What is the difference between Collateralized Mortgage Obligations and other mortgage backed securities?
Rich P questioned:
How do CMO’s differ from any other mortgage-backed bundles? I know fannie mae finances primarily by selling the latter, so what is the benefit in CMO’s in comparison to them?
How do CMO’s differ from any other mortgage-backed bundles? I know fannie mae finances primarily by selling the latter, so what is the benefit in CMO’s in comparison to them?
The original MBS were pass-through MBS — where the cash flows (principal plus interest) were passed through to the investors — except for a small piece of the interest that is taken out for servicing. Investors didn’t like the prepayment risks.
In the mid-1980s, Dexter Senft — then the head of Fixed Income Research at First Boston — came up with the thought for CMOs. With a CMO, the cash flows of the MBS are filtered into several different bonds — each having a different risk profile. These were called Tranches or Classes. Some tranches had very small prepayment risk — while others had a lot. The thought was that by breaking the cash flows into several tranches, it would allow investors to buy pieces that fit their risk profile.