Collateralized Mortgage Obligations (CMO) Explained
If you’re learning how to invest in real estate, the first step can be intimidating. The process is time-consuming, and even though the property market can be a lucrative investment space, there are several barriers to entry. Physical real estate requires significant funding, and it can appreciate slowly, with large sums invested over several years. House flipping, which involves purchasing a property, renovating it then selling it, is risky and requires extensive work.
So, how can individual investors circumvent these barriers to get a stake in the real estate market? Collateralized mortgage obligations (CMOs), also called collateralized mortgage-backed securities, are one solution. A CMO can expose new investors to the property market and its potential returns. However, these investment vehicles are complex, so it's worth understanding how they work as well as the risks involved before getting started.
Read on for our comprehensive guide on CMOs to learn if they’re the right fit for your investment portfolio.
What is a collateralized mortgage obligation (CMO)?
A CMO is an investment vehicle that allows investors to get exposure to the real estate market through collateralized mortgage loans. This makes it a type of mortgage-backed security (MBS), albeit one that is more complex than a basic MBS. Such securities generally consist of residential property mortgage loans.
An MBS entitles investors to a share of the principal and interest payments made on mortgage loans. These mortgage loans are purchased from banks, mortgage companies and other loan providers and consolidated into pools. The pools can contain mortgages with similar terms and rates or a varied collection of mortgages with a mix of terms and rates. The reason for pooling these mortgages is to reduce investor risk in case individual mortgages have higher default risk. MBSs can be issued by government or private entities, and a structure holding a pool of mortgages is known as a real estate mortgage investment conduit (REMIC).
A CMO is a collection of several MBS pools holding different types of mortgages. Some mortgages in these pools can be low risk, while others are high risk. The mortgages also differ in terms of their rates and time horizons for repayment of principal amounts. These different bundles of securities are known as tranches — an important distinction for CMOs.
How CMOs work
When an investor purchases a CMO, it's similar to purchasing a bond. The investor gets regular interest payments — also known as coupon payments — from the issuer of the security until its maturity date. If the interest rate in a CMO is higher, it’ll provide better returns but may also be riskier. In order to pay investors, the issuer of the CMO collects interest and principal payments on the underlying mortgages and, after deducting a fee, passes on the funds to investors.
CMOs combine several tranches to provide buyers with a choice of risk profiles and payment terms. Someone who wants higher returns and has a higher risk tolerance can invest in tranches with higher yields that take longer to mature but which could be subject to interest rate changes. A more risk-averse investor might choose a short-term tranche that has less yield but a faster return. Tranches are also categorized in terms of priority of payments.
The benefits of CMOs
CMOs are a popular type of investment for seasoned investors and can be quite lucrative in the medium and long term. The following section details the main benefits of CMOs and how investing in them may complement an overall investment portfolio.
CMOs provide a variety of investment options
CMOs have different tranches catering to various investment strategies. Tranches can differ in terms of interest rates, principal amounts and maturity dates. Depending on your portfolio’s needs, you can choose tranches according to your preferred strategies. Irrespective of the CMO in which you invest, your investment can be impacted by the real estate market. However, the CMO can give you much more control over your investment than investing in physical real estate.
Investors can choose investments based on their risk tolerance
Tranches in CMOs all get a credit rating depending on the quality of the underlying mortgage pools. Thus, higher-rated tranches are considered safer investments. You choose which tranches to invest in depending on your risk tolerance. You can also choose to purchase higher priority tranches, which pay investors earlier than lower priority tranches, thus making them a safer investment.
CMOs offer higher yields than other fixed-income securities
Fixed-income securities include debt instruments that generally consist of government or private bonds that are purchased by investors. These bonds are essentially like loans taken from the investor and pay a fixed interest until maturity, after which the principal amount is also repaid to the investor.
Conversely, CMOs pay investors using principal and interest payments received from homeowners whose mortgages are part of the CMO. Since mortgage rates can vary, and higher-risk individuals generally have to pay higher mortgage rates, the returns on CMOs are typically higher than those for conventional bonds.
Another factor to consider is maturity. While bonds have a fixed maturity date, CMOs can have flexible maturity dates depending. Therefore, it is possible that the entire stipulated principal and interest amount can be paid sooner than expected. In those cases, the CMO will have a greater yield to maturity.
CMOs help diversify an investment portfolio
CMOs are a great way to diversify an investment portfolio. They can provide access to real estate investment without the funds necessary for physical property ownership. Additionally, since CMOs are not connected to the equity market, they provide a way to hedge a portfolio that’s already heavily invested in equities.
The risks of CMO investing
Though CMO investing can help diversify a portfolio and produce strong yields for income investors, like with any investment, there are risks involved. Understanding which factors can negatively affect CMOs is imperative. The following section details some of those potential drawbacks.
