Two customers can buy pieces of the same pool of home mortgages and get their principal back ten years apart. The structure of the deal decides who waits. The exam asks you to match each piece to the customer it fits.
Collateralized mortgage obligations start from the mortgage pass-through, a security backed by a pool of home loans. Each month, the interest and principal that homeowners pay pass through to every investor pro rata. That includes prepayments, which is principal paid early when owners refinance, sell or pay extra. Owners can prepay at any time, so a pass-through investor never knows when principal will come back.
Collateralized mortgage obligations exist to manage that prepayment uncertainty. A collateralized mortgage obligation (CMO) is a multi-class debt instrument backed by a pool of mortgage pass-throughs or mortgage loans. The pool's cash flows are divided into tranches (French for "slices") that have different payment priorities. As a result, tranches have very different expected lives. One may repay in two years and another in twenty.
Common mistakes
- Calling a PAC guaranteed: Its schedule holds only inside the band. A PAC built for 100% to 300% PSA breaks if speeds reach 400% PSA.
- Swapping the two risks: "Rates fell" points to prepayment risk and shorter lives. "Rates rose" points to extension risk and longer lives.
- Two-sided TAC protection: A TAC is protected from fast prepayments only, so slow prepayments extend it.
Bottom line
- A CMO divides a pool of mortgages or pass-throughs into tranches with different payment priorities and expected lives.
- CMO interest is taxable at the federal, state and local levels, and a Z-tranche holder owes tax on accrued interest not yet received.
- Falling rates speed up prepayments (prepayment risk, with reinvestment at lower rates), and rising rates slow them (extension risk, a longer life while prices fall).
- A PAC is protected from both risks inside its band, the companion absorbs both, and a TAC is protected only against prepayment.
Exam shortcut
Read the direction of the rate move first. "Rates fell" means faster prepayments, shorter average lives, POs up and IOs down. "Rates rose" means extension, longer lives, IOs up and inverse floaters hit twice. Next, find the protected tranche. A PAC is protected both ways, a TAC only from fast prepayments, and the companion absorbs whatever the PAC sheds.
The full lesson (about 4,868 words, 32 min read) adds 2 worked examples, all 7 common mistakes, a self-check, free in the app.
Learning objectives
- C24
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