Mortgage-backed securities (MBS) and collateralized debt obligations (CDO) 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 pooled group of individual assets, mainly various types of loans and other debts, which, similar to bonds, generate interest for investors. Their key difference lies in what these assets are. MBSs, as the name implies, are made up of mortgages – home loans purchased from the banks that issued them. In contrast, CDOs are much broader: They can contain corporate loans, auto loans, home equity loans, credit card receivables, royalties, leases, and yes, mortgages. Therefore, many MBS can be part of CDO; Depending on their structure, they can also qualify as a CDO.
- Not all mortgage-backed securities are secured debt obligations.
- A mortgage-backed security (MBS) is a bond-like investment that is made up of a bundle of home equity loans (mortgages), which pays interest to investors at a fixed rate.
- A collateralized debt obligation (CDO) is also a fixed income security that pays interest based on an underlying debt package; But this group can include a much wider variety of loans and types of debt. CDOs are divided and sold to investors in tranches, reflecting their degree of risk.
- In fact, a CDO can include mortgage-backed securities in its holdings.
- The main overlap between the two lies in the secured mortgage obligation (CMO), a type of MBS that is also a kind of specialized CDO. Like the MBS, it is based on mortgages; But like the CDO, it is divided and sold in tranches, depending on the maturity of the mortgages and the risk factor.
What is a mortgage-backed security (MBS)?
A mortgage-backed security (MBS) is created from the combination of mortgages owned by a financial institution, such as a bank or savings institution. An investment bank or other financial institution will purchase these debts and repackage them, after classifying them into categories such as residential or commercial. Each package becomes an MBS that investors can purchase. Mortgage properties act as collateral, supporting the collateral. Small regional banks often sell their mortgages as a means of raising money to finance other mortgages or loans.
MBS conspicuously played a key role in the subprime collapse and subsequent financial crisis of 2007-08. As a result, stricter regulations and standards were established. To be sold in the markets today, an MBS must be issued by a government sponsored company (GSE) such as Ginnie Mae (the National Government Mortgage Association), Fannie Mae (the Federal Association for National Mortgages) or Freddie Mac (the Federal Mortgage Association). Home Loan Mortgage Corporation) —which are federally backed— or a private finance company. Mortgages must originate from a regulated and licensed financial institution. And the MBS must have received one of the two highest ratings issued by an accredited credit rating agency.
What is a secured debt obligation (CDO)?
Collateralized debt obligations (CDOs) belong to an even larger class of investments, called asset-backed securities (ABS). Although ABS, and therefore CDO, arose from MBS, they are more varied and more complex in structure.
CDOs consist of a variety of loans 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 discrete classes or tranches, based on their level of credit risk. These tranches are sold in parts to investors with the riskiest securities with the highest rates of return. The best parts of the tranches, that is, those with the highest rating, are generally financed first, as they have less risk.
All CDOs are derivatives: their value is derivative of another underlying asset. These assets become collateral in the event of loan default. One variation of CDO that can offer extremely high returns (but higher risk) to investors is the synthetic CDO. Unlike other CDOs, which typically invest in regular debt products such as bonds, mortgages, and loans, synthetics generate income by investing in non-cash derivatives, such as credit default swaps (CDS), options, and other contracts.
CDOs are created by securities firms 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 security, they do not actually own the individual securitized assets. This is why these instruments can be risky: if the underlying debt defaults and the income stream dries up, the investors themselves have no collateral they can take to offset them. However, the entity that created the security may attempt to sue.
How CDO and MBS overlap
As mentioned above, home loans, and indeed the MBS themselves, can
used, along with other types of debt, in the creation of CDOs. Although it is primarily dependent on the underlying assets being securitized, CDOs tend to be riskier than MBSs. Secured debt obligations are often created from low-grade mortgages (that is, those that credit bureaus have rated most likely to default) as a means of spreading risk across multiple products and borrowers. CDOs also played an important role in the financial crisis of 2007-08.
Along with CDOs that are based on MBS, there are certain types of MBS that are structured as CDOs. MBSs come in two basic varieties: transfers and guaranteed mortgage obligations. Transfers are structured as trusts in which mortgage payments are collected and transferred to investors; they normally have declared maturities of five, 15 or 30 years. Secured Mortgage Obligations (CMO) consist of multiple groups of mortgages divided into portions or tranches; Each tranche is organized by maturity and risk level and is sometimes even assigned a credit rating.
If this looks a lot like a CDO, well, it is. A CMO is essentially a specialized CDO that only invests in mortgages. It is this type of mortgage-backed collateral that creates confusion between the two instruments, as the name is often used interchangeably with (not to mention sounding very similar) secured debt obligation. And it was this type of MBS that in particular caused problems in the subprime collapse.