Collateralized Mortgage Obligations (CMOs)

The exam's core skill here is ranking the tranche types by risk and yield, and knowing what protection each one does and does not provide.

What Is the Purpose of a CMO?

• CMOs are multi-class (tranche) securities backed by pools of mortgage pass-through securities or mortgage loans
• Created to address the prepayment uncertainty of plain pass-through MBS by redirecting principal and interest cash flows into separate tranches with different maturities and risk profiles
• CMOs do NOT eliminate prepayment risk; they redistribute it among tranches
• Issued by government agencies (Government National Mortgage Association (GNMA), Federal National Mortgage Association (FNMA), Federal Home Loan Mortgage Corporation (FHLMC)) or private entities

Think of it this way: A CMO takes the unpredictable stream of mortgage payments and slices it into layers. Some layers get paid first (lower risk), others absorb whatever is left over (higher risk). The total risk stays the same; it just gets divided up differently.

Exam Tip: Gotchas

• CMOs redistribute prepayment risk; they do NOT eliminate it. The total prepayment risk in the underlying mortgage pool is unchanged.

What Are the Two Directions of Prepayment Risk?

Mortgage prepayments respond to interest rates, which creates two opposite risks the tranche structure is built to manage:

• Contraction risk: when rates fall, homeowners refinance and prepay faster, so principal is returned earlier than expected and must be reinvested at the new, lower rates
• Extension risk: when rates rise, prepayments slow, so principal is returned later than expected and stays locked in at the old rate while market rates climb

The tranche types below differ mainly in how much they shield the holder from one or both of these directions.

What Are the CMO Tranche Types?

Sequential-Pay Tranches

The simplest CMO structure:

• All tranches receive interest payments simultaneously
• Principal is directed to tranches in order (Tranche A first, then B, then C, etc.)
• Tranche A has the shortest average life and the least extension risk
• The last tranche has the longest average life and the most extension risk

Planned Amortization Class (PAC) Tranches

The most predictable CMO tranche:

• PAC tranches have a prepayment band (collar) defined by two prepayment speeds
• As long as actual prepayments stay within the band, PAC holders receive principal on schedule
• Provides dual-sided protection against both contraction and extension risk
• Because of their predictability, PAC tranches typically carry the lowest yields among CMO tranches

Exam Tip: Gotchas

• PAC has dual-sided protection (contraction AND extension). TAC only protects against contraction. This is a frequently tested distinction.

Targeted Amortization Class (TAC) Tranches

A step down from PAC in predictability:

• Based on a single target prepayment speed (not a band)
• Provides protection against contraction risk only (faster prepayments), NOT extension risk
• Less predictable than PAC, but more predictable than companion tranches
• Yields more than PAC but less than companion tranches

Companion (Support) Tranches

The risk absorbers of the CMO structure:

• Every CMO with PAC or TAC tranches must have companion tranches to absorb the variable prepayment cash flows
• Receive excess principal when prepayments are fast (protecting the PAC)
• Receive less principal when prepayments are slow (also protecting the PAC)
• Bear the most prepayment risk and have the most volatile average life
• Offer the highest yields to compensate for the risk absorbed

Think of it this way: CMO cash flows work like a tower of cups stacked by priority. Mortgage principal pours in from the top. The PAC cup fills first to its scheduled amount, overflow drips down to TAC, and whatever is left reaches the companion. When prepayments are slow and less principal arrives, the lower cups stay empty until the higher ones are filled. That is why PAC holders see steady cash flows and companion holders see the most volatile.

Exam Tip: Gotchas

• Companion tranches exist to protect PAC tranches. Without companions, PAC tranches cannot maintain their predictable schedule. Companion = highest risk and highest yield; PAC = lowest risk and lowest yield.

Z-Tranches (Accrual Tranches)

The last in line:

• Receive no interest or principal payments until all prior tranches are retired
• Interest that would be paid is accrued and added to the Z-tranche's principal balance (similar to a zero-coupon bond)
• After all other tranches are paid off, the Z-tranche begins receiving both principal and interest
• The last to be paid with the longest average lives
• The accruing interest supports faster paydown of the earlier tranches

How Do the Tranches Compare on Risk and Yield?

Risk and yield move together. The tranche with the least prepayment risk (PAC) offers the lowest yield. The tranche absorbing the most risk (companion) offers the highest yield.

What Other CMO Characteristics Are Tested?

• Indenture: The governing document that specifies the rights, responsibilities, and rules of the CMO structure, including how tranches are defined and how cash flows are allocated
• Accrued interest: Calculated on a 30/360 day-count basis (not actual/actual like Treasuries)
• Interest payments: Monthly or quarterly, depending on the tranche
• Form of ownership: Book-entry
• Collateral: Residential mortgage loans or mortgage pass-through securities
• Priority of claim: Determined by tranche structure (senior tranches paid first)
• Call and put features: A clean-up call lets the issuer retire remaining bonds when the pool balance falls below a threshold, typically 10%; a put feature, when present, lets the bondholder require the issuer to repurchase the tranche under specified conditions
• Maturities: CMO tranches have different expected average lives (not fixed maturities); stated final maturity may be 30 years, but weighted average life (WAL) is typically shorter

Exam Tip: Gotchas

• 30/360 day count for CMOs. Unlike Treasuries (which use actual/actual), CMOs calculate accrued interest on a 30/360 basis, the same convention as corporate bonds.

What Should You Check on Exam Day?

• Rank tranches from most to least protected: PAC (lowest risk, lowest yield), TAC (one-sided protection), sequential (varies by position), companion (highest risk, highest yield), Z-tranche (last paid, longest life).
• Confirm PAC protection is dual-sided (contraction and extension) while TAC protection is single-sided (contraction only), a frequently confused pair.
• Remember companion tranches exist specifically to absorb the prepayment variability that keeps the PAC schedule on track.
• Apply 30/360 day-count to CMO accrued interest, not the actual/actual convention used for Treasuries.
• Treat "CMOs eliminate prepayment risk" as a false statement; they redistribute it among tranches, they do not remove it from the pool.