Mortgage-backed securities (MBS) and collateralized debt obligations (CDOs) are technically two different financial instruments, though they share many features and frequently overlap. Both MBS and CDOs are fixed-income securities: They consist of a bundled group of individual assets—mainly various types of loans and other debt—that, bond-like, generate interest for investors. Their key difference lies in what these assets are. MBS, as their name implies, are made up of mortgages—home loans bought from the banks that issued them. In contrast, CDOs are much broader: They may contain corporate loans, auto loans, home equity loans, credit card receivables, royalties, leases, and, yes, mortgages. So, many MBS may be part of CDOs; depending on their structure, they may also qualify as CDOs.
- Not all mortgage-backed securities are collateralized debt obligations.
- A mortgage-backed security (MBS) is a bond-like investment that is made up of a bundle of home loans (mortgages), which pays interest to investors at a fixed rate.
- A collateralized debt obligation (CDO) is also a fixed-income security that pays interest based on a bundle of underlying debt; but this pool can include a much bigger variety of loans and types of debts. CDOs are divided and sold to investors in tranches, reflecting their degree of risk.
- A CDO may in fact include mortgage-backed securities in its holdings.
- The main overlap between the two lays in the collateralized mortgage obligation (CMO)—a type of MBS that is also a sort of specialized CDO. Like the MBS, it is based on mortgages; but like the CDO, it is divided and sold in tranches, based on the mortgages' maturities and risk factor.
What Is a Mortgage-Backed Security—MBS?
A mortgage-backed security (MBS) is created from the pooling of mortgages that a financial institution, like a bank or a thrift, owns. An investment bank or other financial institution will buy these debts and repackage them, after sorting them into categories such as residential or commercial. Each package becomes an MBS that can be purchased by investors. The mortgages properties act as collateral, providing backing for the security. Often, small regional banks sell their mortgages as a means of raising money to fund other mortgages or loans.
MBS notoriously played a key role in the subprime mortgage meltdown, and subsequent financial crisis, of 2007-08. Regulations and tighter standards resulted. In order to be sold on the markets today, an MBS must be issued by a government-sponsored enterprise (GSE) like Ginnie Mae (the Government National Mortgage Association), Fannie Mae (the Federal National Mortgage Association) or Freddie Mac (the Federal Home Loan Mortgage Corporation)—which have federal backing—or a private financial company. The mortgages must have originated from a regulated and authorized financial institution. And the MBS must have received one of the top two ratings issued by an accredited credit rating agency.
What Is a Collateralized Debt Obligation—CDO?
Collateralized debt obligations (CDOs) belong to yet a larger class of investments, called asset-backed securities (ABS). Although ABS—and thus CDOs—grew out of MBS, they are more varied and more complex in structure.
CDOs consist of a variety of loans and debt instruments. To create a CDO, investment banks gather cash flow-generating assets—such as mortgages, bonds, and other types of debt—and repackage them into discrete classes, or tranches, based on their level of credit risk. These tranches are sold in pieces to investors with the riskiest securities commanding higher rates of return. The best pieces of tranches—i.e., the highest-rated—are typically funded first, as they have less risk.
All CDOs are derivatives: Their value is derived from another underlying asset. These assets become the collateral if the loan defaults. One variation of CDO that can offer extremely high yields (but higher risk) to investors is the synthetic CDO. Unlike other CDOs, which typically invest in regular debt products such as bonds, mortgages, and loans, the synthetics generate income by investing in noncash derivatives such as credit default swaps (CDSs), options, and other contracts.
CDOs are created by securities firms and investment companies. They are usually sold to institutional investors.
Although investors in MBS and CDOs receive income from the underlying assets held by the security, they don't actually own the individual, securitized assets. This is why these instruments can be risky: Should the underlying debt go into default, and the income stream dry up, investors themselves have no collateral they can seize to compensate them. The entity that created the security can try to sue, though.
How CDOs and MBS Overlap
As mentioned earlier, mortgage loans—and in fact, MBS themselves—can be
used, along with other types of debts, in the creation of CDOs. Though it primarily depends on the underlying assets being securitized, CDOs tend to be riskier than MBS. Collateralized debt obligations are often created from low-grade mortgages (that is, ones credit agencies have rated as more likely to be defaulted on) as a means of spreading risk across multiple products and borrowers. CDOs played a significant role in the financial crisis of 2007-08 as well.
Along with CDOs that are based on MBS, there are certain types of MBS that are structured like CDOs. MBS come in two basic varieties: pass-throughs and collateralized mortgage obligations. Pass-throughs are structured as trusts in which mortgage payments are collected and passed through to investors; they typically have stated maturities of five, 15, or 30 years. Collateralized mortgage obligations (CMOs) consist of multiple pools of mortgages divided into slices, or tranches; each tranche is organized by maturity and level of risk, and sometimes even given a credit rating.
If this sounds a lot like a CDO—well, it is. A CMO is essentially a specialized CDO that only invests in mortgages. It's this type of mortgage-backed security that is the source of confusion between the two instruments, as the name is often used interchangeably with (not to mention sounds a lot like) collateralized debt obligation. And, it was this type of MBS that in particular caused problems in the subprime mortgage meltdown.