Collateralized mortgage obligations are investments that contain home mortgages. These mortgages underlie the securities themselves. These CMO yields and results derive from the home mortgage loans’ performance on which they are based. This is true with other mortgage backed securities as well.
Lenders sell these loans to an intermediary firm. Such an intermediary pools these loans together and issues certificates based on them. Investors are able to buy these certificates to earn the principal and interest payments from the mortgages. The payments these homeowners make go through the intermediary firm before finally reaching the investors who bought them.
The performance of collateralized mortgage obligations depends on the track record of the mortgage payers. What makes them different from other types of mortgage backed securities is that it is not only a single loan on which they are based. Rather they are categorized by groups of loans according to the payment period for the mortgages within the pool itself.
Issuers set up CMOs this way to try to reduce the effects of a mortgage being prepaid. This can often be a problem for investments based on only a single mortgage as owners refinance their loans and pay off the initial one on which the investment was based. With the CMOs, the risk of home owners defaulting is spread across a number of different mortgages and shared by many investors.
Tranches are the different categories within the mortgage pools on which the collateralized mortgage obligations are based. The tranches are often divided according to the mortgage repayment schedules of the loans. For each tranche, the issuer creates bonds with different interest rates and maturity dates. These CMO bonds can come with maturity dates of twenty, ten, five, and two years. The bondholders of each individual tranche receive the coupon or interest payments out of the mortgage pool. Principal payments accrue initially to those bonds in the first tranche which mature soonest.
The bonds on collateralized mortgage obligations turn out to be highly rated. This is especially the case when they are backed by GSE government mortgages and similar types of high grade loans. This means that the risk of default is low compared with other mortgage backed securities.
There are three types of groups who issue these CMOs. The FHLMC Federal Home Loan Mortgage Corporation issues many of them. Other GSE Government Sponsored Enterprises like Ginnie Mae provide them as well. There are also private companies which issue these CMOs. Many investors consider the ones issued by the government agencies to be less risky, but this is not necessarily the case. The government is not required to bail out the GSEs and their CMOs.
There are investors who choose to hold their CMO bonds until they mature. Others will re-sell or buy them using the secondary market. The prices for these investments on this market go up and down based on any changes in the interest rates.
The other most common type of mortgage backed securities besides these CMOs are pass through securities. Pass throughs are usually based on a single or few mortgages set up like a trust that collects and passes through the interest and principal repayments.
The term 'Collateralized Mortgage Obligation (CMO)' is included in the Banking edition of the Financial Dictionary. You can get your copy on amazon in Kindle or Paperback version. See more details here.