TANA-NOMICS: Investing in CMOs

TANA-NOMICS: Investing in CMOs


A number of people have approached me for advice on an investment being advertised in the local paper called a CMO. Calm down, this has nothing to do with the Chief Medical Officer, Dr. Roshan Akash Parasram, the girls dem sugar. I know some of you wouldn’t mind the CMO making an investment in you.

No, CMO stands for Collateralized Mortgage Obligation and is basically a pool of mortgages bundled together and sold as an investment. Any security backed by mortgages is cleverly called…**drum roll**…a mortgage-backed security (MBS) by us finance types.

I’m not going to go into the specific merits or demerits of this particular investment because 1. them not paying me to advertise and 2. I don’t want anybody to say I gave them investment advice. However, I will explain the general characteristics and the risks you should be aware of.

Ok, if you’re like me, just hearing the words MBS should make the hairs on the little knob inside your ear stand on end because those little suckers were at the heart of the 2007-2008 financial crisis. However, not all MBS are bad and even the ones that were a problem have been restructured to be less risky.

Here’s the two second explanation on how they work. The company selling the CMO is called the issuer and they either create (“originate”) the mortgages or they purchase them from another entity. These mortgages are put together into groups (called “tranches”) within the CMO based on common characteristics like maturity and risk profile. The CMO receives cash flows as borrowers repay the mortgages that act as collateral on these securities. In turn, CMOs distribute principal and interest payments to their investors based on predetermined rules and agreements.

The tranches are arranged in somewhat of a waterfall structure and while ALL tranches receive INTEREST payments, they receive PRINCIPAL repayments based on where they are in the waterfall. Sounds like a sou sou eh but it’s not, it’s a real investment. So if you have tranches A to I with A being the least risky then everyone gets interest but tranche A gets it’s principal paid first, then tranche B is paid, and so on. This is what is known as a sequential pay CMO.

As we all should know by now, interest is not only the price of money but it is the price of risk. Hence the saying “the higher the risk the higher the reward”. Therefore the riskier the tranche the higher the interest rate that is paid. The longer the time to maturity means more time for something to go wrong and thus the more interest will be paid.

So let’s talk the risks now. One of the main risks is that if money runs out before your tranche can be fully repaid due to something catastrophic happening to the underlying pool then you could be SOOL (“….out of luck”). I’m not saying that is the case with this investment but just understand that.

Therefore the key to investing in CMOs is understanding the characteristics of the underlying pool of mortgages. So here are some questions you could ask the issuer or your investment advisor and sound semi-intelligent nah. What is the quality of the mortgages? How are they selected for the pool? What is the default rate on the mortgages? Which tranche am I investing in and what is the rate, maturity, risk etc.? What happens if homeowners just say “heh, look allyuh ting” and hand back the keys? Is it somehow guaranteed by the issuer? What is the credit rating of the issuer and the CMO itself?

Hopefully, you have a better understanding of CMOs now, even if you still don’t know why they don’t smile during pressers or use cuss words with journalists.

TANA

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