Collateralized mortgage obligations: Defined and explained

If you want to invest in real estate without becoming a landlord, collateralized mortgage obligations (CMOs) may offer a passive way to earn income from home loans. A CMO is a type of mortgage-backed security that pools many mortgages and sends investors periodic principal and interest payments. In this guide, we explain how CMOs work, where their risks and rewards come from, and how they compare to other options, such as pass-through MBSs and REITs.

Key takeaways:

• CMOs are passive investments. They pool thousands of home loans into a single investment, offering a way to invest in the real estate market without owning physical property.
• Risk and return are segmented. These investments are divided into tranches, which allow investors to fine-tune their desired balance of risk, return, and maturity date.
• Economic factors affect returns. While they can offer reliable cash flow, CMOs are subject to unique risks, such as homeowners paying off their mortgages early and changes in interest rates, that may affect an investor's overall return.

What is a CMO?

A collateralized mortgage obligation is a pool of mortgages that are similar in various ways, such as credit score or loan amount. The mortgages are combined and resold to investors as a single packaged investment called a security.

A CMO is a type of mortgage-backed security, which is an investment in a collection of home loans. A standard MBS – known as a pass-through MBS – distributes the principal and interest payments on the pool of loans to the MBS investors based on their proportion of ownership. A CMO, however, takes those payments and divides them into categories with varying levels of risk and maturity dates.

CMOs date to 1983, when investment banks First Boston and Salomon Brothers created the first collateralized mortgage obligation for Freddie Mac. The new offering was meant to make MBSs more attractive for investors who wanted greater control over their risk exposure.

Today, the major players in the CMO market include government-sponsored enterprises like Fannie Mae and Freddie Mac, as well as the government agency Ginnie Mae. Private financial institutions also create non-agency MBSs for loans that don't fit strict government standards.

A CMO's structure is similar to that of a stock dividend. Investors buy the investment and may receive payments at a set schedule after mortgage borrowers make their monthly payments.

Furthermore, because some CMOs are tied to dynamic pricing mechanisms such as the Secured Overnight Financing Rate (SOFR), they’re responsive to varying interest rate environments.

The role of CMOs in the economy

CMOs play an essential role in keeping the housing market functioning. By buying loans from mortgage lenders and packaging them into securities, the institutions that issue CMOs are giving lenders the money they need to fund more mortgages for more home buyers. This constant flow of money ensures that the mortgage market doesn't dry up.

The secondary market created by CMOs and other mortgage-backed securities helps keep mortgage interest rates competitive and borrowing costs down for everyday consumers.

Because of their immense impact on the financial system, CMOs and the real estate mortgage investment conduits (REMICs) that often hold them are subject to strict regulations to ensure market stability and transparency.

How CMOs work and their risk level

When evaluating different types of real estate investments, it is important to understand the mechanics of the asset.

CMOs are fixed-income investments, meaning investors who buy them can expect steady payments over a set period.

CMO securities are sold in a secondary market, typically through broker-dealers, and not on the regular stock market. Investors may make money on CMOs through the generation of cash flow and returns. Cash flow refers to the regular stream of principal and interest payments coming in from the pool of loans, while the return is the overall profit an investor might make on the capital they initially invested.

The value of a CMO is derived not just from the interest rate on the mortgages, but also from the projected speed at which those mortgages will be paid off.

Market analysts use complex models to predict how homeowners may behave under various economic conditions, and these predictions directly affect how the securities are priced on the secondary market.

CMOs are organized into groups called tranches, which are determined by factors such as the maturity date of the mortgage and the risk level. 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 across the bond maturity spectrum.

There can be many different CMO tranches within a set, based on factors such as the mortgage balance owed, the overall interest rate, and the borrower's credit risk.

CMO tranches are usually named by letters of the alphabet and indicate the level of risk. For example, an “A" tranche would be the lowest-risk category that gets paid first, while a “Z" tranche could be the highest-risk segment that gets paid last.

The lower the risk, the lower the potential return, but low-risk investments are the safest for ensuring investors can make their money back. Conversely, higher-risk tranches would contain borrowers with lower credit scores or loans with higher foreclosure rates and interest rates.

When selecting investments, it’s important to understand how long you’re willing to tie up your money and your risk tolerance relative to the desired return.

Investing risks and considerations

Often investors seek out CMOs and other types of mortgage bonds because they're considered lower risk, but that doesn't mean none exist. Let's go over some of them.

Default

When a mortgage default happens, a borrower stops paying their mortgage loan. Because CMOs rely entirely on payments from homeowners, a default means less money is paid into the loan pool, and less flows back to investors. If a significant number of borrowers default, the investors holding the lower, riskier tranches may lose some or all their principal.

