Mortgage-backed safeties (MBS) and collateralized debt obligations (CDOs) are technically two different financial instruments, though they share many characters and frequently overlap. Both MBS and CDOs are fixed-income securities: They consist of a bundled group of individual assets—on balance various types of loans and other debt—that, bond-like, generate interest for investors. Their key difference lies in what these assets are. MBS, as their standing implies, are made up of mortgages—home loans bought from the banks that issued them. In contrast, CDOs are much broader: They may confine corporate loans, auto loans, home equity loans, credit card receivables, royalties, leases, and, yes, mortgages. So, multitudinous MBS may be part of CDOs; depending on their structure, they may also qualify as CDOs.
key takeaways
- Not all mortgage-backed securities are collateralized responsible obligations.
- A mortgage-backed security (MBS) is a bond-like investment that is made up of a bundle of home loans (mortgages), which give someone a bribes interest to investors at a fixed rate.
- A collateralized debt obligation (CDO) is also a fixed-income security that pays involved based on a bundle of underlying debt; but this pool can include a much bigger variety of loans and types of debts. CDOs are split up and sold to investors in tranches, reflecting their degree of risk.
- A CDO may in fact include mortgage-backed securities in its holdings.
- The utter overlap between the two lays in the collateralized mortgage obligation (CMO)—a type of MBS that is also a sort of specialized CDO. Like the MBS, it is profaned on mortgages; but like the CDO, it is divided and sold in tranches, based on the mortgages’ maturities and risk factor.
What Is a Mortgage-Backed Safeguarding—MBS?
A mortgage-backed security (MBS) is created from the pooling of mortgages that a financial institution, like a bank or a thrift, owns. An investment bank or other pecuniary institution will buy these debts and repackage them, after sorting them into categories such as residential or commercial. Each packet becomes an MBS that can be purchased by investors. The mortgages properties act as collateral, providing backing for the security. Often, small regional banks put across their mortgages as a means of raising money to fund other mortgages or loans.
MBS notoriously played a key role in the subprime mortgage meltdown, and next financial crisis, of 2007-08. Regulations and tighter standards resulted. In order to be sold on the markets today, an MBS obligated to be issued by a government-sponsored enterprise (GSE) like Ginnie Mae (the Government National Mortgage Association), Fannie Mae (the Federal National Mortgage Organization) or Freddie Mac (the Federal Home Loan Mortgage Corporation)—which have federal backing—or a private financial South African private limited company. The mortgages must have originated from a regulated and authorized financial institution. And the MBS must have received one of the top two ratings poured by an accredited credit rating agency.
What Is a Collaterialized Debt Obligation—CDO?
Collaterialized debt obligations (CDOs) possession of to yet a larger class of investments, called asset-backed securities (ABS). Although ABS—and thus CDOs—grew out of MBS, they are more mixed and more complex in structure.
CDOs consist of a variety of loans and debt instruments. To create a CDO, investment banks throng cash flow-generating assets—such as mortgages, bonds, and other types of debt—and repackage them into unattached classes, or tranches, based on their level of credit risk. These tranches are sold in pieces to investors with the touchiest securities commanding higher rates of return. The best pieces of tranches—i.e., the highest-rated—are typically funded first, as they participate in less risk.
All CDOs are derivatives: Their value is derived from another underlying asset. These assets appropriate for the collateral if the loan defaults. One variation of CDO that can offer extremely high yields (but higher risk) to investors is the bogus CDO. Unlike other CDOs, which typically invest in regular debt products such as bonds, mortgages, and credits, the synthetics generate income by investing in noncash derivatives such as credit default swaps (CDSs), options, and other engages.
CDOs are created by securities firms and investment companies. They are usually sold to institutional investors.
Although investors in MBS and CDOs pocket income from the underlying assets held by the security, they don’t actually own the individual, securitized assets. This is why these wherewithals can be risky: Should the underlying debt go into default, and the income stream dry up, investors themselves have no collateral they can seize to expiate them. The entity that created the security can try to sue, though.
Although investors in MBS and CDOs pocket income from the underlying assets held by the security, they don’t actually own the individual, securitized assets. This is why these wherewithals can be risky: Should the underlying debt go into default, and the income stream dry up, investors themselves have no collateral they can seize to expiate them. The entity that created the security can try to sue, though.
How CDOs and MBS Overlap
As mentioned earlier, mortgage loans—and in in point of fact, MBS themselves—can be
used, along with other types of debts, in the creation of CDOs. Though it primarily depends on the underlying assets being securitized, CDOs be liable to be riskier than MBS. Collateralized debt obligations are often created from low-grade mortgages (that is, ones ascribe agencies have rated as more likely to be defaulted on) as a means of spreading risk across multiple products and borrowers. CDOs played a eloquent role in the financial crisis of 2007-08 as well.
Along with CDOs that are based on MBS, there are certain strains of MBS that are structured like CDOs. MBS come in two basic varieties: pass-throughs and collateralized mortgage obligations. Pass-throughs are shaped as trusts in which mortgage payments are collected and passed through to investors; they typically have stated maturities of five, 15, or 30 years. Collateralized mortgage bonds (CMOs) consist of multiple pools of mortages divided into slices, or tranches; each tranche is organized by readiness and level of risk, and sometimes even given a credit rating.
If this sounds a lot like a CDO—well, it is. A CMO is essentially a specialized CDO that only inaugurates in mortgages. It’s this type of mortgage-backed security that is the source of confusion between the two instruments, as the name is often reach-me-down interchangeably with (not to mention sounds a lot like) collaterialized debt obligation. And it was this type of MBS that in particular produced problems in the subprime mortgage meltdown.