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.
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.
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.
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.
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.
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.
The aftermath of the global financial crisis resulted in increased regulations for mortgage-backed securities. Most recently, in December 2016, the SEC and FINRA introduced new regulations that mitigate the risk of these securities by creating margin requirements for covered agency transactions, including collateralized mortgage obligations.