What's the difference between a collateralized debt obligation (CDO) and a collateralized mortgage obligation (CMO)?

A collateralized mortgage obligation, or CMO, is a type of mortgage-backed security (MBS) issued by an lender that handles home mortgages. A collateralized debt obligation, or CDO, is sometimes backed by residential mortgage-based securities, but it can also be backed by commercial mortgage-backed securities, bonds, bank loans or just about any other financial instrument.

To create a CMO, a mortgage lender, investment bank subsidiary or some other financial institution pools groups of home loans with similar characteristics into a security that can be sold. However, the risk to the purchaser of a CMO can be affected by factors such as fluctuating interest rates, prepayments and credit risk.

If interest rates go up, the market value of most kinds of CMO tranches drops in proportion to the time remaining to maturity. By extending the life of the CMO, rising rates can cause the investor's principal to be committed for longer than expected.

One concept behind the CDO is to lower total costs of investing by appealing to investors with different investment horizons. Instruments with various amounts of credit quality are grouped into three or more tranches, each with the same maturity. The senior tranches offer the best credit quality but also the lowest yield. The mezzanine tranches have somewhat lower credit quality but a higher yield. The equity tranches are the riskiest, but they also pay the highest yield, almost invariably more than 10%. Financial professionals can resell the high yield, low-credit equity tranches while spreading the risk over a wider pool of investments.

However, the more complicated structure of CDOs makes them harder for investors to analyze. CDOs are bought primarily by life insurance companies, hedge funds and other institutions that are willing to take some risk in hopes of outperforming Treasury yields.

The added risk of the equity tranches does bring higher returns when the economy is strong, but when the economy slows or mortgage defaults increase, greater losses tend to occur. In addition, some CDO structures use leverage and credit derivatives that make it very risky to invest in even the senior tranches.