What Is a Collateralized Mortgage Obligation (CMO)?

What Is a Collateralized Mortgage Obligation?

A collateralized mortgage obligation (CMO) is a type of mortgage-backed security that contains a pool of mortgages bundled and sold as an investment. CMOs receive cash flows as borrowers repay the mortgages that act as collateral. They distribute principal and interest payments to investors based on predetermined rules and agreements.

Understanding Collateralized Mortgage Obligations (CMO)

Collateralized mortgage obligations consist of several tranches, or groups of mortgages, organized by risk profiles. Tranches have different principal balances, interest rates, maturity dates, and potential repayment defaults. CMOs are sensitive to interest rate and economic changes, such as foreclosure rates, refinance rates, and property sale rates. Each tranche has a different maturity date and size, and bonds with monthly coupons are issued against it, making monthly principal and interest rate payments.

Key Takeaways

• Collateralized mortgage obligations are investment debt securities consisting of packaged mortgages organized by risk profiles.
• They are similar to collateralized debt obligations, which are a broader collection of debt obligations across multiple financial instruments.
• CMOs played a prominent role during the 2008 financial crisis.

Imagine an investor with a CMO made up of thousands of mortgages. Their profit potential depends on the repayments of the mortgage holders. If only a few homeowners default and the rest make expected payments, the investor recoups principal and interest. However, if thousands of people cannot make mortgage payments and go into foreclosure, the CMO loses money and cannot pay the investor.

Investors in CMOs, sometimes referred to as Real Estate Mortgage Investment Conduits (REMICs), want access to mortgage cash flows without originating or purchasing mortgages.

Collateralized Mortgage Obligations vs. Collateralized Debt Obligations

CDOs, like CMOs, consist of loans bundled and sold as investments. However, while CMOs only contain mortgages, CDOs include a range of loans such as car loans, credit cards, commercial loans, and mortgages. Both types peaked in 2007 before the global financial crisis, and their values fell sharply after that time. For example, the CDO market was worth $1.3 trillion at its peak in 2007, compared to $850 million in 2013.

Organizations that purchase CMOs include hedge funds, banks, insurance companies, and mutual funds.

Collateralized Mortgage Obligations and the Global Financial Crisis

First issued in 1983 by Salomon Brothers and First Boston, CMOs were complex and included many different mortgages. Investors focused on the income streams offered by CMOs rather than the health of the underlying mortgages. As a result, many investors purchased CMOs full of risky mortgages with high default risks.

The use of CMOs has been criticized as a factor in the 2007-2008 financial crisis. Rising housing prices made mortgages appear fail-proof, enticing investors to buy CMOs and other mortgage-backed securities. However, market and economic conditions led to a rise in foreclosures and payment risks that financial models did not accurately predict. Regulations for mortgage-backed securities have increased since the crisis. In December 2016, the SEC and FINRA introduced new regulations that mitigate risk by creating margin requirements for covered agency transactions, including collateralized mortgage obligations.

The use of CMOs has been criticized as a factor in the 2007-2008 financial crisis. Rising housing prices made mortgages appear fail-proof, enticing investors to buy CMOs and other mortgage-backed securities. However, market and economic conditions led to a rise in foreclosures and payment risks that financial models did not accurately predict. Regulations for mortgage-backed securities have increased since the crisis. In December 2016, the SEC and FINRA introduced new regulations that mitigate risk by creating margin requirements for covered agency transactions, including collateralized mortgage obligations.