Derivative Securities (Derivatives), Mortgage Backed Securities (MBS) and Collateralized Mortgage Obligations (CMOs)

There will always be debates over the advantages and risks of complicated investments. But, one fact will remain constant: Securities with qualities that make a bid and unclear asked prices that are difficult to determine will remain favorites of securities salespersons.

Quotes on stocks are now pennies per share apart and spread on government bonds are often 64th of a percent of their face value. Meanwhile, spreads and/or commissions on Derivatives, MBS, and CMOs can often be hundreds of times higher.

Both institutional and individual investors can become victims of unscrupulous tactics in selling MBS, CMOs, and Derivative Securities. If you believe you or your company may be a victim of such practices, contact our team of seasoned securities lawyers for a free, confidential consultation.

Although Derivatives, MBS, and CMOs were initially designed to meet the investment needs of the most sophisticated institutional investors. The securities industry quickly sought to market these to smaller institutions, individuals, and other investors. As these investments become more complex and challenging to comprehend, institutional and individual investors continue to sell these products with less and less comprehension of what they purchased or sold.

In finance, a derivative is a financial instrument derived from an underlying asset’s value. Market participants can agree to exchange money, assets, or some other commodities at a mutually agreed future date based on the underlying asset. They can be gold, stock, or even an interest rate.

A simple example is a futures contract: an agreement to exchange the underlying asset at a future date. The terms of the derivative can depend on but not precisely correspond to the behavior or performance of the underlying asset.

The most common type of swaps are interest rate swaps, in which one party agrees to swap cash flows with another. For example, a business may have a fixed-rate loan, while another business may have a variable-rate loan; each business would prefer to have the other type of loan. Rather than cancel their existing loans, the two companies can agree to “swap” cash flows: the first pays the second based on a floating-rate loan, and the second pays the first based on a fixed-rate loan (in practice, the two will net out the amounts owing). By swapping the cash flow, each has “converted” or “swapped” one type of loan into another.

Just as is true in the commodities market, from this basic concept arose a speculative market of betting on outcomes of events or circumstances.

While Derivatives can be used to limit risk or erase risk to some investors, \this can sometimes result in an unlimited risk to the “other side” of the same transactions. Unfortunately, Derivatives are too varied and complex for further generalized discussion.

Mortgage-Backed Securities (MBS) is the general term for securities created with the underlying assets being real estate debt. Generally, a “trust” fund is set up containing mortgage loans. Then securities are created that represent ownership of that fund.

Mortgage-backed security (MBS) are “securitized” pools of mortgage loans put together by residential and commercial mortgage “originators” throughout the United States. The loans are thus pooled and “securitized” asset-backed securities with cash flow and return of principal determined by the principal and interest payments of a pool of mortgage loans. Payments are typically made monthly over the lifetime of the underlying loans.

The pass-through mortgage-backed security is the most common MBS. These are securitized pools of mortgage loans held in trust which “pass-through” to the investor the mortgage payments by the borrowers as these are received. These can then be sub-categorized into residential mortgage-backed security (RMBS), commercial mortgage-backed security (CMBS), or in other groupings, such as mortgages on mobile homes, etc.

Collateralized mortgage obligations (CMOs) are financial debt vehicles first created in 1983 by investment banks Salomon Brothers and First Boston. Legally, a CMO is a special purpose entity that is wholly separate from the institution(s) that create it.

The entity is the legal owner of a set of mortgages, called a pool. Investors in a CMO buy bonds issued by the entity, and receive payments according to a defined set of rules. The mortgages themselves are called the collateral, the bonds are called “tranches” (also called classes), and the set of rules that dictates how money received from the collateral will be distributed is called the structure.

In simple terms, MBS and CMO are two different types of asset-backed securities. Which use mortgage-backed securities as collateral.

The basic MBS is similar to shares of a mutual fund of mortgages. The securities can be bonds or other securities instruments, whereas the Collateralized Mortgage Obligation (CMO) has a “pass-through” payout structure.

Similarly, all securities ultimately backed by mortgages are classified as an MBS. This can be confusing because securities derived from MBS are also referred to as MBS. To distinguish the basic MBS bond from other mortgage-backed instruments the qualifier pass-through is used, in the same way, that ‘vanilla’ designates an option with no special features.

Another subcategory of MBS is Collateralized mortgage obligations (CMOS). These are even more complicated MBS in which the mortgages are ordered into tranches by some quality (such as repayment time), with each tranche sold as separate security and are further described below.

