• What are Collateralized Mortgage Obligations
• The Basic CMO Structure
• Who Invests in CMOs?
• Benefits
• Risks
• Tax Treatment of CMOs
• Other Definitions Relating to OID

What are Collateralized Mortgage Obligations?

Collateralized Mortgage Obligations (CMOs) are one of the most innovative investment vehicles available today, offering regular payments, relative safety, and notable yield advantages over other fixed-income securities of comparable credit quality.

The Basic CMO Structure

The process begins when mortgage collateral (FNMA, FHLMC or GNMA) is placed into a protective trust structure. The trust maintains the credit quality of the CMO by protecting the integrity of the collateral underlying the bond. In other words, the trust maintains the collateral exclusively for the benefit of the tranche holders. For instance, even if mortgage prepayments drop to zero, the collateral in the trust is sufficient to pay off all tranches that were issued. The protective trust structure is one of the reasons why, in most cases, CMOs are able to attain a 'AAA' rating.

From the trust, several different classes of bonds with various maturities and coupon rates are issued. In one of the most basic structures, known as a 'plain vanilla' structure, the different tranches are retired sequentially by targeting all principal returns from the underlying collateral to only one tranche at a time. For example, if the CMO has four tranches, A, B, C and Z, all scheduled interest is paid to tranches A, B and C with all principal being paid only to tranche A. This process continues until tranches A, B, and C are retired. At that point, the Z-tranche, which receives no interest or principal until the other classes are retired, will then begin to pay both principal and interest to the holders of this issue on a monthly basis until it also is fully retired.

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Who Invests in CMOs?

Although Collateralized Mortgage Obligations were originally designed to meet the investment needs of institutional investors, the individual investor has quickly become one of the most important participants in the CMO market. Individual investors have been drawn to this dynamic market by its diversity and attractive returns. The unique tranche structure offers investors a wide variety of coupons and maturities.

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Benefits

• Credit QualityThe high quality of the collateral (GNMA, FNMA and FHLMC), along with the protective structure of the trust, enables these securities to generally carry the highest investment grade credit rating awarded (AAA).
• YieldCMOs offer investors attractive yield premiums over Treasury, Agency and even some Corporate bonds.
• Maturity StructureThe very nature of the CMO structure is to carve out different tranches from straight collateral in order to provide a variety of effective maturities to investors. This nature of the CMO structure offers investors a multitude of maturity ranges, as well as a variety of coupon rates.
• Unique StructuresSince CMOs include a variety of tranches in one series, investors have the benefit of choosing from a wide range of tranche types.
• Payment FrequencyMost CMO tranches provide investors with monthly interest payments. Additionally, principal payments are returned on a monthly basis over the life of the security. Since most other fixed income investments (Treasuries, Agencies, and Corporates) offer only semi-annual payments of interest, income-oriented investors can benefit from the more frequent cash flows of CMOs.
• Event RiskSince CMOs are essentially free from default risk, they are also free from events that cause price fluctuations in the corporate world, e.g. LBOs, corporate restructurings, takeovers and credit downgrades, just to name a few&#middot;

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Risks

• Prepayment RiskChanges in prepayment rates of the underlying collateral will impact the average life and return of a CMO tranche. While some types of tranches will help protect against extension and/or contraction risk, prepayment risk can never be completely eliminated.
• Liquidity RiskAs stated earlier, CMOs are created by 'carving up' the underlying mortgage collateral. As tranches are created to meet specific investor needs, liquidity may suffer. However, the sheer size of the CMO market helps to alleviate liquidity problems.
• Interest Rate RiskJust as with any fixed income security, CMOs bear exposure to changes in interest rates. The inverse relationship between the level of interest rates and the value of a security holds true for CMOs. That is, as interest rates rise, the value of the CMO will tend to decrease. Accrual tranches, like Z-bonds, tend to have the greatest interest rate risk exposure.
• Spread RiskJust as with other fixed income investments, the spread margin between CMOs and comparable treasuries can vary. This means that, even if the treasury market were unchanged, if spreads between CMOs and treasuries widened, the market value of the CMO will decline. The reverse is also true.

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Tax Treatment of CMOs

Introduction

The following explanation, although not in detail, was written to assist in understanding where to report the supplied tax information on your individual tax return. We will also attempt to explain the impact of the payment delay on reported income and the classifications of ordinary income as original issue discount (OID).

The IRS requires that holders of REMIC interest must include accrued interest and any accrued OID as part of their current income even if the holders have not received any cash. This process of reporting is referred to as 'accrual basis.' All amounts required to be reported on a holder's individual tax return have been reported on the corrected Consolidated Form 1099 (e.g., line 1, part 1 of Schedule B-form 1040) if you report more than $400 taxable interest income from all sources during the year or otherwise required.

Payment Delay Defects

Payment delay on mortgages occur when there is a difference between the time the interest is earned and the time it is actually paid by the REMIC. This difference represents the amount of interest accrued and usually occurs only in the year of acquisition and reverses itself in the year sold. As a result of the payment delay, the security holder is earning interest but must wait through the payment delay period before they receive that income. The timing difference will cause a discrepancy between the income received by the investor and the income reported on the 1099. Consider the following illustration.

• Timing Difference Between Interest 'Earned' and Interest 'Received' Year 1: An investor purchases $100M of a CMO with a 7.50% coupon on 9/30/97. There is a 30-day pass-through delay on the security. The following chart will show the difference between the interest 'earned' and interest 'received' at the end of the first year.

