Collateralized mortgage obligation

(CMO)

A mortgage-backed, investment-grade bond that separates mortgage pools into different maturity classes (tranches). Unlike a mortgage pass through, in which all investors participate proportionately in net cash flows from the mortgage collateral, with a CMO, different bond classes are issued, which participate in different components, called tranches, of the net cash flows. CMOs are backed by mortgage backed securities with a fixed maturity. They eliminate risks associated with prepayment because each security is divided into maturity classes are paid off in order. As a result, they yield less than other mortgage backed securities. The maturity classes are called tranches, and are differentiated by a type of return. A given tranch may receive interest, principal, or a combination of the two, and can include more complex stipulations. One negative aspect of collateralized mortgage obligations is lower interest rates compensating for the reduction in prepayment risk and increased predictability of payments. Also, collateralized mortgage obligations can be illiquid, which can increase cost of buying and selling.

A security backed by a pool of pass-through rates, structured so there are several classes of bondholders with varying maturities, called tranches. The principal payments from underlying pool of pass through securities are used to retire the bonds on a priority basis as specified in the prospectus.

Many arrangements are possible. One of the simplest is a sequential pay structure comprising three or four tranches that mature sequentially. All tranches participate in interest payments from the mortgage collateral, but initially, only the first tranch receives principal payments. It receives all principal payments until it is retired. Next, all principal payments are paid to the second tranch until it is retired, and so on.

Like mortgage pass-throughs, CMOs typically have minimal credit risk. Either they have a high quality mortgage pass-through or similar MBS as collateral, or the collateral is bundled with suitable credit enhancement.

The bond was invented in June 1983 by investment banks Salomon Brothers and First Boston,

The process of dividing an MBS into CMO tranches is referred to as structuring.

CMOs usually offer low returns because they are very low risk and sometimes backed by government securities.

Collateralized Debt Obligation (CDO).

The tranches could be made in several ways.

* Credit Tranching. Many CMO bonds are backed by collateral, which is issued and guaranteed by the "Federal Agencies" (Freddie Mac, Fannie Mae, or Ginnie Mae). Those not are called "whole loan CMOs". Whole loan CMOs are subjected to the risk of the home owners not paying the entire principal balance on their loans (in other words defaulting on their mortgages). This is often handled by designating some of the tranches (called "B" pieces) to have any losses passed on to them. When a mortgage default causes a loss, the balance of one of the B pieces is reduced by the amount of the loss.
* Sequential Tranching (also called by time). All of the available principal payments go to a first sequential tranche, until its balance is decremented to zero, then to the second, and so on. There are several reasons this type of tranching would be done:
o The tranches could be expected to mature at different times and therefore would have different Yields that correspond to different points on the Yield Curve.
o The underlying mortgages could have a great deal of uncertainty as to when the principal will be received since home owners have the option to make their scheduled payments or to pay their loan off early at any time. The sequential tranches each have much less uncertainty.
* Parallel Tranching means tranches that pay down pro-rata. The coupons on the tranches would be set so that in aggregate the tranches pay the same amount of interest as the underlying mortgages. The tranches could be either fixed rate, or floating rate. If they have floating coupons, they would have formulas that make their total interest equal to the collateral interest. For example, with collateral that pays a coupon of 8%, you could have two tranches that each have half of the principal, one being a floater that pays libor with a cap of 16%, the other being an inverse floater that pays a coupon of 16 minus libor.
o A special case of parallel tranching is known as the IO/PO split. IO and PO refer to Interest Only and Principal Only. In this case, one tranche would has a coupon of zero (meaning that it would get no interest at all) and the other would get all of the interest. These bonds could be used to speculate on prepayments. A principal only bond would be sold at a deep discount (a much lower price than the underlying mortgage) and would rise in price rapidly if many of the underlying mortgages were prepaid. The interest only bond would be very profitable if few of the mortgages prepaid, but could get very little money if many mortgages prepaid.
* Z bonds. This type of tranche supports other tranches by not receiving an interest payment. The interest payment that would h accrue to Z tranche is used to pay off the principal of other bonds, and the principal of the Z tranche increases. The Z tranche starts receiving interest and principal payments only after the other tranches in the CMO have been fully paid. This type of tranche is often used to customize sequential tranches, or VADM tranches.
* Schedule bonds (also PAC or TAC bonds). This type of tranching has a bond (often called a PAC or TAC bond) which has even less uncertainty than a sequential bond by receiving prepayments according to a defined schedule. The schedule is maintained by using support bonds (also called companion bonds) that absorb the excess prepayments.
o Planned Amortization Class (PAC) bonds have a principal payment rate determined by two prepayment rates, which together form a band (also called a collar). Early in the life of the CMO, the prepayment at the lower PSA will yield a lower prepayment. Later in the life, the principal in the higher PSA will have declined enough that it will yield a lower prepayment. The PAC tranche will receive whichever rate is lower, so it will change prepayment at one PSA for the first part of its life, then switch to the other rate. The ability to stay on the schedule is maintained by a support bond, which absorbs excess prepayments, and will receive less prepayments to prevent extension of average life. However, the PAC is only protected from extension to the amount that prepayments are made on the underlying MBSs. When the principal of that bond is exhausted, the CMO is referred to as a "busted PAC", or "busted collar".
o Target Amortization Class (TAC) bonds are similar to PAC bonds, but do not provide protection against extension of average life.
* Very Accurately Defined Maturity (VADM) bonds are similar to PAC bonds in they protect against both extension and contraction risk, but their payments are supported in a different way. Instead of a support bond, they are supported by accretion of a Z bond. Because of this, a VADM tranche will receive the scheduled prepayments even if no prepayments are made on the underlying.

The tranches typically separate the original bond (referred to as the collateral) cash flows in time or by interest and principle.

An investment-grade security backed by a pool of bonds, loans and assets. CDOs do not specialize in a type of debt but are often non mortgage loans or bonds. Similar in structure to collateralized mortgage obligation (CMO) or collateralized bond obligation (CBO), CDOs are unique in they represent different types of debt and credit risk. In case of CDOs, these different types of debt are often referred to as 'tranches' or 'slices'. Each slice has a different maturity and risk associated with it. The higher the risk, the more the CDO pays.

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