Mortgage-backed securities and CDOs are technically two different financial instruments, although they share many characteristics and often overlap. Both MBS and CDOs are fixed-income securities: they consist of a bundle of individual assets, mostly loans and other debts of various types, that pay interest to investors like bonds. Their key difference is what those assets are. MBS, as the name suggests, is made up of home mortgages purchased from the banks that issued them. By contrast, CDOs are much broader: they may include corporate loans, auto loans, home equity loans, credit card receivables, royalties, leases, and of course, mortgages. Therefore, many mortgage-backed securities may be part of a CDO; depending on their structure, they may also qualify as a CDO.
- Not all mortgage-backed securities are CDOs.
- Mortgage-backed security (MBS) is a bond-like investment consisting of a bundle of home loans (mortgage loans) that pays investors a fixed rate of interest.
- A collateralized debt obligation (CDO) is also fixed-income security that pays interest on a bundle of the underlying debt, but this collection can include a larger variety of loans and debt. CDOs are split and sold to investors in tranches to reflect their level of risk.
- A CDO may include mortgage-backed securities among its holdings.
- The main overlap between the two is in a collateralized-backed bond (CMO)—a type of MBS that is also a specialized CDO. Like mortgage securities, it is mortgage-based; but like CDOs, it is divided and sold in tranches based on mortgage maturity and risk factors.
What are mortgage-backed securities?
Mortgage-backed securities (MBS) are a collection of mortgage loans owned by a financial institution, such as a bank or savings bank. Investment banks or other financial institutions will buy the debt and repackage it into residential or commercial categories. Each scheme becomes an MBS that investors can buy. Mortgage property is used as collateral to back up the guarantee. Often, small regional banks sell mortgages as a means of raising funds to fund other mortgages or loans.
It is well known that MBS played a key role in the 2007-08 subprime mortgage crisis and the subsequent financial crisis. Regulations and stricter standards emerged. To be sold in today’s market, mortgage securities must be issued by a government-sponsored enterprise (GSE) such as Ginnie-Mae (Government National Mortgage Association), Fannie-Mae (Federal National Mortgage Association), or Freddie Mac (Federal Home Loans) Mortgage Corporations), which have federally backed or private financial corporations. Mortgage loans must come from a regulated and authorized financial institution. And mortgage securities must have one of the top two ratings issued by an accredited credit rating agency.
What is a collateralized debt CDO?
Collateralized debt obligations (CDOs) belong to a larger investment class called asset-backed securities (anti-lock braking systems). Although asset-backed securities and CDOs are derived from residential mortgage-backed securities, they are more diverse and complex in structure.
CDOs consist of various loan and debt instruments. To create a CDO, investment banks collect cash flow-generating assets, such as mortgages, bonds, and other types of debt, and repackage them into different classes or segments based on their level of credit risk. These installments These bonds are sold in tranches to investors with the highest risk and higher returns. The best tranches — those with the highest ratings — are usually funded first because they are less risky.
All CDOs are derivatives: their value is derived from another underlying asset. These assets become collateral if the loan defaults. A variant of CDOs that can offer investors extremely high yields (but with higher risk) is synthetic CDOs. Unlike other CDOs, which typically Invest in conventional debt products such as bonds, mortgages, and loans, synthetic bonds are created by investing in Non-cash derivatives such as credit default swaps (CDS), options, and other contracts to generate income.
CDOs are created by securities companies and investment companies. They are usually sold to institutional investors.
Although investors in MBS and CDOs receive income from the underlying assets held by the securities, they do not own the separate securitized assets. That’s why these instruments are risky: If the underlying debt defaults and the income stream dries up, investors themselves have no collateral available to compensate them. However, the entity that created the security could try to sue.
How CDO and MBS overlap
As mentioned earlier, mortgages and mortgage securities themselves can be
used to create CDOs along with other types of debt. Although CDOs mainly rely on securitized underlying assets, they tend to be riskier than MBS. CDOs are typically created from lower-grade mortgages (that is, mortgages rated by credit agencies as more likely to default) as a means of spreading risk among multiple products and borrowers. CDOs played an important role in the 2007-08 financial crisis as well.
In addition to mortgage-backed securities that are based on mortgage-backed securities, there are certain types of mortgage-backed securities that are structured like mortgage-backed securities. There are two basic types of residential mortgage-backed securities: pass-through and mortgage-backed debt. By structuring in the form of a trust, in which mortgage payments are collected and passed on to investors; they typically have maturities of 5, 15, or 30 years. Collateral-backed obligations (CMOs) consist of multiple collateral-backed obligations (CMOs) pools divided into tranches; each tranche is organized by the maturity date, risk level, and sometimes even a credit rating.
If that sounds a lot like a CDO, yes. A CMO is essentially a specialized CDO that only invests in mortgages. It’s this type of mortgage-backed securities that have led to confusion between the two instruments, as the name is often used interchangeably with mortgage debt (not to mention the resemblance it sounds). It was this type of mortgage-backed securities that caused problems in particular during the subprime mortgage crisis.