CMO vs CDO: Same Outside,

Different Inside
By Michael Schmidt | Updated November 12, 2013AAA |
One of the most important innovations from Wall Street was the act of pooling loans together
to then split up into separate interest bearing instruments. This concept of collateralizing and
structured financing predates the market for collateralized mortgage obligations (CMOs) and
collateralized debt obligations (CDOs). It was not until the early 1980s that the concept was
formalized by repackaging mortgages to create the mortgage backed security industry (MBS).
MBSs are secured by a pool of mortgages where all the interest and principal simply pass
through to investors. CMOs were created to give investors specific cash flows instead of just
the pass through of interest and principal. CMOs were first issued in 1983 for Federal Home
Loan Mortgage Corp (Freddie Mac) by the investment banks First Boston and Salomon
Brothers, which took a pool of mortgage loans, divided them into tranches with different
interest rates and maturities, and issued securities based on those tranches. The originating
mortgages served as collateral.
In contrast to CMOs, CDOs, which came along later in the 1980s, encompass a much
broader spectrum of loans beyond mortgages. While there are many similarities between the
two, there are some distinct differences in their construction, the types of loans held in
aggregate and the types of investors seeking out either one.
CMO - Born Out of a Need
Collateralized mortgage obligations (CMO), a type of mortgage backed security (MBS), are
issued by a third party dealing in residential mortgages. The issuer of the CMO collects
residential mortgages and repackages them into a loan pool which is used as collateral for
issuing a new set of securities. The issuer then redirects the loan payments from the
mortgages and distributes both the interest and principal to the investors in the pool. The
issuer collects a fee, or spread, along the way. With CMOs, the issuers can slice up
predictable sources of income from the mortgages by using tranches, but like all MBS
products, CMOs are still subject to some prepayment risk for investors. This is the risk that
mortgages in the pool will be prepaid early, refinanced, and/or defaulted on. Unlike an MBS,
the investor can choose how much reinvestment risk he is willing to take in a CMO.

Below is an example of a simplified version of three tranches of various maturities using a

sequential payout structure. Tranche A, B and C will all receive interest payments over their
life but the principal payout flows sequentially until each CMO is retired. For example: Tranche
C will not receive any principal payouts until Tranche B is retired, and Tranche B will not
receive any principal payouts until Tranche A is retired.

While the securities themselves can seem complicated and its easy to get lost in all the
acronyms, the process of collateralizing loans is quite simple.
The issuer of the CMO, as a legal entity, is the legal owner of a pool of mortgages which are
purchased from banks and mortgage companies. Prior to the advent of repackaging
mortgages, a borrower would visit his local bank who would lend out money for the purchase
of a home. The bank would then hold the mortgage using the house as collateral until it was
paid off or the house was sold. While some banks still hold mortgages on their books, the
majority of mortgages are sold off soon after closing to third parties who repackage them. For
the initial lender, this provides some sense of relief as they no longer own the loan or have to
service the loan. These mortgages then become collateral and are grouped together with
loans of similar quality into tranches (which are just slices of the pool of loans). By creating
CMOs from a pool of mortgages, issuers can design specific, separate interest and principal
streams in various maturity lengths to match investors needs with the cash flows and
maturities they desire. For legal and tax purposes, CMOs are held inside a real estate
mortgage investment conduit (REMIC) as a separate legal entity. The REMIC is exempt from
federal tax on the income they collect from the underlying mortgages at the corporate level,
but income paid to investors is considered taxable.
CDO - Some Good Some Bad
The collateralized debt obligation (CDO) came to life in the late 1980s and shares many of
the characteristics of a CMO: loans are pooled together, repacked into new securities,

