What is Collateralized Mortgage Obligation (CMO)?

A Collateralized Mortgage Obligation (CMO) is type of mortgage-backed security.

It represents a special purpose vehicle (SPV or also known as special purpose entity - SPE) that is completely separate from the institution that has created it and is an owner of a set of mortgages, referred to as a pool.

Investors in CMOs buy bonds issued by the entity. The cash flow from the underlying collateral (the mortgages) is distributed over a series of tranches (also known as classes) with varying maturities and prepayment risks, designed to meet specific investment objectives.

Investors in collateralized mortgage obligations include banks, insurance companies, hedge funds, mutual funds, pension funds, government agencies, and since the recent financial crisis even central banks.

How does a Basic CMO (Sequential CMO) Work?

Each tranche in a CMO differs in the order bondholders receive principal payments. As payments on the underlying mortgage loans are collected, the interest is first paid to the bondholders in each tranche till it is completely paid off. The principal payments on the other hand are paid out first to investors in the first tranches until they are completely paid off. Then investors in the second tranche are paid off followed by investors in the next tranche.

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