Chris wraps up his series on residential mortgage securities, discussing collateralized mortgage obligations (CMOs), how they work, and their benefits and risks.
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Hi there, welcome to Bond Investment Mentor! I'm your host, Chris Nelson, and this is a podcast dedicated to helping community financial institutions master the art of fixed-income investments. If you're working for a community bank or credit union, and you have responsibilities for the investment portfolio, you've come to the right place. I'll be your personal investment guide as we help you boost your fixed-income investment knowledge, level up your portfolio management skills, and help you gain the know-how you need to help your institution achieve its financial goals.
In this episode, we're going to wrap up our series on residential mortgage-backed securities with a look at collateralized mortgage obligations, otherwise known as CMOs. We're going to explore what they are, how they work, and some of the benefits and risks that they bring to the table. So, buckle in, keep your hands inside the ride, and let's get started.
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Hey there! Welcome to Bond Investment Mentor, how are you? I hope that your week is going well. Today we're going to wrap up the series on mortgage-backed securities. So far, we've covered the basics of mortgage securities and spent time discussing the wonderful world of prepayments and prepayment risk. If you haven't had a chance yet, I would encourage you to go back and listen to the last two episodes first so that you have some of those concepts and context for what we're going to cover here.
Today, I'm going to provide an overview of collateralized mortgage obligations CMOs, how they work, and the benefits and risks that are associated with investing in them. But before we go there, I have a couple of other items that I'd like to cover.
First, we're going to take a look at a couple of recent financial stories. I want to share with you a recent podcast series I found on LIBOR and the LIBOR transition that was very interesting, and I want to tell you about a project that I'm working on that will help you build your investment skills. I'm really excited about this, so stay tuned for that!
So, let's start with a couple of financial market stories. First of all, I wanted to touch base on the prepayment report that came out recently. The June prepayment numbers were released recently and well they weren't really pretty. Overall, they jumped between 11 and 18% month over month. Ginnie Mae prepayment speeds spiked with some speeds doubling over the previous month. They just went to town.
Mortgage prepayment speeds are now at multi-year highs with some trading at their fastest speeds in 15 to 20 years. And that's not likely to change anytime soon, as low mortgage rates and increased refinancing activity continue to keep prepayment speeds elevated. With conditions as they are in Mortgage Land, paying close attention to prepayment risk on both new and existing investments is going to be essential. There are ways to help manage and mitigate prepayment risk, which we covered in the last episode. If you need a refresher, go back and listen. And if you have questions, please reach out and let me know.
In other news, the Federal Reserve released the minutes from the June Federal Open Market Committee meeting recently. And there were two big takeaways that I wanted to share with you. First of all, the committee maintained a strong commitment to forward guidance and ongoing asset purchases. That was pretty much made clear in the FOMC statement when it came out on June 10th. During Federal Reserve Chair Jay Powell's press conference afterward, some of the things from the minutes that were mentioned specific to this were that participants generally indicated support for outcome-based forward guidance.
And participants agreed that asset purchase programs can promote accommodative financial conditions by putting downward pressure on term premiums and longer term yields. Translation -what you've been seeing over the past few months in terms of forward guidance and asset purchase activity is going to continue. The other takeaway was the committee's discussion on yield curve control. They called it “yield curve targets” in the minutes. And this was something that Federal Reserve Chair Powell mentioned in his press conference, as well. The consensus was that yield curve control was a viable tool for the toolbox potentially.
The committee spent some time discussing some of the past uses of yield curve control. Specifically, how the Reserve Bank of Australia, which is Australia's central bank, has utilized yield curve control recently. They've been targeting three-year rates as their means of implementation. The committee did recognize the potential risk for far more in asset purchases than they've been doing, and really growing the Fed's balance sheet faster than they've been doing if they choose to implement yield curve control.
They discussed how to balance any implementation of this policy with other monetary policy tools like forward guidance and asset purchases. It really starts to become a balancing act for them. And right now, the idea of yield curve control is on hold. But it's a story that we'll be watching.
I know that some in the financial markets were anticipating that the Fed might start some form of yield curve control later this year. But based on what we see in the comments, I don't think that that's going to be likely. So this falls into the “more to come department.”
In terms of the interest rate environment, the yield curve has remained pretty much range-bound over the past week or so. 10-year Treasuries are trading between 0.60% and 0.70%. The seven-year interest rate has been between 0.45% and 0.50%. The five-year is between 0.25% and 0.30%. And the two-year has been firmly entrenched between 0.15% and 0.18%. Can I just say for a minute how strange it is that I am quoting Treasury rates at these levels? They are all in basis points! This is just wild. But hey, that's the market in which we find ourselves.
