A collateralized mortgage obligation (CMO) is essentially a bundle of numerous mortgages combined in a package and sold to investors.
A collateralized
mortgage obligation (CMO) is one of a number of mortgage-backed security used by banks to boost their liquidity. In simple terms, a CMO is a collection of several mortgages taken out by different people or companies bundled together. This bundle of loans is then offered to investors so that the bank can quickly attain some liquidity. In contrast, the investor receives a collateralized loan package and any further repayments on the loans.
CMOs are a very versatile type of investment. On the one hand, they carry significant risks for the company or fund purchasing them. As this is essentially a mixture of several mortgages, the risk increases as more than one of these might turn into a defaulted loan. However, on the flip side of things, the investor receives a lot of collateral with these bundles. Imagine a CMO consists of five different mortgage loans — this means that the new owner of the CMO either receives payments on five different loans or, if these loans default, gets ownership over five different properties.
In this sense, CMOs are a useful tool for both banks and investors alike. Unfortunately, because of the highly unpredictable nature of the financial market, CMOs are also among the riskiest investments.
A good example of CMOs in action was the financial crisis of 2008. The financial world in the US, and later on globally, crashed because of an influx of defaulting
collateralized debt obligations (CDOs). CDOs essentially take the principle of CMO one step further and allow banks to bundle up mortgage loans and other types of credits. In 2008, many of the CMOs in these debt obligations started defaulting, as more and more people couldn’t afford to pay their monthly installments. While in theory, this should have been good for the investors, as they started owning a lot of property, the whole housing market crashed, and the value of property fell significantly. This essentially meant that a lot of institutional investors lost significant amounts of money while people were losing their homes.
Since 2008,
central banks and regulators have introduced better and stricter rules regarding CDOs and CMOs. Considering this, the investors are now turning their attention back to this type of security-backed purchase. While the financial crisis hit hard, CMOs remain a viable investment opportunity. With improved regulation, and more vigilant banks, the housing market is bouncing back, and CMOs are becoming more valuable. CMOs are also a great way to
diversify your investment portfolio.