Course 203: Collateralized Mortgage Obligations
What Are Collateralized Mortgage Obligations?
In this course
1 Introduction
2 What Are Collateralized Mortgage Obligations?
3 Companion Bonds and PACs
4 Strategic Considerations for Collateralized Mortgage Obligations
5 Are They For You?

The "mortgage" in collateralized mortgage obligation (CMO) refers to the home mortgages on which these securities are based. Like other mortgage-backed securities--Ginnie Maes, Freddie Macs, and the like--CMOs are based on the performance of home mortgage loans that are sold by their lenders to an intermediary company. This company packages the loans as certificates that investors can buy. The interest and principal payments on the mortgages go from the homebuyer through the intermediary and then to the investor--which is why they are called pass-through securities.

With other kinds of pass-throughs, the performance of your investment depends on how and when the homebuyer pays the mortgage. CMOs are fundamentally different in that they are based not on one mortgage but on a pool of loans that are categorized based on the payment period of the mortgages in the pool. In this way, CMOs seek to limit the uncertainty that can be caused when mortgages are prepaid--a problem for pass-through investors when declining interest rates lead many people to refinance their home loans. They also spread the risk of default among a number of investors.

The mortgage pools that underlie CMOs are divided into categories called tranches based on the repayment schedules of the mortgages. Bonds are then issued on each of the tranches, each with a differing maturity date and interest rate. CMO bonds are issued with maturities of 2, 5, 10, and 20 years. Coupon payments from the mortgage pool are paid to the bondholders for each tranche while principal payments are applied first to the bonds with the shortest maturity (the first tranche).

CMO bonds are highly rated; because they are often based on government-backed mortgages and other top-grade loans, there is little default risk involved.

CMO bonds are issued by the Federal Home Loan Mortgage Corporation (FHLMC), the federally sponsored corporation that also issues Freddie Mac pass-throughs. CMOs are also issued by other government-sponsored agencies as well as private issuers. Some investors hold CMO bonds to maturity; they can also be sold and bought on the secondary market, where their prices fluctuate with changes in interest rates.

Next: Companion Bonds and PACs >>

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