Mortgage-backed securities connect real estate lending with the broader capital markets. By converting pools of mortgage loans into securities that can be sold to investors, securitization can provide lenders with additional liquidity to originate new loans.
Two terms commonly associated with this process are mortgage-backed securities, or MBS, and collateralized mortgage obligations, or CMOs. They are closely related, but they are not separate categories at the same level: a CMO is a more complex type of mortgage-backed security.
Understanding this distinction can provide real estate investors with useful context about how capital moves through the mortgage market.
A mortgage-backed security is a debt instrument representing a claim on cash flows generated by a pool of mortgage loans.
Banks, mortgage companies, and other originators make loans to property owners. Those loans may later be sold to or pooled by a government agency, government-sponsored enterprise, or private institution. Securities backed by the pool are then issued to investors.
As borrowers make principal and interest payments, the resulting cash flows—after applicable servicing and other fees—are distributed to MBS investors according to the terms of the security.
A collateralized mortgage obligation is a multi-class mortgage-backed security. Instead of distributing mortgage cash flows proportionally to every investor, a CMO divides those cash flows among separate classes known as tranches.
Each tranche may have a different:
CMOs do not eliminate the risks associated with mortgage cash flows. They redistribute those risks among the different tranches.
MBS is the broader category. CMOs are one type of MBS.
A basic pass-through MBS distributes each investor’s proportional share of principal and interest payments from the underlying mortgage pool. A CMO redirects those payments through a defined priority structure.
That structure may make one tranche’s cash flows more stable under certain assumptions while making another tranche more sensitive to changes in mortgage prepayments.
A pass-through MBS gives investors a proportional interest in the cash flows from a pool of mortgage loans.
When borrowers make scheduled payments, refinance, sell their properties, or otherwise pay off their loans, principal and interest flow through the security to its investors, after applicable fees.
The timing of those cash flows is not completely predictable. Borrowers generally control when they refinance or make permitted early principal payments. That creates prepayment risk for investors.
If mortgage rates fall, borrowers may refinance more quickly, returning principal to investors sooner than expected. If rates rise, refinancing may slow, extending the period during which investors hold the security.
A CMO uses rules known as a priority of payments to allocate cash flows among its tranches.
In a simplified sequential-pay structure, principal payments are directed to the first tranche until it is retired. Principal then flows to the next tranche in sequence. Other CMO structures use more complex rules to target particular average lives or cash-flow patterns.
The underlying mortgage pool may be the same for every tranche, but the allocation rules can cause each tranche to perform differently.
CMO structures can include numerous types of tranches. Their exact features depend on the governing documents.
In a sequential-pay CMO, principal is generally directed to one tranche at a time according to a specified order. Earlier tranches are paid down first, while later tranches begin receiving principal after the preceding classes have been retired.
The actual timing still depends on payments from the underlying mortgages.
A planned amortization class, or PAC, tranche is designed to receive principal according to a specified schedule when mortgage prepayments remain within an assumed range.
Companion or support tranches absorb variations in principal payments to help protect the PAC schedule. If prepayments move outside the modeled range for a sustained period, that protection may weaken or disappear.
A PAC tranche can therefore provide greater cash-flow stability than some other CMO classes, but its payment schedule is not guaranteed.
A targeted amortization class, or TAC, tranche is designed around a targeted principal-payment schedule.
TAC tranches generally provide less protection from changes in prepayment speeds than PAC tranches. Their performance will depend on the structure and the actual behavior of the underlying mortgage loans.
Companion tranches absorb changes in principal payments to support the payment schedules of PAC or other priority tranches.
Because they receive the excess or shortfall created when prepayments differ from expectations, companion tranches can have highly variable average lives and significant price volatility.
They should not be described simply as non-amortizing tranches or as classes that automatically absorb credit losses. Their primary role in many CMO structures is to absorb prepayment variability.
A Z-tranche generally does not receive current cash payments while specified earlier tranches remain outstanding. Instead, its accrued interest is added to its principal balance.
Once the earlier tranches have been paid down as provided in the structure, the Z-tranche begins receiving cash payments. This structure can create significant sensitivity to interest rates, prepayments, and the timing of the underlying cash flows.
Residential mortgage-backed securities, or RMBS, are backed by loans secured by residential properties. RMBS may be issued or guaranteed by an agency or government-sponsored enterprise, or they may be issued as private-label securities.
Commercial mortgage-backed securities, or CMBS, are backed by loans secured by commercial real estate. CMBS structures, underwriting considerations, and borrower behavior can differ materially from residential MBS.
Stripped mortgage-backed securities separate principal and interest cash flows into different classes.
Principal-only securities receive principal payments, while interest-only securities receive specified interest cash flows. The two classes can respond very differently to changing interest rates and mortgage prepayment speeds.
The issuer or guarantor is an important part of an MBS’s risk profile.
The Government National Mortgage Association, or Ginnie Mae, is a U.S. government corporation. Ginnie Mae guarantees the timely payment of principal and interest on qualifying securities, and that guaranty is backed by the full faith and credit of the U.S. government.
The guaranty applies to the security’s required payments. It does not protect an investor from market-price changes, prepayment risk, reinvestment risk, or losses associated with paying more than face value for a security.
