[1] CMOs were first created in 1983 by the investment banks Salomon Brothers and First Boston for the U.S. mortgage liquidity provider Freddie Mac.
Investors in a CMO buy bonds issued by the entity, and they receive payments from the income generated by the mortgages according to a defined set of rules.
Unlike traditional mortgage pass-through securities, CMOs feature different payment streams and risks, depending on investor preferences.
[1] For tax purposes, CMOs are generally structured as Real Estate Mortgage Investment Conduits, which avoid the potential for "double-taxation".
The most basic way a mortgage loan can be transformed into a bond suitable for purchase by an investor would simply be to "split it".
However, this format of bond has various problems for various investors Salomon Brothers and First Boston created the CMO concept to address these issues.
More frequently, a deal is embedded with certain "triggers" related to quantities of delinquencies or defaults in the loans backing the mortgage pool.
If a balance of delinquent loans reaches a certain threshold, interest and principal that would be used to pay junior bondholders is instead directed to pay off the principal balance of senior bondholders, shortening the life of the senior bonds.
Because of the excess collateral, investors in the CMO will not experience losses until defaults on the underlying loans reach a certain level.
Another way to enhance credit protection is to issue bonds that pay a lower interest rate than the underlying mortgages.
For example, if the weighted average interest rate of the mortgage pool is 7%, the CMO issuer could choose to issue bonds that pay a 5% coupon.
If some of the mortgage loans go delinquent or default, funds from the excess spread account can be used to pay the bondholders.
The principal (and associated coupon) stream for CMO collateral can be structured to allocate prepayment risk.
The VADM bond concept was named after its inventor, Vadim Khazatsky, a trader at Solomon Brothers, highlighting its innovative approach to managing prepayment risks associated with mortgage-backed securities.
NAS bonds are designed to protect investors from volatility and negative convexity resulting from prepayments.
NAS tranches are usually found in deals that also contain short sequentials, Z-bonds, and credit subordination.
Unlike with a NAS, no shifting interest mechanism is employed after the initial lockout date.
The support-like cashflows falling out on the other side of NASquentials are sometimes referred to as RUSquentials (Relatively Unstable Sequentials).
The construction of CMO Floaters is the most effective means of getting additional market liquidity for CMOs.
CMO floaters have a coupon that moves in line with a given index (usually 1 month LIBOR) plus a spread, and is thus seen as a relatively safe investment even though the term of the security may change.
The CMO inverse is a more complicated instrument to hedge and analyse, and is usually sold to sophisticated investors.
The first stage is to synthetically raise the effective coupon to the target floater cap, in the same way as done for the PO/Premium fixed rate pair.
The floater will pay LIBOR + 0.40% each month on an original balance of $75mm, subject to a coupon cap of 8%.
Therefore, IOs have investor demand due to their expected negative effective duration as they can be used as a hedge against conventional fixed-income securities in a portfolio.
POs have investor demand as hedges against IO-type streams (e.g. mortgage servicing rights).