Collateralized Mortgage Obligations (CMOs) for Financial Institutions

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(Last Updated On: June 11, 2020)

Your mission is all about helping people thrive through a range of financial milestones. To continue this effort, you must remain solvent and profitable. A concept called Collateralized Mortgage Obligations might just help advance both goals.

Read on to learn if this investment strategy makes sense for your bank or credit union.

Why discuss investment strategies?

Stable portfolio investment is essential for your financial institution.

In fact, the Credit Union Journal recently encouraged management teams to “rethink their investment strategy.” Why? “Credit unions have not seen an investment environment like this one in more than a decade,” explained the article.

At any given time, there are events affecting global markets. As of this writing (early 2020), some of them include trade disputes, pandemic impacts, Federal Reserve interest rate changes, and uncertainty in government intervention.

Despite this, Reuters recently reported that the global Collateralized Debt Obligation Market, which includes Collateralized Mortgage Obligations (CMOs), is expected to continue to grow over the next five years.

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This article will answer the two main questions you have right now:

  1. What are CMOs?
  2. Why are they a preferred investment vehicle for financial institutions?

Let’s find out.

What are CMOs?

To define CMOs, we first need to explain two other investment terms:

  • Collateralized Debt Obligations (CDOs)
  • Mortgage-backed Securities (MBS)

These investments originated through a process called securitization.

Securitization benefits the originator, typically a bank or credit union, by providing liquidity on a group of assets the institution no longer wants to keep nor service. The assets are typically auto or mortgage loans.

Then, the originator sells the portfolio to an issuer, who creates tradable securities. In other words, it enables your institution to sell loans to buy an investment.

Collateralized Debt Obligations (CDOs)

CDOs are investment products backed by underlying assets, such as car loans, credit card debt, corporate debt, or bonds. Those underlying assets are what give CDOs their value and determine their level of risk.

These types of investment are known as “pass-through securities” because the security “passes through” payments from debtors to investors.

A CMO is a type of CDO. Stay with us. It’s going to make sense in just a second.

Collateralized Mortgage Obligations (CMOs)

A CMO is just a CDO where the underlying assets are made up of mortgage-backed securities (MBS…yes, another acronym). These are investments comprised of a bundle of home loans. They are “secured” by the mortgages within.

With those terms in mind, we can define CMO this way: CMOs are Collateralized Debt Obligations (CDOs) made up of mortgage-backed securities (MBS) that are separated into groups of mortgages, which are organized by their risk profiles.

In creating this graphic, I was able to wrap my brain around the hierarchy. Hopefully it helps you, too:

CMO Explanation Chart
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A CMO’s value is based on the underlying mortgages. The CMO issuer buys mortgage loans or MBS certificates from a bank, and creates tranches. (At least this one isn’t an acronym!) A tranche defines different classes of securities or bonds.

Tranches represent ownership interest and are offered with varying lifetimes, interest rates, risks, and cash-flow certainties. Here’s where the flexibility of the CMO structure may appeal to your institution’s investors.

You can choose the CMO that best meets your investment objectives and risk profiles.

Sidebar

Yes, there’s a reason CMOs and mortgage-backed securities sound familiar. They played a role in the economic crisis of 2008. However, the problem-causing investments had misleading risk levels.

The mortgages were not as “rock-solid” as advertised. Thus, once the tower of investments was built, issues with the foundation (ie. actual mortgages) emerged, and things went badly fast.

It’s an oversimplification of the 2008 crisis, but for now, let’s focus on this: Some CMOs at the time were filled with mortgages which weren’t worth nearly what was claimed. And others included mortgages which couldn’t be paid by their owners.

Regulations and new banking practices should prevent that in the future. (But may not (The Atlantic))

Yes, I know, regulations frustrate you and your team. However, when implemented properly, they can protect everyone (including you and your members) from dangerous financial strategies.

Like any other new initiative, due diligence and research is essential to determine if it fits your mission. We’re sharing this information because it’s important you know. Whether or not you use it is your decision.

Ok, back to the article!

How Your Institution Profits

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CMO investors receive regular payments based on the details of the tranche. Remember, these are the groups you can choose based on your choices. Here’s how it works:

  • On CMO purchase, the investor chooses a tranche with the preferred level of risk. These are usually grouped A, B, or C, with A being the highest risk.
  • As you may expect, tranche A can provide the highest returns, at the cost of the highest risk. Tranche A includes mortgages that have a long term left, so investors face the risk of interest and principal default, as well as prepayment. While this tranche is the first to absorb losses, it’s also the first to receive money from prepayments.
  • Tranche C has a much lower rate of return, but carries the least risk. Mortgages in this tranche are approaching full repayment. Investors are receiving interest payments with some principal, but few or no returns from prepayments.

Pros and Cons

As with any investment, there are pros and cons to your choice. We’re focused on transparency, so we’ll include the downsides as well as the Pros.

