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Updated Oct. 4, 2022 Read time 4 minReady To Buy a Home?
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Start My ApplicationCollateralized mortgage obligations (or CMOs) are complex securities backed by bundled mortgages. As homeowners pay back their loans, CMO investors earn dividends and income from homeowners’ interest and principal payments.
CMO investments can be a savvy way to balance portfolios that are heavy in other types of assets. For example, if you’re holding a lot of stocks and no real estate, CMOs allow you to benefit from real estate income without having to own or maintain property.
But, all investments carry a certain level of risk. And one of the biggest disadvantages of CMOs is homeowner repayment risk. If lots of homeowners default on their loans, the value of the security will drop. Investors should carefully weigh the risks of CMOs in their portfolios, especially when the mortgage market is weak and foreclosure rates are high.
CMOs are complex financial products. Keep reading to find out how these investments work.
CMOs are created when multiple mortgage loans are packaged and sold as an investment. Typically, these securities are made up of hundreds or even thousands of mortgage loans.
A CMO with only a few mortgage loans would be extremely risky. If just one homeowner defaulted, the security would likely face instant devaluation. When there are thousands of mortgages bundled in a CMO, a low rate of homeowner defaults won’t put an investor’s earnings at significant risk.
CMOs are organized by their level of risk and loan maturity (when a loan is due to be paid off). These two factors are used to create categories, also known as tranches, that group mortgage loans by risk. (BTW: tranche is the French word for slice or portion.)
Tranches with higher-risk loans offer higher earnings to investors. If payments are made on the mortgage loans in the higher-risk tranche (or equity tranche), the investor gets a bigger payout. Lower-risk loans are safer investments, but they offer investors lower earnings.
Money Term DiversificationIn investing, diversification holds a variety of assets in your portfolio to balance it out. If some assets lose value, other assets will keep your portfolio stable.
