All About CMOs

In this article we are going to review a number of the different types of CMOs you are likely to be tested on, on your exam.  Many FINRA exams have a number of questions relating to collateralized mortgage obligations. Some of the questions will be definitional in nature. Some of the questions will require you to understand the operational and risk characteristics of each of the different types of CMOS. CMOS are not suitable for every investor. These products should be carefully monitored by compliance professionals to ensure that registered representatives only recommend these products to investors who understand and can afford the risks. Collateralized mortgage obligations are designed to provide income to investors and the performance and features of the CMOS vary depending upon the structure of the product. 

What are CMOS?

A collateralized mortgage obligation (CMO) is a mortgage-backed security issued by private finance companies, as well as by FHLMC and FNMA. The securities are structured much like a pass-through certificate and their term is set into different maturity schedules, known as tranches. Pools of mortgages on one to four-family homes collateralize CMOs. Because CMOs are backed by mortgages on real estate, they are considered relatively safe investments and are often given an AAA rating. In addition to rare default risks that the owner of a CMO faces is the risk of early refinance. CMOs pay interest and principal monthly. However, they pay the principal to only one tranche at a time in $1,000 payments. The CMO pays off each tranche until the final tranche, known as a Z tranche, is paid off. The Z tranche is the most volatile CMO tranche. 

How are CMOS affected by a change in interest rates?

CMOs, like other interest-bearing investments, will be affected by a change in the interest rate environment. CMOs may experience the following if interest rates change: 

• If interest rates fall, homeowners will refinance more quickly, and the investors will be paid off more quickly than they had hoped. 

• The rate of principal payments may vary. 

• If interest rates rise, refinancing may slow down, and the investors will be paid off more slowly than they had hoped. 

Most CMOs have an active secondary market and are considered relatively liquid securities. However, the more complex CMOs may not have an active secondary market and may be considered illiquid. Interest earned by inves- tors from CMOs is taxable at all levels: federal, state, and local. 

Is there more than one type of CMO?

Like many other investments, there are several different types of CMOs. They are: 

• Principal only (PO) 

• Interest only (IO) 

• Planned amortization class (PAC) 

• Targeted amortization class (TAC) 

What are  principal only CMOs? 

Principal-only CMOs, as the name suggests, receive only the principal payments made on the underlying mortgage. Principal-only CMOs receive both the scheduled principal payments as well as any prepayments made by the homeowners in the pool. Because the principal-only CMO does not receive any interest payments, it is sold at a discount to its face value. The appreciation of the CMO, up to its face value represents the investor’s return. The price of a principal-only CMO will be sensitive to a change in interest rates. As interest rates fall, the value of the CMO will rise as prepayments accelerate. A rise in interest rates will have the opposite effect. 

 What are interest-only CMOs? 

Interest-only CMOs receive the interest payments made by homeowners in the pool of underlying mortgages. Interest-only CMOs will also sell at a dis- count to their face value due to the amortization of the underlying mortgages. Interest-only CMOs will increase in value as interest rates rise and decrease in value as interest rates fall as a result of the changes in prepayments on the underlying pool of mortgages. The changes in the prepayments on the underlying mortgages will affect the number of interest payments the holder of the CMO will receive. As interest rates rise, prepayments will slow, thus increasing the number of interest payments the investor receives. The more interest payments the CMO holder receives, the more valuable the CMO becomes. 

What are  planned amortization class CMOs? 

Planned amortization class CMOs (PACs) are paid off first and offer the investor the most protection against prepayment risk and extension risk. If prepayments come in too quickly, those principal payments will be placed into another CMO known as a support class to protect the owner of the PAC from prepayment risk. If principal payments are made more slowly, principal payments will be taken from a support class to protect the investor against extension risk. 

What are targeted amortization class CMOs?  

Targeted amortization class CMOs (TACs) only offer the investor protection from prepayment risk. If principal payments are made more quickly, they will be transferred to a support class. However, if principal payments come in more slowly, payments will not be taken from a support class and will be subject to extension risk. 

TAKENOTE! 

More complex CMOs are not suitable for all investors and investors should sign a suitability statement before investing. The secondary market for complex CMOs may also be very illiquid. 

What are private label CMOs? 

Private-label CMOs are issued by investment banks, and the payment of interest and principal payments are the responsibility of the issuing invest- ment bank. The payments due to a holder of a private-label CMO are not guaranteed by any government agency. The credit ratings of the private-label CMOs are based on the collateral that backs the CMO and the credit rat- ing of the issuer. If the private-label CMO uses agency issues as collateral for the CMO, those agency issues still carry the guarantee of the issuing government agency. 

TAKENOTE! 

When recommending a CMO to an investor it is important that the CMO never be compared to bonds and CDs. The complex structure of CMOs have a risk and performance profile that greatly differs from these investments. 

We hope that this article has helped you better understand collateralized mortgage obligations. 

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 good luck on your exam!

 The Securities Institute of America 

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