CMO Overview
Collateralized Mortgage Obligations (CMOs) are a type of mortgage-backed security (MBS). The Federal Home Loan Mortgage Corporation (more commonly known as “Freddie Mac”) first introduced CMOs in 1983. The Tax Reform Act of 1986 authorized the establishment of Real Estate Mortgage Investment Conduits (REMICS), creating certain tax and accounting advantages for issuers and for certain large institutional and foreign investors. For investment purposes, REMIC securities are indistinguishable from CMOs. The CMO market has grown to over $4 trillion in size since its inception in 1983 and today accounts for an ever increasing and important segment of the overall mortgage market.
CMOs…The Evolution
One of the first types of mortgage-backed securities created were mortgage pass-through securities. These securities are now also used as collateral for CMO issues. To create these pass-through securities, similar home mortgages meeting the standard criteria of the issuing Government Agency are grouped together into “pools”. Investors are then able to purchase an interest in these pass-through securities. As the mortgage holders make monthly payments of principal and interest, the pass-through security holder is entitled to a pro rata portion of the payments received. The mutual advantage of this process is that it makes funds available for home mortgages at attractive rates, while at the same time creating high quality securities for investors. Mortgage pass-through securities are typically considered to have an investment horizon of approximately ten to twelve years on average, even though the mortgages are typically thirty-year loans. This shortened horizon occurs because most mortgage loans pay back monthly principal and also allow borrowers to prepay their principal before the stated maturity of the mortgage-backed security. Prepayments can occur as a result of refinancing, homeowners moving, death, foreclosure, etc. In an effort to attract clients with investment objectives shorter or longer than the typical pass-through security, the CMO was created. This was achieved by using pools of mortgage pass-throughs as collateral, which produce monthly cash flow of principal and interest, and then redirecting the cash flow to create short, intermediate and long term bonds.
Please consult your financial advisor prior to investing any money in these or other products. These products are offered through many but not all broker-dealers. This information does not constitute an offer to sell or a solicitation of an offer to buy the securities, nor shall there be any sale of those securities, in any state or jurisdiction in which such an offer, solicitation or sale would be unlawful. Certain products are offered by prospectus or offering circular only. Product suitability must be determined for each individual investor.
CMOs are complex securities and are not suitable for all investors. The average life and yield of a CMO will fluctuate depending on the actual prepayment experience of the underlying mortgages and changes in current interest rates. If CMOs are sold in the secondary market prior to maturity, the proceeds received may be more or less than the original amount invested. When considering the benefits of investing in CMOs, potential investors should equally consider the risks of CMO investing, including but not limited to, credit, interest rate, extension and pre-payment risks.