Question

1) How does a CMO differ from a CDO?

2) What does a CDO offer to someone with credit risk from lending that is not available otherwise.

Please provide a well-written/detailed answer for both please!

Answer 1

1.) The main difference between CMO and CDO is in the type of pooled asset that they both have. Basically, both CMO and CDO are both the products of a process in Finance called Securitization. During securitization, generally institutions like investment banks transfer the assets present on their balance sheet like bonds of a certain type to an entity called SPV( Special Purpose Vehicle) which pools the assets and later turns then into other type of securities which may be traded and receive theirc cash flows from the bonds issued to the holders in the first place according to the tranches defined in the structure.

CDO's have the pooled asset in the form of underlying assets of asset backed securities, Real Estate Trust Investment Debt, RMBS or CMBS (Residential or commercial mortgage backed securities), money market debt securities and other credit derivatives instruments.

CMO'S have pooled assets only in the form of mortgage bonds which are the bonds backed by mortgage( properties which could be residential or commercial)

2.) CDO reduced the credit risk with lending and increases the rating eg. From BB to AA issues by agencies such as Moody's and S&P Global. This is possible because of the following features it brings :-

i.) Bond insurance is one of the very amazing features of this process and is made possible because of the presence of intermediaries like insurance agencies.

ii.) Senior Subordinate Credit Structures- The presence of senior subordinate credit structure makes possible the issuance of securities with less rating earlier to be issued at a more possible credit rating implying less risk. This is possible because of the segregation of cash flows into various senior subordinate tranches.

iii) Also it offers diversification of risk by pooling distinct variety of securities.

I hope this makes sense and helps you :)

Feel free to ask any questions in the comments section.

Also, press the thumbs up button.

Thanks & Regards.