Collateralized Mortage Obligation

Definition of Collateralized Mortage Obligation

Collateralized Mortgage Obligation (CMO) refers to an investment backed by mortgages wherein mortgages of similar nature are pooled by the banker lending institution and sold as bonds to the CMO investors and such investors receive their money back when the original borrowers repay their loan amounts in time which the lending institutions pass to the CMO investors at the agreed terms.

Explanation

• You can assume CMO is an obligation of the banker. Normally when a banker provides a home loan to individual borrowers, it asks for the mortgage from the borrower. Mortgage means security provided by the borrower, in case he does not honor the installments in time.
• Now the banker has many such mortgage-backed loans. The banker further wants to issue more loans but it is short of funds. Here, comes the role of CMO. There are CMO investors who are interested in funding the banker and receiving the interest and principal amount. The banker in return of such investment, provides bonds to the CMO investors.
• CMO investors can be institutions that always have surplus funds with them such as mutual funds, government agencies, insurance companies, hedge funds, bankers, and even the Central Bank of the country.
• Please do not get carried away with the complex wording of this concept. Let’s make it simple with the following chart:

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Source: Prepared using https://lucid.app/lucidchart/61a0fbee-24a8-4096-b800-ce90bcfae1bf/edit?beaconFlowId=368D55592801B602&page=0_0#

• As per the chart above, the banker has already provided the loan to the real estate owners. Each housing loan differs according to the risk profile and maturity levels. The banker clubs similar mortgages together for identification i.e. it pools the mortgages together. These pooled mortgages are sold as investment securities to CMO investors.
• CMO Investors will invest according to their risk appetite and requirement of funds.
• However, changes in the economic conditions will affect the ability of home-owner to repay the loan in time. This has an impact on CMO investors.

Purpose of Collateralized Mortgage Obligations

• The main lender (i.e., the lender of the original loan) needs funds for reinvestment. Thus, it offers bonds to CMO investors. These investors will invest accordingly to the risk profile, risk category and maturity of the bonds.
• CMO provides diversification of risk to the investor and thus, the profit earned from the investment is also diversified.
• Subdivisions or tranches are made as per the risk preferences of the CMO investors.
• Collateralized Mortage Obligation allows the main lender to reduce the risk of default. It further increases the lending power of the main lender by way of transfer of debt amount to the CMO investor through a structured set of securities.

Characteristics of Collateralized Mortgage Obligations

• There are various types of CMOs based on the needs of the investors. Also, the amount of investment depends on the securities offered, the risk category, and the maturity level of the bonds.
• The CMO investor will receive interest for their investment made.
• The homeowner is nowhere concerned with the CMO or the CMO investment. His only job is to pay the home-loan installments on time to the lender. The lender will then pass on the payment to the investment as per the terms set out in the agreement.
• Installment amounts are fixed during the entire tenure of the loan. At the starting phase of the loan, the interest amount is higher and the principal amount is lower. Thus, the CMO investor will receive interests first. Thus, the initial period is called as “lockout period” wherein interest is served and the later year is called as “window” wherein the principal amount is served.
• However, it may happen that the borrower repays the loan amount earlier than the pre-decided tenure. In this case, the CMO investor will get its money back early, which forces him to reinvest at the lower interest rate. This risk is called a “pre-payment risk”.
• Pre-payment risk is natural in case of a reduction in the market interest rate.
• In the later years of the bond term, the CMO investor will full repayment of the loan& thus the CMO investor will have to reinvest the proceeds at the interest rate prevailing at that time. This risk is called “reinvestment risk”.
• The CMO investor may also go through extension risk wherein tranche repayments are increased due to increased interest rates.
• The CMO investor may also face default risk wherein the borrower fails to repay the loan amount. This results in a loss for the investor.

How Does It Work?

• The main lender (i.e., the banker) pools similar investments as per risk category and maturity levels. The tranches of bonds are then named as A, B, C, D, E, F, etc.
• Class A tranche is a higher risk tranche with the highest chances of returns. The term is long term. Here, the CMO investor is exposed to interest risk, prepayment risk, and default risk. If the CMO investor suffers the loss, it would be due to a Class A tranche. Similarly, if the CMO investor receives early repayment, it would be due to Class A.
• The risk reduces ahead tranches. So for the Class C tranche, the risk would be least offering a lower rate of return for the CMO investor. For Class C tranches, the borrowers have almost paid their dues and therefore approaching for full payment.
• The profit of the investor depends on the repayment cycle of the mortgage holders. The investor would be at a profit if the majority of mortgage holders repay as per schedule and vice-e-versa.

Example of Collateralized Mortgage Obligations

Assume that ABC Bank has created a pool of $ 1000 million mortgage loans. It has divided the pool into three tranches as explained below:

Advantages

Some of the advantages of collateralized mortgage obligation are:

• Diversification of risk and diversified returns for the CMO investor.
• The lender gets more funds at its disposal. This helps the investor to earn more by lending.
• The CMO investors can invest as per their risk profiles and risk appetites since tranches are based on the same.
• The mortgages are structured as per needs of the investors.
• CMO investors can choose their preferred mortgage loans available under the same lender.
• The lender can earn higher through reinvestment of proceeds from the CMO investors.
• The lender is hedged against all the risks related to repayments.

Disadvantages

Some of the disadvantages of collateralized mortgage obligation are:

• In case of a reduction in the market interest rate, the homeowners will repay faster. This risk suffered by the investor is prepayment risk.
• The economic conditions impact the homeowner’s ability to repay the loan amount. This risk suffered by the investor is market risk.
• In the case of prepayment, there is a reduction of the term of the CMO.
• In the case of Class A tranches, there is the risk that the homeowner will not pay the installment in time. This risk suffered by the investor is default risk.
• There is lower liquidity is the case of CMOS. Money is blocked for a longer span of time.

Conclusion

Collateralized Mortgage Obligations are complex financial instruments which are materialized by the different characteristic of the mortgage pools made by the lender. Higher risk comes with higher returns. Thus, it depends on the risk appetite of the investor.

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