A collateralized mortgage obligation (CMO) is a type of mortgage-backed security (MBS). Unlike a mortgage pass-through, in which all investors participate proportionately in the net cash flows from the mortgage collateral, with a collateralized mortgage obligation, different bond classes are issued, which participate in different components, called tranches, of the net cash flows. A collateralized mortgage obligation is any one of those bonds. The tranches are structured to each have their own risk characteristics and maturity range. In this way, investors can select a bond offering the characteristics which most closely meet their needs. Collateral for the securitization may be a pool of mortgages, but it is often a mortgage pass-through.
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. This process is illustrated for a three-tranch sequential pay structure in Exhibit 1:
Exhibit 1: The segregation of cash flows into three sequential pay tranches is illustrated. All three participate in interest payments, but principal payments flow exclusively to the A bonds until they are retired. After that, all principal payments flow to the B bonds until they are retired. Finally, all principal payments flow to the C bonds until they are retired.
Collateralized mortgage obligations entail the same prepayment risk as mortgage pass-throughs. The prepayment risk of a specific bond depends upon how that tranch is structured and on the underlying collateral. Many different structures are used in practice, including stable PAC bonds or risky IOs and POs. There are floaters and inverse floaters. There are also Z-bonds, which are analogous to zero-coupon bonds.
The first collateralized mortgage obligation was created for Freddie Mac in 1983 by Salomon Brothers and First Boston. With Freddie Mac guaranteeing the payment of principal and interest on the underlying mortgages, the instrument posed essentially no credit risk. This became the norm with collateralized mortgage obligations for many years, with collateral comprising mortgages guaranteed by Fannie Mae, Freddie Mac, or Ginnie Mae, all of which had, explicitly or implicitly, the full backing of the US Treasury. Investors took prepayment risk, for which they were compensated with higher yields, but no credit risk. The collateralized mortgage obligations market boomed, with “vanilla” structures, such as PAC bonds, routinely held in fixed income portfolios.
Banks started issuing their own “private label” collateralized mortgage obligations with underlying mortgages that were not guaranteed by Fannie, Freddie or Ginnie. Those “nonconforming” mortgages added credit risk to the familiar collateralized mortgage obligation model. At first, the banks addressed that credit risk by purchasing credit insurance, over-collateralizing or by other means. Once private label collateralized mortgage obligations were broadly accepted in the market, the banks started passing more of the credit risk on to investors. This made collateralized mortgage obligations staggeringly complex, with the interrelated uncertainties of prepayment and default. Tranching allocated both cash flows and possible credit losses among investors, with each tranch receiving its own credit rating from a rating agency. This opened the door to a variety of abuses involving three parties:
- mortgage originators
- banks
- credit rating agencies
Mortgage originators sourced mortgages which banks packaged into collateralized mortgage obligations that the rating agencies rated for sale to investors. The business was extremely profitable for all three parties, and investors were taking the prepayment and credit risk. The pace of mortgage origination quickened. Credit standards fell. Some mortgage originators falsified mortgage applications so they could lend to home buyers who could not afford the mortgages they were receiving. That was more than credit risk. It was fraud. None of this was adequately reflected in the credit ratings of collateralized mortgage obligations because banks “shopped” the bonds among rating agencies to find who would give the the best ratings. The rating agencies understood they wouldn’t be paid to give collateralized mortgage obligations low ratings. They proved all to willing to inflate ratings to satisfy banks. With all the money flowing into mortgages, the housing market boomed, forming a real estate bubble. The market faltered in 2007. The following year it collapsed in what has come to be known as the financial crisis of 2008.