Mortgage Cash Flow Obligation (MCFO)

Mortgage Cash Flow Obligation (MCFO)

Investopedia / Jake Shi

What Is a Mortgage Cash Flow Obligation (MCFO)?

A mortgage cash flow obligation (MCFO) is a type of mortgage pass-through unsecured general obligation bond that has several classes or tranches. MCFOs use cash flow from a pool of mortgages that generate revenue to repay investors their principal plus interest. Payments are received from mortgages in the pool and passed on to holders of the MCFO security. 

Understanding Mortgage Cash Flow Obligation (MCFO)

Mortgage cash flow obligations (MCFOs) resemble collateralized mortgage obligations (CMOs) in some respects, but they are not the same. MCFOs do not hold a lien on the mortgages held by the security. They are merely obligated by contract to use the income from the mortgages to pay their investors. MCFO owners have no legal rights to the actual underlying mortgages, thus MCFOs are riskier than CMOs.

Like CMOs, MCFOs are a form of mortgage-backed security created through the securitization of individual residential mortgages that draw interest and principal payments from that specific pool of mortgages. Because they do not hold the same legal protections as CMOs, MCFOs typically offer investors higher coupon rates. 

Risks and Structure of Mortgage Cash Flow Obligations

Like CMOs, MCFOs package mortgages into groups with different payment characteristics and risk profiles called tranches. The tranches are paid back with mortgage principal and interest payments in a specified order, with the highest rated tranches coming with credit enhancement, which is a form of protection against prepayment risk and repayment default. MCFO performance is subject to changes in interest rates as well as foreclosure rates, refinance rates and the pace of home sales.

The stated maturities of MCFO tranches are determined based on the date when the final principal from a pool of mortgages is expected to be paid off. But maturity dates for these types of MBS do not take into account prepayments of the underlying mortgage loans and thus may not be an accurate representation of MBS risks. Most mortgage pass-through securities are collateralized by 30-year fixed-rate mortgages, but prepayments due to home sales or refinancings cause many loans to be paid off earlier.

CMOs, MCFOs and other non-agency mortgage-backed securities – those mortgage bonds not backed by the government-sponsored enterprises Fannie Mae, Freddie Mac or Ginnie Mae - were at the center of the financial crisis that led to the bankruptcy of Lehman Brothers in 2008 and resulted in trillions of dollars in losses on mortgage loans and millions of homeowners losing their homes to default.

Following the financial crisis, government agencies stepped up their regulation of mortgage-backed securities and forced lenders to increase the transparency of subprime loans and the qualifying standards to obtain such mortgages. In December 2016, the SEC and FINRA announced new rules to dampen MBS risk with margin requirements for CMO and related MBS transactions.

Article Sources
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  1. U.S. Securities and Exchange Commission. "Mortgage-Backed Securities and Collateralized Mortgage Obligations." Accessed April 13, 2021.

  2. Financial Industry Regulatory Authority. "Regulatory Notice 16-31." Accessed April 13, 2021.

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