investors are paid interest and principal as income and the pools are sliced into tranches with
varying degrees of risk and maturity. A CDO falls under the category known as an asset
backed security (ABS) and like an MBS, uses the underlying loans as the asset or collateral.
The development of the CDO filled a void and provided a valid way for lending institutions to
essentially move debt into investments through securitization, the same way mortgages were
securitized into CMOs. Similar to CMOs issued by REMICs, CDOs use special purpose
entities (SPE) to securitize their loans, service them and match investors with investment
securities. The beauty of a CDO is that it can hold just about any income producing debt like
credit cards, automobile loans, student loans, aircraft loans and corporate debt. Like CMOs,
the slicing up of the loan pieces is structured from senior to junior with some oversight from
rating agencies who assign grade ratings just like a single issue bond, e.g. AAA, AA+, AA,
etc.
Below is an example of how a CDO is structured. Each CDO has a balance sheet just like any
company would have. The assets are comprised of the income producing components like
loans, bonds, etc. Each bond issued on the left is tied to a specific pool of assets on the right.
The bonds are then rated by third parties based on the seniority of their claims to the pool and
the perceived quality of the underlying assets. In theory, bonds of lower quality ratings and
seniority would command higher rates of return by investors.

CMOs vs. CDOs

There are many similarities between CMOs and CDOs as the latter were modeled after the
former by design. CMOs can be issued by private parties or backed by quasi
government lending agencies (Federal National Mortgage Association, Government National
Mortgage Association, Federal Home Loan Mortgage Corp., etc.) while CDOs are private
labeled.

While CMOs and CDOs have similar wrappers on the outside, they are different on the inside.
The CMO is a little easier to understand as the cash flow it provides is from a specific pool of
mortgages while the CDO cash flows can be backed by automobile loans, credit card loans,
commercial loans and even some tranches from a CMO. While the CMO market did suffer
some impact from the real estate implosion of 2007, the CDO market was hit harder. Only a
small portion of the CMO market was considered sub-prime while CDOs made sub-prime
CMOs their core holdings. The CDOs that purchased the lowest ranked, riskiest tranches of
CMOs blending them with other ABS assets suffered dearly when the sub-prime tranches
went south. Its unlikely the mistakes of the past will be made again as there is much more
oversight from the SEC than there was before, but sometimes history repeats itself. Both
products play the same role of pooling loans and assets together then matching investors with
the cash flows, so its up to the investor to decide how much risk they want to take.
CDOs were a relatively small segment of the ABS market with only $340 million outstanding
issues in 2002 compared to the total CMO market of $4.7 trillion. The CDO market ballooned
after 2002 as the securitization of asset backed loans grew and issuers advanced their
purchases of the riskier CMO tranches. As the real estate markets mushroomed, so did the
CDO/CMO markets as the total outstanding CDOs peaked at $1.3 trillion in 2007. This
phenomenal growth came to an abrupt halt as the real estate bubble burst, reducing the CDO
market to around $850 million in 2013.
While it looked good on paper to buy the riskier tranches of CMOs that were not in demand
and bundling them into CDOs, the quality of those tranches which were presumed to be subprime turned out to be much more sub-prime than first thought. Rating agencies and CDO
issuers are still being held accountable, paying fines and making restitution after the housing
market collapse of 2007 which led to billions in losses in CDOs. Many became worthless
overnight, downgraded from AAA to junk. Those who invested heavily in the riskiest CDOs
experienced larges losses when those issues ultimately failed. A number of CDO issuers were
charged and/or fined for their role in packaging risky assets that failed. One of the largest and
most publicized cases was against Goldman Sachs (NYSE:GS) in 2010, who was officially
charged and fined for structuring CDOs and not properly informing its clients about the
potential risks. Based on estimates from the Securities and Exchange Commission, investors
lost more than $1 billion after the dust settled in 2010.
CDOs still exist today but will forever wear the scars of good decisions gone bad.

The Bottom Line

Investors worldwide learned a valuable lesson from the early days of collateralizing. It took
some creative thinking to find a way to take a large pool of loans and create secured
investments for investors. This freed up capital for lenders, created many jobs for issuers,
created liquidity in a not so liquid market, and helped fuel homeownership. The same process
that fueled homeownership eventually fueled a real estate bubble and subsequent collapse.
The process of collateralization energized itself but ultimately caused its own collapse.

Read more: CMO vs CDO: Same Outside, Different Inside

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