Chapter 33. Structuring Collateralized Mortgage Obligations and Interest-Only/ Principal-Only Securities


President and Founder, Andrew Davidson & Co., Inc.


John W. Galbraith Chair and Professor of Finance, Ohio State University


Fredell & Co. Structured Finance Ltd.


Senior Consultant, Andrew Davidson & Co., Inc.

Abstract: The mortgage market has found a way to restructure mortgage cash flows to meet the needs and views of a variety of investors. The basic mortgage pass-throughs all have very similar cash-flow structures and performance characteristics. Discounts and premiums differ to some extent, but the overall investment patterns are quite similar. While the investment characteristics of these loans are similar, the needs of the investors vary significantly. The collateralized-mortgage obligation (CMO) has become the vehicle to transform mortgage cash flow into a variety of investment instruments. The driving force behind the creation of CMOs is arbitrage. CMOs will be created when the underwriter sees the ability to buy mortgage collateral, structure a CMO, and sell the CMO bonds for more than the price of the underlying collateral plus expenses. Because of the dynamic nature of arbitrage opportunities, the types of CMOs created will reflect current market conditions and can change significantly. If the end result of the cash flow structure were simply a rearrangement of cash flows, it would be difficult to create added value. ...

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