Collateralized Mortgage Obligation - Explained
What is a Collateralized Mortgage Obligation?
Written by J. Mance Gordon
Updated at April 23rd, 2024
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What is a Collateralized Mortgage Obligation?
A collateralized mortgage obligation (CMO) is structured security or mortgage-backed security that contains a set of mortgages structured and traded as an investment. A CMO is fixed income security that is designed based on the level of risks and maturity of the mortgages. Similar to other structured securities, CMOs are sold to investors in tranches, each tranche with a varying degree of risk and maturity. The cash inflow realized when mortgage borrowers make repayments serve as collateral for CMOs, the cash flows are in turn distributed as interests to investors.
How Does a Collateralized Mortgage Obligation Work?
A collateralized mortgage obligation (CMO) is regarded as complex debt security that is made of different groups of mortgages repackaged and sold to investors as financial products. The mortgages in a CMO are grouped in line with their level of risks and maturity. CMOs are offered in tranches, each tranche has a distinct interest rate, maturity date, and principal balance. Generally, CMOs are affected by market changes and changes in economic conditions such as changes in interest rate, foreclosure rates, refinancing rates, among others. Primarily, investors receive interest payments when mortgage holders make payments, this means when there is a default by mortgage holders, interest payment and rate can also be affected. As complex debt securities, CMOs were first issued in 1983, they were sold to investors who are interested in generating cash flow from mortgages without having to purchase any mortgage. CMOS can be purchased by individual investors or organizations, these investors are commonly called Real Estate Mortgage Investment Conduits (REMIC). Oftentimes, CMO investors are carried away by the return they would generate from the investment and pay little or no attention to the risks involved. This led to an increase in the purchase of risky mortgages by many investors. Examples of corporate organizations that purchase CMOs are banks, insurance companies, mutual funds, and hedge funds.