What is a Collateralized Mortgage Obligation (CMO)?

The meaning of Collateralized Mortgage Obligation (CMO) refers to a type of financial instrument that pools together mortgages and then sells them to investors as a single security. This security is called a CMO. The mortgages that are pooled together are called the "collateral" of the CMO, and the income generated from the CMO comes from the interest and/or payments on the underlying mortgages.

CMOs were popular in the US before the 2008 financial crisis, but the way they were structured and sold contributed to the crisis. They were created by taking a large pool of mortgages, slicing them into different tranches, and selling them to investors. Each tranche had a different level of risk and a different payment priority. The higher-quality tranches, known as "senior tranches" had lower risk, but also lower returns, while the lower-quality tranches, known as "subordinate tranches" had higher risk, but also higher returns.

When housing prices started to decline in the early 2000s, many homeowners began to default on their mortgages. This caused the value of the mortgages in the CMOs to decline, which in turn caused the value of the CMOs to decline. Because the subordinate tranches had more risk, they were hit harder by the decline in housing prices, which meant that many investors in these tranches lost a significant amount of money.

Simplified Example

A collateralized mortgage obligation (CMO) is a type of investment that is created from a pool of mortgage loans. It works by grouping together a large number of mortgages and then using the payments from those mortgages to create different investment tranches. These tranches have different levels of risk and reward, with some being more risky but offering higher returns, and others being less risky but with lower returns.

One analogy to explain CMOs is to imagine a big basket of apples. Each apple in the basket represents a mortgage loan, and the basket as a whole represents the pool of mortgage loans that are used to create the CMO. Now imagine that you take some of the apples out of the basket and put them in a smaller basket, and label that smaller basket "risky". These apples represent the mortgages that are more likely to default, but that also offer higher returns. Then you take some more apples out of the big basket and put them in another smaller basket, which you label "less risky". These apples represent the mortgages that are less likely to default, but that offer lower returns.

Finally, you have two baskets with different levels of risk and reward, and you can sell these baskets to investors. The investors who buy the "risky" basket will receive higher returns, but they are also taking on more risk because the mortgages in that basket are more likely to default. The investors who buy the "less risky" basket will receive lower returns, but they are also taking on less risk because the mortgages in that basket are less likely to default. The CMO issuer uses the payments from the mortgage loans to pay the investors in each basket, based on the terms of the investment tranches.

History of the Term Collateralized Mortgage Obligation (CMO)

In the early 1980s, mortgage-backed securities (MBSs) were the primary way for investors to participate in the mortgage market. However, these single-tranche MBSs had limitations, including limited diversification and sensitivity to interest rate fluctuations. To address these shortcomings, Salomon Brothers and First Boston, two leading investment banks, collaborated with Freddie Mac to develop collateralized mortgage obligations (CMOs).

The CMO market experienced rapid growth in the 1980s and 1990s, fueled by the increasing popularity of mortgage-backed securities. However, CMOs also played a role in the subprime mortgage crisis of the early 2000s. The crisis stemmed from the excessive issuance of subprime mortgages, high-risk loans that were given to borrowers with poor credit histories.

As subprime borrowers defaulted on their loans in increasing numbers, the value of CMOs plummeted, causing significant losses for investors. The subprime mortgage crisis highlighted the inherent risks of CMOs and the importance of careful risk management.

Despite the challenges of the subprime mortgage crisis, CMOs have continued to evolve and play a role in the mortgage market. Modern CMOs have incorporated safeguards to address the issues that led to the crisis, and investors now have access to a wider range of CMO products with varying risk profiles.

Examples

Government National Mortgage Association (Ginnie Mae) CMOs: These CMOs are created by Ginnie Mae, a government agency that guarantees mortgage-backed securities (MBS) issued by approved lenders. The CMOs are backed by pools of mortgages insured or guaranteed by the Federal Housing Administration (FHA), the Department of Veterans Affairs (VA), or the Rural Housing Service (RHS).

Freddie Mac and Fannie Mae CMOs: Freddie Mac and Fannie Mae are two government-sponsored enterprises (GSEs) that buy and securitize mortgages. They create CMOs by pooling together mortgages with similar characteristics, such as interest rates and maturities. The CMOs are sold to investors, who receive interest and principal payments based on the performance of the underlying mortgages.

Private-label CMOs: These CMOs are created by investment banks and other financial institutions, rather than government agencies or GSEs. They are backed by pools of mortgages that do not meet the criteria for government-backed MBS or GSE securitization. Private-label CMOs can be much riskier than government-backed CMOs, as they often include subprime or non-performing mortgages. During the financial crisis of 2008, many private-label CMOs suffered significant losses and contributed to the collapse of several large financial institutions.

Related terms

• Collateral: Collateral is an asset or property that a borrower pledges to a lender as security for a loan or other financial obligation.

• Exchange-Traded Fund (ETF): An Exchange-Traded Fund (ETF) is a type of security that tracks the performance of a particular market, such as stocks, bonds, commodities, or a combination of assets.