A mortgage-backed security, or MBS, and a collateralized mortgage obligation, or CMO, are different types of asset-backed securities that use mortgage-backed securities as collateral. Collateralized mortgage obligations are one type of MBS, which are divided into tranches based on their risk classifications.
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. Therefore, the investment bank has 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 shares are known as MBS.
While an MBS is a broad term describing asset-backed securities, a CMO is a more specific class of a 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, where 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.