What Is a Calamity Call?
A calamity call is a protective measure for investors in a collateralized mortgage obligation (CMO) that is triggered if defaults or prepayments on the underlying mortgages threaten to interrupt the cash flow generated by the investment.
If the cash flow generated by the underlying collateral is not enough to pay the scheduled principal and interest payments, the issuer will retire a portion of the CMO. The measure is designed primarily to reduce the issuer's reinvestment risk.
A calamity call also may be called a "clean-up call."
Understanding the Calamity Call
A CMO is a security that is backed by a pool of mortgages. These products are sometimes known as Real Estate Mortgage Investment Conduits (REMICs).
Banks that offer mortgages directly to home buyers sell those mortgages on to investment firms at a discount from their full value. That clears up cash for the banks to lend out again. The firms that buy the mortgages package them for sale to investors as CMOs.
- A calamity call provision is used to replace losses in CMO cash flow that can be caused by defaults or early repayments.
- They are most often used in second-lien mortgages, which have limited protection from default risks.
- A calamity call provision may also be found in municipal bonds.
Investors buy CMOs in order to access the cash flow from mortgages without having to originate or purchase the mortgages. CMOs earn their income as the borrowers repay their mortgages, and the repayment serves as the collateral.
A calamity call provision reduces the risk for CMO investors, guaranteeing an uninterrupted cash flow.
It is only one type of protection used in CMOs. Others include over-collateralization and pool insurance.
A calamity call is sometimes known as a "clean-up call."
The calamity call may be used in CMOs structured from second-lien mortgages, which have limited protection against default losses. For conventional fixed-rate mortgages, over-collateralization may provide sufficient protection to the underlying pool of mortgages.
The Calamity Call in Bonds
The calamity call is also used occasionally in municipal bonds. In this case, it is a type of extraordinary redemption provision.
For example, a calamity call may be used to offset lost revenue from a municipal bond that was issued to fund the construction of a community facility that later suffers significant damage, limiting its ability to generate revenue to repay the bond.
This kind of calamity call is sometimes known as a catastrophe call.
Example of a Calamity Call
Say Company A issues a $10 million CMO that generates $500,000 monthly from underlying mortgage interest and principal payments.
A significant number of mortgage holders either default on their loans or prepay them in full. The CMO no longer produces enough income to pay its investors.
Company A could then be required to retire part of the CMO in order to pay the investors.