CDO MBS

By: EconomyWatch Content   Date: 30 January 2010

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A Mortgage Backed Security (MBS) is a credit portfolio that is asset-backed or secured by mortgage(s). An MBS portfolio is created by government agencies, government-backed entities as well as private corporations, by purchasing mortgage loans from banks and other originators. Consequently, investing in MBSs equals lending money to home buyers; wherein the MBS originators act as middlemen between the home buyers and the investors.

A collateralized debt obligation (CDO) is similar to an MBS. However, while an MBS portfolio is created exclusively with mortgaged assets, a CDO can be constructed with different debt obligations, such as bonds and loans.  

Collateralized Mortgage Obligation: Underlying Component of CDO and MBS

Collateralized Mortgage Obligations (CMOs) are created with a pool of generic mortgage-backed securities or MBSs and fixed-rate mortgages, which are typically a component of CDOs. Thereby, CMOs act as a common ground between standard collateralized debt obligations and specific mortgage backed securities. 

CMOs were initially relatively simple instruments. However, over time, their structure has become extremely complex, with the incorporation of several tranches or classes within the same asset pool. Each tranche of a CMO has different principals, coupon rates, maturity dates and prepayment risks. 

Impact of CDO and MBS on Financial Markets

Collateralized mortgage obligations as well as mortgage-backed securities are highly sensitive to interest rate fluctuations as well as to changes in the home resale and refinance values. This makes investment in these securities extremely vulnerable to market and liquidity risks.

While investors as well as analysts assumed CDOs and MBSs to be diversified and, consequently, less risky, in reality, the different components of these portfolios are highly correlated than anticipated. This is because these portfolios are constructed with the same type of securities, wherein a downturn in one security market is likely to spill over to another.

In fact, CDOs and MBSs have been blamed for exacerbating the 2008 sub-prime crisis in the US, wherein several sub-prime (poor credit rating) individuals borrowed the full value of their property from banks and financial institutions. The mortgage lenders subsequently integrated these high-risk loans into Mortgage-Backed Security portfolios and sold off to investment banks, thereby reducing their default risk. The investment bankers very tactfully combined low grade MBSs with investment grade bonds and sold these packages (CDOs) in tranches to investors. This created a ripple effect through the global financial industry.


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