Commercial Mortgage-Backed Security (CMBS)
What it is:
How it works (Example):
A CMBS is comprised of numerous commercial mortgages of varying terms and values, such as multi-family dwellings, commercial real estate, etc. Unlike a residential mortgage-backed security (RMBS), a CMBS offers reduced pre-payment risk, since the term on commercial mortgages is generally fixed.
Investors who hold a CMBS receive, as payment, the interest and principal repayments on these mortgages. Therefore, investors principally take on the borrower's risk of default (non-repayment). Unlike residential mortgage-backed securities, however, a CMBS does not present pre-payment risk to the holder, since commercial mortgage loans are set at a fixed term.
Similar to collateralized mortgage obligation mortgage obligations (CMO), the mortgages that back the securities are classified into tranches of risk. This allows investors to purchase a CMBS that fits their risk preference. Higher tranches (usually designated as A) have a higher rate of return because they receive both interest and principal payments, but also have a greater amount of risk (if the borrower can't make the payments, the investor gets nothing). Lower tranches (usually designated as B, C, or even D) carry lower risk at a lower rate of return because they absorb only interest payments on mortgages with shorter terms to repayment.
Why it Matters:
A CMBS presents a reduced-risk alternative to a RMBS, since prepayment risk is nearly eliminated. Moreover, the CMBS is a way for lending institutions to reduce risk and increase lending power by packaging outstanding debt receivables, such as mortgages, into potentially profitable securities that can be purchased by investors.