CMOs carry a prepayment risk
One of the foremost risks of investing in CMOs is prepayment risk — when homeowners decide to repay their mortgage loan early and avoid prolonged interest payments. This can happen when homeowners decide to refinance their loans, or when they sell the mortgaged property and use the proceeds to repay their loan. Prepayment rates also go up when interest rates fall because it becomes easier for mortgage holders to refinance their loans.
In either case, a prepayment of the loan reduces the amount of interest received by the issuer and, therefore, by the investor as well. Thus, prepayment reduces the return on a CMO investment.
Market interest rates can affect earning potential
Mortgage holders may decide to refinance their home loans when interest rates fall in order to get better payment terms and lower their interest payments. This leads to prepayment risk. Additionally, if the investor receives the principal payment during a period of low market interest rates, they'll find it difficult to reinvest the funds in a way that gives them similar yields. This is referred to as reinvestment risk.
As a result, CMOs are highly sensitive to market interest rates. This also means that they aren’t set-it-and-forget investments. Instead, someone investing in a CMO will have to routinely monitor interest rates and the real estate market to determine whether or not the CMO is still a good investment.
CMOs are complex investments
CMOs are complex financial instruments that are influenced by various factors. This means that they carry several inherent risks. In the case of a collective market crash or just a slump in the housing market, even low-risk CMOs may fail, thus wiping out investor funds. Even in the best cases, it is relatively difficult for investors to get a clear idea of the quality of underlying mortgages that are responsible for the CMO's cash flow.
Because of this, the complexity of CMOs makes them difficult to model and forecast. For this reason, investing in this type of security should always be undertaken with caution.
CMO vs. MBS (Collateralized Mortgage Obligation vs. Mortgage-Backed Security)
When it comes to investing in debt securities in the residential real estate market, one can choose between a CMO and an MBS. Though these securities may seem similar because they both draw from underlying pools of mortgage payments, and while it is true that they are both susceptible to prepayment and interest rate risks, there is a significant difference between a CMO and an MBS.
MBSs are pass-through securities, meaning they are pools of fixed-income securities backed by a package of assets with a portion of the interest and principal payments “passed through” to the investor. In this case, the risk depends on the underlying mortgages in the pool.
On the other hand, the CMO structure contains multiple securities — or tranches — with different time frames, returns and risk profiles. In order to achieve this, the cash flow from the CMO’s underlying assets is redirected according to the predetermined distribution schedule. Thus, priority bondholders or investors get paid from the pool first. Once all the interest and principal payments for a particular tranche are paid, that tranche is retired and subsequent tranches (and their investors) then receive funds from the underlying assets.
CMO vs. CDO (Collateralized Mortgage Obligation vs. Collateralized Debt Obligation)
While the underlying assets a CMO relies on for cash flow are all real estate mortgage loans, a collateralized debt obligation (CDO) can be based on any debt instrument. Thus, the proceeds an investor receives from a CDO can stem from payments for credit card debt, car loans, leased equipment and a variety of other financial borrowings.
Thus, the basic difference between a CMO and a CDO is their underlying assets. An investor looking for exposure to the real estate market will put money into a CMO, while someone looking for a broader investment opportunity in debt instruments could consider a CDO.
CMOs and CDOs are highly complex, and it’s often difficult to clearly judge the quality of their underlying assets. Both can have tranches to attract investors with various risk tolerances and both are sensitive to interest rate changes and prepayment risk.
How to buy collateralized mortgage obligations
CMO security certificates can be purchased from various issuers, including government agencies such as the Government National Mortgage Association (Ginnie Mae) or government-sponsored enterprises such as the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). Prospective investors can also buy CMOs from private banks and financial institutions.
When purchasing CMOs, investors get access to the prospectus, which details the investment’s rate of return, estimated maturity and risk profile. It’s important to look at whether the issuer backs the CMO or not. For example, some banks will guarantee that they will buy back their CMOs, giving the investor better liquidity. Ginnie Mae securities are similarly backed by the U.S. federal government in order to protect investors.
How are CMOs taxed?
CMOs are held inside a REMIC as a separate legal entity. Since its income is passed through, the REMIC is typically exempt from federal tax on the income it collects from the underlying mortgages. However, since investors receive interest payments, that is considered taxable income. Proceeds from investing in CMOs can be taxed at federal, state and local levels. However, payback of the principal amount is not taxable.
Summary of Money's collateralized mortgage obligations (CMO)
CMOs are a type of asset-backed security that use residential home mortgages as their underlying assets to generate cash flow for investors. CMOs contain varying levels or tranches, which affect how the interest and principal mortgage payments are disbursed to investors. Through this mechanism, they are able to offer different risk profiles, rates of return and maturity dates to investors, as well as a means of diversifying their portfolios with real estate without having to own physical property.
However, the complexity of CMOs tends to make them opaque, and it’s usually difficult for investors to clearly assess the quality of the underlying assets. Like other debt-based securities, CMOs are also highly susceptible to interest rate fluctuations and prepayment risk. Like any type of investment, be sure to weigh the pros and cons of CMOs before deciding whether or not to invest in them.