By John Vermillion
In the constantly evolving world of financial products, there has been a notable increase in collateralized mortgage obligations issuance over the past few years. CMO issuance has experienced considerable fluctuations since 2019, with a noticeable upward trend beginning in late 2022. The trend in CMO issuance is a product of the economic environment, particularly the high interest rate environment driven by the Federal Reserve’s fight to bring inflation to their 2 percent target.
What are CMOs?
Before exploring the recent rise in CMO issuance, it’s important to consider what CMOs are, and how their structure appeals to a broad spectrum of investors. A CMOs is a type of mortgage-backed security that divides a pool of mortgage loans into tranches, or slices. Each tranche is organized with different levels of risk, return and maturity. CMO issuance typically gets placed into one of these five buckets that allows CMOs to cater to different investment appetites:
- Fixed tranches. These offer predictable payments, making them ideal for conservative investors seeking stability.
- Floating rate tranches. Pegged to interest rate indexes, these tranches appeal to investors looking to hedge against interest rate fluctuations.
- Zero-coupon tranches. These do not pay interest until maturity, suiting long-term investors focused on significant growth over time.
- Variable tranches. Combining features of both fixed and floating tranches, these provide a balanced option for investors.
- Equity tranches. These are the riskiest tranches and they are the first to absorb losses if the underlying mortgage defaults. However, equity tranches offer the highest potential returns to compensate for the higher risk of holding this tranche.
The intricate structuring of CMOs ensures they can be tailored to meet specific investment goals, enhancing their versatility in the financial markets. Given the current economic environment and market sentiment, an instrument with predictable streams of cash is very preferable, and we see in large part that fixed tranche are driving a large portion of total CMO issuance since the start of the Fed’s tightening cycle in 2022. Since floating rate CMOs offer interest payments that adjust according to interest rates, as interest rates rise, payments from floating rate tranches also increase. As a result of increased payments from increased rates, floating rate CMOs are attractive to investors seeking protection from interest rate risk. While zero coupon tranches have not been utilized as much recently as their counterparts, they can be an important tool for investors to match long term liabilities. Equity tranches, despite their elevated risk, may provide investors with substantial yield and may appeal to investors seeking to maximize potential yield.
Impact of interest rates on prepayments
The rise in CMO issuance since late 2022 can be attributed to the Federal Reserve’s restrictive policy stance. Higher interest rates directly impact mortgage prepayments. When interest rates are low, homeowners are more likely to refinance their mortgages, leading to higher prepayment rates. Conversely, in a high-interest-rate environment like the current one, refinancing activity decreases, resulting in lower prepayment rates. A product of the high-rate environment, 2022 HMDA Data show a 72.8% percent decrease in standard one-to-four family property refis.
How do prepayments affect CMO issuance?
Lower prepayment rates enhance the attractiveness of CMOs. Lower prepayment rates mean that principal payments for different tranches are received at a steady rate over time. Thus, investors gain more predictable cash flows as the likelihood of early repayment is reduced. The predictability of cash flows generated from CMOs are highly valued, especially in uncertain economic times. The notable upward trend in CMO issuance observed from late 2022 onward, as depicted in the graph, aligns with the most recent tightening from the Federal Reserve.
The data on CMO issuance from 2019 to the present clearly indicate a rising trend from late 2022 onwards. This increase can be linked to the high-interest-rate environment that reduces prepayment rates, stabilizing cash flows, thereby making CMOs more attractive to investors. Understanding the structure and appeal of CMOs sheds light on the fact that these complex financial instruments continue to be a popular choice among a diverse class of investors.
John Vermillion is an economic policy research associate at ABA.