I wanted to share something with you that I came across recently that I found pretty interesting. I was catching up on some podcasts, and I was listening to Bloomberg’s “Odd Lots” podcast, which is co-hosted by Joe Weisenthal and Tracy Alloway. And they produced a really interesting series on LIBOR and the transition or retirement of LIBOR that'll be coming up next year.
Some of what they cover in this series - it's about five episodes - includes an interview with the man who first raised concerns about LIBOR back in the 1990s, and a discussion of SOFR, the secured overnight funding rate, which is the recommended replacement rate for LIBOR. They have an interview with the CEO of the American Financial Exchange about their proposed LIBOR replacement, AMERIBOR, and discussions on how the LIBOR transition is going and how LIBOR behaved recently when the Covid 19 pandemic broke out.
It was really interesting and full of history, context, and perspective. I pulled an article together on the Bond Investment Mentor website, which includes links to all of the episodes, all five of them in the series. You'll find the link in the show notes. If it's something that you're interested in learning more about, give it a listen.
Now before we get to our main topic, I wanted to take some time to let you know about something that I've been working on. I'm still working out some of the details, but I wanted to let you be among the first to know. One thing that I've heard from community bankers over the years is the need for investment education and training. And of course, now it's easier to deliver that training online. I've been doing it through banking schools, other conferences, and so forth for years. But it's so much easier to be able to offer online education and training now.
So, I'm pleased to let you know that I'm working on offering some online courses. The courses are going to cover fixed income securities, bond and finance basics, investment portfolio management, and other related financial topics. Now, I'm still working out some of the logistics, but my plan is to have the first course ready in the next month or so. So, it's coming up pretty quickly. Now, one thing that I could really use your help on is this - what course should I create first? I'd love to hear your thoughts on this. So please go to BondInvestmentMentor.com/courses.
First of all, if you're interested in being notified, you can sign up when the new course offerings are available and I'll let you know. You just pop in your email address, and I'll get back to you. And in addition, you'll have the opportunity to tell me what the key areas are that you would like me to develop courses for. There are some topics listed there. Check off all the ones that you'd love courses on and that will help me as I begin the process of putting course materials together. Your input is going to be really important. So, take some time and let me know. I'm really excited about being able to offer this and I hope you are as well. Again, go to BondInvestmentMentor.com/courses for more information. Check it out!
Let's move on to our main topic now: collateralized mortgage obligations or CMOs. Let's start off with some history first.
CMOs were originally created back in the 1980s, and their original purpose was to help investors manage the principal cash flows that they received from residential mortgage-backed securities. Now, as those of you that hold mortgage securities know, you're going to get monthly principal payments every month until the final maturity date, which in some cases can be years down the road.
Well, in developing CMOs, the way that they're built is that the principal cash flows from all of these mortgage securities are prioritized. Different pieces of the CMO deal receive principal in a predetermined order in terms of the payments. And as we'll see - we'll go into this in a little more detail - this can create bonds that have shorter or longer weighted average lives and durations, and it allows different investor needs to be met.
So let's get into the mechanics of CMOs. Let's start with, first of all, what is a CMO? A CMO is a pooled investment security. It's like a mortgage-backed security. However, the difference is that mortgage-backed securities pool loans together. We talked about this a couple of episodes ago where you take a group of residential mortgage loans, and you pool them together into a mortgage-backed security. In the case of a CMO, what we're pooling are mortgage-backed securities. And so, the mortgage-backed securities are grouped together, and they're pooled together in creating the CMO.
CMOs are available as either agency-backed or non-agency-backed - known as “private label” offerings. Most of the time, what I have found community bankers working with are agency-backed CMOs, so backed by Ginnie, Fannie, or Freddie.
Now, let's compare CMOs to mortgage-backed securities. When the monthly mortgage payments are received in a mortgage-backed security, every investor receives principal and interest cash flows in proportion to their ownership. It's a prorated thing. And so, as principal and interest come in each month, everybody gets a piece of the action.
In the case of a CMO, the principal received from this group of mortgage security pools is broken up into different segments, otherwise referred to as tranches. The word “tranche” is a French word, it means “slice.” So, they slice up these principal payments, and they put them into different securities. Each tranche in the CMO deal represents a slice or a piece of the overall cash flows that are received over time. The prioritized principal payouts created by these tranches result in securities with different characteristics in terms of when principal and interest are received, weighted average life and duration, and so forth.
CMOs pay their interest monthly just like mortgage pass-through securities. This is all about slicing up and prioritizing the principal cash flows when we're looking at CMOs. Tranches that are eligible to receive principal payments will receive them at the same time that the interest comes out. But there can be cases as we'll see, where if you own a CMO, you might not receive principal right away.
