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A collateralized mortgage obligation (CMO) is a security consisting of a pool of mortgages organized by maturity and risk. Technically, the CMO is a special-purpose entity that owns and administers the mortgage loans by receiving the homeowners’ mortgage payments, and then passing those payments on to the various investors in the CMO. The investors don’t own the CMO directly, but rather, own bonds issued by the CMO. Typically, the minimum bond price of a CMO is $1,000.

The mortgages underlying the CMO serve as collateral securing the mortgage debt. These mortgages are arranged into different pools (called tranches) by maturity and the risk profile of the homeowners.  At creation, the CMO sets a very explicit set of rules for how interest and principal payments are to be distributed among the various tranches. The rules are listed in the CMO’s prospectus.

Investors purchase bonds in the CMO that represent cash streams from the different tranches.  Some tranches are riskier than others, so investors pick bonds according to their risk tolerance and investment needs.  For instance, one tranche may represent principal payments from the first two or three years of the mortgages underlying the CMO.  This tranche would be less risky than one representing the mortgage principal payments for years 12 through 15 of the underlying mortgages.

Due to the volatile nature of mortgage interest and principal payments, CMO’s are very complex and often have very complicated payout rules.

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