CMOs vs. Mortgage-Backed Securities: What's the Difference?

Collateralized Mortgage Obligation (CMO) vs. Mortgage-Backed Security (MBS): An Overview

Mortgage-backed securities (MBS) and collateralized mortgage obligations (CMO) are different types of asset-backed securities that use mortgage-backed securities as collateral. Securities are investments that trade on the secondary market. Collateralized mortgage obligations are one type of MBS, which are divided into tranches based on their risk classifications.

Key Takeaways

  • A collateralized mortgage obligation, or CMO, is a type of MBS in which mortgages are bundled together and sold as one investment, ordered by maturity and level of risk.
  • A mortgage-backed security, or an MBS, is a kind of asset-backed security that represents the amount of interest in a pool of mortgage loans.

Collateralized Mortgage Obligation

While "mortgage-backed security" is a broad term describing asset-backed securities, a collateralized mortgage obligation is a more specific class of mortgage-backed security. A CMO is one type of MBS that is divided into categories based on risk and maturity dates. A CMO involves pooling mortgages into a special purpose entity, from which different tranches of the securities are then sold to investors.

For example, one type of CMO tranche is the Z-tranche or accrual bond. This is one of the riskiest tranches of CMOs because it does not receive interest or payment until all of the other tranches are paid.

Some investors like investing in CMOs because they want to be able to have access to mortgage cash flows but not have to be responsible for originating or buying any actual mortgages. Hedge funds, banks, insurers, and mutual funds are among the biggest buyers of CMOs.

Collateralized mortgage obligations and mortgage-backed securities allow interested investors to financially benefit from the mortgage industry without having to buy or sell a home loan.

Mortgage-Backed Security

An MBS is a type of asset-backed security that represents the amount of interest in a pool of mortgage loans. For example, assume an investment bank buys mortgages from a mortgage broker, which lent property owners money. The investment bank has thus become a lender to these property owners and their mortgage payments go to the bank.

Then, the investment bank sets up a special purpose entity, or corporation, to hold the mortgages. The investment bank divides the special purpose entity into shares and begins to sell them to investors; the individual shares are known as MBS.