Loading the player...

What is a 'Collateralized Mortgage Obligation - CMO'

Collateralized mortgage obligation (CMO) refers to a type of mortgage-backed security that contains a pool of mortgages bundled together and sold as an investment. Organized by maturity and level of risk, CMOs receive cash flows as borrowers repay the mortgages that act as collateral on these securities. In turn, CMOs distribute principal and interest payments to their investors based on predetermined rules and agreements.

BREAKING DOWN 'Collateralized Mortgage Obligation - CMO'

CMOs consist of several tranches, or groups of mortgages, organized by their risk profiles. As complex financial instruments, tranches typically have different principal balances, interest rates, maturity dates and potential of repayment defaults. CMOs are sensitive to interest rate changes as well as to changes in economic conditions, such as foreclosure rates, refinance rates and the rates at which properties are sold.

To illustrate, imagine an investor has a CMO made up of thousands of mortgages. His potential for profit is based on whether the mortgage holders repay their mortgages. If only a few homeowners default on their mortgages and the rest make payments as expected, the investor recoups his principal as well as interest. In contrast, if thousands of people cannot make their mortgage payments and go into foreclosure, the CMO loses money and cannot pay the investor.

Why Investors Use CMOs

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

Collateralized Mortgage Obligations Versus Collateralized Debt Obligations

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.

CMOS and the Global Financial Crisis

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.

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.

RELATED TERMS
  1. Real Estate Mortgage Investment ...

    A special purpose vehicle (SPV) that is used to pool mortgage ...
  2. Mortgage

    A debt instrument, secured by the collateral of specified real ...
  3. Second Mortgage

    A type of subordinate mortgage made while an original mortgage ...
  4. Calamity Call

    A call feature of a Collateralized Mortgage Obligation (CMO) ...
  5. Mortgage Rate

    The rate of interest charged on a mortgage. Mortgage rates are ...
  6. Primary Mortgage Market

    The market where borrowers and mortgage originators come together ...
Related Articles
  1. Personal Finance

    Behind the Scenes of Your Mortgage

    Four major players slice and dice your mortgage in the secondary market.
  2. Investing

    Understanding Collateralized Mortgage Obligations

    A collateralized mortgage obligation (CMO) is a security consisting of a pool of mortgages organized by maturity and risk.
  3. Personal Finance

    Understanding the Mortgage Payment Structure

    We explain the calculation and payment process as well as the amortization schedule of home loans.
  4. Personal Finance

    Shopping for a mortgage in 2016? Use this tool first.

    As home-buying technology has progressed, the process of finding the best mortgages rates for 2016 can all be done online.
  5. Personal Finance

    Shopping for a mortgage in 2016? Use this tool first.

    As home-buying technology has progressed, the process of finding the best mortgages rates for 2016 can all be done online.
  6. Insights

    How Interest Rates Affect the Housing Market

    Understand how rate changes can affect home prices and learn how you can keep up.
  7. Personal Finance

    Why Are Mortgage Rates Increasing?

    Learn how the secondary mortgage market and investor demand affect the cost of home ownership.
  8. Personal Finance

    Comparing Reverse Mortgages vs. Forward Mortgages

    Which one a homeowner chooses depends on where you are at this point in your life, personally and financially.
  9. Retirement

    Additional Streams of Income for Seniors

    Find out how a reverse mortgage can work in your favor during retirement.
  10. Financial Advisor

    Reverse Mortgages: Right for Clients? Not Often

    Reverse mortgages are a legitimate vehicle for folks age 62 and up to tap into the equity in their homes for other uses. Here's what to consider with them.
RELATED FAQS
  1. Were collateralized mortgage obligations (CMOs) responsible for the financial crisis ...

    Learn how collateralized mortgage obligations helped to fuel the 2008 financial crisis, and see how many failed to understand ... Read Answer >>
  2. Can small investors buy collateralized mortgage obligations (CMOs)?

    Read about collateralized mortgage obligations and their relationship with small investors, plus what risks small investors ... Read Answer >>
  3. What is the difference between a collateralized mortgage obligation (CMO) and a collateralized ...

    Both collateralized mortgage obligations (CMOs) and collateralized bond obligations (CBOs) are similar in that investors ... Read Answer >>
  4. What's the difference between a collateralized mortgage obligation (CMO) and a mortgage-backed ...

    Find out more about collateralized mortgage obligations and mortgage-backed securities and the difference between the two ... Read Answer >>
  5. What are the pros and cons of a simple-interest mortgage?

    Learn the difference between a simple interest mortgage and a standard mortgage, along with their relative advantages and ... Read Answer >>
  6. What's the difference between a collateralized debt obligation (CDO) and a collateralized ...

    Find out how a collateralized mortgage obligation (CMO) is similar to a collateralized debt obligation (CDO), as well as ... Read Answer >>
Trading Center