratings.
How CMOs pass cash flows (cash‑flow waterfall)
1. Collect monthly principal and interest from underlying mortgages.
2. Pay servicing and administrative fees.
3. Distribute interest to eligible tranches according to the indenture.
4. Apply principal payments to tranches in the priority order defined by tranche type (e.g., sequential pay, PAC structure).
5. Reallocate excess principal or interest to subordinate tranches once higher‑priority tranches are retired.
Common tranche types (what they mean for timing and risk)
– Sequential‑pay tranche: principal is paid to the first tranche until it is retired; remaining tranches receive principal later. This concentrates prepayment and extension risk unevenly across tranches.
– PAC (Planned Amortization Class): uses a companion tranche to absorb prepayment variability and aims to deliver a predictable principal schedule within a range of prepayment speeds. PAC tranches have a “support” or “companion” (sometimes called support/Z) that takes volatility.
– Support (or Companion/Z) tranche: designed to absorb excess and shortfall principal to protect PAC tranches. These have higher risk and typically higher yield.
– Interest‑only (IO) tranche: receives only interest cash flows. IO values fall if prepayments or interest rates increase (because principal — and future interest — is extinguished).
– Principal‑only (PO) tranche: receives only principal cash flows. PO benefits from faster prepayments; its value rises when prepayments accelerate.
– Floating‑rate tranches and inverse floaters: coupon payments vary with a reference rate; risk characteristics differ with interest‑rate moves.
Worked numeric example — simple sequential CMO
Assume a mortgage pool of $100,000,000 with level monthly principal + interest payments, but for illustration use lump sums:
– Two tranches: Tranche A (senior) $60,000,000; Tranche B (junior