Collateralized Mortgage Obligation

Definition

Collateralized mortgage obligation is basically a kind of security that has mortgage backing and establishes separated pools of pass-through rates for multiple bondholder classes with a variety of maturities known as tranches. Any repayment from the pool of securities is utilized for retiring of bonds in an order that is laid down in the prospectus of the bonds.

How Collateralized Mortgage Obligation Works?

The investors in Collateralized Mortgage Obligation (CMO) are put into three different classes and are typically called class A, class B and class C. Each of the classes is different in the order of receiving principal amount payments, but they receive interest related payments till the time the CMO isn’t paid off completely. Investors from class-A are paid first with repayments and prepayments till the time their payments are fully done. After this, investors from Class-B, followed by Class-C are paid. In such as situation, it is the investors from Class A who bear maximum prepayment related risk, whereas investors of Class C are subject to least amount of risk.

Creation of CMOs

Since Collateralized Mortgage Obligations are a kind of security that is sold off to investors, they are produced by the investment banks. The mortgages that are utilized for creating CMOs can be easily bought from just about any organization, which owns mortgage in addition to its reselling rights, such as mortgage banks and brokers. It is because of the CMOs complicated structure that they can be divided into several distinct bonds that are capable of meeting the requirements of several different investors. One single mortgage pool can be split to provide few bonds which are conservative and others that are speculative, in addition to bonds that are paid off as per different timings.

Risks in CMO

Those who invest in CMOs may have to face a number of different types of risks at the time of investing in Collateralized Mortgage Obligations, based on the bond type held by them. Apart from this, there is also a risk that the CMO may decline in terms of value owing to prepayment. The investors of CMO can also witness a decline in the bonds if the default rate on the mortgages that are underlying increases to a significant extent.