Pros

  • Lower risk. CMOs are considered a relatively safe investment. Most are “agency CMOs” because they are guaranteed by government entities, such as Ginnie Mae, Fannie Mae, or Freddie Mac.
  • Credit safety. “Non-agency CMOs” are the sole responsibility of the issuer, meaning they are not backed by the government. However, they often receive a AAA credit rating, indicating their credit safety.
    • Discover if they rate the CMO using “default correlation“, which is “a measure of the likelihood of loans defaulting at the same time”
    • Historical note: Freddie Mac first developed the CMO in 1983 as a way to address the instability of MBS due to fluctuating prepayment rates. The intricate way CMOs are structured divides and compartmentalizes the risk of prepayments, whether they are “agency” or “non-agency” CMOs.
  • Flexible. Tranches allow CMOs to meet a range of goals. Want a conservative investment? There’s a bond type for you. Looking to be more speculative (based on industry regulations and compliance)? There’s a CMO to match.
    • Example: A group of CMOs that contain adjustable rate mortgages. One tranche might contain the low-interest portion of the mortgage, while another contains just the portion with the higher rates. Conservative investors can opt to invest only in the low-interest, lower risk tranche. More aggressive investors can choose the higher interest tranche.
  • Minimal investment. CMOs can be purchased for a relatively low amount. A CMO bond can be obtained for as little as $1,000.
    • Other pass-through securities can have a $25,000 minimum, while being similarly structured. The primary different is the collateral they use, including car loans, credit card, or corporate debt.
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We should note: Fees and commissions may apply. However, the overall cost of CMOs is still relatively low. We’ll look more into the costs in the final “Before you Invest…” section.

Cons

  • Lower yields. Because risk is low, CMOs yield lower returns than other pass-through securities.
  • Bias among the tranches. Low-tier tranche investors are only paid if there is yield to pay the higher-tiered tranche investors.
  • Some risk. No investment is without risk. If the portfolio experiences default, investors risk non-payment of both the interest and the remaining principal.
    • CMOs are susceptible to interest rate fluctuations and consumer behavior. This can include rates at which homeowners sell, refinance, or prepay their loans. Additionally, market fears can bring trading to a near standstill, resulting in liquidity challenges.
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Before You Invest…

The purpose of this article is to help you understand what CMOs are and if they make sense as a part of your investment strategy.

To review: CMOs are issued by government entities, such as the Federal Home Loan Mortgage Corporation. They can also be purchased from private issuers, usually investment banks.

For example, you know from above Freddie Mac developed the investment vehicle. However, investment banks First Boston and Salomon Brothers created its precursor, known at the time as a “Real Estate Mortgage Investment Conduit.”

Today you can opt to invest in agency or “private-label” CMOs. Investment banks, financial institutions, or even home builders issue the latter.

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“Private-Label” CMOs

Companies such as Fidelity, Wells Fargo, Citibank, Wilmington Trust as well as many other investment companies now offer CDOs (and thus, CMOs). They act as a trustee or collateral administrator.

These entities handle duties such as compliance tests, noteholder reports, composition and liquidity tests, and executing payment waterfall models.

CMO Portfolio Maintenance

Key players in the maintenance of your CMO portfolio include:

  • Trustee
  • Asset Manager
  • Underwriter

Their roles ensure that very little time and resources are required by the investor. However, you will pay fees of around 1.5 to 2 percent via equity from the investment, which correlates to 25-100 basis points.

Regardless of which issuer you choose, it’s important to understand the types of CMOs available.

4 Common Types of CMOs

  • Sequential Class CMO: Structured so that only one tranche is paid at a time. Once the first tranche is retired, the principal is redirected to the next. Tranches are paid based on the corresponding average maturities.
  • Planned Amortization Class (PAC): Based on a fixed principal schedule and has two or more tranches active at the same time. Cash flow irregularities caused by prepayments are directed away from the PAC class. If repayment is less than scheduled, the principal is still paid to the PAC class, but not to the other classes or tranches. A range of prepayment speeds is based upon each class.
  • Targeted Amortization Class (TAC): Based on one prepayment speed instead of a range. If the prepayment speed deviates, investors could get more or less principal than scheduled.
  • Support class: Part of the structure of both PACs and TACs. The goal of a support class is to stabilize the principal payments. Monies get redistributed in the event of payment variability, instead of being eliminated or reduced.

Opportunity, Risk, and Knowledge

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CMOs may be an untapped opportunity for your financial institution. We hope this started you on the path of profitable decisions.

As you know, all investment carries risk. And CMOs played a role in the 2008 financial crisis. Fortunately, you have more ability today to analyze the risks in any investment vehicle you may choose.

With strategic planning, CMOs can contribute to a calculated risk and profitable investment program.

Knowledge is power. Other institutions take advantage of CMOs. It may help give them a profit edge. Isn’t it worth looking at someone else’s “secret sauce”?

Change is Now

The financial services sector is experiencing enormous changes. New technologies, expectations, and even providers emerge with innovative offerings. Where do you fit in this evolving new world?

That’s a great question and one we encourage you to continuously ask. We’ll do our best to answer it! Our goal is to share tools and strategies to help face these changes and grow your bank or credit union.

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Image credits: Photos by Tierra Mallorca, Helloquence, Matthew T Rader on Unsplash

Joe Winn - CU Geek

Blogger. Speaker. Part-time Jedi.

Focused on helping your bank or credit union grow in the face of emerging challenges.