What are mortgage-backed securities and collateralized mortgage obligations?
Banks or mortgage companies that own a large amount of mortgages can spread the risk of default on payment to a wide range of investors through securitization. To begin with, the financial institution puts certain mortgages into a group. Then they sell the rights to payments on those mortgages to investors in pieces. These pieces are called securities. There are two general classes of mortgage-backed securities: (1) mortgage-backed “pass through” securities, and (2) “collateralized mortgage obligations.” Pass-through securities are similar to bonds: whoever owns the pass-through gets a pre-established, fixed payment over time. These are low-risk investments, but also provide a limited return to investors. Collateralized mortgage obligations (CMOs) allow investors to get a higher return. CMOs are separated into tranches (which are like uneven slices of a pie). When homeowners make payments on their mortgages the money is directed to the investors of each tranche. The highest tranche, e.
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