Clean-Up Call
What it is:
A clean-up call, also known as a calamity call, is a feature of a collateralized mortgage obligation (CMO) that requires the issuer to pay off a portion of the CMO if the underlying mortgages don't generate enough cash to make the principal and interest payments on the CMOs.
How it works (Example):
Let's say Company XYZ has issued $450 million of CMOs that have principal and interest payments of $2 million per month. CMOs are bonds that are backed by a pool of underlying mortgages. The interest and principal payments toward those mortgages become the interest and principal payments that go to the CMOs.
If several of the homeowners suddenly default on their mortgages or prepay their mortgages (by selling their houses before the mortgage is paid off), the CMO issuer might find itself unable to make those $2 million monthly payments to its holders. In this situation, a clean-up call may require the CMO issuer to pay off a portion of the CMOs.
Why it Matters:
Clean-up calls sound calamitous, but really they are a form of protection against default for buyers of CMOs. They also reduce the issuer's reinvestment risk.
