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# Collateralized mortgage obligation

A collateralized mortgage obligation (CMO) is a type of complex debt security that repackages and directs the payments of principal and interest from a collateral pool to different types and maturities of securities, thereby meeting investor needs.[1]

CMOs were first created in 1983 by the investment banks Salomon Brothers and First Boston for the U.S. mortgage liquidity provider Freddie Mac. The Salomon Brothers team was led by Lewis Ranieri and the First Boston team by Laurence D. Fink,[2] although Dexter Senft also later received an industry award for his contribution[3]).

Legally, a CMO is a debt security issued by an abstraction—a special purpose entity—and is not a debt owed by the institution creating and operating the entity. The entity is the legal owner of a set of mortgages, called a pool. Investors in a CMO buy bonds issued by the entity, and they receive payments from the income generated by the mortgages according to a defined set of rules. With regard to terminology, the mortgages themselves are termed collateral, 'classes' refers to groups of mortgages issued to borrowers of roughly similar credit worthiness, tranches are specified fractions or slices, metaphorically speaking, of a pool of mortgages and the income they produce that are combined into an individual security, while the structure is the set of rules that dictates how the income received from the collateral will be distributed. The legal entity, collateral, and structure are collectively referred to as the deal. Unlike traditional mortgage pass-through securities, CMOs feature different payment streams and risks, depending on investor preferences.[1] For tax purposes, CMOs are generally structured as Real Estate Mortgage Investment Conduits, which avoid the potential for "double-taxation".[4]

Investors in CMOs include banks, hedge funds, insurance companies, pension funds, mutual funds, government agencies, and most recently central banks. This article focuses primarily on CMO bonds as traded in the United States of America.

The term "collateralized mortgage obligation" technically refers to a security issued by a specific type of legal entity dealing in residential mortgages, but investors also frequently refer to deals put together using other types of entities such as real estate mortgage investment conduits as CMOs.

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#### Transcription

We've seen that an investment bank can buy a bunch of mortgages, which essentially makes them the lender to the homeowners, and then it could stick those mortgages inside of a special purpose entity. And then it could sell the shares in that special purpose entity, and that these shares would be called mortgage-backed securities. And let's just say, just for the sake of argument, when it sells these shares it sells them at $10 a share, and it promises dividends at$10 a share, the equivalent of an 8% yield. So maybe the homeowners here are paying a higher than 8% interest, some of them default, once you average everything out, and the investment bank keeps a little bit for itself and to do all the operations and all the overhead, and so it can actually give the investors an 8% yield. This might be good for a whole class of investors. They might like the safety profile, the risk profile of the special purpose entity of this mortgage-backed security, and they might like the return, and they might go for it. But there might be a class of investors, may be very risk-averse investors like pensions, that says that this mortgage-backed security is too risky. They've looked at what we're holding, and they are like, hey, some of these are sub-prime mortgages, some of these are shady, some of these are to risky borrowers. I don't like where this is going. And even if they can't look under the hood to see what this is, the investment bank might have hired a ratings agency. So maybe a ratings agency to essentially look under the hood and tell investors what's there. So the ratings agency might look at this special purpose entity and look at these securities and say, look, I would say that these securities should be rated BB. So not super safe, but not super risky either, but for pensions that is not safe enough. Now on the other hand, you might have people who want more risk. So you might have, maybe there's some risky hedge funds, and not all hedge funds are risky, but let's say that there are some risky hedge funds, and then they say that this yield is too low. And the investment bankers, they're very creative people, they say, well, look, here's some people who want to buy securities, but these securities are too risky for them. And there's other people who want to buy securities who are able to take on more risk, but they say the yield is too low. So instead of losing out on these investors, why don't I just split up this special purpose entity in a different way? Why don't I split it up into tranches? So instead of all of the securities being the same, why don't I put them into classes? And they're often called the senior tranche, the mezzanine tranche, I'll just write "Mez" for short or the middle tranche, and then the equity tranche. And the way it works, in a mortgage-backed security everyone gets paid the same amount. In this situation, when you split it this way, the holders of the senior tranche securities are going to get paid first. Only when they are made whole are the owners of the mezzanine tranche security is going to get paid, and only when they are made whole will the owners of the equity tranche security will get paid. And this scenario right over here is called a collateralized debt obligation, CDO. And it's really a derivative security from the mortgages. We've sliced it and diced it in a slightly different way. Now you might be saying, how does this solve the problem? Well, now the ratings agency will say, well, look if the senior people are going to get paid before everyone else, then I'm going to give them a higher rating. And they can even get insurance on this and get a credit default swap, and then maybe they'll give it a AAA rating, and which means that the pensions can now buy the senior rated CDO's. But they'll pay them less interest. Maybe they'll pay them 5%. Maybe the mezzanine, they get paid next, they'll get maybe still a BB rating, and they'll get the 8%. And then the equity tranche, they'll get a higher interest. So they'll get say a 15% interest in exchange for being the last person to get paid. And maybe they don't get any ratings at all. So you could almost view this as a junk rating if you want to view it that way. But that makes both people happy. Pensions get something safe, lower yield. Hedge funds get something risky, but it has a higher yield.

