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. CMOs come with risk, though. Let’s take a look at what CMOs are, how they work and what risks you should be aware of.

What Are CMOs?

Collateralized Mortgage Obligations (CMOs) are mortgage-backed securities that contain several mortgage loans lumped together and sold in a secondary market as a single investment. The loans in this pool of mortgages usually share a commonality, such as similar credit scores or loan amounts. A large CMO might contain thousands of mortgage loans.

How Do CMOs Work?

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.

CMOs only receive cash when borrowers make the monthly payments on the loans included in their tranches. Investors in CMOs then receive these principal and interest payments based on agreed-upon schedules and rules.

How Important Are Risk Levels In CMOs?

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 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.

CMO Vs. MBS Vs. CDO

Now let’s look at how collateralized mortgage obligations compare to other types of fixed-income securities.

Mortgage-Back Securities

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.

Collateralized Mortgage Obligations

A CMO is a type of MBS. What sets CMOs apart from a traditional MBS is that the underlying 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. These include  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 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.

Collateralized Debt Obligations

Like collateralized mortgage obligations, collateralized debt obligations (CDOs) are investment packages – or pass-through securities – that provide cash flows to investors.

The difference is that CMOs are primarily mortgage-based, whereas CDOs are also backed by personal loans, car loans, credit cards and other types of non-mortgage debt.

Collateralized Mortgage Obligation Risks

As with all investments, some risks are 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 Risk

Prepayment is one of the biggest risks that you’ll face as a CMO investor. 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.

Repayment Default

The mortgage holders 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.

Market Risk

When you invest in a CMO, you’re subject to market risk. For example, let’s say mortgage interest rates fall significantly after you’ve invested in a CMO, and a large number of the borrowers in your CMO refinance their loans. This could impact the life of your CMO and its yield.

Why? Lenders pay off mortgage loans when borrowers refinance them. If the loans in your CMO are paid off too quickly, you won’t continue earning money from the interest payments that borrowers are no longer paying. 

The Bottom Line

When investing in a CMO, you have the opportunity to earn more than the returns you’d see on bonds and other lower-risk investments.

But risks are also associated with CMOs. If the borrowers of the mortgages in your CMO pay their loans off too quickly – or too many of the mortgage holders stop making payments completely – you could lose money on your investment.

In general, CMOs are considered to be safe investments. Many of the mortgages in CMOs are conforming loans insured by Fannie Mae and Freddie Mac, so their risk of default is low.

If you’re interested in tapping into your home equity to consolidate debt or invest in your home, speak with a Home Loan Expert who can help determine if a cash-out refinance fits your needs.