Collateralized Mortgage Obligations (CMO)

A collateralized mortgage obligation (CMO) refers to a type of mortgage-backed security that contains a pool of mortgages bundled together and sold as an investment. Organized by maturity and level of risk, CMOs receive cash flows as borrowers repay the mortgages that act as collateral on these securities. In turn, CMOs distribute principal and interest payments to their investors based on predetermined rules and agreements.

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Collateralized mortgage obligations consist of several tranches, or groups of mortgages, organized by their risk profiles. As complex financial instruments, tranches typically have different principal balances, interest rates, maturity dates, and potential of repayment defaults. Collateralized mortgage obligations are sensitive to interest rate changes as well as to changes in economic conditions, such as foreclosure rates, refinance rates, and the rates at which properties are sold. Each tranche has a different maturity date and size and bonds with monthly coupons are issued against it. The coupon makes monthly principal and interest rate payments.

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To illustrate, imagine an investor has a CMO made up of thousands of mortgages. His potential for profit is based on whether the mortgage holders repay their mortgages. If only a few homeowners default on their mortgages and the rest make payments as expected, the investor recoups his principal as well as interest. In contrast, if thousands of people cannot make their mortgage payments and go into foreclosure, the CMO loses money and cannot pay the investor.

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Investors in CMOs, sometimes referred to as Real Estate Mortgage Investment Conduits (REMICs), want to obtain access to mortgage cash flows without having to originate or purchase a set of mortgages.