What is the difference between a cmo and a passthrough security? Is a CMO a type of pass through security?
For a passthrough security, the periodical payments of the loans go straight to the investors after subtracting a servicing fee. A cmo has to be created from mortgages, and typically has different tranches.
Mortgage pass-through securities represent a direct ownership interest in a pool of mortgage loans. As the homeowners whose loans are in the pool make their mortgage loan payments, the money is distributed on a pro rata basis to the holders of the securities (after deducting the fees as mentioned above)
CMOs are repackaged pass-through mortgage-backed securities (or the loans themselves are the collaterals) with the cash flows directed in a prioritized order based on the structure of the bond.
The key difference between traditional mortgage pass-throughs and CMOs is in the principal payment process:
-With traditional MBS each investor receives a monthly pro rata distribution of any principal and interest
-CMOs substitute a principal pay-down priority schedule among tranches for the pro rata process found in pass-throughs, which offers a more predictable rate of principal pay-down.payments made by homeowners…
Thanks for the detailed explanation
So is it safe to say that if I buy a cmo at the priority tranche I am at a safer position (i.e. more guaranteed my cashflows) than if I buy a regular mortgage pass-through security?
If you purchase the most senior bond in the stack and it has lots of credit enhancement it would be safer than the same group of loans than are structured as a pass through. So if by priority stack you mean most senior tranche, then yes. If the tranche you held in the CMO had 30% credit enhancement and losses were 25% you would be fine. In the PT you would lose 25% (assuming no other CE).
Apart from implicit and external credit enhancement supports (see above) I believe the main point is that a CMO has different payment TIMING risk depending on the type of bond you own. Some offer more protection than others from prepayment (contraction or extension) risk. These bonds have a more PREDICTABLE DURATION to the bondholder vs. a pass through agency bond, thus your cash flow is more ‘guaranteed’ in that it is also less volatile (again depending on the seniority of your tranche, the structure of the bond).
With a more senior tranche in a CMO you are not only more ikely to get paid (credit risk) but also you can be more sure about when you receive payments (reinvestment risk).
A pass thru is a simple pass thru of cash flow directly (from borrower of mortgage loan) to the investor - significantly exposing the investor to
prepayment risk therefore reinvestment risk
extension risk/ contraction risk
if non-agency, credit risk as well
so this is a regular FIxed Income instrument
whereas, a CMO is a derivative, created fron pass thru to address primarily, prepayment risk by simply, redistributing it ( using PAC tranches) and therefore, even the sophisticated investor could be exposed to a 'prepayment burn out risk. For addressing the credit risk, support tranches are inserted
So in essence one is a bond (whose value changes with mkt rates and prepayment speeds) if you will, the other can be used as a structured instrument, to hedge cash flows or use it as an ALM tool
i think from what i understand from the earlier comments are that the main difference in the cashflows between the two is pro rata and priority.
Mortgage pass through securities invesstors get their % of cashflows from the amount of securities they own as a % of the whole pool.
CMO owners get their cashflow according to the tranche of the bond that they bought, i.e. if they buy a PAC 1 tranche they will get priority over a PAC 2 tranche and so on.