Collateralized mortgage obligations (CMOs) are a type of mortgage-backed security that is created with the prime motive of redistributing the prepayment risk to different classes of bondholders.

Let’s take a detailed look at how this works. As we learned before, in a pass-through security, the monthly cash flow (scheduled interest, scheduled principal, and unscheduled prepayments) are passed on to all the bond holders on a pro-rata basis. So, all the bond holders are equally exposed to the prepayment risk of the entire pool of mortgage loans.

Collateralized Mortgage Obligations eliminate this problem by creating different sets of securities with different priorities such that some securities face less prepayment risk while others face more prepayment risk. In simple words, the streams of principal and interest payments from mortgages are distributed to different classes of Collateralized Mortgage Obligations, known as tranches. Each tranche will suit the objectives and needs of a different set of investors and will carry different principal balances, coupon rates, prepayment risk and maturities.

Example

Let’s say the collateral pool contains 1,000 loans each amounting to $100,000. So, the total collateral pool has a value of $100 million. This pool can be used to create three tranches of securities with different characteristics as follows:

Characteristics

The above table described the broad structure of how tranches work in Collateralized Mortgage Obligations. Let’s look at some of its characteristics:

1. All tranches receive interest payments based on the outstanding balances.
2. Tranche A receives all the principal payments till completely paid off. This tranche first absorbs all the prepayment risk thereby protecting other tranches from any prepayments. The total prepayment risk however, remains the same.
3. All the securities within a tranche will have the same characteristics and risks.
4. Tranche A will also have shortest maturity followed by Tranche B and then Tranche C.
5. The final maturity of each tranche is more certain compared to pass-through securities.
6. Each tranche uniquely satisfies the portfolio needs of different investors.
7. CMOs are highly sensitive to interest rate changes.
8. CMOs can have pools of pass-through securities as collateral.
9. There are more complex types of CMO tranches such as Planned Amortization Class (PAC) tranche.