Collateralized Mortgage Obligations (CMOs)

With your understanding of how pass-through mortgage-backed securities (MBS) expose investors to unpredictable prepayment risk, CMOs represent the market's solution: restructure the cash flows into tranches with different risk profiles so each investor can choose their level of exposure.

CMO Structure and Purpose

• 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.

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

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

Tranche Risk and Yield Summary

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.

Additional CMO Characteristics

• 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)
• Clean-up call: Issuer can retire remaining bonds when pool balance falls below a threshold, typically 10%
• 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.