Residential-backed securities (CMBS) have the option to pay more than the required monthly payment (curtailment) or pay off the loan in its entirety (prepayment). Because curtailment and prepayment affect the remaining loan principal, the monthly cash flow of an MBS is not known in advance and therefore presents an additional risk to MBS investors.

Commercial mortgage-backed securities (CMBS) are secured by commercial and multifamily properties (such as apartment buildings, retail or office properties, hotels, industrial properties, and other commercial sites). The properties of these loans vary, with longer-term loans (5 years or longer) often being at fixed interest rates and having restrictions on prepayment, while shorter-term loans (1-3 years) are usually at variable rates and freely pre-payable.

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CMOs securities transform relatively illiquid, individual financial assets into liquid and tradeable capital market instruments that allow mortgage originators to replenish their funds, which can then be used for additional origination activities.

Wall Street banks can use CMOs to “monetize” the credit spread between the origination of an underlying mortgage (private market transaction) and the yield demanded by bond investors through bond issuance (typically, a public market transaction).

Banks and other lenders can issue CMOs to transfer the marked and payment risks to other investors in order to free up their own assets to originate additional mortgages and other loans. By packaging, mortgage-backed securities originators and other participants can market these instruments to a wider variety of investors with capital to invest.

The CMO process begins when mortgage collateral (FNMA, FHLMC or GNMA) is placed into a protective trust structure. The trust maintains the credit quality of the CMO by protecting the integrity of the collateral underlying the bond. In other words, the trust maintains the collateral exclusively for the benefit of the tranche holders. For instance, even if mortgage prepayments drop to zero, the collateral in the trust is sufficient to pay off all tranches that were issued. The protective trust structure is one of the reasons why, in most cases, CMOs are able to attain a ‘AAA’ rating.

From the trust, several different classes of bonds with various maturities and coupon rates are issued. In one of the most basic structures, known as a ‘plain vanilla’ structure, the different tranches are retired sequentially by targeting all principal returns from the underlying collateral to only one tranche at a time. For example, if the CMO has four tranches, A, B, C, and Z, all scheduled interest is paid to tranches A, B, and C with all principal being paid only to tranche A. This process continues until tranches A, B, and C are retired. At that point, the Z-tranche, which receives no interest or principal until the other classes are retired, will then begin to pay both principal and interest to the holders of this issue on a monthly basis until it also is fully retired.

While the above example describes CMO structure, there are infinite varieties of CM’s, with different variations possible. Some are so complicated that even the salespeople attempting to describe these have little idea what they are or the inherent risks involved.

Below are a few examples of some of the CMO types being marketed.

Stripped mortgage-backed securities (SMBS): Each mortgage payment is partly used to pay down the loan’s principal and partly used to pay the interest on it. These two components can be separated to create SMBS, of which there are two subtypes:

Interest Only or “IO’s” are securities with cash flows backed by only the interest paid on the mortgage property owner’s mortgage payments. (Note that as the underlying mortgages are paid or pre-paid, as when interest rates fall and borrowers refinance, IO’s become worthless.)

Principle only or “PO’s” are securities with cash flows backed by the principal repayment component of the property owner’s mortgage payments. (Note that if there are few pre-payments, as when interest rates rise, there is very little cash flow on “PO’s” )

Other varieties of mortgages which can be pooled:

Prime: conforming mortgages: prime borrowers, full documentation (such as verification of income and assets, strong credit scores, etc.

Alt-A: an ill-defined category, generally prime borrowers but non-conforming in some way, often lower documentation (or in some other way: vacation home, etc.)

Sub-prime: weaker credit scores, no verification of income or assets, etc.

Jumbo’s Jumbo mortgages, when the size is bigger than the “conforming loan amount” as set by Fannie Mae.

Mobile Home: mortgages on mobile homes, usually set at 15 rather than 20 year maturities

Payment Frequency: Most mortgages are paid monthly, and most CMOs are set up to pay monthly. However, some mortgages are paid bi-weekly and some CMOs are pools of such mortgages.

The unique tranche structure offers investors a wide variety of coupons and maturities. Another attraction is monthly income, unavailable with most bond investments. Although CMOs were originally designed to meet the investment needs of institutional investors, individual investors soon became involved. Most institutional and individual investors into CMOs seek the preservation of capital and income.

However, speculation can be a component of CMOs with some individuals and even institutional investors becoming unknowingly involved in such speculation.

If only newly originated 30-year mortgages are pooled, the average half-life expectancy on principal payments (including both required principal payments and early payoffs) is about 10 to 12 years. Of course, this would mean only half the pool would be paid off by that time and half not paid.

