Collateralized Mortgage Obligations: Defined And Explained
Lauren Bowling5-minute read
September 17, 2021
Collateralized mortgage obligations (CMOs) are a type of passive real estate investment and also a type of mortgage-backed security, also known as an MBS. For those who want to invest in real estate but in a lower-risk way than REITs, house flipping, or becoming a landlord, CMOs enable investors to buy residential mortgage loans that are packaged together into one tidy investment vehicle.
Collateralized Mortgage Obligations, Defined
A collateralized mortgage obligation is a fixed-income security with a pool of mortgage loans that are similar in a variety of ways, like credit score or loan amount, and are combined and resold as a single packaged investment to investors called a security.
CMOs securities are sold in a secondary market and not on the stock market most investors are used to hearing about, but CMOs do work similarly to stock dividends: investors buy the investment and receive money (principal and interest payments) at a set schedule after the mortgage borrowers make the monthly payments on their mortgages. These principal and interest payments are the return investors receive, and CMOs can be a great way for an investor to diversify their holdings.
Understanding How CMOs Work
CMOs are fixed-income, meaning investors who buy them can expect a certain, steady amount of money over a set period of time. CMOs are organized into tranches, or groupings, which are determined by a variety of factors including the maturity date of the mortgage and the risk level. Tranches are usually named by letters of the alphabet, and indicate the level of risk in ascending order. For example, an “A Tranche” would be the highest-risk category, while a D or an E could be the lowest.
Tranche is just a fancy word for a segment, and tranches are used to group securities and sell them to investors looking for something specific in their investments: either risk level, return on investment, or time to maturity. There can be lots of different tranches within a CMO set, based upon a variety of factors such as mortgage balance owed, overall interest rate, and credit risk of the borrower. The lower the risk, the lower the return, but the low-risk investments are the safest in terms of ensuring investors make their money back.
The Importance Of Risk Level
When it comes to collateralized mortgage obligations in particular, discerning risk level is critical.
Since CMOs are often grouped into tranches by risk, it’s important to pay attention. Since CMOs are tied to mortgages, there are several reasons why some tranches are ranked as low-risk, such as the credit scores of the borrowers, or the amount of monthly debt they have. Loans with lower levels of risk are more likely to be repaid in full, which is what you want as an investor. You don’t want to lose money!
Conversely, higher risk tranches would contain borrowers with lower credit, higher foreclosure rates and interest rates. The lower the risk, the more likely it is your money will be repaid in full, although your payouts will likely be lower. Again, it’s all about what an investor is specifically looking for in an investment vehicle. Maybe an investor is OK with the risk of losing money, if it means they could make more in the short term.
CMO Investing Risks
Any investment, no matter what it is, comes with risks involved. Often, investors seek out a CMO because it is lower risk than investing in the traditional stock market with higher returns than traditional government bonds. This doesn’t mean, however, CMOs should be considered “easy money.” In fact, CMOs are highly sensitive to risk due to a variety of factors.
When a mortgage default happens, a borrower stops paying their mortgage loan, which means less money flows back into the CMO, and less money flows back to the investors.
Interest rates already impact the borrower’s risk profile — higher interest rates typically indicate higher risk borrowers. Changing rates have a significant impact on CMOs, far greater than other fixed-interest obligations; when interest rates go down, people refinance and this impacts a CMO’s average life and its yield.
Additionally, when interest rates go up, CMOs’ return rates go down (and vice versa.)
When a borrower pays off the principal faster than the predetermined loan term, this is called prepayment. When this happens, it can affect the rate of return on a CMO because the return on the principal happens over a shorter time frame. Because of this, prepayment can cause a lower interest rate of return on the CMO.
A mortgage extension is put in place by lenders to help borrowers struggling to make mortgage payments. Because the term of the mortgage is extended, investors may have to hold onto their CMO for longer than anticipated, which affects return on investment over time.
Most everyone reading this article likely lived through the global financial crisis of 2008, so you already understand how the housing market and the economy are vitally linked. The overall economy can greatly impact housing interest rates and home sales. While an investor can’t necessarily plan for this risk, it does exist and is something to consider when evaluating a CMO as an investment, but it’s no different from how the economy affects the stock market on a day-to-day basis.
CMO Vs. MBS Vs. CDO
Investing terminology is already confusing enough. Add a couple of acronyms and it gets bananas. Below are definitions for three terms that are often discussed in tandem: CMO, MBS, and CDOs.
A mortgage-backed security is a type of investment product with a pool of mortgage loans that are packaged together and resold as a new security. MBS pass through all principal and interest to the investors. A CMO is a type of MBS, but CMOs are different because they are broken up into tranches, and the way the investors who own them get paid is different than with a traditional MBS.
Now, think of collateralized mortgage obligations and collateralized debt obligations (CDOs) as sandwich cookies. They’re very similar, except CMOs have a vanilla filling and CDOs have chocolate. I’m using this analogy because CMOs and CDOs are both packaged investments, it’s just that what they’re packaging up is different, hence the different type of filling in the middle. CMOs are mortgage-specific, while CDOs can have many different types of non-mortgage debt, such as credit cards, personal loans and corporate debt.
The Bottom Line: CMOs Are A Passive Real Estate Investment That Can Provide Reliable Income
The biggest buyers of MBS and CMOs are the big hedge funds and investment banks, but it’s still important for single investors to know about MBS and non-agency mortgage-backed securities. Below is what is most important to know about collateralized mortgage obligations:
- CMOs are a type of mortgage-backed security; CMOs are born when mortgages are pooled together and packaged as a single security.
- CMOs are divided up into tranches by level of risk and this impacts how much an investor can buy a CMO for and how much they’ll make.
- Investors make money on CMOs when people repay their mortgages.
Learn more about real estate investing terminology in the Rocket Mortgage® Learning Center.
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