What Are Collateralized Mortgage Obligations? How Do They Work?

CMOs are graded by risk, and some are far riskier than others. 

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What Are Collateralized Mortgage Obligations?

Collateralized Mortgage Obligations, or CMOs, are a type of mortgage-backed security. Thousands of individual mortgages are pooled together into classes, or tranches, and categorized by their risk level. 

CMOs are one way for traders to invest in residential mortgage loans, and they typically offer higher yields than Treasury securities. CMOs are traded on secondary markets—and we’ll discuss more about how to purchase them below.

It’s important to note that because CMOs depend on the cash flows generated by their underlying assets, they are vulnerable to interest rate fluctuations and other economic changes. For example, if homeowners fail to make their mortgage payments, the securitized assets become worthless.

“It’s important to note that because CMOs depend on the cash flows generated by their underlying assets, they are vulnerable to interest rate fluctuations and other economic changes.”

For these reasons, CMOs are also known as “pass-through securities” because they effectively serve as the conduit of payments from debtors to investors.

How Do CMOs Work?

Individual home loans are difficult to trade. That’s why banks or government-sponsored enterprises, like Ginnie Mae, group mortgage loans together. These loans are then securitized, which means they are turned into a more liquid financial vehicle that can be traded easily.

CMOs are complex instruments that could be made up of as many as 50 tranches. In French, the word “tranche” means slice, and each slice is investable.

A tranche consists of loans with similar characteristics, such as amount values. They are also categorized by the credit score of the homeowner. Credit ratings agencies, such as Standard & Poor’s, Fitch Ratings, and Moody’s assign each tranche a credit rating based on the credit risk of the underlying mortgage holders.

An AAA rating is the highest. It means the mortgage holder is capable of meeting all of its financial commitments. The lowest grade, D, means they are currently in default.

Senior vs. Junior Tranches

Senior tranches include Class A CMOs and have the lowest yields because their mortgages are usually A-rated. Investors in senior tranches usually get paid first.Junior tranches include Class B and Class C—they represent subprime mortgages. Investors in these tranches get paid last, although to offset the increased risk, the yields associated with these tranches are also the highest.

Most tranches contain interest and principal because homeowners typically pay down their loan by making monthly payments that are a combination of both. These payments usually contain greater amounts of interest in the early years of the loan. If a tranche is not yet receiving principal, that’s known as the “interest only” period.

If a homeowner decides to refinance their loan or buy a new home, their mortgage prepayments increase, which effectively shortens the life of the CMO. All of these different variables can have an impact on the yield that is offered per tranche.

CMO issuers actually designate the amount of principal and interest that will go into different tranches, and, for full transparency, they publish payment schedules in the CMO’s prospectus.

Are CMOs Backed by the U.S. Government?

Homeowner credit isn’t the only aspect of a CMO that is graded; the issuer is as well.

CMOs issued by Ginnie Mae, the Government National Mortgage Association, are backed by the “full faith and credit” of the U.S. government, which is virtually guaranteed never to default. For this reason, they receive the highest (AAA) credit rating, and their yields are typically the lowest.

Other government-sponsored enterprises, such as Fannie Mae, also issue CMOs, but they are not government-backed. Still other CMOs are created by private issuers and do not carry government backing.

When Did Collateralized Mortgage Obligations Begin?

The first CMO was created in 1983 by two investment banks, Salomon Brothers and First Boston, for Freddie Mac, the Federal Home Loan Mortgage Corporation. It was designed as a way to provide liquidity for home mortgage loans so they could be traded more easily.

Are Collateralized Mortgage Obligations the Same as Collateralized Debt Obligations?

Collateralized debt obligations (CDOs) are similar to CMOs in that they contain investable pools of loans. However, CMOs only contain mortgages, while within CDOs are packages of car loans, credit card loans, mortgages, and other commercial loans. Individual investors usually cannot invest in CDOs; rather, they are purchased by institutional investors, such as hedge funds and investment banks.

Why Have CMOs Been in the News?

During the Financial Crisis of 2007–2008, a new category of home loan, the subprime mortgage, was offered to homebuyers with less-than-perfect credit. These loans featured adjustable rates that increased every year after a low “teaser period,” or whenever prevailing interest rates changed.

During this timeframe, a bubble had formed in the housing market, artificially inflating home values. At the same time, the Federal Reserve began a series of Fed Funds Rate increases to quell inflationary pressures. It was a “perfect storm” of disaster for subprime borrowers: Rates skyrocketed, many borrowers became unable to make their loan payments, and some defaulted or entered foreclosure as a result.

This crisis caused a ripple effect throughout financial markets. As toxic debt imploded inside CMOs and rendered them worthless, mortgage lenders declared bankruptcy, government-sponsored enterprises like Fannie Mae and Freddie Mac teetered on the verge of insolvency, and global investment banks, like Lehman Brothers, collapsed.

The U.S. government needed to step in with emergency funding to prevent a total meltdown of the financial system. In 2008, the U.S. Congress approved a $700 billion “bailout bill,” while the Troubled Asset Relief Program (TARP) added billions more.

Stricter regulatory measures were added through the Dodd-Frank Wall Street Reform and Consumer Protection Act, prohibiting banks from investing in high-risk securities like CMOs. It also protected consumers from predatory lending practices. The Federal Reserve also slashed interest rates to zero and would keep them there for the next 6 years.

How Do Interest Rates Affect CMOs?

Just like with bonds, rising interest rates cause CMOs to lose value. That’s because interest rate increases affect both CMO valuations as well as the prepayments associated with their underlying mortgages. When mortgage prepayments become affected by interest rate changes, this, in turn, affects both the average life of the CMO, which is the timeframe the mortgage principal is expected to be outstanding, as well as its yield.

Where Can I Buy Collateralized Mortgage Obligations?

Individuals can invest in CMOs, but there is typically a $1,000 minimum. However, most CMOs are bought and traded by institutional investors, such as pension funds, insurance companies, and commercial and investment banks.

The CMO market is an over-the-counter market, which means that securities are bought and sold between dealers and investors. Online brokerages like Fidelity, Charles Schwab, and TD Ameritrade offer over-the-counter services.

CMOs can take up to a month after their trade date to settle because there is typically a delay associated with the interest and principal accrual periods. The collateral must also be assembled and deposited with a trustee, and any required reporting must be completed. CMOs that are traded on the secondary market usually settle within three business days.

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Union Capital Financial Group Ltd, registered in the British Virgin Islands, does not provide investment services inside the United States. The company only provides consulting, advisory and educational services.