Skip to content
All library documents

How Mortgage IO/PO Securities Differ from CMO Strips

Article Quant Q&A · Author: Anonymous
Read the original

Summary

The document distinguishes stripped mortgage-backed securities with interest-only and principal-only classes from IO or PO classes created inside a collateralized mortgage obligation. In the former structure, a mega pool issues paired classes that may, subject to conditions and fees, be exchanged for the underlying pass-through securities. That connection historically supported liquidity and made the securities useful for taking or hedging prepayment risk, including in TBA trading.

A CMO strip generally lacks an exchangeable companion, so it tends to be less liquid and harder to short. It is more often held as a standalone investment and may be further structured, for example as an inverse IO. The answer says traditional SMBS trading had largely stopped, describes an IOS market that later diminished amid capital constraints, and notes that CMO structured IO trading remained active. These are market-history observations, not current liquidity data or a pricing model.

Key ideas

  • Paired SMBS IO and PO classes could be exchanged for underlying pass-throughs under specified conditions and fees.
  • The exchange feature supported liquidity and use in managing prepayment exposure.
  • CMO IO or PO classes usually lack an exchangeable companion and tend to be less liquid.
  • CMO strips are commonly standalone investments and may be difficult to short.
  • CMO interest-only cash flows can be further structured into forms such as inverse IOs.

Tags

Fixed incomeOptionsRisk managementMarket microstructure
Full text
# what is the difference between Interest-only/Principal-only securities and CMO strips?


# what is the difference between Interest-only/Principal-only securities and CMO strips?












In the definition available here

It seems that both

- Interest-only/principal-only securities.

- Collateralized Mortgage Obligation Strips.

are types of Stripped Mortgage-Backed Securities (SMBS). However, it seems that somehow the first is also known by mortgage strips. While the second in the same webpage is defined by

One of the classes in a CMO structure can be a principal-only or an interest-only class. These are called CMO strips or structured IOs.

It seems to me that they are both the same or designed for the same purpose. What is the difference between both and why are they considered a different type of SMBS?

## Answer by Sharad (score 2)

https://quant.stackexchange.com/a/58176

To understand the distinction, it is useful to briefly review how Stripped MBSs (SMBSs) were created. We combine a number of pass-through pools to create a Mega pool which then (loosely speaking) issues an SMBS certificate with an IO and PO class. The crucial point here is that the IO and PO class can be combined and exchanged for the underlying pass-throughs based on certain conditions and fees. This feature substantially added to the liquidity of the IO and PO because the MBS pass-through market is one of the most liquid fixed income markets in the world.

On the other hand, an IO (or PO) structured as a CMO class has no such "companion" and consequently is typically much less liquid.

The two markets were created for very different reasons: the IO/PO (SMBS) market allowed you to go long or short prepayment risk in various coupons and could be used to hedge prepayment risk in TBA trades. On the other hand, the IO (or PO) class of a CMO is a byproduct of the structuring process and is usually purchased as a standalone investment; it is not easy to short this class. It is worth noting that is quite rare to see a "pure" IO class in a CMO, the interest-only cash flows are usually further structured to create an Inverse IO etc.

I use the word "were" in the first sentence above because SMBSs have stopped trading for the past several years. The SMBS market was replaced by the IOS market which was, among other things, a little more balance-sheet friendly, but that market too has more or less vanished due to some of the capital constraints introduced by Basel III.

Trading the structured IO classes from a CMO remains fairly active.

Shown in full with attribution under the source's licence. Licence: CC BY-SA 4.0 (Stack Exchange)

This summary was written by Stratmill's research agent from the original; it is not a copy of the source.