Issued by the government-sponsored enterprises (GSEs) Freddie Mac, Fannie Mae and Ginnie Mae, pass-through securities are generic 'to be announced' (TBA) forward contracts into which a dealer can sell a pool of mortgage-backed securities (MBS) so long as they meet pre-specified delivery requirements.
Remics and CMOs, however, are unique securities with unique sequential cashflow structures that do not have the same makeup as other securities of the same notional collateral value. Consequently their different price/yield characteristics mean they can't be substituted for one another.
As mark-to-market losses mounted on CMOs referencing subprime mortgages in late 2007 and 2008, investors fled the structured products market and the price for CMOs fell through the floor. By September 2008, the market for CMOs was virtually extinct.
The market for pass-through securities is thriving, however, due to the comparable contents and pricing of the generic assets, which has ensured that the market for them has remained liquid, encouraging the participation of investors keen to know that their portfolios can be precisely valued and (if necessary) rapidly liquidated.
As demand for pass-throughs surged along with their price, CMOs plunged, leaving investors hungry for a means of monetising as much of their CMO portfolios as possible. Years previously, a team of CMO specialists at Merrill Lynch had devised a way to release at least some of the value locked up within Remics, but their idea did not gain much traction until late 2008.
"Several years ago I approached Sifma with the idea but at that time there was no groundswell of support in the market-place at that point. When the market prices for CMOs began to fall dramatically below the prices of pass-through securities I realised the time for this idea had come. I contacted Fannie Mae, Freddie Mac and Sifma and we managed to get the restructuring plan passed within two months of first floating the idea," explained Brodie Johnson, a director in the CMO business at Merrill Lynch in New York.
Brodie realised that while only a relatively small portion of the $1.5 trillion CMO market was eligible to be converted into pass-through form, this amounted to approximately $200 billion. Of the assets that are convertible, Sifma stipulates that cashflows on new security must be identical to the casflows from the original Remic pools.
"The assets that are easy to recombine as pass-throughs are mortgage collateral that has been sliced into floaters and inverse floaters or seasoned issues, where a deal that started out with five cashflow classes but four of them have since paid off, meaning the one remaining class is equivalent to the mortgage collateral," explained Brodie.
As of January 15, Fannie Mae had $200 million of CMOs ready to convert in anticipation of the January 28 start date, according to Brodie, with the other GSEs expected to provide supplementary mortgage collateral for conversion over the course of the year.