Collateralized Mortgage Obligation - CMO

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DEFINITION of 'Collateralized Mortgage Obligation - CMO'

A type of mortgage-backed security in which principal repayments are organized according to their maturities and into different classes based on risk. A collateralized mortgage obligation is a special purpose entity that receives the mortgage repayments and owns the mortgages it receives cash flows from (called a pool). The mortgages serve as collateral, and are organized into classes based on their risk profile. Income received from the mortgages is passed to investors based on a predetermined set of rules, and investors receive money based on the specific slice of mortgages invested in (called a tranche).

INVESTOPEDIA EXPLAINS 'Collateralized Mortgage Obligation - CMO'

Collateralized mortgage obligations are complex financial instruments. Each CMO tranche can have different principal balances, interest rates, maturities and repayment risks. They are sensitive to interest rate changes as well as changes in economic conditions, such as foreclosure rates, refinance rates and the rate at which properties are sold.

Investors in CMOs look to obtain access to mortgage cash flows without having to originate or purchase a set of mortgages themselves. Organizations that purchase collateralized mortgage obligations include hedge funds, banks, insurance companies and mutual funds.

The use of collateralized debt, such as collateralized mortgage obligations and collateralized debt obligations, has been criticized as a precipitating factor in the 2007-2008 financial crisis. Rising housing prices made mortgages look like attractive investments, but market and economic conditions led to a rise in foreclosures and payment risks that financial models did not accurately predict. Because CMOs were complex and involved many different mortgages, investors were more likely to focus on income streams rather than the health of the underlying mortgages themselves.

The first CMO was created by two banks, Salomon Brothers and First Boston, for Freddie Mac in 1983. 

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