The Collateralized Mortgage Obligations bond investor is able to buy and sell directly from David Lerner Associates, one of the major Collateralized Mortgage Obligation bond firms in the New York tri-state area.

THE CMO: AN OVERVIEW
Collateralized Mortgage Obligations (CMOs) — also known as Real Estate Mortgage Investment Conduits (REMICs) — are one of the most innovative investment vehicles available today, offering regular payments, relative safety, and notable yield advantages over other fixed-income securities of comparable credit quality.

By the end of December 2009, the total volume of outstanding securities came to over $2.5 trillion. A wide variety of CMO securities with different cash flow and expected maturity characteristics have been designed to meet specific investment objectives. While CMOs offer advantages to investors, they also carry certain risks, which are explained on this page. To determine if CMOs have a place in your portfolio, you should first understand the distinctive features of these securities.

THE BUILDING BLOCKS OF CMOs: MORTGAGE LOANS & MORTGAGE PASS-THROUGHS
The creation of a CMO begins with a mortgage loan extended by a financial institution to finance a borrower’s home or other real estate. The homeowner usually pays the mortgage loan in monthly installments composed of both interest and “principal.” Over the life of the mortgage loan, the interest component of payments, which typically comprises a majority of the payments in the early years, gradually declines as the principal component increases.

To obtain funds to make more loans, mortgage lenders either “pool” groups of loans with similar characteristics to create securities or sell the loans to issuers of mortgage securities. The securities most commonly created from pools of mortgage loans are “mortgage pass-through securities,” often referred to as mortgage-backed securities (MBS) or participation certificates (PCs). Mortgage pass-through securities represent a direct ownership interest in a pool of mortgage loans. As the homeowners whose loans are in the pool make their mortgage loan payments, the money is distributed on a pro rata basis to the holders of the securities.

Several factors can affect the homeowners’ payments. Typically, the homeowner will “prepay” the mortgage loan by selling the property, refinancing the mortgage, or otherwise paying off the loan in part or whole. Most mortgage pass-through securities are based on fixed-rate mortgage loans with an original maturity of 30 years. But experience shows that most of these mortgage loans will be paid off much earlier.

While the creation of mortgage pass-through securities greatly increased the secondary market for mortgage loans by pooling them and selling interests in the pool, the structure of such securities has inherent limitations. Mortgage pass-through securities only appeal to investors with a certain investment horizon — on average, 10 to 12 years.

CMOs were developed to offer investors a wider range of investment time frames and greater cash-flow certainty than had previously been available with mortgage pass-through securities. The CMO issuer assembles a package of these mortgage pass-through securities, or in some cases mortgage loans themselves, and uses them as collateral for a multi-class security offering. The different classes of securities in a CMO offering are known as “tranches,” from the French word for “slice.” The CMO structure enables the issuer to direct the principal and interest cash flow generated by the collateral to the different tranches in a prescribed manner, as defined in the offering’s prospectus, to meet different investment objectives.

THE HIGH CREDIT QUALITY OF CMOs
Most mortgage pass-through securities are guaranteed by the Government National Mortgage Association (GNMA or Ginnie Mae), an agency of the U.S. government, or by U.S. government-sponsored enterprises (GSE) such as the Federal National Mortgage Association (FNMA or Fannie Mae) or the Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac). Ginnie Mae is a government-owned corporation within the Department of Housing and Urban Development. Fannie Mae and Freddie Mac have Federal charters and are subject to some oversight by the Federal government but are publicly owned by their stockholders. (The term “agency” is commonly used to refer to Fannie Mae and Freddie Mac as well as to GNMA. This discussion follows that usage, but readers should bear in mind that Fannie Mae and Freddie Mac are federally chartered and privately owned companies).

Some private institutions such as subsidiaries of investment banks, financial institutions, and home builders, also issue mortgage securities. When issuing CMOs, they often use agency mortgage pass-through securities as collateral, however, their collateral may also include different or specialized types of mortgage loans or mortgage loan pools, letters of credit, or other types of credit enhancements. These so-called “private label” CMOs are the sole obligation of their issuer. To the extent that private-label CMOs use agency mortgage pass-through securities as collateral, their agency collateral carries the respective agency’s guarantees. Private-label CMOs are assigned credit ratings by independent credit agencies based on their structure, issuer, collateral, and any guarantees or outside factors. Many carry the highest AAA credit rating.

As an additional investor protection, the CMO issuer typically segregates the CMO collateral or deposits it in the care of a “trustee” who holds it for the exclusive benefit of the CMO bond holders.

A DIFFERENT SORT OF BOND: PREPAYMENT RATES AND AVERAGE LIVES
Although CMOs entitle investors to payments of principal and interest, they differ from corporate bonds and Treasury securities in significant ways. Corporate and Treasury bonds are issued with stated maturities. The purchase of a bond from an issuer is essentially a loan to the issuer in the amount of the principal, or face amount, of the bond for a prescribed period of time in return for a specified annual rate of interest. The bondholder receives interest, generally in semiannual payments, until the bond is redeemed. When the bond matures or is called by the issuer, the issuer returns the “face value” of the bond to the investor in a single principal payment.

With a CMO, the ultimate borrower is the homeowner who takes on a mortgage loan. Because the homeowner’s monthly payments include both interest and principal, the mortgage security investor’s principal is returned over the life of the security, or “amortized,” rather than repaid in a single lump sum at maturity. CMOs provide monthly or quarterly payments to investors which include varying amounts of both principal and interest. As the principal is repaid or prepaid, interest payments become smaller because they are based on a lower amount of outstanding principal.

A mortgage security “matures” when the investor receives the final principal payment. Most CMO tranches have a stated maturity based on the last date on which the principal from the collateral could be paid in full. This date is theoretical because it assumes no prepayments on the underlying mortgage loans.

Mortgage securities are more often discussed in terms of their “average life” rather than their stated maturity date. Technically, the average life is defined as the average time to receipt of each dollar of principal, weighted by the amount of each principal payment. In simpler terms, the average life is the average time that each principal dollar in the pool is expected to be outstanding based on certain assumptions about prepayment speeds. If prepayment speeds are faster than expected, the average life of the CMO will be shorter than the original estimate; if prepayment speeds are slower, the CMO’s average life will be extended.

For more information contact me directly at:

John Felice
Investment Counselor
201-371-2626