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CMOs Vs. Mortgage-Backed Securities: How Do They Differ?

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Published on December 8, 2020
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Collateralized Mortgage Obligations are a type of mortgage-backed security that allows you to invest in the cash flow generated by mortgage loans. These investment vehicles, better known as CMOs, are a collection of mortgage loans that you buy as a single investment.

The mortgage loans inside a CMO are ranked in tranches, or categories, according to two factors: a loan’s maturity (or due date) and how risky the loan is. Loans are considered riskier if there’s a higher chance that their borrowers will stop making their payments and default on their mortgages.

Answer box: CMOs are mortgage-backed securities that are made up of several mortgage loans that are sold as a single investment. A large CMO might contain thousands of mortgage loans. These mortgages are organized by both their maturity – when they are due to be paid off in full, and their risk – how likely it is that the borrowers won’t pay these loans back.

Collateralized Mortgage Obligation FAQS Explained:

How Often Do CMOs Pay Interest?

CMOs receive cash flow when the borrowers of the mortgages inside them repay these loans each month. Each of the monthly payments borrowers make includes dollars used to pay down the principal balance of a mortgage and to cover the interest on that loan.

CMOs pay out returns to their investors in the form of principal and interest payments. These regular payments are one of the advantages of CMOs, though the payments might vary each month depending on how many people pay their loans on time or whether borrowers pay off their mortgages early.

These interest and principal payments are divvied out to investors based on each CMO's predetermined rules and agreements. When you invest in a CMO, you’ll receive the rules, which will spell out when you will receive payments.

CMOs can make these payments if most of the borrowers pay their mortgages on time. There is always the risk that some borrowers will default on their mortgage loans, not making payments until their lenders start the foreclosure process. If only a small number of homeowners default on the loans in a CMO, the investment vehicle should still have enough financial health to make its regularly scheduled interest and principal payments. If too many borrowers default, though, the CMO will lose money and won’t be able to pay its investors.

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What Are Tranches, And How Do They Work?

The mortgage loans in a CMO are organized in different tranches. “Tranch” is basically another word for category. With CMOs, loans are organized in tranches, or categories, according to their maturity dates and how risky they are. The riskiest loans might be organized in their own tranch, while low-risk mortgages are contained in another tranch.

It’s important for investors to understand the different tranches in their CMOs. That’s because each tranch has its own interest rates, maturity dates and payout schedules.

How Risky Are CMOs?

All investments come with risk. But CMOs are relatively safe investments because many of the mortgage loans in CMOs are insured by large mortgage investors such as Ginnie Mae, Fannie Mae or Freddie Mac. These loans, because of the agencies insuring them, generally carry a lower risk of default.

You can also invest in CMOs backed by private companies such as banks and lenders. These CMOs, known as private-label CMOs, can be riskier. But independent credit agencies assign private-label CMOs a credit rating. Because of this, you can easily gauge how likely the loans in private CMOs are to fall into foreclosure. You can then invest according to your tolerance for risk.

What are the risks involved in CMOs? Prepayment is a big one. If the borrowers of the loans in your CMO pay back their mortgages too quickly, you'll miss out on the interest payments that they would have made if they would have held onto their loans longer. This can reduce your rate of return.

Another big risk is defaults. If the borrowers behind the loans in your CMO don't make their payments, their loans could fall into foreclosure. If too many loans in your CMO go do into foreclosure, it will lose money and won't be able to pay investors.

Market risk is a real threat, too. If mortgage interest rates fall after you've invested in a CMO, a large number of the borrowers repaying the loans in it could decide to refinance. When borrowers refinance, their loans are paid off by their lenders and replaced with new loans. Their old loans, the ones in your CMO, are now paid off and the borrowers behind them aren't paying as much interest. Again, this could result in a lower return on your investment.

Who Typically Invests In CMOs?

Anyone can invest in a CMO. The minimum you’ll need to invest in one of these vehicles will vary, but usually you’ll need to come up with at least $1,000 to make an investment in a CMO.

What Questions Should I Ask Before Investing In CMOs?

Before investing in a CMO, it’s important to ask some key questions.

The first should be to determine if the CMO is issued by an agency such as Freddie Mac or Fannie Mae or is it a private-label CMO issued by a private company.

That leads to a second key question. There’s nothing wrong with a private label CMO, but you should know what rating it has been given by independent credit agencies. If you’re worried about risk, investing in an agency-issued CMO or a private-label CMO that is rated highly by credit agencies is a smart move.

You should also ask questions about the various tranches in a CMO. What is the estimated average lifespan of the loans in your CMO's tranches? What are the estimated final maturity dates of the loans in your CMO's tranches?

It’s important, too, to ask yourself how much risk you are willing to take on. If you want a surer investment, look for a highly rated or agency-issued CMO, one with the least amount of risky mortgage loans contained inside it.

Make sure that you understand the payout schedule of your CMO. You want to know when it’s expected to make both interest and principal payments.

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