What are secured mortgage bonds?
Collateralized mortgage bonds, or CMOs, are a type of mortgage-backed securities. Thousands of individual mortgages are grouped into classes, or tranches, and ranked according to their level of risk. CMOs are a way for traders to invest in residential mortgages, and they typically offer higher yields than Treasuries. CMOs are traded on secondary markets – and we’ll discuss how to buy them in more detail below.
It is important to note that because CMOs depend on the cash flows generated by their underlying assets, they are vulnerable to fluctuations in interest rates and other economic changes. For example, if homeowners don’t make their mortgage payments, the securitized assets lose their value.
For these reasons, CMOs are also known as “passage bonds” because they effectively serve as a conduit for payments from debtors to investors.
How do CMOs work?
Individual home loans are difficult to negotiate. That’s why banks or government-sponsored companies, like Ginnie Mae, pool mortgages. These loans are then securitized, which means that they are transformed into a more liquid and easily negotiable financial vehicle.
CMOs are complex instruments that can have up to 50 tranches. In French, the word “tranche” means slice, and each slice is investable.
A tranche consists of loans with similar characteristics, such as amount values. They are also ranked according to the credit rating of the owner. Credit rating agencies, such as Standard & Poor’s, Fitch Ratings and Moody’s, assign each tranche a credit rating based on the credit risk of the underlying mortgage holders.
AAA rating is the highest. This means that the mortgage holder is able to meet all of their financial commitments. The lowest grade, D, means they are currently in default.
- Senior tranches include Class A CMOs and have the lowest yields because their mortgages are generally A-rated. Investors in senior tranches are generally paid first.
- Junior tranches include class B and class C – they represent subprime mortgages. Investors in these tranches are paid last, although to compensate for the increased risk, the returns associated with these tranches are also the highest.
Most tranches contain interest and principal because homeowners typically repay their loan in monthly installments that are a combination of the two. These payments usually contain higher interest during the first years of the loan. If a tranche does not yet receive the principal, this is called the “interest only” period.
If a homeowner decides to refinance their loan or buy a new home, their mortgage prepayments increase, which shortens the life of the CMO. All of these different variables can have an impact on the yield offered per tranche.
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CMO issuers actually designate the amount of principal and interest that will go into the different tranches and, for complete transparency, they publish payment schedules in the CMO’s prospectus.
Are CMOs supported by the US government?
Proprietary credit isn’t the only aspect of a CMO that is graduated; so is the sender.
- CMOs issued by Ginnie Mae, the Government National Mortgage Association, are backed by the “full faith and credit” of the US government, which is virtually guaranteed never to default. For this reason, they receive the highest credit rating (AAA) and their yields are usually the lowest.
- Other government-sponsored companies, such as Fannie Mae, also issue CMOs, but they are not government-backed.
- Still other CMOs are created by private issuers and do not have government support.
When did guaranteed mortgage bonds start?
The first CMO was created in 1983 by two investment banks, Salomon Brothers and First Boston, for Freddie Mac, the Federal Home Loan Mortgage Corporation. It was designed as a way to provide liquidity for home mortgages so they could be negotiated more easily.
Are secured mortgage bonds the same as secured debt securities?
Debt-backed bonds (CDOs) are similar to CMOs in that they contain loan pools that can be invested. However, CMOs only contain mortgages, while CDOs contain sets of auto loans, credit card loans, mortgages, and other business loans. Individual investors generally cannot invest in CDOs; rather, they are bought by institutional investors, such as hedge funds and investment banks.
Why have CMOs made the headlines?
During the financial crisis of 2007-2008, a new category of home loans, subprime mortgages, was offered to buyers whose credit was not perfect. These loans had adjustable rates that increased each year after a short “window of anticipation” or whenever prevailing interest rates changed.
During this period, a bubble formed in the housing market, artificially inflating home values. At the same time, the Federal Reserve launched a series of hikes in the federal funds rate to ease inflationary pressures. It was a “perfect storm” of disaster for subprime borrowers: Rates soared, many borrowers became unable to make their loan repayments, and some defaulted or were foreclosed on. result.
This crisis had a knock-on effect on the financial markets. As toxic debt imploded inside CMOs and rendered them worthless, mortgage lenders declared bankruptcy, government-sponsored companies like Fannie Mae and Freddie Mac tipped to the brink of insolvency, and banks global investment companies, such as Lehman Brothers, have collapsed.
The US government needed to step in with emergency funding to prevent a total collapse of the financial system. In 2008, the US Congress approved a $700 billion “bailout bill”, while the Troubled Asset Relief Program (TARP) added billions more.
Stricter regulatory measures were added through the Dodd-Frank Wall Street Reform and Consumer Protection Act, prohibiting banks from investing in high-risk securities, such as CMOs. It also protected consumers from predatory lending practices. The Federal Reserve also cut interest rates to zero and would keep them there for the next 6 years.
How do interest rates affect CMOs?
As with bonds, rising interest rates cause CMOs to lose value. Indeed, interest rate increases affect both the valuations of CMOs as well as the prepayments associated with their underlying mortgages. When mortgage prepayments are affected by changes in interest rates, this in turn affects both the average life of the CMO, which is the length of time the mortgage principal is expected to be outstanding, as well as its performance.
Where can I buy secured mortgage bonds?
Individuals can invest in CMOs, but there is usually a minimum of $1,000. However, most CMOs are bought and traded by institutional investors, such as pension funds, insurance companies, and commercial and investment banks.
The CMO market is an over-the-counter market, which means securities are bought and sold between brokers and investors. Online brokers like Fidelity, Charles Schwab, and TD Ameritrade offer over-the-counter services.
CMOs can take up to a month after their trade date to settle as there is usually a delay associated with interest and principal accumulation periods. Collateral must also be assembled and deposited with a trustee, and any required reports must be completed. CMOs traded on the secondary market are usually settled within three business days.