Mortgage Cash Flow Obligation (MCFO)

What Is a Mortgage Cash Flow Obligation (MCFO)?

A mortgage cash flow obligation (MCFO) is a type of mortgage pass-through unsecured general obligation bond that has several classes or tranches. MCFOs use cash flow from a pool of mortgages that generate revenue to repay investors their principal plus interest. Payments are received from mortgages in the pool and passed on to holders of the MCFO security.

Understanding Mortgage Cash Flow Obligation (MCFO)

Mortgage cash flow obligations (MCFOs) look like collateralized mortgage obligations (CMOs) in certain regards, yet they are not something similar. MCFOs don't hold a lien on the mortgages held by the security. They are just committed by contract to utilize the income from the mortgages to pay their investors. MCFO owners have no legal rights to the genuine underlying mortgages, subsequently MCFOs are riskier than CMOs.

Like CMOs, MCFOs are a form of mortgage-backed security made through the securitization of individual residential mortgages that draw interest and principal payments from that specific pool of mortgages. Since they don't hold similar legal protections as CMOs, MCFOs ordinarily offer investors higher coupon rates.

Risks and Structure of Mortgage Cash Flow Obligations

Like CMOs, MCFOs package mortgages into bunches with various payment qualities and risk profiles called tranches. The tranches are paid back with mortgage principal and interest payments in a predetermined order, with the highest rated tranches accompanying credit enhancement, which is a form of protection against prepayment risk and repayment default. MCFO performance is subject to changes in interest rates as well as foreclosure rates, refinance rates and the pace of home sales.

The stated maturities of MCFO tranches are resolved in light of the date when the last principal from a pool of mortgages is expected to be paid off. However, maturity dates for these types of MBS don't consider prepayments of the underlying mortgage loans and hence may not be an accurate representation of MBS risks. Most mortgage pass-through securities are collateralized by 30-year fixed-rate mortgages, however prepayments due to home sales or refinancings make many loans be paid off before.

CMOs, MCFOs and other non-office mortgage-backed securities - those mortgage bonds not backed by the government-sponsored undertakings Fannie Mae, Freddie Mac or Ginnie Mae - were at the center of the financial crisis that prompted the bankruptcy of Lehman Brothers in 2008 and brought about trillions of dollars in losses on mortgage loans and a great many homeowners losing their homes to default.

Following the financial crisis, government agencies moved forward their regulation of mortgage-backed securities and forced lenders to increase the transparency of subprime loans and the qualifying standards to get such mortgages. In December 2016, the SEC and FINRA announced new guidelines to hose MBS risk with margin requirements for CMO and related MBS transactions.