Login

Collateralized Mortgage Obligations (CMOs)

Instructor: Chang Park

Chang has taught college Finance & Accounting courses and has a terminal degree in Finance.

In this lesson, you will learn about a type of complex security called the collateralized mortgage obligation (CMO). A collateralized mortgage obligation is a type of security that uses mortgage backed security as collateral, hence the name of collateralized mortgage obligation.

Overview

Sub-prime mortgage and the collateralized mortgage obligations (CMOs) that packaged them were singled out for precipitating the financial crisis of 2008.

What is a collateralized mortgage obligation (CMO) that bundles these sub-prime mortgages? It is the product of financial engineering that transforms a group of illiquid financial assets into a security. For instance, there are special bonds backed by financial receivables such as credit card receivables, auto loans, leases and home-equity loans.

These are called asset backed securities (ABS). This special debt market is relatively new but expanding fast. When a pool of residential mortgages are used in the place of these other financial receivables, this particular asset backed security (ABS) is called a mortgage backed security (MBS). Finally, a type of mortgage backed security (MBS) is called a collateralized mortgage obligation when the mortgage backed security (MBS) is divided into portions of the debt based on maturity and/or risks of the pool.

Mechanics of a Collateralized Mortgage Obligation (CMO)

Firstly, an investment bank buys mortgages from retail mortgage banks and brokers, that originated residential mortgage loans to the property owners.Then, different slices of IOUs are sold by the investment bank to satisfy different tastes of risk/return combination of investors. Investors (banks, hedge funds, pension funds, insurance companies, mutual funds, and governmental agencies including central banks) in a collateralized mortgage obligation (CMO) buy these IOUs to receive payments from the income generated by the pool of underlying home mortgages.

Types of CMOs

In accordance to pre-defined and complicated rules, a collateralized mortgage obligation (CMO) pools and re-directs the payments of principal and interest from large pools of home mortgages to different types and maturities of CMOs. These different types of collateralized mortgage obligations (CMOs) are known as tranches. This French word tranche means a portion of money. Each type of a collateralized mortgage obligation (CMO) may have different principal balances, coupon rates, maturity dates, and other details of the rights and risks of ownership of any bonds.

The most simple form of CMO is composed of classes that are retired in a strict sequence. In other words, all the outstanding classes of collateralized mortgage obligation (CMO) receive regular interest payments, but principal payments are made to the first class exclusively until it gets paid fully. This is called Sequential Pay.

There also are more complicated types such as Planned Amortization Class, Targeted Amortization Class, Companion Tranches, Principal-Only, Interest-Only, Floating-Rate, etc. that are all beyond the scope of this lesson.

History of CMOs

A collateralized mortgage obligation (CMO) was first created in 1983 by two investment banks (Salomon Brothers and First Boston) for the U.S. Federal Home Loan Mortgage Corporation whose main function is to provide liquidity for the U.S. home mortgage loans. The value of CMOs peaked in 2007 just before the global financial crisis.

The CMOs were singled out in the mass media for starting the global financial crisis in 2008. Even though the underlying mortgages went bad rapidly, investors for whatever reasons got fixated on the income streams generated by the CMOs instead. Rating agencies and other esoteric financial models failed to pick up increasing foreclosure and payment default rates in the middle of rising housing prices.

Risks of CMOs

When Freddie Mac guaranteed the payment of principal and interest on the underlying pool of mortgages in 1983, the collateralized mortgage obligation (CMO) posed essentially no credit risk. This was true since government agencies such as Fannie Mae, Freddie Mac, or Ginnie Mae, at least implicitly, have the full backing of the US Government. Investors took prepayment, interest, market and liquidity risks, however, for which they were compensated with higher yields.

To unlock this lesson you must be a Study.com Member.
Create your account

Register for a free trial

Are you a student or a teacher?
I am a teacher
What is your educational goal?
 Back

Unlock Your Education

See for yourself why 10 million people use Study.com

Become a Study.com member and start learning now.
Become a Member  Back

Earning College Credit

Did you know… We have over 95 college courses that prepare you to earn credit by exam that is accepted by over 2,000 colleges and universities. You can test out of the first two years of college and save thousands off your degree. Anyone can earn credit-by-exam regardless of age or education level.

To learn more, visit our Earning Credit Page

Create an account to start this course today
Try it free for 5 days!
Create An Account
Support