Markets Explained

The Building Blocks of CMOs: Mortgage Loans & Mortgage Pass-Throughs

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The Building Blocks of CMOs: Mortgage Loans & Mortgage Pass-Throughs

The creation of a CMO begins with a mortgage loan extended by a financial institution (savings and loan, thrift, commercial bank, or mortgage company) to finance a borrower’s home or other real estate. The homeowner usually pays the mortgage loan in monthly installments composed of both interest and “principal.”² Over the life of the mortgage loan, the interest component of payments, which typically comprises a majority of the payments in the early years, gradually declines as the principal component increases.

To obtain funds to make more loans, mortgage lenders either “pool” groups of loans with similar characteristics to create securities or sell the loans to issuers of mortgage securities. The securities most commonly created from pools of mortgage loans are “mortgage pass-through securities,” often referred to as mortgage-backed securities (MBS) or participation certificates (PCs).³ Mortgage pass-through securities represent a direct ownership interest in a pool of mortgage loans. As the homeowners whose loans are in the pool make their mortgage loan payments, the money is distributed on a pro rata basis to the holders of the securities.

Several factors can affect the homeowners’ payments. Typically, the homeowner will “prepay” the mortgage loan by selling the property, refinancing the mortgage, or otherwise paying off the loan in part or in whole. Most mortgage pass-through securities are based on fixed-rate mortgage loans with an original maturity of 30 years, but experience shows that most of these mortgage loans will be paid off much earlier.

While the creation of mortgage pass-through securities greatly increased the secondary market for mortgage loans by pooling them and selling interests in the pool, the structure of such securities has inherent limitations. Mortgage pass-through securities only appeal to investors with a certain investment horizon—on average, 10 to 12 years.

CMOs were developed to offer investors a wider range of investment time frames and greater cash-flow certainty than had previously been available with mortgage pass-through securities. The CMO issuer assembles a package of these mortgage pass-through securities, or in some cases mortgage loans themselves, and uses them as collateral for a multiclass security offering. The different classes of securities in a CMO offering are known as “tranches,” from the French word for “slice.” The CMO structure enables the issuer to direct the principal and interest cash flow generated by the collateral to the different tranches in a prescribed manner, as defined in the offering’s prospectus, to meet different investment objectives.

² Most words in quotes appear in the glossary.

³ In this guide, the generic term “mortgage pass-through securities” will be used to refer to these types of securities. The term “mortgage securities” is used to refer to both mortgage pass-through securities and CMOs.