Collateralized Mortgage Obligation - Explained
What is a Collateralized Mortgage Obligation?
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Table of ContentsWhat is a Collateralized Mortgage Obligation?How Does a Collateralized Mortgage Obligation Work?Academic Research on Collateralized Mortgaged Obligation (CMO)
What is a Collateralized Mortgage Obligation?
A collateralized mortgage obligation (CMO) is structured security or mortgage-backed security that contains a set of mortgages structured and traded as an investment. A CMO is fixed income security that is designed based on the level of risks and maturity of the mortgages. Similar to other structured securities, CMOs are sold to investors in tranches, each tranche with a varying degree of risk and maturity. The cash inflow realized when mortgage borrowers make repayments serve as collateral for CMOs, the cash flows are in turn distributed as interests to investors.
How Does a Collateralized Mortgage Obligation Work?
A collateralized mortgage obligation (CMO) is regarded as complex debt security that is made of different groups of mortgages repackaged and sold to investors as financial products. The mortgages in a CMO are grouped in line with their level of risks and maturity. CMOs are offered in tranches, each tranche has a distinct interest rate, maturity date, and principal balance. Generally, CMOs are affected by market changes and changes in economic conditions such as changes in interest rate, foreclosure rates, refinancing rates, among others. Primarily, investors receive interest payments when mortgage holders make payments, this means when there is a default by mortgage holders, interest payment and rate can also be affected. As complex debt securities, CMOs were first issued in 1983, they were sold to investors who are interested in generating cash flow from mortgages without having to purchase any mortgage. CMOS can be purchased by individual investors or organizations, these investors are commonly called Real Estate Mortgage Investment Conduits (REMIC). Oftentimes, CMO investors are carried away by the return they would generate from the investment and pay little or no attention to the risks involved. This led to an increase in the purchase of risky mortgages by many investors. Examples of corporate organizations that purchase CMOs are banks, insurance companies, mutual funds, and hedge funds.
Academic Research on Collateralized Mortgaged Obligation (CMO)
- Rational prepayments and the valuation of collateralized mortgage obligations, McConnell, J. J., & Singh, M. (1994). The Journal of Finance, 49(3), 891-921. This paper explains how to evaluate CMO (Collateralized Mortgage Obligation). This is related to dynamic programming where the decision of a mortgagor to prepay becomes the feedback control variable. He tries to minimize the mortgage value depending on the refinancing costs. The authors provide a solution to estimate the optimal prepayment boundary for a mortgagors class. Each of them bears similar proportional refinancing cost. Then, these prepayment boundaries are used with Monte Carlo simulation for valuing the tranches of CMO. The authors make a deep analysis to estimate the robustness of this model. The results show the significance of accurate estimation of the refinancing cost distribution.
- Faster valuation of financial derivatives, Paskov, S. H., & Traub, J. F. (1995). Journal of portfolio management, 22(1), 113. This paper presents a method of pricing European contingent options on the basis of Monte Carlo simulation joined with variance reduction. The option price evolution can be elaborated as a problem of Kolmogorov final value. The authors get it from a Girsanov stochastic differential equation transformation with the help of a correction term which they get as a solution of the partial differential equation. It is calculated using the classical numerical method. The authors investigate the trade-off between these models. The results show that the composite method provides a more efficient solution as compared to the classical numerical method or the standard Monte Carlo method. It helps to find the value of financial derivatives faster.
- Valuation and analysis of collateralized mortgage obligations, McConnell, J. J., & Singh, M. (1993). Management Science, 39(6), 692-709. This paper presents a method for the valuation of CMOs (Collateralized Mortgage Obligations) on the basis of 2 factors model of the term structure and embeds a statistically calculated mortgage prepayment function. This model helps in analysing different CMO tranches, i.e. standard sequential pay tranches of fixed rate, TAC tranches (Targeted Amortization Class), tranches of IO (Interest Only) and PO (Principal Only), PAC tranches (Planned Amortization Class), Z-bonds, floating rate tranches and Residuals. The results show how sensitive different tranches are to differences in the structure of CMO, mortgage prepayments, interest rate changes and the features of the underlying collateral.
- Information, liquidity, and the (ongoing) panic of 2007, Gorton, G. (2009). American Economic Review, 99(2), 567-72. In the credit markets, the failure of an increase in the housing prices caused a trust collapse during the credit crisis. Particularly, the United States repurchase agreement market estimated approximately twelve trillion USD, more than their total assets worth 10 trillion USD, became very liquid because of the threat of counterparty default. Consequently, repo haircuts increased leading to massive deleveraging. The author investigates this problem by considering the breakdown in the ABX.HE indices arbitrage foundation during the panic. It allows an overview of the information problems which, in the repo markets, caused Illiquidity and demand for security from subprime risk.
