What Is a Collateralized Mortgage Obligation?
Let me explain what a collateralized mortgage obligation, or CMO, really is. It's a type of mortgage-backed security made up of a pool of bundled mortgages that we sell as an investment. We organize them by maturity and risk level, and they provide cash flows from the repayments on those underlying mortgages. As an investor, you receive principal and interest payments based on predetermined agreements, but remember, the complex structure makes these sensitive to changes in interest rates and economic conditions.
Key Takeaways
- A collateralized mortgage obligation (CMO) is a type of mortgage-backed security that organizes mortgages based on maturity and risk levels.
- CMOs consist of tranches, which are categorized by risk profiles, maturity dates, and interest rates.
- Investors in CMOs receive principal and interest payments influenced by the repayment behavior of the underlying mortgages.
- During the 2008 financial crisis, CMOs gained notoriety due to their ties with subprime mortgages.
- The risks associated with CMOs have prompted regulatory changes to mitigate potential financial instability.
How Collateralized Mortgage Obligations Operate
Collateralized mortgage obligations consist of several tranches, or groups of mortgages, organized by their risk profiles. These tranches usually have different principal balances, interest rates, maturity dates, and risks of repayment defaults. You need to know that CMOs are sensitive to interest rate and economic changes, like foreclosure and refinance rates, and property sale rates. Each tranche has a different maturity date and size, and we issue bonds with monthly coupons for them. The coupon makes monthly principal and interest rate payments.
Imagine you're an investor with a CMO of thousands of mortgages. Your profit depends on whether the mortgages are repaid. If only a few homeowners default but most pay as expected, you recover both principal and interest. In contrast, if thousands of people cannot make their mortgage payments and go into foreclosure, the CMO loses money and cannot pay you.
Investors in CMOs, sometimes referred to as Real Estate Mortgage Investment Conduits (REMICs), want to obtain access to mortgage cash flows without having to originate or purchase a set of mortgages.
Comparing CMOs and CDOs: Key Differences and Similarities
Like CMOs, collateralized debt obligations (CDOs) consist of a group of loans bundled together and sold as an investment vehicle. However, whereas CMOs only contain mortgages, CDOs contain a range of loans such as car loans, credit cards, commercial loans, and even mortgages. Both CDOs and CMOs peaked in 2007 just before the global financial crisis, and their values fell sharply after that time. For example, at its peak in 2007, the CDO market was worth $1.3 trillion, compared to $850 million in 2013.
The Role of CMOs in the 2008 Financial Crisis
First issued by Salomon Brothers and First Boston in 1983, CMOs were complex and involved many different mortgages. For many reasons, investors were more likely to focus on the income streams offered by CMOs rather than the health of the underlying mortgages themselves. As a result, many investors purchased CMOs full of subprime mortgages, adjustable-rate mortgages, mortgages held by borrowers whose income wasn't verified during the application process, and other risky mortgages with high risks of default.
The use of CMOs has been criticized as a precipitating factor in the 2007-2008 financial crisis. Rising housing prices made mortgages look like fail-proof investments, enticing investors to buy CMOs and other MBSs, but market and economic conditions led to a rise in foreclosures and payment risks that financial models did not accurately predict. The aftermath of the global financial crisis resulted in increased regulations for mortgage-backed securities. Most recently, in December 2016, the SEC and FINRA introduced new regulations that mitigate the risk of these securities by creating margin requirements for covered agency transactions, including collateralized mortgage obligations.
The Bottom Line
Collateralized mortgage obligations (CMOs) are complex financial instruments that bundle mortgages into investment securities, organized by risk and maturity. As an investor, you should be mindful of their sensitivity to interest rate fluctuations and economic changes, which can significantly impact returns.
Despite their popularity and role in the 2008 financial crisis, CMOs offer a structured way to invest in mortgage flows, yet caution is advised due to the risk of default, especially in volatile markets. Always consider consulting a financial professional before engaging in investments involving CMOs or similar securities.
Other articles for you
Financial inclusion aims to make financial services accessible and affordable to underserved populations to promote economic participation and growth.
Asset-based lending uses business assets as collateral to secure loans for short-term cash flow needs.
A pledged asset is collateral used to secure a loan, allowing borrowers to reduce down payments and interest rates while retaining ownership.
A loan participation note is a financial instrument allowing investors to share in loans issued by banks or credit unions, distributing risks and payments proportionally.
The secondary market is where investors trade securities among themselves after initial issuance in the primary market, providing liquidity and price discovery.
Value investing focuses on buying undervalued stocks based on their intrinsic worth for long-term profits.
A cash flow statement details a company's cash inflows and outflows from operations, investing, and financing activities over a period.
Hacktivism combines hacking with activism to target computer systems for social or political causes.
A bond quote gives the current market price and essential details like coupon rate and maturity date for bonds.
Restricted stock units (RSUs) are a form of employee compensation where stock shares are granted after meeting vesting conditions, providing value upon vesting but subject to taxes.