Lesson 4 of 5 · 15 min
Collateralized mortgage obligations (CMOs)
A CMO takes the cash flows of mortgage pools and pass-throughs and carves them into tranches with different prepayment exposures, so the risk is not removed but moved to the investors best able to bear it.
In short
- A CMO securitizes pass-throughs or several loan pools and redistributes the cash flows across tranches with different exposure to prepayment risk.
- Tranching cannot eliminate prepayment risk; it redistributes it. The more senior a tranche, the less prepayment and default risk it carries.
- Sequential-pay: principal retires tranches one at a time. Early tranches are protected against extension; later tranches against contraction.
- PAC tranches pay a fixed principal schedule as long as prepayments stay within a band; the support (companion) tranche absorbs the prepayment risk.
- Other structures: Z-tranche (accrues interest, paid later), PO and IO strips, floaters and inverse floaters, and the residual tranche.
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