- Creating liquidity out of spatial fixity: The secondary circuit of capital and the subprime mortgage crisis, Gotham, K. F. (2009). International Journal of Urban and Regional Research, 33(2), 355-371. This paper investigates the political and institutional roots of the mortgage crisis. The author discusses the role of the HUD (Department of Housing & Urban Development) and OCC (Office of the Controller of the Currency), Treasury Department of the United States in making policies and creating legal regulatory conditions which helped the market evolving for securitizing subprime debts. Statistically, it locates the present turmoil of the United States mortgage sector in regard to a series of regulatory and legal actions taken to boost the securitization. Theoretically, the author evaluates the crisis of the subprime mortgage as an example of the capital circulation contradictions presented in the capital tendency to eliminate space through time.
- On the determinants of yield spreads between mortgage pass-through and Treasury securities, Rothberg, J. P., Nothaft, F. E., & Gabriel, S. A. (1989). The Journal of Real Estate Finance and Economics, 2(4), 301-315. Yield spread in United States Treasury securities and mortgage pass-through may show differences in taxation, default compensation, factors affecting relative demand and supply and risks on mortgage instruments. This paper statistically models these differences. The findings are that the term structure of rates, interest rate volatility and factors mostly referred to the mortgage pricing, mainly, determine the movements of spreads. In addition, the importance of these effects has increased nowadays because the prepayment option exercise has moved up. The authors provide evidence about it that credit concerns and liquidity influence the pass-through securities pricing.
- Mortgage-backed securities & collateralized mortgage obligations: Prudent cra investment opportunities, Kelman, A., & Sales, S. (2002). Prudent cra investment opportunities. Community Investments, 14(1), 20-23. In this research, the authors describe the importance of Mortgage-Backed Securities (MBS) and Collateralized Mortgage Obligations (CMOs) for the financial success of an economy. Mortgage securities have a vital role in housing finance in the United States, making financing accessible to home buyers at minimum costs. It ensures that the funds are accessible all around the country. Mortgage-Backed Securities are getting popularity because they are beneficial for investors in many ways, e.g. yield, liquidity and capital management flexibility. CRA officers need to avail it and carefully benefit from investment opportunities with bank investment officers.
- Making markets for structured mortgage derivatives, Oldfield, G. S. (2000). Journal of Financial Economics, 57(3), 445-471. This article explains the difference between securitisation that creates sample pass-through instruments and structuring that creates mortgage derivative claims. The author provides details on how a transaction structuring brings value to the underwriter of a deal. An underwriter should overcome arbitrage between derivatives and pass-throughs. For examining the structuring process, the underwriter uses potential for price discrimination, the restrictions on allowed price discrimination and market segmentation. The authors discuss the algebraic principles for structuring and legal regulations for trusts. The results show the crucial features of the analysis.
- Globalization of Mortgage-Backed Securities, Fernandez, H. A. (1987). Colum. Bus. L. Rev., 357. The Mortgage-Backed Securities (MBS) market is a comparatively latest phenomenon. Though it started in the 1970s, already, the industry has outperformed in terms of invested dollars, the markets for municipal bonds and corporate bonds. It, indeed, has the potential to be greater than the United States Treasury market in the upcoming years. The growth of the CMOs (Collateralized Mortgage Obligations) is a crucial factor contributing to this faster development. The CMOs use has been substantial in terms of USD alone. Since July 1983, the CMO issues have surpassed 90 billion USD. It has caused the expansion of MBSs into the global arena.
- The effects of securitization on consumer mortgage costs, Todd, S. (2001). Real Estate Economics, 29(1), 29-54. The author evaluates the securitisation effects on 2 dimensions of costs of consumer mortgage. Loan origination charges and coupon rates. He does not find any evidence that securitisation decreases coupon rates on adjustable or fixed rate mortgages. Rather it reduces the mortgage loan origination charges. As a result, the consumers can make savings. Securitisation activities are the creation of CMOs and pass-through. The author distinguishes in the impacts of CMO and pass-through creation on the primary costs of the mortgage. He suggests that for consumers, a big derivatives market for these mortgage loans does not create value.
- Deterministic simulation for risk management, Papageorgiou, A., & Paskov, S. (1999). Journal of Portfolio Management, 25, 122-127. This paper makes a comparison of the deterministic simulation efficiency with the help of low discrepancy sequences for the calculation of VaR (Value at Risk) with Monte Carlo. Particularly, the authors demonstrate how we can use the deterministic methods for the calculation of VaR. They converge quicker as compared to Monte Carlo. The authors perform 2 tests: the 1st one uses a portfolio of currency and equity European call options. The 2nd one uses a portfolio of CMOs tranches. The low discrepancy sequence selected for these tests is the common Faure sequence because of Tezuka.