What Is A Collateralized Mortgage Obligation?

"What is a collateralized mortgage obligation?" is a question many people have asked themselves during the financial industry collapse that began in 2007. Collateralized mortgage obligation is a bond paid by the cash flow from a large group of home mortgages. The new investment product was created by the Wall Street investment bank Salomon Brothers in the early '80s to rid itself of home mortgages purchased from newly deregulated savings and loans.

Collaterlized mortgage obligations are very sensitive to interest rate changes as well as homeowner sales, refinancing or mortgage pre-payment. Other risks include liquidity and housing market changes. A collateralized mortgage obligation might differ debt classes (thus varying amounts of risk) to attract a variety of investors, which, in this case, were "institutional investors" such as mutual funds.

A "collateralized mortgage obligation" or CMO distributes the mortgage holder's principal and interest payments to the investment's classes, or tranches, based upon how the deal is structured. Tranche types include planned amortization class, targeted amortization class, companion, accretion or accrual bonds, principal-only securities, interest-only securities, floating rate and residuals. A single collateralized mortgage obligation might have 50 tranches.

The first tranche, which receives the mortgage holder's principal payments exclusively until its investment is paid back, might last two or three years. The second might last five to seven years and so on until the collateralized mortgage obligation is paid off.

A collateralized mortgage obligation became an attractive product for banks because selling a mortgage releases that capital and allows the bank to make more loans. It provided a way for banks to get around capital requirements that limits how many loans they could make. The banks also made money, essentially an "origination fee," by selling the collateralized mortgage obligation itself.