Fannie Mae and Freddie Mac are government-sponsored enterprises. They provide guarantees for eligible securities they issue, but those securities are not backed by the full faith and credit of the U.S. government.
Although both enterprises have operated under federal conservatorship since 2008, investors should not treat their securities as identical to U.S. Treasury obligations or Ginnie Mae securities.
Private-label MBS are issued by private financial institutions rather than Ginnie Mae, Fannie Mae, or Freddie Mac.
Their credit protection may come from structural features such as subordination, reserve accounts, overcollateralization, excess spread, or private insurance. The strength and availability of those protections vary by transaction.
Borrowers may repay mortgages sooner than expected through refinancing, property sales, or additional principal payments.
When principal is returned early, investors may need to reinvest it when comparable yields are lower. Prepayments can also change a security’s expected average life and return.
When interest rates rise, refinancing activity may slow. Investors may receive principal later than expected and remain invested in a below-market security for longer.
MBS and CMO prices can decline when market interest rates rise. Their price behavior can be more complex than that of traditional fixed-rate bonds because interest-rate changes may also affect mortgage prepayments.
Credit risk depends on the underlying loans and any agency, enterprise, or private credit support.
Private-label securities may expose investors directly to losses from borrower defaults. Agency or enterprise guarantees can reduce certain credit risks but do not eliminate all investment risks.
Some agency pass-through securities trade in deep, active markets. Other MBS and individual CMO tranches may be less liquid, particularly during periods of market stress.
An investor may not always be able to sell a security quickly or at an expected price.
CMO cash flows often depend on assumptions about prepayments, defaults, recoveries, and interest rates. Actual borrower behavior may differ substantially from those assumptions.
Two tranches backed by the same mortgage pool can therefore have very different average lives, yields, and price volatility.
The structure of a CMO can be difficult to evaluate. Investors need to understand the tranche’s priority, expected average life, prepayment assumptions, collateral, credit support, and performance under different interest-rate scenarios.
Mortgage-backed securities may offer features that appeal to certain investors, but none should be viewed as guaranteed benefits.
MBS and CMOs may provide periodic payments derived from the principal and interest paid on the underlying mortgage loans.
The amount and timing of those payments may change because of prepayments, defaults, servicing advances, and the security’s structure.
MBS allow investors to gain exposure to pools of residential or commercial mortgage loans without directly originating or servicing individual loans.
CMO tranches can provide different expected cash-flow profiles. Investors may select a tranche based on their objectives, duration preferences, and tolerance for prepayment or extension risk.
Mortgage-backed securities may provide exposure that differs from corporate bonds, municipal bonds, or other fixed-income investments.
Diversification does not guarantee against loss, and securities backed by many loans can still be affected by common economic, geographic, interest-rate, or housing-market risks.
The key differences can be summarized as follows:
FeaturePass-Through MBSCMOStructureInvestors receive proportional cash flows from a mortgage poolCash flows are divided among multiple tranchesPrincipal paymentsGenerally distributed pro rataDistributed according to a priority of paymentsRisk allocationInvestors in the same class generally share similar exposurePrepayment, extension, and other risks may vary substantially by trancheExpected lifeDepends on mortgage performance and prepaymentsDepends on both mortgage performance and tranche structureComplexityGenerally less complexOften significantly more complexInvestor analysisFocuses on the mortgage pool, guaranty, prepayments, and market conditionsAlso requires detailed analysis of tranche priority and structural assumptions
Before considering an MBS or CMO, investors should understand:
Because CMOs can be complex, prospective investors should carefully review the offering documents and consult a qualified investment professional.
Most borrowers never invest directly in the securities backed by their mortgages. Even so, the MBS market can influence the availability and pricing of real estate credit.
Securitization allows eligible mortgage loans to be pooled and financed through the capital markets. This can provide liquidity to lenders and support additional loan originations.
The connection is not always direct. A borrower’s interest rate and loan terms depend on factors including the lender, loan program, property, credit profile, market conditions, capital costs, and the terms of the transaction.
The sale or securitization of a loan also does not generally change a borrower’s obligations under the loan documents.
Mortgage-backed securities are instruments backed by cash flows from pools of mortgage loans. A collateralized mortgage obligation is a type of MBS that distributes those cash flows among separate tranches according to a defined priority structure.
Pass-through MBS generally provide investors with proportional cash flows from the mortgage pool. CMOs restructure those cash flows to create classes with different expected lives, payment priorities, and exposure to prepayment and extension risk.
Neither MBS nor CMOs should be viewed as automatically stable, liquid, predictable, or government-backed. Their risks depend on the underlying mortgages, issuer or guarantor, market conditions, and security structure.
CoreVest offers business-purpose financing solutions for residential real estate investors. Contact our team to discuss financing options for your next rental, renovation, or construction project.
This article is provided for informational purposes only and does not constitute legal, tax, investment, financial, securities, or lending advice, or an offer to buy or sell any security. Investment and loan structures involve risk and may vary by issuer, lender, program, jurisdiction, and transaction. All loans are subject to underwriting, credit approval, eligibility requirements, and applicable terms and conditions.
CoreVest Finance | NMLS #1627183
