CMO Primer: An update for the age of the floater

Research evidence excerpt

CMO Primer: An update for the age of the floater

r of any need to master the credit risk of the asset. Each tranche is also tradable

as an individual security with its own CUSIP, maturity, coupon, and other traditional

features.

III. The Process of Creating a CMO

Because of the range of possible structures and the ready availability of pass-throughs,

few markets match agency CMOs in customizing cash flows to individual portfolio

needs. In corporate bonds, the issuer often determines the timing of a bond issuance and

most of its features. Most features of an agency CMO—timing, collateral, and structure

—can change to meet investor needs, although change can incur costs in the form of

price, yield, liquidity, or their combinations.

A CMO usually comes out of an ongoing dialogue between structurers and a range of

current and potential investors. Investors reflect their changing preferences to CMO

structuring desks to see about the possibility of creating a new class tailored to the

investor’s needs. A structurer also needs to estimate where it can sell the cash flows left

over after creating a class to meet a particular investor’s needs, helped along by the

presence of secondary markets for these securities. After all, customizing the features of

one class can affect a range of other classes. If customizing one class impairs the pricing

of others, then the structuring desk will need to charge the inquiring investor to

compensate for the possible losses on other classes.

A structuring desk also keeps a careful eye of the price of pass-throughs, the raw

material for creating a CMO. If the price of a pass-through rises or falls without any

change in the market price of certain CMO classes, then the economics of creating a

new class may change dramatically.