What is a Collateralized Mortgage Obligation (CMO)?
A collateralized mortgage obligation (CMO) is a type of mortgage-backed security constructed by pooling multiple mortgages into one investment. This investment is organized by maturity and risk levels. As mortgage borrowers make their payments, the cash flows from these mortgages serve as collateral and are distributed to investors according to predefined rules.
Delving into Collateralized Mortgage Obligations (CMO)
CMOs are structured into various tranches, or groups, based on their risk profiles. These tranches are complex financial tools that may vary in principal balances, interest rates, maturity dates, and the likelihood of default. The value of CMOs can be highly sensitive to changes in interest rates and economic conditions, such as foreclosure rates, the frequency of refinancing, and property sale rates. Monthly coupon bonds are issued against these tranches, which then facilitate monthly principal and interest payments to investors.
Key Takeaways
- CMOs are investment debt securities comprised of packaged mortgages sorted by risk profiles.
- They resemble Collateralized Debt Obligations (CDOs) but are specific to mortgages rather than a broader range of loans.
- CMOs were significant contributors to the 2008 financial crisis owing to their complexity and risk profiles.
An Illustrative Example
Imagine an investor holding a CMO comprised of thousands of mortgages. Their profit potential depends on the mortgage holders’ ability to repay. If only a few homeowners default but the majority continue paying on time, the investor benefits from both principal and interest. Conversely, if a substantial number of homeowners default and go into foreclosure, the CMO incurs losses, and the investor might not recover their principal or gain interest.
Investment Strategy with CMOs
Investors, often referred to as obtaining Real Estate Mortgage Investment Conduits (REMICs), leverage CMOs to access mortgage cash flows without needing to originate or acquire a set pool of mortgages.
Distinguishing CMOs from CDOs
Although both CMOs and Collateralized Debt Obligations (CDOs) involve pooling and selling loans as investments, CMOs exclusively contain mortgages, whereas CDOs can include diverse forms of debt including car loans, credit card debt, commercial loans, and mortgages. Both financial entities hit peaks before the 2007 financial crisis — for instance, the CDO market was valued at $1.3 trillion in 2007, dropping to $850 million by 2013.
Investment firms such as hedge funds, banks, insurance companies, and mutual funds commonly purchase CMOs.
The Role of CMOs in the Global Financial Crisis
First issued by Salomon Brothers and First Boston in 1983, CMOs were intricate and loaded with various mortgage types. The attractive income streams often distracted investors from scrutinizing the underlying mortgage health. This lack of diligence led to large investments in CMOs filled with subprime, adjustable-rate, and other high-risk mortgages. As a result, the surge in foreclosures during the 2007-2008 financial crisis precipitated widespread CMO and mortgage-backed security failures.
The catastrophic fallout led to enhanced regulations. Notably, in December 2016, the SEC and FINRA rolled out new regulations to attenuate these risks, including creating margin requirements for collateralized mortgage obligations.
Related Terms: mortgage-backed securities, tranches, interest rates, default risk.
