Collateral mortgage security (CMS) is a type of asset-backed security (ABS) backed by a pool of residential mortgage loans.
How CMS Works:
- Origination: CMS is created when a financial institution originates a pool of residential mortgage loans. These loans are typically conforming loans, meaning they meet the underwriting standards of Fannie Mae and Freddie Mac.
- Securitization: The loans are then packaged together and sold to a special purpose entity (SPE). The SPE issues CMS securities to investors, which represent ownership in the pool of loans.
- Payment Structure: Investors receive regular interest payments from the SPE, which are derived from the interest payments made by the borrowers on the underlying mortgage loans.
- Collateral: The mortgage loans themselves serve as collateral for the CMS securities. This means that if borrowers default on their loans, investors in the CMS securities could lose some or all of their investment.
Types of CMS:
There are different types of CMS securities, each with its own risk and return profile. Some common types include:
- Pass-through certificates: These securities pay investors a portion of the interest and principal payments received from the underlying mortgage loans.
- Collateralized mortgage obligations (CMOs): These securities are structured to create different tranches of CMS with varying levels of risk and return. Some tranches may be more senior, meaning they have a higher priority for receiving payments.
- Mortgage-backed bonds (MBBs): These securities are similar to CMS, but they are typically issued by government-sponsored enterprises (GSEs) like Fannie Mae and Freddie Mac.
Advantages of CMS:
- Diversification: Investing in CMS allows investors to diversify their portfolios by gaining exposure to a large pool of mortgage loans.
- Regular Income: CMS securities typically provide investors with regular interest payments.
- Liquidity: CMS securities are generally considered to be more liquid than other types of fixed-income securities.
Disadvantages of CMS:
- Interest Rate Risk: CMS securities are sensitive to changes in interest rates. If interest rates rise, the value of CMS securities may decline.
- Credit Risk: There is a risk that borrowers may default on their mortgage loans, which could result in investors losing some or all of their investment.
- Prepayment Risk: Borrowers may prepay their mortgages, which can reduce the cash flow received by investors in CMS securities.
Examples of CMS:
- Fannie Mae MBS: Fannie Mae issues a variety of mortgage-backed securities, including CMS.
- Freddie Mac MBS: Freddie Mac also issues mortgage-backed securities, including CMS.
- Private Label MBS: These are CMS securities that are issued by private institutions, rather than GSEs.
Conclusion:
Collateral mortgage security (CMS) is a type of asset-backed security backed by a pool of residential mortgage loans. CMS offers investors a way to gain exposure to the mortgage market, but it is important to understand the risks involved before investing.