Some investors, such as banks, often prefer to have high cash flow and short maturities such that they are often willing to take a bit less income to get their money first. Meanwhile, other investors, such as insurance companies that prefer to do longer term planning, are willing to invest long term and make a bit higher income.

CMOs are structured into “tranches” to purposefully provide different maturities to fit the needs of various investors desiring to or required to have different maturity dates. For example, a CMO can be divided into A, B, C, D and Z tranches. The designations concern who will receive the principle payments first. In the above example, those who purchase the “A” tranche will receive all of the principle first – both scheduled payments and payoffs (plus any defaults paid by guarantee), then B tranche holders will be paid, then C, et cetera. There may be fewer or more tranches than in this example, but longest tranche is generally designated as a “Z” tranche.

Pricing a vanilla corporate bond is based on two sources of uncertainty: default risk (credit risk) and interest rate (IR) exposure. The CMO adds the third risk: early redemption (prepayment). The number of homeowners in residential CMO securitizations who prepay goes up when interest rates go down. One reason for this phenomenon is that homeowners can refinance at a lower fixed interest rate. Commercial CMOs often mitigate this risk using call protection.

Since these two sources of risk (IR and prepayment) are linked, solving mathematical models of CMO value is a difficult problem in finance. The level of difficulty rises with the complexity of the IR model, and the sophistication of the prepayment IR dependence, to the point that no closed-form solution exists. In models of this type numerical methods provide approximate theoretical prices. These are also required in most models which specify the credit risk as a stochastic function with an IR correlation. Practitioners typically use the Monte Carlo method or Binomial Tree numerical solutions.

Another factor that influences pricing is prepayment speed. When a mortgage refinances or the borrower prepays during the month, the prepayment measurement increases. This is usually measured in units of CPR or PSA. However, it may be advantageous to the holder for the borrower to prepay: if the pool was bought at a discount.

This is due to the fact that when the borrower pays back the mortgage he does so at “par.” So if the investor bought a bond at 95 cents on the dollar, as the borrower prepays he gets the full dollar back, and his yield increases. This is unlikely to happen as holders of low-coupon CMOs have very little incentive to refinance. If the buyer acquired a pool at a premium (>102), as is common for higher coupons then they’re at risk for prepayment. If the purchase price was 105, the investor loses 5 cents for every dollar that’s prepaid, possibly significantly decreasing the yield. This is likely to happen as holders of higher-coupon CMOs have a good incentive to refinance.

Loan Balance is yet a third factor in pricing. The average loan balance for a pool is calculated by dividing the Current Amount (or face amount) by the number of loans. Low Loan Balance: <85k Mid Loan Balance: Between 85k – 150k High Loan Balance: >150k. Mortgage prepayments are most often made because a home is sold or because the homeowner is refinancing to a new mortgage, presumably with a lower rate or shorter term.

Pension funds, insurance companies, banks, savings and loans, and other institutions can often find higher returns on traditional pass-through CMOs than in government and other highly rated income investments. CMOS are usually more liquid than bank loans, and non-securitized assets.

Many individual investors are also attracted to the idea of avoiding the “middle man” and purchasing what banks and other institutions purchase rather than putting their money into CD’s and other instruments offered by the institutions.

The high quality of the collateral (GNMA, FNMA and FHLMC), along with the protective structure of the trust, enables these securities to generally carry the highest investment grade credit rating awarded (AAA). Yield CMOs offer investors attractive yield premiums over Treasury, Agency and even some Corporate bonds.

The very nature of the CMO structure is to carve out different tranches from straight collateral in order to provide a variety of effective maturities to investors. This nature of the CMO structure offers investors a multitude of maturity ranges, as well as a variety of coupon rates.

Since CMOs include a variety of tranches in one series, investors have the benefit of choosing from a wide range of tranche types.

Most CMO tranches provide investors with monthly interest payments. Additionally, principal payments are returned on a monthly basis over the life of the security. Since most other fixed income investments (Treasuries, Agencies, and Corporates) offer only semi-annual payments of interest, income-oriented investors can benefit from the more frequent cash flows of CMOs.

CMOs are complex securities that are claimed to be innovative investment vehicles, offering regular payments, relative safety, and notable yield advantages over fixed-income securities of comparable credit quality. Yet, CMOs have for decades also been a tool of some unscrupulous con-artists who have invaded the multi-trillion dollar mortgage debt market to take advantage of even the seemingly most sophisticated investors.