The impact of a default depends heavily on which tranche you own. Senior tranches are insulated from initial default losses, which are absorbed by the lower, subordinated tranches first. This means that investors seeking lower risk can prioritize top-tier tranches.

Investors can mitigate default risk by choosing agency CMOs. Because these are backed by government-sponsored enterprises or agencies such as Ginnie Mae, timely payment of principal and interest is guaranteed, effectively removing default risk for investors. For non-agency CMOs, investors must rely on credit enhancements to protect their principal.

Interest rates

Interest rates already affect the borrower’s risk profile – higher interest rates typically indicate higher-risk borrowers. Beyond that, changing rates have a significant impact on CMOs, far greater than many other fixed-interest obligations. The value of a fixed-income security has an inverse relationship with interest rates.

To mitigate this, investors should closely monitor forecasted mortgage rates to anticipate shifts in the market. Understanding the yield curve could help you select tranches with maturities that align with your interest rate expectations.

Prepayment

When a borrower pays off the principal faster than the predetermined loan term, this is called prepayment. Homeowners frequently pay off their mortgage early when interest rates fall, allowing them to refinance into a cheaper loan. Some loans carry a prepayment penalty to discourage this.

When prepayment happens, it can drastically affect the rate of return on a CMO because the return on the principal happens over a shorter time frame, meaning less interest is earned. Prepayment also creates reinvestment risk because investors have to find a new place for money sooner than expected, possibly at lower interest rates.

To mitigate this risk, investors might specifically purchase tranches designed to absorb prepayment shocks, such as Planned Amortization Class (PAC) tranches, which offer a more stable payment schedule.

Extensions

Extension risk is the exact opposite of prepayment risk and typically occurs when interest rates rise significantly. Because the mortgage term is extended or homeowners are no longer moving or refinancing, investors may have to hold onto their CMOs for longer than anticipated, which affects returns on investment over time.

When borrowers prioritize investing over paying off their mortgages and hold onto their low-rate loans, the CMO's cash flow slows.

Market volatility

The overall economy can greatly affect mortgage interest rates and home sales. Factors such as high unemployment, inflation, or an oversupply of homes could trigger a wave of defaults and disrupt the MBS market.

While an investor can’t necessarily plan for this risk, keeping an eye on housing market predictions is worth considering when evaluating a CMO as an investment.

CMOs vs. other investment vehicles

Investing terminology is already confusing enough. Let’s break down the differences in some of the common terms you see.

CMOs vs. pass-through MBSs

A pass-through MBS is an investment product in which a pool of mortgage loans is packaged, and the cash flows are passed directly to investors. Everyone who buys into a pass-through MBS receives a share of the principal and interest payments equal to their ownership percentage in the MBS.

In contrast to pass-through MBSs, a CMO pays investors according to tranches based on the level of risk assumed and the maturity date. Those with the most senior claims get paid first but might get back the lowest levels of interest. Those in later tranches may receive higher interest due to a higher risk of nonpayment.

CMOs vs. REITs

A real estate investment trust (REIT) is a company that owns, operates, or finances income-producing real estate. You can think of an equity REIT almost like a mutual fund for real estate.

Investors buy shares in the company, and the company uses that pool of capital to acquire physical properties such as apartment complexes, office buildings, or shopping malls.

REITs typically focus on the physical ownership and equity of commercial or residential real estate, paying out dividends based on rent collection and property appreciation. CMOs are strictly debt instruments; they do not own physical property, but rather the mortgage loans secured by those properties.

CMOs vs. CDOs

A collateralized debt obligation (CDO) is a complex structured finance product that is backed by a pool of loans and other assets and sold to institutional investors.

CMOs are mortgage-specific, meaning they only contain residential real estate loans. CDOs, on the other hand, can have many different types of non-mortgage debt, such as credit cards, student loans, personal loans, and corporate debt.

Because CDOs often include unsecured consumer debt or highly volatile corporate loans, their overall risk profile can look very different from that of a CMO secured by physical real estate.

The bottom line on investing in CMOs

The biggest buyers of mortgage-backed securities and collateralized mortgage obligations are the big hedge funds and investment banks, but it's still important for individual investors to know about MBS and non-agency mortgage-backed securities. CMOs offer a unique, passive way to participate in the housing market, potentially turning everyday mortgage payments into a reliable fixed-income stream. Investors may profit from CMOs when borrowers repay their mortgages.

If you’re evaluating ways to free up cash to reinvest – or to consolidate higher-interest debt – see your financing options with Rocket Mortgage.

This article is for informational purposes only and is not intended to provide financial, investment, or tax advice. You should consult a qualified financial or tax professional before making decisions regarding your retirement funds or mortgage.

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