T O R ’ S G E S U I V D N I E T N O A COLLATERALIZED MORTGAGE OBLIGATIONS CMOs Income paid monthly or quarterly to meet investment goals. CONTENTS THE CMO: AN OVERVIEW The CMO: An Overview 1 1 Collateralized Mortgage Obligations (CMOs) —also known as Real Estate Mortgage Investment Conduits The Building Blocks of CMOs: (REMICs)—are one of the most innovative invest- Mortgage Loans and Mortgage Pass-throughs ment vehicles available today, offering regular pay- 2 ments, relative safety, and notable yield advantages The High Credit Quality of CMOs over other fixed-income securities of comparable 3 credit quality. A Different Sort of Bond: Prepayment Rates and Average Lives $241.0 billion in new agency CMOs were issued 5 in the first half of 2002, bringing the total volume Calculating Prepayment Speeds of outstanding securities to $892.9 billion as of 7 June 30, 2002. A wide variety of CMO securities Interest Rates and Yields on CMOs with different cash flow and expected maturity 7 characteristics have been designed to meet specific investment objectives. While CMOs offer advantages The Effect of Interest Rates on CMO Values and Prepayment Rates to investors, they also carry certain risks, which are 8 explained in this brochure. To determine if CMOs Basic Characteristics of a CMO Tranche have a place in your portfolio, you should first under- 9 stand the distinctive features of these securities. The Various Types of CMOs OUTSTANDING VOLUME OF AGENCY 10 CMO SECURITIES $ BILLIONS CMO Settlement Dates and Payment Dates FNMA FHLMC GNMA 892.9 900 16 801.3 800 Minimum Investments, 700 662.1 664.1 600.8 Transaction Costs, and Liquidity 600 578.7 579.7 540.9 521.0 17 500 Tax Considerations for CMO Investors 400 17 300 200 Questions You Should Ask 100 Before Investing in CMOs 0 Source: FNMA, FHLMC, GNMA 19 1994 1995 1996 1997 1998 1999 2000 2001 2002:Q2 Glossary 21 1 CMOs were first introduced in 1983. The Tax Reform Act of 1986 allowed CMOs to be issued in the form of Real Estate All information and opinions contained in this publication were produced by The Mortgage Investment Conduits (REMICs), creating certain tax Bond Market Association from our membership and other sources believed by the and accounting advantages for issuers and for certain large Association to be accurate and reliable. By providing this general information, The institutional and foreign investors. Today, almost all CMOs are Bond Market Association makes neither a recommendation as to the appropriateness issued in REMIC form. In this brochure, as in common market of investing in fixed-income securities nor is it providing any specific investment advice for any particular investor. Due to rapidly changing market conditions and the usage, the terms “REMIC” and “CMO” are interchangeable, complexity of investment decisions, supplemental information and sources may be except where otherwise noted. required to make informed investment decisions. 1 THE BUILDING BLOCKS OF While the creation of mortgage pass-through secu- CMOS: MORTGAGE LOANS & rities greatly increased the secondary market for MORTGAGE PASS-THROUGHS mortgage loans by pooling them and selling inter- ests in the pool, the structure of such securities has inherent limitations. Mortgage pass-through The creation of a CMO begins with a mortgage loan securities only appeal to investors with a certain extended by a financial institution (savings and loan, investment horizon—on average, 10 to 12 years. thrift, commercial bank, or mortgage company) to CMOs were developed to offer investors a wider finance a borrower’s home or other real estate. The range of investment time frames and greater cash- homeowner usually pays the mortgage loan in month- ly installments composed of both interest and “princi- flow certainty than had previously been available pal.”2 Over the life of the mortgage loan, the interest with mortgage pass-through securities. The CMO component of payments, which typically comprises a issuer assembles a package of these mortgage majority of the payments in the early years, gradually pass-through securities, or in some cases mortgage declines as the principal component increases. loans themselves, and uses them as collateral for a multiclass security offering. The different classes of To obtain funds to make more loans, mortgage securities in a CMO offering are known as “tranch- lenders either “pool” groups of loans with similar es,” from the French word for “slice.” The CMO characteristics to create securities or sell the loans structure enables the issuer to direct the principal to issuers of mortgage securities. The securities and interest cash flow generated by the collateral to most commonly created from pools of mortgage the different tranches in a prescribed manner, as loans are “mortgage pass-through securities,” often defined in the offering’s prospectus, to meet differ- referred to as mortgage-backed securities (MBS) or ent investment objectives. participation certificates (PCs).3 Mortgage pass- through securities represent a direct ownership