We're going to cover the two most common CMOs structures that you are likely to consider. We're going to talk about sequentials and we're going to talk about PACs, and we'll get to those momentarily.
The other thing I want to talk about at kind of a high level first is the liquidity of CMOs. CMOs are slightly less liquid than mortgage-backed securities. If you were to compare one against the other, the liquidity is less than traditional pass-throughs but probably more comparable to corporate bonds. I mean, they're not illiquid, but they're not going to be as liquid as a pass-through security. So, if you are a community bank or credit union that buys and holds mortgage securities, It's probably not a major challenge, but it is something that you need to be aware of. And because they're slightly less liquid, CMOs will generally trade at a slightly higher spread over Treasuries than mortgage-backed pass-through securities.
So, we're going to cover the two basic plain vanilla structures that you will come across when it comes to investing in CMOs.Those are sequentials and PACs.
A sequential CMO, a sequential deal, takes the principal payments and prioritizes their payout by time period. Here's an example. Let's assume that we have a sequential CMO deal with three tranches: first, second, and third tranches. Each month, the principal and interest payments from the mortgage securities underlying this CMO deal are going to come in. All tranches are going to receive monthly interest income.
The first tranche receives all of the principal cash flows, both the scheduled payments and any prepayments. The remaining tranches receive nothing. They are basically just receiving interest. Once the first tranche is paid down or paid off, then the second tranche begins receiving the principal cash flows. The third tranche still receives nothing but interest. And then after the second tranche is paid off, the third tranche finally begins receiving principal payments.
So, this structure takes the mortgage payments that are coming in and creates three securities with shorter and longer characteristics in terms of weighted average life or duration. The first tranche is a shorter security because it's receiving earlier principal paydowns. The other tranches have what's referred to as a “lockout period,” where they are interest only. The lockout will limit prepayment risk for a time. That's the good news. But it also makes the second and third tranches longer securities when we're looking at things like weighted average life and duration.
So, the sequential structure meets the needs of multiple investors based on their desire for short or long investments. As you can see, a sequential is a pretty straightforward structure. In many ways, it will act just like a regular mortgage pass-through security. The difference is that the principal payments are prioritized and paid out to different tranches depending on the order of the structure.
Now let's discuss the second type of CMO structure that you're likely to come across, and that's what's referred to as a PAC structure. PACs - P-A-C - stands for “planned amortization class,” and it's a little different from a sequential in two ways.
First, the structure's performance is going to be based upon a set of predetermined prepayment assumptions. This is referred to as the PAC band and it's a range of prepayment speeds that are quoted in PSA, which we talked about in a previous episode. As long as prepayments remain within that predetermined assumed range, then the CMO deal is going to behave as expected. And this is designed to help control prepayment risk within that given set of assumptions.
The second difference is that the PAC has what's known as a “support tranche.” It has an extra tranche within the deal to help manage prepayments. Let me explain how that works. When principal prepayments occur, the support tranche will absorb those prepayments until it's gone, until it's paid off. Only scheduled payments will go to the PAC bonds, so it's a way of diverting the prepayments away from the initial tranches.
So, what happens if prepayments differ from the assumptions that we talked about earlier? Then the average life and behavior of the PAC deal will behave differently than originally expected.
For example, if prepayments are faster than assumed, the support tranche will be paid down more quickly. What happens when the support tranche is gone? Well, then the PAC is going to act like a regular sequential like we discussed before. It's referred to as a “busted PAC.” And so now, scheduled and prepayment principal cash flows now go through each tranche. There's no support to absorb those prepayments.
If prepayments are slower than expected, then less principal is being paid to the support tranche and that means it will last longer. So, it will be there to act as a cushion for a little bit longer.
PACs are built to be a stable investment in mortgage securities and are considered more stable than sequentially. But it all depends on the underlying assumptions and structure. And so it's something that needs to be paid attention to. There are other types of CMO structures beyond sequentials and PACs.You will hear things like floaters and inverse floaters and interest only in principle only and Z-bonds and VADMs and many, many others way too many to cover in a podcast episode. But what we're going to find is that those two common ones that community bankers are investing in are the sequential structure and the PAC structure.
So why consider investing in CMOs? Well, they are another mortgage security option for investment portfolios. And one of the benefits is that they allow investors to select bonds that have weighted average lives and durations that are more in line with what they're trying to do in their portfolio. They may provide some mitigation against prepayment risk depending on the structure. And since they should trade at higher spreads than traditional mortgage pass-through securities, you can realize a slightly better yield in the process. That's the good news.
What are the risks? Well, CMOs are subject to the same risks as regular mortgage-backed securities. We're speaking specifically about prepayment risk or extension risk.