  Period	Interest Earned*	Interest Received*
  09/30-10/31	$ 625.00	$ 0.00
  10/31-11/30	$ 625.00	$ 625.00
  10/31-11/30	$ 625.00	$ 625.00
  Total	$1,875.00	$1,250.00

As you can see, the investor has earned more interest than received (i.e., $1,875 accrued versus $1,250 received). Keep in mind that even though the investor will pay taxes based on the interest earned, this process will reverse if the security is sold.

• The Effects of the Sale of a CMO

  Year 3: The same investor sells their CMO investment on March 31, 1996. The following table will show the effects of the sale and what needs to be reported.

As illustrated, the investor received more than needed to be reported for tax purposes ($2,500 versus $1,875). Therefore, the only difference between using the accrual basis and the cash basis is one of timing.

• Original Issue Discount

OID is considered the difference between the bond's issue price and the stated redemption price at maturity. For instance, if a bond was issued at a discount to par (e.g., at a price of $99.25 instead of $100) equaling $9,925 for a par value of $10,000, the bond would have an OID of $75.00 ($10,000 - $9,925) and would be considered an OID bond. OID is included in income and is allocated over the life of the instrument through adjustments to the issue price of each accrual period. A constant yield method is used to compute the OID on a bond.

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Other Definitions Relating to OID

Qualified Stated Interest (QSI)QSI is generally coupon interest that is paid every period and is based on a fixed or variable coupon rate.

Adjusted Issue Price (AIP)The original issue price plus all OID included in taxable income by all previous holders, reduced by any payments made on the bond other than Qualified States Interest (i.e., prepayments of principal). AIP can be found on the supplemental statement received with the Corrected Consolidated Form 1099 in the year of purchase.

Accrual PeriodAn accrual period is the time interval over which the accrual of OID is measured. The accrual period will not be longer than one year.

Purchase of CMOs in the Secondary Market

If an investor purchased a CMO in the secondary market, it is most likely that it was either purchased at a market discount or acquisition premium to the original issue price. Once this is determined, an investor should adjust the amount of OID income which is reportable. If an issue was purchased at its original price, the entire amount of income and OID on the 1099 must be reported.

• Acquisition PremiumIf an investor purchases a CMO in the secondary market for more than its Adjusted Issue Price* (see definitions). The excess (difference) between the purchase price and the AIP is called the acquisition premium, which can be used to reduce an OID currently included in income. Consider the following example:

Example of acquisition premium: On 5/1/92, an 8.00% CMO was originally issued at a price of $93.500 and paid income on a monthly basis with a projected average life of 10 years and a yield-to-maturity upon issuance of 9%. Assuming no prepayment of principal, $100,000 face value of the CMO provides monthly payments of $667.67.

If an investor purchased the $100,000 worth of this CMO in the secondary market on 4/30/97 for $96.500 or $96,500, the adjusted issue price at the time of purchase would be $93,924.34. This amount would appear as the 'Beginning Adjusted Issue Price (per 1000),' or in this case $93,924.34, on the supplemental statement with the Corrected Consolidated Form 1099 in the year of purchase. (The adjusted issue price should be kept on hand for use in calculating OID for future income tax returns. We strongly recommend that an investor consult their tax advisor for assistance in determining how to calculate the amortization of acquisition premium.)

Market Discount

If an investor purchases a CMO in the secondary market for less than its Adjusted Issue Price* (see definition above), the purchase price is reported on the original confirmation and the AIP appears on the supplemental statement on the Corrected Consolidated Form 1099 in the year of purchase. A market discount usually occurs when interest rates rise. If this occurs, the resulting market discount may need to be reported as market discount income. It is only considered 'required' if it is significant enough. That means that if the market discount is less than one-fourth of 1% (.0025) of the redemption value at maturity multiplied by the number of full years to maturity as of the date of acquisition (e.g., $100,000 x 9 yrs. Average life x .0025 = $2.250), the investor may choose not to report the accrued market discount income as taxable income. If the investor opts not to report the accrued market discount income as taxable income, upon sale of the CMO, a portion of any gain must be reclassified as interest income to the extent of the accrued market discount (i.e., all current and previously accrued market discount). Once again, we strongly recommend that an investor consult their tax advisor for assistance in determining how to calculate the amortization of acquisition premium.

Sale of a CMO

The sale of a CMO generally results in a capital gain or loss which is reflected on Schedule D of the Form 1040 for the year in which the sale occurred. The long- or short-term determination will depend upon the length of time the CMO was held.

• Sale of an OID CMO-- The portion of the gain that is attributed to OID, which wasn't previously reported by the holder, must be reported as interest income with remaining amount of OID, if any, as a capital gain.
• Sale of a Market Discount CMO-If the investor chooses not to report the market discount until the sale of the security, a portion of any gain must be recognized as interest income to the extent of the total accrued market discount which was not previously included as taxable income. The remainder of the gain, once the total market discount is deducted, is considered a capital gain.

  Special Note: This information is meant to better acquaint the reader with CMOs. The information contained herein is based upon sources we believe to be reliable, however, its accuracy is not guaranteed by UBS PaineWebber, Inc. Please consult your tax advisor for assistance in determining the tax consequences of a particular CMO investment.