What is a CMO?
A CMO, or collateralized mortgage obligation, is a fixed-income investment backed by a pool of mortgages. It's different from most other mortgage-backed securities because the payments are divided into various types of bond, known as tranches, which pay investors different rates at different times.
Where have you heard about CMOs?
CMOs figured prominently in the 2008 financial crash. Soaring housing prices made mortgages seem like foolproof investments, seducing investors into buying CMOs. However, worsening economic conditions led to a rise in repossessions and mortgage payment risks that financial models failed to predict.
What you need to know about CMOs.
If you invest in a CMO made up of thousands of mortgages, your potential profit is based on whether the homeowners repay their mortgages. If just a few people default and the rest make payments as scheduled, you recoup your principal sum plus interest. If, on the other hand, thousands of people are unable to make their mortgage payments on time and default, the CMO loses money.
Because CMOs organise mortgage-backed securities into tranches, they mitigate prepayment risk. Therefore, they offer lower interest rates than other mortgage investment schemes.
CMO bonds typically mature after 2, 5, 10 or 20 years.