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Sub-prime mortgage and the collateralized mortgage obligations (CMOs) that packaged them were singled out for precipitating the financial crisis of 2008.

What is a collateralized mortgage obligation (CMO) that bundles these sub-prime mortgages? It is the product of financial engineering that transforms a group of illiquid financial assets into a security. For instance, there are special bonds backed by financial receivables such as credit card receivables, auto loans, leases and home-equity loans.

These are called asset backed securities (ABS). This special debt market is relatively new but expanding fast. When a pool of residential mortgages are used in the place of these other financial receivables, this particular asset backed security (ABS) is called a mortgage backed security (MBS). Finally, a type of mortgage backed security (MBS) is called a collateralized mortgage obligation when the mortgage backed security (MBS) is divided into portions of the debt based on maturity and/or risks of the pool.

!!!Mechanics of a Collateralized Mortgage Obligation (CMO)

Firstly, an investment bank buys mortgages from retail mortgage banks and brokers, that originated residential mortgage loans to the property owners.Then, different slices of IOUs are sold by the investment bank to satisfy different tastes of risk/return combination of investors. Investors (banks, hedge funds, pension funds, insurance companies, mutual funds, and governmental agencies including central banks) in a collateralized mortgage obligation (CMO) buy these IOUs to receive payments from the income generated by the pool of underlying home mortgages.

!!!Types of CMOs

In accordance to pre-defined and complicated rules, a collateralized mortgage obligation (CMO) pools and re-directs the payments of principal and interest from large pools of home mortgages to different types and maturities of CMOs. These different types of collateralized mortgage obligations (CMOs) are known as ”tranches”. This French word ”tranche” means __a portion of money__. Each type of a collateralized mortgage obligation (CMO) may have different principal balances, coupon rates, maturity dates, and other details of the rights and risks of ownership of any bonds.

The most simple form of CMO is composed of classes that are retired in a strict sequence. In other words, all the outstanding classes of collateralized mortgage obligation (CMO) receive regular interest payments, but principal payments are made to the first class exclusively until it gets paid fully. This is called __Sequential Pay__.

There also are more complicated types such as Planned Amortization Class, Targeted Amortization Class, Companion Tranches, Principal-Only, Interest-Only, Floating-Rate, etc. that are all beyond the scope of this lesson.

!!!__History of CMOs__

A collateralized mortgage obligation (CMO) was first created in 1983 by two investment banks (Salomon Brothers and First Boston) for the U.S. Federal Home Loan Mortgage Corporation whose main function is to provide liquidity for the U.S. home mortgage loans. The value of CMOs peaked in 2007 just before the global financial crisis.

The CMOs were singled out in the mass media for starting the global financial crisis in 2008. Even though the underlying mortgages went bad rapidly, investors for whatever reasons got fixated on the income streams generated by the CMOs instead. Rating agencies and other esoteric financial models failed to pick up increasing foreclosure and payment default rates in the middle of rising housing prices.

!!!__Risks of CMOs__

When Freddie Mac guaranteed the payment of principal and interest on the underlying pool of mortgages in 1983, the collateralized mortgage obligation (CMO) posed essentially no credit risk. This was true since government agencies such as Fannie Mae, Freddie Mac, or Ginnie Mae, at least implicitly, have the full backing of the US Government. Investors took prepayment, interest, market and liquidity risks, however, for which they were compensated with higher yields.

__Private label collateralized mortgage obligations (CMOs)__ were soon issued by investment banks with underlying mortgages that were not guaranteed by Fannie, Freddie or Ginnie. These unconventional collateralized mortgage obligations (CMOs) re-introduced credit risk to the collateralized mortgage obligations (CMOs) market. Credit insurance was mainly used to deal with the credit risk of private label non-conforming collateralized mortgage obligations (CMOs).

With the banks starting to pass more of the credit risk on to investors, collateralized mortgage obligations (CMOs) became absurdly complicated game among three parties of investment banks, mortgage brokers, and credit rating agencies. Soon, therefore, each tranche had to receive its own credit rating from a rating agency.

!!!__Lesson Summary__

Collateralized mortgage obligations (CMOs) provided enormous amount of liquidity into the secondary residential mortgage loan market; thereby enabling various mortgage originators to make more home loans to more property owners. Mortgage banks originated mortgages that the investment banks re-packaged into collateralized mortgage obligations (CMOs) that the investors devoured with the blessings of the rating agencies. The added liquidity quickened the pace of mortgage origination in turn.

However, there were limited numbers of houses and qualified borrowers to finance; credit standards had to fall to keep up with the profitable business. Many mortgage lenders eventually got involved in falsifying loan applications. Credit rating agencies did not adequately reflected the underlying fraud going on in the front line. With investment banks shopping the bond ratings, the real estate market inevitably ended up in a huge ”bubble”. The market started to lose momentum in 2007; in the following year, it collapsed in the worst financial crisis since the Great Depression of the 1930s.

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