What are Collateralized Mortgage Obligations?
Collateralized mortgage obligations, or CMOs for short, are a type of investment that’s backed by mortgages on homes and buildings. Banks and other lenders give people money to buy houses. The lenders then take a whole bunch of those mortgage loans and package them together into a CMO.
How CMOs Get Chopped Up
The CMO gets divided into different chunks called “tranches.” Each tranche gets a slice of the money that people pay on their mortgages each month. Some tranches are riskier than others. The risky tranches might offer higher interest rates to investors, but they’re also first in line to take losses if people don’t pay their mortgages.
Why Investors Like CMOs
Investors buy pieces of CMOs because they can earn interest on them. As long as people keep paying their mortgages, the money keeps flowing to the CMO investors. CMOs let investors choose which tranches match their appetite for risk and reward.
The Problem of Prepayments
A prepayment happens when someone pays off their mortgage early. They might sell their house, refinance their mortgage, or just decide to pay it off sooner. Prepayments can really throw a wrench in the works for CMOs.
When Prepayments Mess Up CMO Math
CMOs are set up expecting a certain amount of money to come in each month from all those mortgage payments. The interest and principal payments are divided up between the different tranches based on those expectations. But if a bunch of people suddenly pay off their mortgages early, there’s less money coming into the CMO.
The Prepayment Ripple Effect
With less cash coming in, some of the CMO tranches might not get the interest payments they were promised. Even worse, there might not be enough money to pay back the principal to investors when the CMO matures. This prepayment risk can make CMOs less attractive to investors.
Calamity Calls to the Rescue
To help protect CMO investors from the prepayment problem, some CMOs include a special rule called a “calamity call” provision. Calamity calls help keep CMOs on track even when prepayments go haywire.
How a Calamity Call Works
Let’s say prepayments suddenly spike and there’s not enough cash coming into the CMO to make all the payments to investors. The calamity call provision says that if this happens, some of the CMO tranches have to be retired early.
Retiring a tranche means paying back the investors’ principal ahead of schedule. The money to do this comes from the principal payments that are still coming into the CMO. By retiring some tranches early, there’s more cash available to keep payments flowing to the remaining tranches.
Which Tranches Get the Ax?
The calamity call provision spells out which tranches get retired first if prepayments cause problems. It’s usually the riskiest tranches that are first to go. These are the “subordinate” tranches that are already first in line for losses. The “senior” tranches that are last in line for losses are protected.
The Investor Impact
For investors in the subordinate tranches, a calamity call can be a double-edged sword. On one hand, they’re getting their principal back early, which protects them from potential losses. On the other hand, their high-yield investment is getting cut short. They’ll have to find somewhere else to put that money to earn a high return.
Investors in the senior tranches breathe easier when a calamity call happens. The call retires the riskier tranches below them, improving the credit quality of their investment. More of the CMO’s cash flow is now directed to servicing their tranches.
Pros and Cons of Calamity Calls
Calamity calls aren’t perfect, but they do help reduce some of the risks that prepayments pose for CMOs. Still, they have their advantages and drawbacks.
On the Plus Side
The biggest benefit of a calamity call is that it helps keep the CMO afloat if prepayments surge. Without the call provision, a spike in prepayments could cause the whole CMO to collapse. The calamity call acts like a pressure release valve.
The call also helps protect senior tranche investors. By retiring the riskier tranches, more cash is available to pay the senior tranches. This makes the senior tranches less likely to suffer losses.
The Downside
A calamity call usually means bad news for subordinate tranche investors. Their higher-yielding investment suddenly gets paid off early. They may have trouble finding a new investment with the same high return.
The calamity call also reduces the size of the CMO. With some tranches getting retired, there’s less money invested overall. This can make the CMO less liquid and harder to trade in the secondary market.
Weighing the Trade-Offs
In the end, whether a calamity call is a good or bad thing depends on your perspective. Senior tranche investors probably like the extra protection. Subordinate tranche investors may not be so thrilled about giving up their high-yield investment. And the CMO issuer has to balance between keeping the CMO healthy and keeping investors of all stripes happy.
