CMO: Collateralized Mortgage Obligations

By: EconomyWatch Content   Date: 2 February 2010

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CMO or Collateralized Mortgage Obligations are types of asset backed securities that represent claims to cash flows arising from large pools of home mortgages. CMOs are issued under a complicated deal structure, wherein the principal and the interests received from the mortgage holders are distributed amongst the various classes or tranches. The principal amount, the coupon rate, the prepayment risk, and the maturity date may differ amongst the various tranches.

Collateralized Mortgage Obligations: Purpose and Investors

First created in June 1983 by the investment banks Saloman Brothers and First Boston for Freddie Mac, CMOs addressed the issue of creating various types of bonds from the same mortgage loan.

The CMO issuers assembles a package of the mortgage pass through securities or the mortgage loans and uses them as collateral for multi class security offering. The different tranches of the security offered receive payments according to a pre-defined set of rules set to meet different investment objectives. Bonds issued by CMOs are generally purchased by banks, hedge funds, insurance companies, pension funds, mutual funds, government agencies and even central banks. CMOs are highly sensitive to changes in interest rates and any resulting change in the rate which can have an impact on the sale, refinance or prepayment decisions of homeowners. Investors in CMOs face prepayment risk, besides exposure to significant market and liquidity risks.

The simplest form of CMO structure involves sequential payment of the principal to the various tranche holders. However, several complex structures of CMOs have been introduced in recent years.

Agency vs Privately Issued CMOs

Securities guaranteed, or guaranteed and issued Freddie Mac, Fannie Mae, Ginnie Mae and the Department of Veteran Affairs are known as “agency” mortgage securities. The agency guarantees enhance their credit quality for investors. These agencies offer a guarantee regarding the timely payment of principal and interest on the mortgage securities, whether or not the payments have been actually collected from the borrowers.

Privately issued CMOs are issued by the subsidiaries of investment banks, financial institutions and home builders. The collateral of securities issued by these companies may include agency mortgage pass-through securities, different or specialized types of mortgage loans or mortgage loan pools, letters of credit, or other types of credit enhancements. Private-label CMOs are assigned credit ratings by independent credit agencies based on their structure, issuer, collateral and any guarantees or outside factors.


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