CMOs and Asset-Backed Securities

The structure

A CMO is a security backed by a pool of mortgages or by mortgage pass-through certificates, issued in classes called tranches. Interest is generally paid to all outstanding tranches, but principal — including prepaid principal — is directed according to the deal's rules.

In the simplest structure, sequential pay, all principal goes to the first tranche until it is fully retired, then to the second, and so on. The result is a set of securities with short, medium and long expected lives, carved from a pool whose own maturity profile is uncertain.

A CMO is issued by a trust or a special purpose entity, not by the Treasury, and the credit quality depends on the collateral. A CMO collateralized by Ginnie Mae pass-throughs carries the underlying federal guarantee of timely payment; one collateralized by non-agency mortgages does not, whatever its rating. That distinction — the guarantee attaches to the collateral, not to the CMO wrapper — is a point representatives get wrong in front of customers.

A collateralized debt obligation applies the same tranching idea to a pool of other debt obligations — corporate loans, bonds, or other structured securities. The mechanics are the same; the collateral and the credit analysis are not.

The tranche types

Planned amortization class — PAC — tranches have a principal repayment schedule that is protected within a band of prepayment speeds. If prepayments run faster or slower than expected but stay within the band, the PAC holder still gets the scheduled principal. This makes the PAC the most predictable and therefore the lowest-yielding class.

The protection has to come from somewhere, and it comes from the companion or support tranche. Companions absorb the variation: they receive extra principal when prepayments accelerate and are starved when prepayments slow. They therefore have the most variable average life and the highest yield in the structure. If a question describes an investor who wants the highest yield and can tolerate an unpredictable maturity, the companion is the answer; if the investor wants predictability, it is the PAC.

Targeted amortization class — TAC — tranches are protected against fast prepayment but not against slow prepayment, so they sit between a PAC and a companion in both predictability and yield.

A Z tranche, or accrual tranche, receives no cash at all for an initial period. Interest accrues and is added to its principal balance while earlier tranches are being paid down; only then does it begin receiving payments. It behaves like a zero-coupon instrument for its accrual phase, is the longest and most volatile class, and is entirely unsuitable for a customer who needs current income.

A floating-rate tranche pays a rate that resets against a benchmark, which appeals to investors worried about rising rates.

The risks, stated honestly

Every risk of a pass-through is present in a CMO, concentrated differently by tranche.

Prepayment risk. When rates fall, homeowners refinance, principal comes back early, and it must be reinvested at lower rates. The early tranches absorb this first.

Extension risk. When rates rise, prepayments slow and the expected life lengthens, leaving the holder in a below-market security for longer than planned. Later tranches and companions feel this most.

Interest rate risk in the ordinary sense, worsened by the fact that the average life moves in the unhelpful direction each time — the negative convexity described in lesson 3.4.

Credit risk, dependent on the collateral. Agency-backed collateral has federal or GSE support; private-label collateral has neither.

Liquidity risk. Individual tranches, particularly companions and Z tranches, can be thinly traded, and a customer needing to sell may find the bid far from the last indicative price.

And model risk, which is the honest name for the fact that every stated yield and average life depends on an assumed prepayment speed. A yield quoted on an assumption is not a promise, and describing it as one is a misrepresentation.

The selling rules

FINRA wrote Rule 2216 specifically for communications about collateralized mortgage obligations, which tells you how much mis-selling there has been. Its requirements shape how a CMO may be presented.

Communications must not compare a CMO to any other investment vehicle — notably not to a certificate of deposit — because the comparison invites a customer to import a false sense of safety. They must disclose that a CMO is a security whose value fluctuates, that the yield and average life will change with prepayment rates, and that government agency backing, where present, applies to the underlying collateral's payments and not to the market price of the CMO itself. Retail communications must include the specific educational disclosure the rule prescribes, and firms are expected to offer customers FINRA's CMO investor materials.

The generic communications rule, FINRA Rule 2210, applies as well, along with the underlying obligation of fair dealing. And Regulation Best Interest applies to the recommendation itself: a representative recommending a Z tranche to an income-seeking retiree is not saved by having delivered every prescribed disclosure.

The practical test to apply before recommending any tranche: can the customer tolerate the average life moving by years in the direction they do not want, and do they understand that the monthly payment includes returned principal rather than being pure income? A customer who spends the principal portion of every payment is liquidating their investment and usually does not know it.