Define Collateralized Mortgage Obligation (CMO)

Collateralized Mortgage Obligation (CMO)

What Is a Collateralized Mortgage Obligation, and How Does It Work?

A collateralized mortgage obligation (CMO) is a mortgage-backed asset that consists of a group of mortgages that have been packaged together and offered as an investment. CMOs get cash flows as borrowers return the mortgages that serve as collateral on these securities, which are organised by maturity and risk category. CMOs, in turn, pay principal and interest to their investors according to preset regulations and agreements.

Collateralized Mortgage Obligations: What You Need to Know (CMO)

Collateralized mortgage obligations are made up of a number of tranches, or groupings of mortgages, that are grouped together according to their risk profiles. Tranches are complicated financial instruments with varying principal amounts, interest rates, maturity dates, and the possibility of repayment failures. Interest rate fluctuations, as well as changes in economic conditions such as foreclosure rates, refinancing rates, and the rates at which properties are sold, affect collateralized mortgage obligations. Bonds with monthly coupons are issued against each tranche, which has a separate maturity date and amount. The coupon is used to pay the principal and interest rate on a monthly basis.

TAKEAWAYS IMPORTANT

• Collateralized mortgage obligations (CMOs) are investment debt instruments made up of packaged mortgages arranged by risk profile.

• They're related to collateralized debt obligations, which are a bigger collection of debt obligations spread over a variety of financial instruments.

• CMOs grew in prominence during the 2008 financial crisis, when their size exploded.

Consider an investor that owns a CMO made up of thousands of mortgages. Their profit potential is determined by whether or not the mortgage holders return their loans. The investor recoups both principal and interest if just a few homeowners default on their mortgages while the remainder complete their payments on time. Alternatively, if

Thousands of customers are unable to make their mortgage payments and face foreclosure; as a result, the CMO loses money and is unable to pay the investor.

CMO investors, also known as Real Estate Mortgage Investment Conduits (REMICs), want access to mortgage cash flows without having to originate or acquire a set of mortgages.

Mortgage Obligations with Collateral vs. Debt Obligations with Collateral

Collateralized debt obligations (CDOs) are similar to CMOs in that they are made up of a number of loans that are packaged together and offered as an investment vehicle. CDOs, on the other hand, contain a variety of loans, including auto loans, credit cards, commercial loans, and even mortgages, whereas CMOs exclusively contain mortgages. CDOs and CMOs both peaked in 2007, right before the global financial crisis.

Following the financial crisis, their values plummeted. For example, the CDO market peaked in 2007 at $1.3 trillion, compared to $850 million in 2013.

Hedge funds, banks, insurance firms, and mutual funds are among the companies that buy CMOs.

The Global Financial Crisis and Collateralized Mortgage Obligations

CMOs, which were first issued in 1983 by Salomon Brothers and First Boston, were complicated and involved a variety of mortgages. For a variety of reasons, investors were more concerned with the revenue streams provided by CMOs than with the soundness of the underlying mortgages. As a result, numerous investors bought CMOs with subprime mortgages.

mortgages, adjustable-rate mortgages, mortgages owned by borrowers whose income was not confirmed throughout the application process, and other high-risk mortgages

The usage of CMOs has been blamed for contributing to the financial crisis of 2007-2008. Rising house prices made mortgages appear to be fail-safe investments, attracting investors to purchase CMOs and other MBSs. However, market and economic conditions resulted in an increase in foreclosures and payment risks that financial models failed to forecast.

Mortgage-backed securities have been more regulated as a result of the global financial crisis. In December 2016, the Securities and Exchange Commission (SEC) and the Financial Industry Regulatory Authority (FINRA) issued new rules to reduce the risk of these securities by establishing margin requirements for covered agency transactions, such as collateralized mortgage obligations.