Collateralized Mortgage Obligation (CMO)

A collateralized mortgage obligation (CMO) is a type of bond backed by a pool of residential mortgage loans or by mortgage-backed securities. Instead of passing every borrower's payment straight through to all investors equally, a CMO divides the pool's cash flows into several classes, called tranches, each with its own rules for receiving interest and principal. This lets investors choose securities with different maturities and different exposure to the risk that homeowners repay early or late.

CMOs are a form of securitization and are traded in the fixed income markets. In the United States, most are backed by mortgages guaranteed by the government-sponsored enterprises Fannie Mae and Freddie Mac or by Ginnie Mae, while "private-label" CMOs are issued by banks without that guarantee. CMOs are often confused with collateralized debt obligations, which pool various debts and divide them mainly by credit risk.

Imagine thousands of homeowners each paying their mortgage every month into one big pipe. A simple mortgage bond lets every investor drink equally from that pipe. A CMO instead runs the water through a set of buckets. The first bucket fills first and is emptied quickly; the next starts filling only once the first is full, and so on.

An investor who wants their money back soon buys the first bucket; one who is happy to wait buys a later one. The tricky part is that homeowners do not pay on a fixed schedule. When interest rates fall, many refinance and repay early, so the water rushes through faster than expected. When rates rise, the flow slows down. The bucket design decides who feels those changes most.

An issuer gathers mortgage-backed securities into a trust and issues several tranches against them. The most common structure is sequential pay: all tranches receive interest, but principal goes entirely to the first tranche until it is repaid, then to the second, and so on. Other common tranche types include:

• Planned amortization class (PAC). Receives principal on a fixed schedule as long as prepayments stay within a set range, giving more predictable cash flows.
• Support or companion tranches. Absorb the excess or shortfall of prepayments to protect PAC tranches, making their own cash flows very uncertain.
• Floating and inverse floating tranches. Pay rates that move with, or against, a benchmark interest rate.
• Z-tranche (accrual). Receives no cash at first; its interest is added to its balance until earlier tranches are paid off.
• Interest-only and principal-only strips. Separate the interest and principal of the pool, creating securities that react in opposite ways to prepayment speeds.

Different investors gravitate to different tranches. Banks and money market investors tend to favour short, predictable tranches; insurers and pension funds, which have long-dated liabilities, often prefer later or scheduled tranches; and hedge funds and specialist managers buy the more volatile support, residual and strip tranches in search of higher yields. The pool's total cash flow does not change, only the way it is shared.

Freddie Mac issued the first CMO in 1983, with investment banks Salomon Brothers and First Boston, as a way to make mortgage securities appeal to a wider range of investors. The Tax Reform Act of 1986 created the real estate mortgage investment conduit (REMIC), a tax-efficient vehicle through which most CMOs have since been issued, and the terms CMO and REMIC are often used interchangeably. Complex CMO tranches suffered heavy losses when interest rates rose sharply in 1994, which led to the failure of several funds. Private-label mortgage securities, many backed by sub-prime mortgages, played a central role in the 2008 financial crisis, after which issuance of private-label deals fell sharply.

The main risks of CMOs are interest rate risk and prepayment risk. Falling rates bring early repayment, which shortens some tranches and forces investors to reinvest at lower yields; rising rates bring extension risk, lengthening tranches just when investors would rather have their money back. Private-label CMOs also carry credit risk if borrowers default, while agency CMOs rely on the guarantee of the issuing agency. Because tranche cash flows depend on detailed models of borrower behaviour, some CMOs are hard to value and can become illiquid in stressed markets. Regulators and dealers generally consider complex tranches suitable only for experienced investors, and the analysis of their cash flows is a specialised field within fixed income investing. Their place in the wider market is described under Secondary Mortgage Market.