Level 1 CFA® Exam:
CMOs & CMBS

Last updated: January 04, 2023

CFA Exam: Collateralized Mortgage Obligations (CMOs)

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CMOs - Introduction

Collateralized mortgage obligations (CMOs) are created when the cash flows of mortgage pass-through securities or pools of loans are redistributed to different bond classes (tranches).

Because different institutional investors have a different appetite for different forms of prepayment risk (extension risk or contraction risk), creating different bond classes (tranches) allows us to meet their expectations.

It’s very important to remember that creating CMOs doesn’t eliminate prepayment risk but redistributes it to different investors.

CMOs Structures

CMOs structures that you should know in your level 1 exam include:

  • sequential-pay CMOs,
  • Planned Amortized Class (PAC) and support tranches,
  • other CMOs structures (e.g. tranches with a floating rate).

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CFA Exam: Commercial Mortgage-Backed Securities (CMBS)

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Commercial mortgage-backed securities (CMBS) are backed by a pool of commercial mortgage loans on income-producing properties. Note that loans that are used as collateral for CMBS are usually balloon loans with high principal repayments at maturity.

Credit Risk of Commercial Mortgages

The credit risk of commercial mortgages is relatively big because usually, commercial mortgages are non-recourse loans. Thus, the lender foreclosing on the loan doesn’t have the right to require that the borrower pays the difference (shortfall) between the PV of outstanding loan payments (the outstanding mortgage balance) and the amount of money the lender received from selling the property.

Two important credit performance measures are:

  • Debt-Service-Coverage Ratio (DSC, DSCR),
  • Loan-To-Value Ratio (LTV).

The greater the debt-service-coverage ratio (DSC, DSCR), which is defined as the ratio of the net operating income (NOI) to the debt service (interest payments plus principal repayments), the better for CMBS investors.

The lower the loan-to-value ratio (LTV), the better for CMBS investors.

CMBS Structure

Credit tranching (subordination) is often used to distribute credit risk among investors.

If defaults on the loans (from collateral) occur, the losses are charged against the outstanding principal balance of the equity tranche first. The equity tranche is also called the residual tranche or the first-loss piece. Generally, equity tranches are not rated by credit-rating agencies.

Call Protection

One thing that largely distinguishes CMBS from RMBS is call protection (thus, lower prepayment risk).

The call protection is available on 2 levels:

  • loan level, and
  • structure level.

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Level 1 CFA Exam Takeaways: CMOs & CMBS

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  1. Collateralized mortgage obligations (CMOs) are created when the cash flows of mortgage pass-through securities or pools of loans are redistributed to different bond classes (tranches).
  2. In sequential-pay CMOs, each bond class is retired sequentially.
  3. PAC tranches protect investors against prepayment risk (both extension and contraction risk).
  4. Commercial mortgage-backed securities (CMBS) are backed by a pool of commercial mortgage loans on income-producing properties.
  5. The credit risk of commercial mortgages is relatively big because usually, commercial mortgages are non-recourse loans.
  6. Credit performance measures include: Debt-Service-Coverage Ratio (DSC, DSCR) and Loan-To-Value Ratio (LTV).
  7. Credit tranching (subordination) is often used to distribute credit risk among investors.
  8. One thing that largely distinguishes CMBS from RMBS is the call protection for CMBS.
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