Collateralized Mortgage Obligations (CMOs)

A collateralized mortgage obligation (“CMO”) refers to a specific type of mortgage-backed security that consists of a pool of mortgages bundled together as an investment. CMOs are organized by their maturity date and level of risk.

In a nutshell, here is how a CMO works: as borrowers repay on the mortgage obligations that act as collateral on these securities, CMOs capture these payments and distribute principal and interest payments to the investors based on predetermined agreements and governing rules.

CMOs were first created by Salomon Brothers and First Boston in 1983 in order to provide liquidity for Freddie Mac, a U.S. mortgage provider and government sponsored entity (“GSE”).

In the United States, the fixed-income (bond) market is enormous. Depending on how the bond market is measured, its size is anywhere from $35-40 trillion. In general, the bond market consists of:

• treasury debt or government bonds;
• mortgage-backed bonds (which includes CMOs);
• corporate bonds;
• municipal bonds;
• money market debt;
• federal agency debt;
• and asset-backed securities.

With respect to mortgage-backed bonds, these securities make up about 20% of the overall bond market. CMOs are simply another type of mortgage-backed security (“MBS”), or a bond secured by home and other real estate loans. MBS securities include those mortgage-backed bonds issued by the Government National Mortgage Association (“GNMA” or “Ginnie Mae”), the Federal National Mortgage Association (“FNMA” or “Fannie Mae”), or the Federal Home Loan Mortgage Association (“FHMLC” or “Freddie Mac”).

Unlike these other mortgage pass-through securities, in which all investors participate in proportion to their investment in receiving cash flows, CMOs work a bit differently and can be quite complicated and subject to certain risks.

The basic characteristics or features of CMOs are as follows:

• Pooled or bundled mortgages: just like with other mortgage-backed securities, CMOs consist of a large pool of mortgages bundled together – this pool is then typically sold to a federal governmental agency like Ginnie Mae or a GSE such as Fannie Mae or Freddie Mac;

• Frequency and type of payments received: unlike more traditional fixed-income investments such as corporate bonds that pay a semiannual interest or ‘coupon’ payment, mortgage-backed securities including CMOs usually pay monthly cash flows to investors (which makes sense in light of the fact that the borrowers are obligated to pay their mortgage each month).

  In addition, mortgage-backed securities, including CMOs, differ from more traditional fixed-income investments in that the payments made to investors usually consist of both principal and interest. Often, investors who are unfamiliar with the complex nature of CMOs are completely unaware that the payments they are receiving consist of both principal and interest.

  Finally, investors in mortgage-backed securities, including CMOs, should be aware that the duration on their investment is not necessarily fixed. Unlike traditional fixed-income investments, such as corporate or municipal bonds, that have a definite stated maturity date, mortgage-backed securities have an “average” life, an assumption based on the estimated amount of time needed for each dollar of principal and interest to be repaid.

• Tranches or specific slices within the mortgage pool: a typical MBS structure is set up as a pass-through entity. For example, certain mortgages, often with similar features such as duration and interest rate, are pooled together in trust form, and then investors receive payments on the MBS for a predetermined period of time (e.g., 5, 15 or 30 years).

  However, unlike the more basic MBS pass-through structure, CMOs can be very complex. Specifically, with CMOs the underlying mortgage pools are divided into various categories, or tranches, based on the repayment schedules on the mortgages.

  CMO bonds are then issued from each of the tranches, which are structured to have their own risk characteristics and maturity range. Each tranche corresponds to a different maturity date and interest rate. Many CMO arrangements are possible; one of the most basic structures is a Sequential Paying CMO. This structure pays cash flows to investors in a specific sequence, with each class receiving regular interest payments, but the principal payments are made only to the first class until such time as that class is paid in full, and so on until all classes are paid.

There are a number of risks associated with investing in CMOs. As an investor, your financial advisor or stockbroker should make you aware of these risks, including:

• Prepayment Risk: when interest rates fall, homeowners often prepay mortgages faster through mortgage refinancing, which in the context of mortgage-backed securities can result in a CMO’s duration ending much quicker than anticipated. In such an event, an investor in a CMO will be disadvantaged and left to reinvest his or her money at a lower interest rate;

• Extension Risk: when interest rates rise, homeowners may repay their mortgages much slower, and as a result, investors in CMOs may be left holding a security for a longer duration than originally anticipated;

• Market or Interest Rate Risk: as with other fixed-income investments, changes in interest rates can have a significant impact on the underlying value of the CMO, and if sold prior to its maturity, an investor may be forced to absorb a realized loss on the price of the security due to an adverse movement in prevailing interest rates.

CMOs are very complicated fixed-income investments that carry significant risks, including prepayment and extension risk, as well as market risk. Accordingly, if your financial advisor or stockbroker has recommended that you purchase CMOs, then your financial advisor should have first performed the necessary due diligence to ensure that the investment made was suitable for your needs.

While many financial advisors seek to do right by their clients, unfortunately there have been numerous instances of broker misconduct involving unsuitable sales of CMOs to uninformed investors. In fact, in some instances, the Financial Industry Regulatory Authority (“FINRA”) has imposed fines and disciplinary enforcement action against certain brokers in connection with the unsuitable sales of CMOs that resulted in investors incurring significant losses.

At Law Office of Christopher J. Gray, P.C., our securities attorneys have managed cases from inception to conclusion involving a wide range of claims against brokers and financial advisors, including but not limited to: the sale of unsuitable securities, breach of fiduciary duty, churning, as well as misrepresentation and omission claims. If you have invested in what may be unsuitable CMOs, and such investments have incurred considerable losses due to poor performance and/or excessive fees, you may be able to recover your losses in FINRA arbitration. Investors who wish to discuss a possible claim may contact a securities arbitration attorney at Law Office of Christopher J. Gray, P.C. via the contact form on this website, by telephone at (866) 966-9598, or by e-mail at newcases@investorlawyers.net for a no-cost, confidential consultation.