What Is a Collateralized Mortgage Obligation & How Are They Created?

A collateralized mortgage obligation, or CMO, belongs to a class of derivative products that include mortgage-backed securities, or MBS, and collateralized debt obligations, or CDO. They are known as "derivatives" because they "derive" their value from some other asset. In the case of a CMO, that asset is a mortgage.

What is a CMO?

• A CMO has claims over cash flows, mainly interest and principal payments, from a large pool of mortgages, which functions as its collateral. According to The Securities Industry and Financial Markets Association, or SIFMA, the total value of CMOs outstanding was over $1.3 trillion at the end of 2007.

How is it Created?

• The creation of a CMO starts when a mortgage is issued by a lending institution. Pools of these mortgages are then bundled together and, using complex mathematical models, divided into multiple classes of securities known as "tranches." These tranches have different risk profiles and are rated by credit rating agencies accordingly.

  The mortgage holder, usually a homeowner, sits at the bottom of this pyramid. He makes interest and principal payments every month to the bank holding his mortgage. These payments are then channeled by the CMO, which is normally set up as a stand-alone investment vehicle, to the investors according to terms prescribed in the offering prospectus.

What are the Risks?

• There are two main risks for CMO tranche holders: interest rate and default. Interest rate risk exists because homeowners tend to refinance their homes when interest rates fall. By prepaying their mortgages faster than they normally would, they reduce the investment return, or yield, on the CMO.

  The default risk has more severe consequences. In an economic downturn, as was the case in the Great Recession of 2008, thousands of men and women all across the U.S. lose their jobs. For people who are already living paycheck to paycheck, the loss of even one income in the family, let alone two, causes them to miss their mortgage payments or even default completely. If hundreds of these mortgages in a CMO pool start defaulting, it is easy to see how the resulting chain reaction could ricochet through the financial system and end up in the kind of catastrophic collapse that the world witnessed in late 2008.