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CMO: A Brief Guide

CMO: A Brief Guide

What is a CMO?


• A CMO or collateralized mortgage obligation is a type of financial debt investment that was initially created by investment banks First Boston and Salomon Brothers in the early 1980s. At this time, the CMO was primarily structured for United States mortgage lender, Freddie Mac. 
• In a legal context, the collateralized mortgage obligation (CMO) is a special-purpose security that is distinct from the institutions that create or package it. A CMO is made-up of individual mortgages that are transformed into bond-like instruments; it is a debt product that relies on homeowners to pay-off their mortgages.
• The entity maintains legal ownership of the packaged mortgages, known as a pool, while the investors, who purchase (in bond form) the bundle, will receive payments according to a defined set of rules. 
• In regards to terminology, the mortgages within the CMO are referred to as collateral, the bonds are tranches or classes, and the overall structure of the CMO is the set of rules that dictates how funds are transferred. 
• Banks, hedge funds, pension funds, mutual funds, insurance companies, government agencies and central banks will all invest in CMO packages. 
What is the Point of a CMO?
• A mortgage loan can be transformed into a fragmented bond suited for purchase if it is spliced and sold to investors. For example, a $200,000 30 year mortgage with an attached interest rate of 5% could be split into 200 1000 dollar bonds. This package is then attached with the 30 year amortization and a decreased interest rate of say 4.5%–the remaining interest would be delivered to service companies. Although this process seems fairly simple, due to a number of factors, the above package would not be feasible for investment.
• As a result of problems facing the simplified CMO, Solomon Brothers and First Boston revamped the CMO market to create a number of different bonds from a uniform mortgage loan to encourage a number of different investors. 
Different types of Bonds in a CMO:


• A group of mortgages can effectively create 4 different classes of bonds: the first group will receive prepayments before the rest, thus enabling the first group to be paid off sooner. That being said, because of the expedited pay-off, the first class would also have a lower interest rate than the rest. As a result, the 30 year mortgage in a CMO bundle is transformed into bonds of various lengths suitable for a number of investors with varied goals.
• In addition, a group of mortgages can be packaged has the 4 distinct types of bonds. In this fashion, any losses incurred by the CMO would go against the first group before any others. In this structure, the first group would possess the highest rate of return, while the second would have a slightly lower one etc. As a result of this structure, the investor can choose a bond class that fits his or her risk level. 
• Mortgages can also be split into interest-only or principal-only bonds. Because of their zero-coupon status, a principal-only bond will sell at a discount, while the interest-only bond will include only the interest payments of the underlying pool of loans. These bonds will fluctuate in value based on interest rate movements. 
• When a CMO is split into multifarious classes of bonds, the risk associated does not vanish; instead, it is simply reallocated among the different classes. 

CDO: Everything to Know

CDO: Everything to Know

What is a CDO?


• A CDO, or collateralized debt obligation, is a type of structured asset-backed security that possesses multiple Tranches, are issued by special purpose organizations and packaged with debt obligations including loans and bonds. 
• CDOs will vary in formation and the underlying assets that make up the product; however, the basic principle will remain the same—a CDO is an asset-backed security created by a corporate entity to hold assets as collateral or to sell packages of debt and cash flows to investors. 
• Each tranche of a CDO offers a varying level of risk and return to meet fluctuating investor demands. The value of a CDO is derived from the portfolio of underlying fixed-income assets; the tranches are divided into different classes based on a risk assessment, whereby “senior” tranches are regarded as the safest securities. This division is necessary because interest and principal payments are delivered in order of seniority. As a result, a junior tranche, due to the increased risk, will offer higher coupon payments or lower prices to entice investors and offset the increased exposure to default risk. 
CDO Example:
• A CDO is a fairly complex and unique investment product. To simplify the explanation, think of a CDO as a promise to distribute cash flows to investors in a predetermined sequence, based on how much money the CDO collects from its pool of fixed income assets. If the cash collected by the CDO is not enough to pay to all of its investors, those in the lower tranches will suffer losses first. 
How is a CDO Created?
• A CDO is structured when a special purpose organization acquires a portfolio of assets, such as commercial real estate bonds, mortgage-backed securities and corporate loans. The SPE, once packaged, will the issue bonds to investors in exchange for cash. 
• The cash is then used to purchase the portfolio of investments or debt. The bonds, when issued, are organized by different risk factors (tranches). As stated before, senior tranches are paid from the cash flows of the underlying securities before junior and equity securities. If the CDO loses money, losses are first assumed by the equity securities, then by the junior tranches and lastly by the senior tranches. 
• The return and associated risk of the CDO depends on how the tranches are formulated and the performance of the underlying assets. A CDO enables the creator of the bundle to pass credit risk to other investors (institutions or individuals); as a result of this basic premise, it is crucial to understand how the particular CDO is calculated.  
• A CDO is typically created by an investment bank; the investment security requires the presence of an underwriter and an asset manager before the bundle can be sold to other institutions or individual investors.