One thing to keep in mind, as is the case with any mortgage security, is the underlying collateral that makes up the CMO. Even though the CMO bond that you might be considering has a structure, a weighted average life, or a duration that could be shorter than a traditional pass-through, the underlying collateral - for example, a 30-year residential mortgage loan - is still going to be what drives the bond’s behavior in terms of prepayment.
So, how can you analyze these? What are some things that you can use? Let's spend some time here talking about the Bloomberg screens that you can get from your broker to take a look at as you're analyzing and evaluating these types of bonds.
Certainly, the first thing you can look at is the yield tables, which we talked about in the last episode. One thing that I do want to touch on that's an additional factor to look at when you're evaluating CMOs securities is something referred to as the date window. You'll find that toward the lower part of the Bloomberg yield table screen. What the date window will indicate is the period of time during which you would receive your principal paydowns based on a certain prepayment speed. So that's something you could look at in addition to the other information that's contained on the yield table.
The yield table - the YT screen - is one that's probably pretty common. That will show you the breakdown in different rate environments on a PSA prepayment basis. My preference, as I've mentioned before, is screens like the YTR, which allows you to look at the yield table in CPR as opposed to PSA.
The third type of yield table which we talked about is the YTH. Unfortunately, it doesn't work as well here because Bloomberg defaults to PSA for the YTH for CMOs, but you can build your own YTH screen using the YTR and then entering in the prepayment speeds for the various periods. You can manually construct one or ask your broker for help on that.
And then the other screen we talked about is the BAM model, the Bloomberg model, which is the YT BAM screen. And those are available for CMOs, as well.
There are some additional screens that I would recommend taking a look at when you're considering CMOs. And I'll just go through them briefly here.
One is referred to as the SPA screen, the “structure paydown analysis.” And this provides a look at the whole CMO structure, not just the tranche that you might be considering. It's all the tranches. Some CMO deals are pretty simple, and they're pretty straightforward. Others can be quite complex. And the SPA screen provides a peek at how the deal is structured. And it gives you an idea as to how it would behave under different prepayment speed assumptions. You can change the prepayment speed and see how the principal pay downs will behave under different scenarios.
Another screen that you can use is referred to as the cash flow graph, the CFG screen. And this provides a graphic visualization of the cash flows for the tranche that you're considering. You can see how that's going to behave under different prepayment scenarios.
In addition, you can use the weighted average life graph, that's the WALG screen. And what this shows is how the tranche’s weighted average life will behave under all prepayment speeds. One thing I like about this particular screen is that you can switch it from PSA, which is the default, to CPR so that I can look at the tranche’s behavior under all CPR speeds to get a better understanding of how the principal is going to behave.
And then you also want to look at the collateral composition screens, which we discussed previously in another episode, the CLC screens. And these will give you the same information on the underlying loan collateral that you'll see with a mortgage-backed security in terms of geographic information, servicers, originations, etc.
The other thing that's helpful is it lets you take a look at the underlying pools that make up the CMO. Remember, we're talking about the CMO being a group of mortgage-backed securities. So, you can actually see what mortgage-backed securities are included in the CMO. And this helps with identifying if there are a handful of mortgage bonds that might be driving the behavior of the CMO. If they represent a larger percentage of the CMO deal, they're going to drive how that CMO behaves. And with that info, you can take a quick look at the mortgage pools themselves if you want to dig a little deeper in terms of prepayment history, the underlying collateral, and so forth. It's a nice way to get down into the detailed information on the CMO.
And then the last screen I want to speak about that Bloomberg provides is something called the FFIEC high-risk security test. You just need to know it as the FMED screen, F-M-E-D. This takes the CMO and compares it against three specific tests under different interest rate scenarios and they shock the security up and down 100, 200, and 300 basis points.
The three tests are the maximum weighted average life, the maximum change in the weighted average life in years, and the maximum percentage price change. It gives you a quick look at that and you can determine how this particular CMO tranche is going to behave under certain circumstances.
So in conclusion, agency CMOs can be an attractive investment but they do still require you to do your homework. They have exposure to prepayment and extension risk just like mortgage securities do. But they do allow you to mitigate it under certain circumstances, because of the way that the tranches are structured and the ability to control - a little bit - how the principal cash flow is paid out to investors.
What's also important is going to be evaluating the underlying collateral that makes up the CMO deal. As I've said before, it's really important to know the loans that you own. So, spending some time looking at the collateral in these deals is very, very critical.
Well, that's it, we did it! We have covered mortgage-backed securities and CMO basics. I hope that you found this information helpful. If you have any questions regarding anything I covered today - I know we went over a lot - please drop me an email at Chris@BondInvestmentMentor.com. I will get back to you and love to help people out with specific questions on securities like these.
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I look forward to catching up with you soon. Have a great rest of your week! Take care, and have a good one!
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