One of the most important innovations from Wall Street was the act of pooling loans together to then split up into separate interest bearing instruments. This concept of collateralizing and structured financing predates the market for collateralized mortgage obligations (CMOs) and collateralized debt obligations (CDOs). It was not until the early 1980s that the concept was formalized by repackaging mortgages to create the mortgage backed security industry (MBS).
MBS’s are secured by a pool of mortgages where all the interest and principal simply pass through to investors. CMOs were created to give investors specific cash flows instead of just the pass through of interest and principal. CMOs were first issued in 1983 for Federal Home Loan Mortgage Corp (Freddie Mac) by the investment banks First Boston and Salomon Brothers, which took a pool of mortgage loans, divided them into tranches with different interest rates and maturities, and issued securities based on those tranches. The originating mortgages served as collateral.
In contrast to CMOs, CDOs, which came along later in the 1980s, encompass a much broader spectrum of loans beyond mortgages. While there are many similarities between the two, there are some distinct differences in their construction, the types of loans held in aggregate and the types of investors seeking out either one.
CMO—Born Out of a Need
Collateralized mortgage obligations (CMO), a type of mortgage backed security (MBS), are issued by a third party dealing in residential mortgages. The issuer of the CMO collects residential mortgages and repackages them into a loan pool which is used as collateral for issuing a new set of securities. The issuer then redirects the loan payments from the mortgages and distributes both the interest and principal to the investors in the pool. The issuer collects a fee, or spread, along the way. With CMOs, the issuers can slice up predictable sources of income from the mortgages by using tranches, but like all MBS products, CMOs are still subject to some prepayment risk for investors. This is the risk that mortgages in the pool will be prepaid early, refinanced, and/or defaulted on. Unlike an MBS, the investor can choose how much reinvestment risk he is willing to take in a CMO.
Below is an example of a simplified version of three tranches of various maturities using a sequential payout structure. Tranche A, B and C will all receive interest payments over their life but the principal payout flows sequentially until each CMO is retired. For example: Tranche C will not receive any principal payouts until Tranche B is retired, and Tranche B will not receive any principal payouts until Tranche A is retired.
While the securities themselves can seem complicated and it’s easy to get lost in all the acronyms, the process of collateralizing loans is quite simple.
The issuer of the CMO, as a legal entity, is the legal owner of a pool of mortgages which are purchased from banks and mortgage companies. Prior to the advent of repackaging mortgages, a borrower would visit his local bank who would lend out money for the purchase of a home. The bank would then hold the mortgage using the house as collateral until it was paid off or the house was sold. While some banks still hold mortgages on their books, the majority of mortgages are sold off soon after closing to third parties who repackage them. For the initial lender, this provides some sense of relief as they no longer own the loan or have to service the loan. These mortgages then become collateral and are grouped together with loans of similar quality into tranches (which are just slices of the pool of loans). By creating CMOs from a pool of mortgages, issuers can design specific, separate interest and principal streams in various maturity lengths to match investor’s needs with the cash flows and maturities they desire. For legal and tax purposes, CMOs are held inside a real estate mortgage investment conduit (REMIC) as a separate legal entity. The REMIC is exempt from federal tax on the income they collect from the underlying mortgages at the corporate level, but income paid to investors is considered taxable.
CDO—Some Good Some Bad
The collateralized debt obligation (CDO) came to life in the late 1980’s and shares many of the characteristics of a CMO: loans are pooled together, repacked into new securities, investors are paid interest and principal as income and the pools are sliced into tranches with varying degrees of risk and maturity. A CDO falls under the category known as an asset backed security (ABS) and like an MBS, uses the underlying loans as the asset or collateral. The development of the CDO filled a void and provided a valid way for lending institutions to essentially move debt into investments through securitization, the same way mortgages were securitized into CMOs. Similar to CMOs issued by REMICs, CDOs use special purpose entities (SPE) to securitize their loans, service them and match investors with investment securities. The beauty of a CDO is that it can hold just about any income producing debt like credit cards, automobile loans, student loans, aircraft loans and corporate debt. Like CMOs, the slicing up of the loan pieces is structured from senior to junior with some oversight from rating agencies who assign grade ratings just like a single issue bond, e.g. AAA, AA+, AA, etc.
Below is an example of how a CDO is structured. Each CDO has a balance sheet just like any company would have. The assets are comprised of the income producing components like loans, bonds, etc. Each bond issued on the left is tied to a specific pool of assets on the right. The bonds are then rated by third parties based on the seniority of their claims to the pool and the perceived quality of the underlying assets. In theory, bonds of lower quality ratings and seniority would command higher rates of return by investors.
CMOs vs. CDOs
There are many similarities between CMOs and CDOs as the latter were modeled after the former by design. CMOs can be issued by private parties or backed by quasi government lending agencies (Federal National Mortgage Association, Government National Mortgage Association, Federal Home Loan Mortgage Corp., etc.) while CDOs are private labeled.
While CMOs and CDOs have similar wrappers on the outside, they are different on the inside. The CMO is a little easier to understand as the cash flow it provides is from a specific pool of mortgages while the CDO cash flows can be backed by automobile loans, credit card loans, commercial loans and even some tranches from a CMO. While the CMO market did suffer some impact from the real estate implosion of 2007, the CDO market was hit harder. Only a small portion of the CMO market was considered sub-prime while CDOs made sub-prime CMOs their core holdings. The CDOs that purchased the lowest ranked, riskiest tranches of CMOs blending them with other ABS assets suffered dearly when the sub-prime tranches went south. It’s unlikely the mistakes of the past will be made again as there is much more oversight from the SEC than there was before, but sometimes history repeats itself. Both products play the same role of pooling loans and assets together then matching investors with the cash flows, so it’s up to the investor to decide how much risk they want to take.
CDOs were a relatively small segment of the ABS market with only $340 million outstanding issues in 2002 compared to the total CMO market of $4.7 trillion. The CDO market ballooned after 2002 as the securitization of asset backed loans grew and issuers advanced their purchases of the riskier CMO tranches. As the real estate markets mushroomed, so did the CDO/CMO markets as the total outstanding CDOs peaked at $1.3 trillion in 2007. This phenomenal growth came to an abrupt halt as the real estate bubble burst, reducing the CDO market to around $850 million in 2013.
While it looked good on paper to buy the riskier tranches of CMOs that were not in demand and bundling them into CDOs, the quality of those tranches which were presumed to be sub-prime turned out to be much more sub-prime than first thought. Rating agencies and CDO issuers are still being held accountable, paying fines and making restitution after the housing market collapse of 2007 which led to billions in losses in CDOs. Many became worthless overnight, downgraded from AAA to junk. Those who invested heavily in the riskiest CDOs experienced larges losses when those issues ultimately failed. A number of CDO issuers were charged and/or fined for their role in packaging risky assets that failed. One of the largest and most publicized cases was against Goldman Sachs (NYSE:GS) in 2010, who was officially charged and fined for structuring CDOs and not properly informing its clients about the potential risks. Based on estimates from the Securities and Exchange Commission, investors lost more than $1 billion after the dust settled in 2010.
CDOs still exist today but will forever wear the scars of good decisions gone bad.
Investors worldwide learned a valuable lesson from the early days of collateralizing. It took some creative thinking to find a way to take a large pool of loans and create secured investments for investors. This freed up capital for lenders, created many jobs for issuers, created liquidity in a not so liquid market, and helped fuel homeownership. The same process that fueled homeownership eventually fueled a real estate bubble and subsequent collapse. The process of collateralization energized itself but ultimately caused its own collapse.