A collateralized mortgage obligation, or CMO, is a form of mortgage-backed security (MBS) issued by a lender that handles residential mortgages. A collateralized debt obligation, or CDO, is sometimes supported by home mortgage-based securities, but it can also be supported by commercial mortgage-backed securities, bonds, bank loans, or just about any other financial instrument.
To create a CMO, a mortgage lender, a subsidiary of an investment bank or another financial institution merges groups of home loans with similar characteristics into a security that can be sold. However, the risk for the buyer of a GMO can be influenced by factors such as fluctuating interest rates, prepayments and credit risk.
If interest rates rise, the market value of most types of GMO tranches decreases in proportion to the time remaining until the due date. By extending the lifetime of the CMO, rising prices can lead to the investor’s principal sum being recorded for longer than expected.
A concept behind the CDO is to reduce the total cost of investing by appealing to investors with different investment horizons. Instruments with different amounts of credit quality are grouped in three or more tranches, each with the same duration. The senior tranches offer the best credit quality, but also the lowest yield. The mezzanine tranches have a slightly lower credit quality but a higher yield. The equity tranches are the riskiest, but they also pay the highest returns, almost always more than 10%. Financial professionals can resell the high-yield, low-credit equity tranches and spread the risk over a larger number of investments.
However, the more complicated structure of CDOs makes it more difficult for investors to analyze. CDOs are mainly purchased by life insurance companies, hedge funds and other institutions that are willing to take risks in the hope of outperforming government bond yields.
The extra risk of the equity tranches produces a higher return if the economy is strong, but if the economy slows down or the defaults in the mortgage market rise, greater losses have occurred. In addition, some CDO structures use leverage and credit derivatives, which makes it very risky to invest in even the senior tranches.