What's a Collateralized Mortgage Obligation & How Are They Made?
October 19, 2020
Collateralized mortgage obligations, or CMOsare a sort of financial debt vehicle. The holder of a CMO is entitled to regular payments derived from a pool of mortgages. However, unlike most other mortgage-backed securities, in which the investor receives the interest and principal payments from the mortgages, the payments left on a CMO are divided into various kind of bond, called tranches, that cover investors at various times and at different prices, according to a complex formula.
History
Based on a 2002 paper by Andrew Kelman, an executive in Freddie Mac, Freddie Mac developed the CMO in 1983. It was created in part to address one of the chief problems investors confronted with mortgage-backed securities–the unstable price of these securities because of continuously fluctuating prepayment prices. As interest rates dropped lower, mortgage holders would borrow more and refinance their debt, causing prepayment prices to rise. This earlier-than-expected repayment on the principal will cause the yield of these bonds to decline, reducing their value. The CMO’s construction helps compartmentalize the danger of prepayments.
Creation
Since they’re a sort of security offered to investors, CMOs are usually created by investment banks. The investment banks First Boston and Salomon Brothers helped Freddie Mac make the initial example of a CMO, initially called a”Real Estate Mortgage Investment Conduit.” The mortgages utilized to make CMOs can be bought from any entity which possesses a mortgage and gets the right to resell it, including mortgage banks and brokers.
Benefits
The complex arrangement of a CMO makes it divided into many different kinds of bonds which can satisfy the requirements of many different kinds of investors. A single pool of mortgages can be divided to offer you some bonds which are speculative and many others who are conservative, as well as bonds which pay out on a number of different time frames.
Hazards
Investors can face many different different risks when investing in CMOs, depending on the kind of bond they have. Besides a risk of a decrease in value because of prepayment, CMO investors will also probably see their bonds decrease in value if the rate of defaults on the underlying mortgages increases appreciably.
Significance
CMOs played a prominent part in the financial crisis of 2008. Defaults skyrocketed, as a large number of homeowners had been foreclosed upon and the value of many CMOs plunged. In the wake of that crisis, many investors claimed they had been unaware that the mortgages upon the debt cars were established were in such a high risk of default.