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Understanding Collateralized Mortgage Obligations
When buying and selling mortgages, you will hear the term collateralized mortgage obligation often. This term is important, as it will help your agency lend to clients while remaining protected from risks like defaults.
What is a Collateralized Obligation?
Collateralized mortgage obligations, or CMOs, are a type of mortgage backed security or bond consisting of a pool or group of mortgages, with different types of maturities. The mortgages serve as collateral for securing the mortgage debt.
The CMO is the entity that owns and manages the actual mortgage loans. They receive the mortgage repayments, and then distribute the payments on to the CMO investors. CMOs are sensitive to changes in interest rates and economic conditions and are assessed and organized into classes based on their potential risk.
When dealing with collateralized mortgage obligations, you will come across what is known as a “tranche.” Tranches are the different categories or sections that CMOs are divided into based on their maturities. These divisions make the CMO more attractive to investors because they can invest in a specific tranche instead of the entire CMO.
CMOs Increases Lending Ability
CMOs are typically purchased by the following organizations:
- Mutual Funds
- Hedge Funds
- Insurance Companies
When purchased CMOs give these institutions a way to reduce their interest and default risk. It also helps them increase their lending ability by transferring debt to investors in the form of structured securities.
Watch for Prepayment Risks
Prepayment risk can be an issue with CMOs as the unscheduled return of principal by borrowers can decrease the profit lenders earn on their investment. The reason being, if interest rates fall, investors will receive the principal quicker and not earn as much interest on the investment. However, you can move the risk of prepayment among other tranches so the amount of investment lost is reduced.