Collateralized Mortgage Obligations (CMOs)

CMOs retain many of the yield and credit quality advantages of pass-throughs, while eliminating some of the less desirable elements of the traditional mortgage-backed security. CMOs are bonds or debt obligations issued by mortgage originators by offering whole loan mortgages or mortgage pass-through securities as collateral. The cash flows generated by the assets in the collateral pool are first used for paying interest and then pay principal to the CMO bondholders.

The major difference between traditional pass-throughs and CMOs lies in the principal payment process. In case of pass-through securities, each investor receives a pro rata distribution of any principal and interest payments (net of servicing fees) made by the homeowner. Since mortgages are self-liquidating assets, the holder of a pass-through receives some return of principal each month. Until all the mortgages in the pool are finally retired, complete return of principal and the final maturity of the pass-through does not occur. Thus, a large difference between average life and final maturity is created and there is a great deal of uncertainty with regard to timing of principal return under a pass-through security.

CMOs avoid the problems underlying pass-throughs by issuing bonds in groups and each group is referred to as 'tranche'. This security allows distribution of various risks among the different kinds of bond holders. Further, these securities also satisfy the asset/liability requirements of the institutional investors.

The CMO structure offers issuers a flexible tool with which to design tranches to meet investor needs and respond to market conditions. There are a wide range of CMO tranches designed to reduce an investor's exposure to prepayment risk. The tranche types are defined according to general characteristics; however, investors should carefully evaluate how the security is likely to perform under a range of economic assumptions. Let us go through some of the major ones:

1. Sequential-Pay Tranche
2. Planned Amortization Class (PAC) Tranche 
3. Support or Companion Tranches
4. Accrual Bonds (Z tranches)
5. Floating-rate Tranches