collateralized mortgage backed securities

collateralized mortgage backed securities (CMBS)

Derivative investments created by aggregating mortgage loans into pools and then selling interests,much like bonds,which entitle owners to payments over time until the debt is finally retired. (Note: Commercial mortgage backed securities, a specialized type of collateralized mortgage backed securities, are also known as CMBSs.) The concept is best understood by reference to the various parties involved:

• A loan originator, such as a commercial bank, mortgage banker, or insurance company originates mortgage loans.
• An investment bank acts as an intermediary and sponsors the conduit by purchasing the commercial mortgage loans and warehousing them until they are ready to be converted to securities.
• A rating agency rates the underlying mortgages as AAA, AA, A, BBB, and so on down to CCC, with AAA to BBB being classified as investment-grade and BB downward classified as below investment grade.
• The same investment bank previously mentioned now separates the mortgages into tranches, or classes, of bonds depending on their ratings. The tranches are then offered for sale as securities backed by the entire mortgage pool. One might buy investment-grade tranches, but they are backed by all the loans, not just the investment-grade loans.
• Investors purchase the securities. Investment-grade tranches are usually purchased by insurance companies, pension funds, mutual funds, money managers, and commercial banks. Below-investment-grade tranches are sold to real estate investment funds or CMBS servicing entities.
• A servicer collects mortgage payments, monitors delinquencies and defaults, engages in workout procedures or initiates foreclosure, and handles all accounting and reporting, paying over monies periodically to the trustee for distribution to the investors.
• The trustee, who represents the trust that holds legal title to the mortgages for the benefit of the certificate holders, pays out money to investors according to the terms of their securities. The most common arrangement is the “waterfall” payment, in which class A bond holders receive principal and interest payments in the early years, while class B and class C holders will receive only interest. After a fairly short predetermined period of time, the class A bond holders will have been paid in full, and their bonds will be retired. At that point, the class B holders will begin to receive principal in addition to interest, but the class C holders will still receive only interest. When class B holders have been paid in full, class C holders will begin receiving principal payments. As a result, the class C holders will suffer if there are significant defaults and not enough money to pay everyone in full. For that   reason, class C holders generally receive a higher return on their investment.