interest in a pool of mortgage loans. As the home- THE HIGH CREDIT owners whose loans are in the pool make their QUALITY OF CMOS mortgage loan payments, the money is distributed on a pro rata basis to the holders of the securities. Most mortgage pass-through securities are guar- Several factors can affect the homeowners’ pay- anteed by the Government National Mortgage ments. Typically, the homeowner will “prepay” the Association (GNMA, or Ginnie Mae), an agency of mortgage loan by selling the property, refinancing the U.S. government, or by U.S. government-spon- the mortgage, or otherwise paying off the loan in sored enterprises (GSE) such as the Federal part or in whole. Most mortgage pass-through secu- National Mortgage Association (FNMA, or Fannie rities are based on fixed-rate mortgage loans with Mae) or the Federal Home Loan Mortgage an original maturity of 30 years, but experience Corporation (FHLMC, or Freddie Mac). Ginnie Mae shows that most of these mortgage loans will be is a government-owned corporation within the paid off much earlier. Department of Housing and Urban Development. 2 Most words in quotes appear in the glossary. Fannie Mae and Freddie Mac have federal charters 3 In this brochure, the generic term “mortgage pass-through secu- and are subject to some oversight by the federal gov- rities” will be used to refer to these types of securities. The term “mortgage securities” is used to refer to both mortgage pass- ernment, but are publicly owned by their stockhold- through securities and CMOs. ers. (The term “agency” is commonly used to refer 2 3 to Fannie Mae and Freddie Mac as well as to and CMOs. Some older series of Freddie Mac PCs GNMA. This discussion follows that usage, but read- guarantee timely payment of interest, but only the ers should bear in mind that Fannie Mae and eventual payment of principal. Although neither Freddie Mac are federally chartered and privately Fannie Mae nor Freddie Mac securities carry the owned companies.) additional “full faith and credit” U.S. government guarantee, the credit markets consider the credit on Fannie Mae and Freddie Mac issue and guarantee these securities to be equivalent to that of securities pass-through securities; Ginnie Mae only adds its rated triple-A or better. guarantee to privately issued pass-throughs backed by government-insured (FHA and VA) mortgages. Some private institutions, such as subsidiaries of Fannie Mae and Freddie Mac have issued CMOs for investment banks, financial institutions, and home some time; the Department of Veterans Affairs (VA) builders, also issue mortgage securities. When issu- began to issue CMOs in 1992; and Ginnie Mae initiat- ing CMOs, they often use agency mortgage pass- ed its own CMO program in 1994. Securities guaran- through securities as “collateral”; however, their col- teed or guaranteed and issued by these entities are lateral may also include different or specialized types known generically as “agency” mortgage securities. of mortgage loans or mortgage loan pools, letters of The agency guarantees enhance their credit quality credit, or other types of credit enhancements. These for investors. In addition, the mortgages backing so-called “private label” CMOs are the sole obliga- Fannie Mae and Freddie Mac mortgage securities tion of their issuer. To the extent that private-label must meet strict quality criteria. Those backing CMOs use agency mortgage pass-through securities GNMA pass-throughs are underwritten in accor- as collateral, their agency collateral carries the dance with the rules and regulations of the FHA and respective agency’s guarantees. Private-label CMOs the VA, which insure them against default. are assigned credit ratings by independent credit agencies based on their structure, issuer, collateral, The extent of the agency guarantee depends on and any guarantees or outside factors. Many carry the entity making it. Ginnie Mae, for example, the highest AAA credit “rating.” guarantees the timely payment of principal and interest on all of its mortgage securities, and its As an additional investor protection, the CMO issuer guarantee is backed by the “full faith and credit” of typically segregates the CMO collateral or deposits it the U.S. government. Holders of Ginnie Mae mort- in the care of a “trustee,” who holds it for the exclu- gage securities are therefore assured of receiving sive benefit of the CMO bondholders. payments promptly each month, regardless of whether the underlying homeowners make their A DIFFERENT SORT OF payments. They are guaranteed to receive the full BOND: PREPAYMENT RATES return of face-value principal even if the underlying AND AVERAGE LIVES borrowers default on their loans. Mortgage securi- ties issued by the VA carry the same “full faith and credit” U.S. government guarantee. Although CMOs entitle investors to payments of Fannie Mae guarantees timely payment of both prin- principal and interest, they differ from corporate cipal and interest on its mortgage securities whether bonds and Treasury securities in significant ways.