What is a Collateralized Mortgage Obligation (CMO)?
A collateralized mortgage obligation (CMO) is a type of investment that lets you earn money from home loans.
How it works
Imagine a big pile of home loans bundled together. This bundle is split into different pieces called tranches. You can think of each tranche as a slice of pie. These slices or tranches are sold to investors. Investors receive cash flow from the principal and interest received when homeowners pay their mortgage. Each tranche has its own rules for when and how investors get paid. These rules create a structure that allows each tranche to be characterized by risk level, maturity, and interest rate.
What are the risks?
CMO’s can be a valuable additional to an investment portfolio but they come with some important risks that you need to discuss with a financial professional.
Prepayment Risk
Homeowners refinance or pay off early their mortgage early. This change in cash flow results in investors receiving the principal sooner than expected, reducing returns.
Extension Risk
When interest rates go up, homeowners are less likely to pay off their mortgages early. This means your money could be tied up longer than expected and you might miss out on better investment opportunities.
Interest Rate Risk
The value of your CMO can go up or down as market interest rates change. If rates rise, the value of your CMO may fall and vice versa. Interest rate risk affects the value of the investment and the timing of cash flows.
Credit Risk
If borrowers default, cash flows decline. This risk varies by tranche and by the credit quality of the underlying mortgages. Some CMO’s are backed by government agencies like Ginnie Mae, Fannie Mae or Freddie Mac, which lowers the risk of not getting paid.
Liquidity Risk
Some CMOs are harder to sell quickly. If you need to exit early, you may have to accept a lower price.
Complexity Risk