Updated July 17, 2023
Definition of Collateralized Mortgage Obligation
Collateralized Mortgage Obligation (CMO) refers to an investment backed by mortgages wherein mortgages of similar nature are pooled by the banker lending institution and sold as bonds to the CMO investors.
Such investors receive their money back when the original borrowers repay their loan amounts in time which the lending institutions pass to the CMO investors at the agreed terms.
Explanation
- You can assume CMO is an obligation of the banker. Normally when a banker provides a home loan to individual borrowers, it asks for a mortgage from the borrower. Mortgage means security the borrower provides if he does not honor the installments in time.
- Now banker has many such mortgage-backed loans. The banker wants to issue more loans but is short of funds. Here comes the role of the CMO. CMO investors are interested in funding the banker and receiving the interest and principal amount. In return for such investment, the banker provides bonds to the CMO investors.
- CMO investors can be institutions with surplus funds, such as mutual funds, government agencies, insurance companies, hedge funds, bankers, and even the country’s Central Bank.
- Please do not get carried away with the complex wording of this concept. Let’s make it simple with the following chart:
Source: Prepared using Lucid
- As per the chart above, the banker has already provided the loan to the real estate owners. Each housing loan differs according to the risk profile and maturity levels. The banker clubs similar mortgages together for identification, i.e., it pools them together. These pooled mortgages are sold as investment securities to CMO investors.
- CMO Investors will invest according to their risk appetite and requirement of funds.
- However, changes in the economic conditions will affect the ability of the homeowner to repay the loan in time. This has an impact on CMO investors.
Purpose of Collateralized Mortgage Obligations
- The main lender (i.e., the lender of the original loan) needs funds for reinvestment. Thus, it offers bonds to CMO investors. These investors will invest accordingly to the risk profile, risk category, and maturity of the bonds.
- CMO provides risk diversification to the investor; thus, the profit earned from the investment is also diversified.
- Subdivisions or tranches are made per the CMO investors’ risk preferences.
- Collateralized mortgage Obligation allows the main lender to reduce the risk of default. It further increases the main lender’s lending power by transferring the debt amount to the CMO investor through a structured set of securities.
Characteristics of Collateralized Mortgage Obligations
- There are various types of CMOs based on the needs of the investors. Also, the investment amount depends on the securities offered, the risk category, and the maturity level of the bonds.
- The CMO investor will receive interest for their investment made.
- The homeowner is nowhere concerned with the CMO or the CMO investment. His only job is to pay the home-loan installments on time to the lender. The lender will then pass on the payment to the investment as per the terms set out in the agreement.
- Installment amounts are fixed during the entire tenure of the loan. At the starting phase of the loan, the interest amount is higher, and the principal amount is lower. Thus, the CMO investor will receive interest first. Therefore, the initial period is called the “lockout period,” wherein interest is served, and the later year is called the “window,” wherein the principal amount is served.
- However, the borrower may repay the loan earlier than the pre-decided tenure. In this case, the CMO investor will get their money back early, which forces him to reinvest at a lower interest rate. This risk is called a “pre-payment risk.”
- Pre-payment risk is natural in case the market interest rate reduces.
- In the later years of the bond term, the CMO investor will fully repay the loan& thus, the CMO investor will have to reinvest the proceeds at the prevailing interest rate. This risk is called “reinvestment risk.”
- The CMO investor may also go through extension risk wherein tranche repayments are increased due to increased interest rates.
- The CMO investor may also face default risk wherein the borrower fails to repay the loan amount. This results in a loss for the investor.
How Does It Work?
- The main lender (i.e., the banker) pools similar investments per risk category and maturity levels. The tranches of bonds are then named A, B, C, D, E, F, etc.
- Class A tranche is a higher-risk tranche with the highest chances of returns. The term is long-term. The CMO investor is exposed to interest, prepayment, and default risks. If the CMO investor suffers the loss, it would be due to a Class A tranche. Similarly, if the CMO investor receives early repayment, it would be due to Class A.
- The risk reduces ahead tranches. So for the Class C tranche, the risk would be the least, offering a lower rate of return for the CMO investor. The borrowers have almost paid their dues for Class C tranches and are approaching full payment.
- The investor’s profit depends on the mortgage holders’ repayment cycle. The investor will be at a profit if the majority of mortgage holders repay as per schedule and vice-versa.
Example of Collateralized Mortgage Obligations
Assume that ABC Bank has created a pool of $ 1000 million in mortgage loans. It has divided the pool into three tranches, as explained below:
| Tranche | Value ($ millions) | Interest Payment terms | Principal Payment terms |
| A | $500 | Interest is paid every month. The base of interest shall be the previous month’s outstanding balance. | Here, the principal repayment is made first. The repayment made is scheduled or unscheduled during prepayment risk. |
| B | $300 | Interest is to be paid every month. The base of interest shall be the previous month’s outstanding balance. | Here, the repayments are made only after the full repayment of Tranche A |
| C | $200 | Interest is to be paid every month. The base of interest shall be the previous month’s outstanding balance. | Here, the repayments are made only after the full repayment of Tranche B |
Advantages
Some of the advantages of collateralized mortgage obligation are:
- Diversification of risk and diversified returns for the CMO investor.
- The lender gets more funds at its disposal. This helps the investor to earn more by lending.
- The CMO investors can invest as per their risk profiles and appetites since tranches depend on the same.
- The mortgages are structured as per the needs of the investors.
- CMO investors can choose their preferred mortgage loans available under the same lender.
- The lender can earn higher through reinvestment of proceeds from the CMO investors.
- The lender is hedged against all the risks related to repayments.
Disadvantages
Some of the disadvantages of collateralized mortgage obligation are:
- In case of a reduction in the market interest rate, the homeowners will repay faster. This risk suffered by the investor is prepayment risk.
- The economic conditions impact the homeowner’s ability to repay the loan amount. This risk suffered by the investor is market risk.
- In the case of prepayment, the term of the CMO reduces.
- In the case of Class A tranches, there is the risk that the homeowner will not pay the installment in time. This risk suffered by the investor is default risk.
- There is lower liquidity in the case of CMOS. Money is blocked for a longer span of time.
Conclusion
Collateralized Mortgage Obligations are complex financial instruments materialized by the different characteristics of the mortgage pools made by the lender. Higher risk comes with higher returns. Thus, it depends on the risk appetite of the investor.
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