Collateralized Mortgage Obligations (CMOs) and Collateralized Debt Obligations (CDOs)

Collateralized Mortgage Obligations (CMOs) — also known as Real Estate Mortgage Investment Conduits (REMICs) are sold by financial institutions as fixed income investments offering regular payments, safety of principal and yield advantages over other fixed income securities of comparable credit quality.

The creation of a CMO begins with a mortgage loan to finance a borrower's home or other real estate. The homeowner usually pays the mortgage loan in monthly installments made up of principal and interest payments on the loan. Mortgage lenders typically pool groups of loans with similar characteristics to create securities which can be sold. Pools of mortgage loans are commonly known as mortgage backed securities. These investments represent a direct ownership interest in a pool of mortgage loans. As real estate owners make their monthly payments the principal and interest collected are distributed to the investors.

Some CMOs are guaranteed by the Government National Mortgage Association (GNMA or Ginnie Mae), and agency of the U.S. government or by U.S. government sponsored enterprises such as the Federal National Mortgage Association (FNMA or Fannie Mae) or the Federal Home Loan Mortgage Corporation (FHLMC or Freddie Mac). These are known as agency CMOs.

Some private institutions such as subsidiaries of investment banks, financial institutions and home builders also issue mortgage backed securities. "Private label" CMOs issued by financial institutions are often collateralized with specialized types of loans, loan pools, letters of credit or credit enhancements. Private label CMOs are assigned credit ratings by independent credit agencies based on their structure, issuer, collateral and any guarantees or outside factors.

Factors such as prepayments, credit risk, fluctuating interest rates can effect the overall risk to the purchaser of a CMO. When interest rates rise, the market price or value of most types of CMO tranches drop in proportion to the time remaining to maturity. Rising rates may extend the life of CMOs and cause investor's principal to be committed for a longer period of time than anticipated.

A Collateralized Debt Obligation (CDO) is a structured investment product typically made of lower BBB rated CMO tranches. A CDO is packaged and in turn rated by credit rating agencies, thus allowing Wall Street to re-sell the lowest rated CMO tranches while spreading the risk over a new pool of investments.