Securitization is the process in which certain types of assets are pooled so that they can be repackaged into interest-bearing securities. The interest and principal payments from the assets are passed through to the purchasers of the securities. It also represents an alternative and diversified source of finance based on the transfer of credit risk (and possibly also interest rate and currency risks) from issuers to investors.
A Collateralized Debt Obligation (CDO) is essentially a form of securitization of certain financial assets. It is a complex structured finance product that represents and is backed by a pool of loans and/or other assets and sold by the lender in the market. The grouped debt assets are thereafter divided into tranches that are purchased by investors.
Since a CDO derives its value from that of other underlying assets, it is said to be a derivative instrument. These assets automatically become the collateral if the loan defaults.
Underlying assets in collateralized debt obligations include corporate bonds, government bonds, and mortgages. A CDO gathers income from a collection of collateralized debt instruments and allocates the collected income to a prioritised set of CDO securities.
In the case of mortgage securitization, a number of mortgage loans are grouped together in a securitization pool and then repackaged into tradable securities in the form of bonds. This is referred to as collateralized mortgage obligations.
Generally, Collateralized Mortgage Obligation (CMO) is a type of mortgage-backed security that contains a pool of mortgages bundled together and sold as an investment. They are similar to collateralized debt obligations, which are a broader collection of debt obligations across multiple financial instruments.
CMO comprises different tranches, or groups of mortgages, organised by their maturity and risk level. Each of the tranches have different principal balances, maturity dates, interest rates, and potential of repayment defaults. CMOs distribute principal and interest payments to their investors based on predetermined rules and agreements.
Collateralized Mortgage Obligations are not only sensitive to interest rate changes, but also to changes in economic conditions such as foreclosure rates, refinance rates, and the rates at which properties are sold.
On the good side, CMOs usually offer higher rates of return than government bonds. However, there are also risks involved because if the borrowers of the mortgages pay their loans back too quickly, the return is susceptible to suffering. Also, if too many of the CMO’s mortgage holders default in paying back their mortgages, the CMO might lose a lot of money to provide the expected returns.