Collateralized mortgage obligations (or CMOs) are complex securities backed by bundled mortgages. As homeowners pay back their loans, CMO investors earn dividends and income from homeowners’ interest and principal payments.
CMO investments can be a savvy way to balance portfolios that are heavy in other types of assets. For example, if you’re holding a lot of stocks and no real estate, CMOs allow you to benefit from real estate income without having to own or maintain property.
But, all investments carry a certain level of risk. And one of the biggest disadvantages of CMOs is homeowner repayment risk. If lots of homeowners default on their loans, the value of the security will drop. Investors should carefully weigh the risks of CMOs in their portfolios, especially when the mortgage market is weak and foreclosure rates are high.
CMOs are complex financial products. Keep reading to find out how these investments work.
How Collateralized Mortgage Obligations Work
CMOs are created when multiple mortgage loans are packaged and sold as an investment. Typically, these securities are made up of hundreds or even thousands of mortgage loans.
A CMO with only a few mortgage loans would be extremely risky. If just one homeowner defaulted, the security would likely face instant devaluation. When there are thousands of mortgages bundled in a CMO, a low rate of homeowner defaults won’t put an investor’s earnings at significant risk.
CMOs are organized by their level of risk and loan maturity (when a loan is due to be paid off). These two factors are used to create categories, also known as tranches, that group mortgage loans by risk. (BTW: tranche is the French word for slice or portion.)
Tranches with higher-risk loans offer higher earnings to investors. If payments are made on the mortgage loans in the higher-risk tranche (or equity tranche), the investor gets a bigger payout. Lower-risk loans are safer investments, but they offer investors lower earnings.
Risks Associated With CMOs
Like all investments, CMOs carry risk. During past market downturns, that risk was more prevalent than it is today. The 2008 financial crisis, which also led to a housing bubble, put investors with CMOs at extreme risk.
In 2016, the Securities and Exchange Commission enacted changes to reduce some of the risks in CMO markets and other securities and investments. But, despite the changes, there are still risks associated with CMOs. And it’s important to understand those risks before you wade into the investment waters.
Here are some common risks to consider when investing in CMOs:
- Prepayment: CMO earnings depend on the interest earned on mortgages. If the rate of mortgage loan prepayment in a tranche is high, the interest the tranche was projected to generate may be lower. Reductions in projected interest may make CMO securities less profitable for investors.
- Default: Defaults happen when homeowners fail to pay their mortgages. The less money coming in from mortgage payments means there is less profit and income in the tranche, which means a reduction in profit or even a loss for investors.
- Interest rate: Market rates impact CMO prices. Rising interest rates tend to cause CMO prices to drop while falling rates can cause them to surge. This give-and-take in the market can be risky if you buy or sell a CMO at certain times.
- Market: The housing market plays a role in the types of CMO securities that are available and how much they’re worth.
- Extension: Homeowners’ ability to extend loan payments, which happened during the COVID-19 pandemic, lengthens the time investors are taking on risk. If a large number of mortgages in a tranche get extended by 6 months, for example, that’s 6 more months investors may experience a loss or fail to gain full maturity of the security.
CMO vs. CDO vs. MBS
As if investing doesn’t come with enough complex math, there are acronyms to deal with, too. We’ll leave the math to the mathematicians and tackle the definition of the acronyms.
What are collateralized debt obligations (CDOs)?
Quick refresher: CMO stands for collateralized mortgage obligation.
CDO stands for collateralized debt obligation. Like a CMO, a CDO is a security. CDOs are made up of different assets and loans that are packaged together, including mortgage loans.
A security made up of mortgage, credit card and auto loan debt can’t be a CMO, but it can be a CDO.
What are mortgage-backed securities (MBS)?
MBS, which stands for mortgage-backed security, is a security backed by mortgage loans. A CMO is a type of MBS that is divided into tranches.
Now You’re Ready To Take the Plunge (or Not) Into CMOs
Now that you know what CMOs are and how they can help diversify an investment portfolio, it’s up to you to work with a money manager to add some to your portfolio – or not. When it comes to investing, it’s a personal decision that should always feel well informed and made with care.
Financial Industry Regulatory Authority. “Covered Agency Transactions.” Retrieved March 2022 from https://www.finra.org/sites/default/files/notice_doc_file_ref/Regulatory-Notice-16-31.pdf