For example, the CMO debacle which occurred in Orange County, California, in the 1990’s and which resulted in huge losses to many municipalities was alleged to have been caused by securities salespersons at large Wall Street brokerage firms. Many pension funds, colleges and universities, savings and loans, credit unions and banks have also filed claims for unscrupulous practices by securities broker- dealers involving billions of dollars in damages.

The primary risk of investing in CMOs is simply understanding these securities in general as well as the particular security being purchased. There are so many simultaneous factors at work it is impossible to predict the future of any particular investment. Meanwhile, by using past performance and/or failing to either know or disclose information about a CMO investment, salespersons often misrepresent or omit disclosing the dangers of a CMO investment.

All income-based securities are subject to interest rate risks. In the 1980s, when interest rates rose above 10%, some bonds and CMOs lost 25 to 40 % of their value regardless of the fact that these securities were “insured” and “AAA-rated”.

However, CMOS often have much less upside potential than bonds because when interest rates rise, investors usually re-finance their mortgages which causes higher-paying CMOs to carry a little premium in the marketplace. This is often referred to as the “heads you lose, tails I win” character of CMOs. Longer tranches and accrual tranches, such as Z-bonds, tend to have the greatest interest rate risk exposure.

Pooling many mortgages with similar default probabilities can diversify the portfolio to lessen risks much the same as a mutual fund of stocks. Yet, just as some mutual funds have lost the majority of their values when prices in the market or the specified sector fall, so also can pooled mortgages with similar traits also fall. If the property owner should default, the property remains as collateral. However, one should note that tax liens, costs of foreclosure, bankruptcy expenses, servicing and some other costs have greater priorities than even first lien mortgages. Investors need also be aware that some mortgage-backed securities contain second or even third mortgages.

Prepayment is a risk for CMO investors despite the fact they are receiving their principal. Investors may not realize that despite the fact they are purchasing below “face” value they are actually purchasing underlying mortgages at a premium. Furthermore, lack of prepayment can cause CMO investment not to perform as represented.

CMO investment are often sold on the expected “speed” of prepayment but, when such prepayments do not occur as expected, the expected income return can fall dramatically. There are a variety of factors that can affect the prepayment risk ), independent of the interest rate, for example, economic growth, which is correlated with increased turnover in the housing market; home prices inflation (or deflation) can cause increased sales (or mortgage defaults); unemployment can force sales or defaults.

The credit risk of mortgage-backed securities depends on the likelihood of the borrower paying the promised cash flows (principal and interest) on time. Credit ratings of most MBS are fairly high because many MBS are guaranteed by The Federal National Mortgage Association (FNMA or “Fannie Mae”), The Federal Home Loan Mortgage Association (FHLMC or Freddie Mac), and The Government National Mortgage Association (GNMA or “Ginnie Mae”). These issuers’ guarantees are considered very solid because they are considered to various degrees to be implicitly guaranteed by the U.S. Federal Government.

Other MBS are often considered fairly safe when the mortgage originators properly research the mortgage taker’s ability to repay to lend only to those credit-worthy the quality of the pools can be quite high. (Yet, there are other risks associated with MBS than the credit risks of the mortgagee borrowers.)

While some (but not all) CMOs are protected from default loss by governmental and/or private insurance, there are many risks inherent by CMOs. Insurance on underlying mortgage payments and AAA ratings on CMOs can often be very misleading to investors who are led to believe that CMOs are “safe” investments.

Other CMOs can be fairly safe if mortgage originators properly research the mortgage taker’s credit worthiness and ability to pay. Unfortunately, many lenders have abdicated such responsibilities in recent years. Pooling many mortgages with similar default probabilities can diversify the portfolio to lessen risks much the same as a mutual fund of stocks. Yet, just as some mutual funds have lost the majority of their values when prices in the market or the specified sector fall, so also can pooled mortgages with similar traits also fall. If the property owner should default, the property remains as collateral. However, tax liens, costs of foreclosure, bankruptcy expenses, servicing, and some other costs have greater priorities than even first lien mortgages. CMOs mortgage-backed securities contain second or even third mortgages.

During the early 2000s, many lenders originated loans including “adjustable rates loans”, “teaser rate loans”, “negative amortization loans”, the low credit scores (Sub-Prime Mortgages), et cetera. Many such sub-prime loans were packaged into CMOs and other pools and sold to investors. By 2006, when real estate began to stagnate, many investors began to learn why these securities fit into the “toxic waste” category – that is – worse than “junk”!