Collateralized Mortgage Obligations (CMO) Explained
Looking to invest in residential real estate without buying a rental home or investment property yourself? Collateralized mortgage obligations can be an option. These investment vehicles, commonly known as CMOs, allow you to invest in residential mortgage loans that are packaged together.
On the plus side, CMOs typically offer higher rates of return than government bonds. There is risk, though. If the borrowers of the mortgages in your CMOs pay their loans back too quickly, your return could suffer. And if too many of your CMO’s mortgage holders stop paying back their mortgages, your CMO might lose too much money to provide you with the returns you expected.
What Is A Collateralized Mortgage Obligation?
CMOs are mortgage-backed securities that contain several mortgage loans lumped together and sold as a single investment. A large CMO might contain thousands of mortgage loans.
The mortgages in a CMO are organized according to two main factors: a loan’s maturity or due date and its risk level. These mortgages are placed in different tranches, or groups, according to these factors. Each of these tranches carries loans with different principal balances, maturity dates, interest rates and risk levels.
The risk levels are important. Loans with lower levels of risk are the ones most likely to be repaid in full. The borrowers behind these loans will typically have higher credit scores and lower monthly debt levels. Loans in tranches that are considered higher risk might have been taken out by borrowers with lower credit scores who are more likely to miss payments or stop making them completely.
Investors in CMOs receive principal and interest payments based on agreed-upon schedules and rules. But investors are more likely to receive their payments if their CMOs are made up of a greater share of safer, low-risk loans. The payments might stop if too many loans in a CMO go into foreclosure.
That’s because CMOs only receive cash when borrowers make the monthly payments on the loans included in their tranches.
CMO Vs. MBS
A mortgage-backed security, or MBS, is any investment vehicle that contains a bundle of residential mortgage loans. The entities offering mortgage-backed securities buy those loans from the banks or financial institutions that originated them.
As borrowers repay their mortgage loans, the MBS receives cash. The investors in an MBS receive payments based on a specific schedule. The payments investors receive is based on a percentage – agreed upon by the investor and the entity offering the MBS – of the interest and principal payments made on the loans inside the MBS.
A CMO is a type of MBS. What sets CMOs apart from a traditional MBS is that the mortgage loans in a CMO are divided into categories, or tranches, based on risk and maturity dates.
Most of the mortgage loans in CMOs are offered and insured by large mortgage investors such as the Government National Mortgage Association, better known as Ginnie Mae; the Federal Home Loan Mortgage Corporation, or Freddie Mac; and the Federal National Mortgage Association, known to most mortgage borrowers as Fannie Mae.
You can also invest in CMOs backed by private companies such as home builders, banks and financial institutions. Independent credit agencies will rank these CMOs, giving them credit ratings based on how risky they are.
CMO Investor Risks
As with all investments, there are risks associated with CMOs. The return you’ll receive on these investment vehicles will depend largely on changes in interest rates and the fluctuations of the national economy.
Here are some of the biggest risks when investing in CMOs:
- Prepayment is one of the biggest risks that investors in CMOs face. If the borrowers who took out the mortgages in your CMO pay back their loans too quickly, you'll lose out on the interest payments that these borrowers would normally have made. This means your return on investment would be lower.
- The holders of the mortgages in your CMO need to make their payments for you to earn a profit on your investment. If you've invested in a CMO that contains thousands of mortgage loans, you won't be hurt if just a few borrowers default on their loans. But what if many mortgage holders default and their loans go into foreclosure? Your CMO will lose money. And the entities offering your CMO won't be able to pay its investors, including you.
- You are also subject to market risk when you invest in a CMO. Say mortgage interest rates fall significantly after you've invested in a CMO. If a large number of the borrowers in your CMO refinance their loans, you could lose a significant amount of money. That's because lenders pay off mortgage loans when borrowers refinance them. This can result in many of the loans in your CMO being paid off too quickly, again costing you a good amount of money from the interest payments that borrowers aren't paying.
You have plenty of options when you’re ready to invest your dollars. CMOs are one option. When investing in a CMO you have the opportunity to earn more than the returns you’d see on lower-risk, but lower-reward investments such as bonds. But there are risks associated with CMOs and depending on how the borrowers of the mortgages in your CMO behave – if they pay their loans off to quickly or they stop making payments completely – you could lose money on your investment. If you’re interested in exploring your investment options, be sure to learn more about mortgage bonds and other investment vehicles.