CMO Vs. MBS: What’s the Difference?

If you’re looking to invest in real estate, but don’t want the high risk of flipping houses or buying investment properties, you might want to consider investing in collateralized mortgage obligations or other mortgage-backed securities – also called an MBS.

When it comes to securities, understanding what you’re buying and your risk level is crucial to making the best decisions for your financial future. Knowing the difference between products can help you make decisions based on the risks and rewards.

What Are CMOs?

CMOs are mortgage-backed securities that are made up of a pool of mortgages that are sold as a single investment. As an investor, this allows you to invest in the cash flow generated by a large group of mortgage loans in one package.

A large CMO might contain thousands of mortgage loans. These mortgages are organized by both their maturity – when they are due to be paid off in full, and their risk – how likely it is that the borrowers won’t pay these loans back.

The mortgage loans inside a CMO are ranked in tranches, or categories, according to two factors: a loan’s maturity date (or due date) and how risky the loan is. Loans are considered riskier if there’s a higher chance that their borrowers will stop making their payments and default on their mortgages.

How CMOs Work

CMOs receive cash flow when the mortgage borrowers make payments on their loans each month. Each of the monthly payments borrowers make include dollars used to pay down the principal balance of a mortgage and to cover the interest on that loan.

CMOs pay out returns to their investors in the form of principal and interest payments. These regular payments are one of the advantages of CMOs, though the payments might vary each month depending on how many people pay their loans on time or whether borrowers pay off their mortgages early, also known as prepayment.

How Often Do CMOs Pay Interest?

Interest and principal payments are divvied out to investors based on each CMO’s predetermined rules and agreements and can vary between CMOs. When you invest in a CMO, you’ll receive the rules from the issuer, which will spell out when you will receive payments.

CMOs can make these payments if most of the borrowers pay their mortgages on time. There is always the risk that some borrowers will default on their mortgage loans, not making payments until their lenders start the foreclosure process.

If only a small number of homeowners default on the loans in a CMO, the investment vehicle should still have enough financial health to make its regularly scheduled interest and principal payments. If too many borrowers default, though, the CMO will lose money and won’t be able to pay its investors.

What Are Agency CMOs And Private-Label CMOS?

All investments come with risks and some CMOs are slightly riskier than others. CMOs are relatively safe investments because many of the mortgage loans in CMOs are insured by large mortgage investors such as Ginnie Mae, Fannie Mae or Freddie Mac. These loans are called agency CMOs and generally carry a lower risk of default, because of the agencies insuring them.

You can also invest in CMOs backed by private companies such as banks and lenders. These CMOs, known as private-label CMOs, can be riskier investments. But independent credit agencies assign private-label CMOs a credit rating. Because of this, you can easily gauge how likely the loans in private-label CMOs are to fall into foreclosure. You can then invest according to your risk tolerance.

How Risky Are CMOs?

Like any investment, CMOs do come with risks, so what are the risks involved in CMOs? Prepayment is a big one. If the borrowers of the loans in your CMO pay back their mortgages too quickly, you’ll miss out on the interest payments that they would have made if they would have held onto their loans longer. This can reduce your rate of return.

 

Another big risk is defaults. If the borrowers behind the loans in your CMO don’t make their payments, their loans could fall into foreclosure. If too many loans in your CMO do go into foreclosure, it will lose money and won’t be able to pay investors.

 

Market risk is a real threat, too. If mortgage interest rates fall after you’ve invested in a CMO, a large number of the borrowers repaying the loans in it could decide to refinance. When borrowers refinance, their loans are paid off by their lenders and replaced with new loans. Their old loans, the ones in your CMO, are now paid off and the borrowers behind them aren’t paying interest. Again, this could result in a lower return on your investment.

Questions To Ask Before Investing In CMOs

Before investing in a CMO, it’s important to ask some key questions. Here are some examples of questions you’ll want to ask before committing to a CMO:

Collateralized Mortgage Obligations (CMO) FAQs

Who typically invests in CMOs?

Anyone can invest in a CMO. The minimum you’ll need to invest in one of these vehicles will vary, but usually, you’ll need to come up with at least $1,000 to make an investment in a CMO.

Are CMOS mortgage-backed securities?

Yes, CMOs are one type of mortgage-backed security. Mortgage-backed securities are made up of a pool of mortgages that are packaged together and sold as an investment product.

What are tranches, and how do they work?

The mortgage loans in a CMO are organized in different tranches. “Tranch” is basically another word for category. With CMOs, loans are organized in tranches, or categories, according to their maturity dates and how risky they are. The riskiest loans might be organized in their own tranch, while low-risk mortgages are contained in another tranch.

It’s important for investors to understand the different tranches in their CMOs. That’s because each tranch has its own interest rates, maturity dates and payout schedules.

The Bottom Line

The most important thing to know about CMOs is that they are a type of mortgage-backed security. They let you invest in the real estate market without buying a home or property yourself. Before investing in a CMO, know your risk tolerance and pick a CMO that fits your financial goals.