Financial Markets and Institutions (2-downloads)

participation certificates

(PCs). Freddie Mac pools are distinct from Ginnie Mae pools in that they contain con-

ventional (nonguaranteed) mortgages, are not federally insured, contain mortgages

with different rates, are larger (ranging up to several hundred million dollars), and

have a minimum denomination of $100,000.

One innovation in the FHLMC pass-through market has been the collateralized

mortgage obligation (CMO). CMOs are securities classified by when prepayment

is likely to occur. These differ from traditional mortgage-backed securities in that they

are offered in different maturity groups. These securities help reduce prepayment

risk, which is a problem with other types of pass-through securities.

CMOs backed by a particular mortgage pool are divided into tranches (French

for “slices”). When principal is repaid, the investors in the first tranche are paid

first, then those in the second tranche, and so on. Investors choose a tranche that

matches their maturity requirements. For example, if they will need cash from their

investment in a few years, they purchase tranche 1 or 2 CMOs. If they want the invest-

ment to be long-term, they can purchase CMOs from the last tranche.

Even when an investor purchases a CMO, there are no guarantees about how long

the investment will last. If interest rates fall significantly, many borrowers will pay off

their mortgages early by refinancing at lower rates.

Real estate mortgage investment conduits (REMICs) were authorized by the

1986 Tax Reform Act to allow originators to pass through all interest payments tax

free. Only their legal and tax consequences distinguish REMICs from CMOs.

Private Pass-Throughs (PIPs)

In addition to the agency pass-throughs, interme-

diaries in the private sector have offered privately issued pass-through securities. The

first of these PIPs was offered by BankAmerica in 1977.

One mortgage market opportunity available to private institutions is for mort-

gages larger than the maximum size set by the government. These so-called jumbo

mortgages are often bundled into pools to back private pass-throughs.

Subprime Mortgages and CDOs