Collateralized Mortgage Obligation (CMO)

A Collateralized Mortgage Obligation (CMO) is a type of mortgage-backed security that divides a pool of mortgages into tranches, each with varying levels of risk, return, and repayment schedules. CMOs allow investors to choose tranches that match their risk tolerance and income needs. The payments made by homeowners on the underlying mortgages are distributed to investors based on the structure of the CMO.

Example

An investor might choose a CMO tranche that pays out principal before other tranches, providing more security but offering a lower yield compared to riskier tranches.

Key points

• A CMO is a mortgage-backed security that pools mortgages and divides them into tranches with different risk and repayment schedules.

• Investors can select tranches based on their risk and income preferences.

• Payments from the underlying mortgages are distributed to investors according to the CMO’s structure.

Quick Answers to Curious Questions

How does a CMO work?

A CMO pools mortgages and divides them into tranches, with each tranche having a different level of risk and return. Payments from the mortgages are allocated based on the structure of the CMO.

What is the advantage of investing in a CMO?

Investors can choose tranches that match their risk tolerance and investment goals, providing flexibility in terms of income and security.

What are the risks associated with CMOs?

Risks include prepayment risk, where homeowners pay off their mortgages early, affecting the timing of payments to investors, as well as interest rate risk and credit risk.