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CMO vs CDO: Same Outside,

Different InsideByMichael 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 tocreate 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 intotrancheswith different

interest rates and maturities, and issued securities based on those tranches. The originating

mortgages served ascollateral.

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 inaggregate 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 someprepayment riskfor 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 muchreinvestment riskhe is willing to take in a CMO.

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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 usespecial 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 likeloans, 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 byquasi

governmentlending agencies (Federal National Mortgage Association, Government National

Mortgage Association, Federal Home Loan Mortgage Corp., etc.) while CDOs are private

labeled.

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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 CDOcash flowscan 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 fromthe 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 balloonedafter 2002 asthe securitization of asset backed loansgrew 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 sub-

prime 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.

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The Bottom Line

Investors worldwide learned a valuable lesson from the early days ofcollateralizing. It took

some creative thinking to find a way to take a large pool of loans and create securedinvestments 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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