Question

Describe clearly and completely the cash flow structures in a CMO. How is this structure different from a “vanilla” mortgage pass through security? Why might an investor prefer a CMO instrument over the basic pass through security?

Answer 1

A collateralized Mortgage Obligation (CMO) refers to type of Mortgage backed security that contains a pool of Mortgages bundled together and sold as an investment.Organised by maturity and level of risk,CMO recieves cash flows as borrower repay the mortgages that act as collateral on these securities.Inturn,CMOs distribute principal and interest payments to their investors based on predetermined rules and agreements.CMO consist of several tranches ,or group of mortgages,organised by their risk profile.As complex financial instrument,tranches typically have different principal balances interest rates,maturity dates,and potential of repayment defaults.CMOs are sensitive to interest rate changes as well as to change in economic conditions,such as foreclosure rates,refinance rates and the rates at which properties are sold.Each tranche has a diffrent maturity date and size and bonds with monthly coupons are issued against it.The coupon makes monthly principal and interest rate payments.

CMOs vs Mortgage backed security(MBS).

Mortgage passed through securitiesand collateralized mortgage obligations(CMO)are different types of asset backed securities that use mortgage backed securities as collateral.securities are investments that trade on the secondary market.CMOs are one type of Mortgage backed security,which are divided into tranches based on their risk classification

Difference between CMO and Mortgage pass through security.

.A CMO is a type of Mortgage backed security(MBS) in which mortgages are bundled together and sold as one investment ordered by maturity and level of risk.

.A Mortgage pass through securityty is a type of MBS,in which shares in a pool of mortgages sold by a financial institution or government agency,where mortgage payments less fees are passed through to the security investor.

An investor choose CMOs over basic pass through security may due to avoid fees for the servicing inter mediary in basi pass though security.Also a CMO is more safer for the investors as there were an abligation to pay the money to investor on maturity.