What is Collateralized Mortgage Obligation?

Collateralized mortgage obligation is a debt instrument (a bond) that uses a pool of mortgage loans as collateral. The pool of mortgage loans is created using loans originated by private mortgage lenders, government-sponsored enterprises and large commercial banks. The CMOs are divided into tranches- groups of bonds with similar risk levels. The bonds are sold to investors, who can then either trade them in security markets or earn profits off dividends. CMOs were popular during the real estate bubble. With real estate values and home purchase rates still hovering around their historic lows, CMOs are not as popular (or as profitable) as they used to be, but they are still available to any wiling investors.

How Collateralized Mortgage Obligation Works

When a home buyer takes out a mortgage loan, he or she will need decades to repay them in full. Until they repay it in full, the lending institution that issued them will receive a steady stream of income. CMOs allow mortgage lending institution to use that income to create bonds. The mortgage loans act as collateral, providing financial backing to what would otherwise be worthless documents. The financial value may vary depending on how much the borrower pays each month. Once the borrower repays the loan, the bonds no longer have any value, so they are retired. Until then, the lending institutions can sell the bonds to investors, who can then use them to try to earn as much profit as they can. The investors also earn profit through interest payments that the lender makes to them in monthly basis. The interest payments depend on the value and the structure of the collateral mortgage loans.

The problem with using a mortgage loan as the collateral is that there is always a chance that the home buyer would either repay the loan early or fall behind on payments and default. To reduce that risk, the lending institutions take several different mortgages and put them together into a mortgage pool. The entire pool acts as a collateral. So long as any mortgage in the pool hasn't been repaid, the bonds will have some value. 

Tranches and Collateralized Mortgage Obligation

The lending institutions that create collateral mortgage pools for CMOs divide their mortgages into tranches based on the level of risk. The risk, in turn, is based on how soon the mortgage loans are scheduled to be repaid. In many cases, those tranches are split into smaller tranches based on what type of interest rate the loan has (fixed of variable). The risk determines the bond's interest rates--the higher the risk, the larger the interest rates are.

Generally speaking, the longer the mortgages are scheduled to be repaid, the riskier they are. Variable interest rates add their own risk. Since they are based on market conditions rather then pre-set rates, they are less predictable, and the borrower may not always have enough money to pay for them. 

In the wake of the collapse of the real estate bubble, many lending institutions altered the tranch structure, arranging them according to the borrower's credit score. The bigger the credit score is, the less likely the borrower is to default. so the risk is lower. If the bonds suffer from excessive defaults and/or drop in value, the money generated through shorter-term bonds are used to pay off investors with longer-term bonds. This is meant to reward investors who are willing to take more risk.

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