# 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.

## 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) tranche may be carved from collateral securities to receive just the interest payments from a pool of mortgages. IO holders are only entitled to the actual amount of interest paid, as it is paid, on a pool of mortgage collateral. Since mortgages allow for prepayment, there is no assurance how much interest will actually be paid. Once all an underlying debt is paid off, that debt's future stream of interest is terminated and the IO expires with no terminal value. Therefore, IO securities are annuity-like securities but the amount and timing of payments is uncertain as payments are based on the total interest payments paid on all the underlying mortgages in the collateral pool.

Generally speaking, mortgage prepayments tend to slow down as general interest rates increase. Therefore, IOs prices generally increase as interest rates increase and decrease as interest rates decrease (i.e. negative duration). If mortgage prepayments increase, or the market's expectations of future prepayments increases (i.e. higher expected PSA speed), the expected aggregate dollar amount of interest payments [and therefore the market price of the IO tranche] would generally be expected to decrease. By contrast, if mortgage prepayments decrease, or the market's expectations of future prepayments decreases (i.e. lower expected PSA speed), the expected dollar amount of interest payments [and therefore the market price of the IO tranche] would generally be expected to increase.

Therefore, IOs have investor demand due to their expected negative effective duration as they can be used as a hedge against conventional fixed-income securities in a portfolio. Additionally, since investors are only buying a portion of the overall cash flows and are not entitled to any payments of principal (the PO tranche), the cost of the IO trance may be significantly lower than that of the PO tranche. While IO and PO tranches have different risk characteristics, neither the IO nor the PO represents a leveraged position in the underlying collateral pool.

### Principal only (PO)

A principal only (PO) strip may be carved from collateral securities to receive just the principal portion of a payment. Since the IO tranche has negative duration, 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 rights).