## Purpose

### IO/PO pair

The simplest coupon tranching is to allocate the coupon stream to an IO, and the principal stream to a PO. This is generally only done on the whole collateral without any prepayment tranching, and generates strip IOs and strip POs. In particular FNMA and FHLMC both have extensive strip IO/PO programs (aka Trusts IO/PO or SMBS) which generate very large, liquid strip IO/PO deals at regular intervals.

### Floater/inverse pair

The construction of CMO Floaters is the most effective means of getting additional market liquidity for CMOs. CMO floaters have a coupon that moves in line with a given index (usually 1 month LIBOR) plus a spread, and is thus seen as a relatively safe investment even though the term of the security may change. One feature of CMO floaters that is somewhat unusual is that they have a coupon cap, usually set well out of the money (e.g. 8% when LIBOR is 5%) In creating a CMO floater, a CMO Inverse is generated. The CMO inverse is a more complicated instrument to hedge and analyse, and is usually sold to sophisticated investors.

The construction of a floater/inverse can be seen in two stages. The first stage is to synthetically raise the effective coupon to the target floater cap, in the same way as done for the PO/Premium fixed rate pair. As an example using $100mm 6% collateral, targeting an 8% cap, we generate$25mm of PO and $75mm of '8 off 6'. The next stage is to cut up the premium coupon into a floater and inverse coupon, where the floater is a linear function of the index, with unit slope and a given offset or spread. In the example, the 8% coupon of the '8 off 6' is cut into a floater coupon of: ${\displaystyle 1\times {\text{LIBOR}}+0.40\%}$ (indicating a 0.40%, or 40bps, spread in this example) The inverse formula is simply the difference of the original premium fixed rate coupon less the floater formula. In the example: ${\displaystyle 8\%-\left(1\times {\text{LIBOR}}+0.40\%\right)=7.60\%-1\times {\text{LIBOR}}}$ The floater coupon is allocated to the premium fixed rate tranche principal, in the example the$75mm '8 off 6', giving the floater tranche of '$75mm 8% cap + 40bps LIBOR SEQ floater'. The floater will pay LIBOR + 0.40% each month on an original balance of$75mm, subject to a coupon cap of 8%.

The inverse coupon is to be allocated to the PO principal, but has been generated of the notional principal of the premium fixed rate tranche (in the example the PO principal is $25mm but the inverse coupon is notionalized off$75mm). Therefore, the inverse coupon is 're-notionalized' to the smaller principal amount, in the example this is done by multiplying the coupon by ($75mm /$25mm) = 3. Therefore, the resulting coupon is:

${\displaystyle 3\times \left(7.60\%-1\times {\text{LIBOR}}\right)=22.8\%-3\times {\text{LIBOR}}}$

In the example the inverse generated is a '\$25mm 3 times levered 7.6 strike LIBOR SEQ inverse'.

### Other structures

Other structures include Inverse IOs, TTIBs, Digital TTIBs/Superfloaters, and 'mountain' bonds. A special class of IO/POs generated in non-agency deals are WAC IOs and WAC POs, which are used to build a fixed pass through rate on a deal.

## Attributes of IOs and POs

### Interest only (IO)

An interest only (IO) strip may be carved from collateral securities to receive just the interest portion of a payment. Once an underlying debt is paid off, that debt's future stream of interest is terminated. Therefore, IO securities are highly sensitive to prepayments and/or interest rates and bear more risk. (These securities usually have a negative effective duration.) IOs have investor demand due to their negative duration acting as a hedge against conventional securities in a portfolio, their generally positive carry (net cashflow), and their implicit leverage (low dollar price versus potential price action).

### Principal only (PO)

A principal only (PO) strip may be carved from collateral securities to receive just the principal portion of a payment. A PO typically has more effective duration than its collateral. (One may think of this in two ways: 1. The increased effective duration must balance the matching IO's negative effective duration to equal the collateral's effective duration, or 2. Bonds with lower coupons usually have higher effective durations and a PO has no [zero] coupon.) POs have investor demand as hedges against IO type streams (e.g. mortgage servicing).