Collateralized Mortgage Obligations (CMO)

A multi-class bond backed by a pool of mortgage pass-through securities or mortgage loans.

 

CMOs are securities created from pools of mortgages, similar to pass-through securities. This type of mortgage-backed security was developed to provide investors a greater range of time frames and a greater cash-flow certainty than previously offered by mortgage-backed, pass-through securities.The difference between a CMO and a pass-through security is that in a CMO structure, many different securities are created from pools of mortgages by redirecting the cash flows of principal and interest. The issuer collateralizes a pool of various class mortgage loans and creates a tranche. A tranche segregates portions of the cash flow from the CMO in order to redirect its principal and interest payments to other tranches based on a predetermined distribution schedule established when the CMO was created. One CMO may be entitled to receive a certain amount of principal from the pool before all the others.

Safety

Beyond the basic security of the mortgage loans themselves, mortgage securities issued and/or guaranteed by Ginnie Mae, Fannie Mae and Freddie Mac carry additional guarantees that enhance their creditworthiness.

Ginnie Mae is backed by the full faith and credit of the U.S. government, while both Fannie Mae and Freddie Mac have a line of credit to the U.S. Treasury. The credit markets consider the securities of both entities to be nearly equivalent to those issued by agencies that have the full-faith-and-credit guarantee.

Liquidity

Although there is a sizable and active secondary market for many types of CMOs, the degree of liquidity can vary widely.

The minimum investment for a CMO varies according to the structure of the offering, but most tranches sold to individual investors require a minimum investment of $1,000.

Investors should remember that if they sell their CMOs rather than waiting for the final principal payment, the securities may be worth more or less than their original face value.

Yield

As with any bond, the yield on a CMO depends on the purchase “price” in relation to the interest rate and the length of time the investor’s principal remains outstanding. CMO yields are often quoted in relation to yields on Treasury securities with maturities closest to the CMO’s estimated average life.

The estimated yield on a CMO reflects its estimated average life based on the assumed prepayment rates for the underlying mortgage loans. If actual prepayment rates are faster or slower than anticipated, the investor who holds the CMO until it is fully paid may realize a different yield. For securities purchased at a discount to face value, faster prepayment rates will increase the yield-to-maturity, while slower prepay-ment rates will reduce it. For securities purchased at a premium, faster prepayment rates will reduce the yield-to-maturity, while slower rates will increase it. For securities purchased at face value (“par”), these effects should be minimal.

*All information and opinions contained on this web page were produced by Freddie Mac. Citation: Freddie Mac. An Investor's Guide to Pass-Through and Collateralized Mortgage Securities. New York City: The Bond Market Association, 1997-2002. Print.