Collateralized Mortgage Obligation

Summaries

CMO – Collateralized Mortgage Obligation – secured by passthrough securities. Have different tranches to redistribute the prepayment risks.

A. Sequential Pay CMO – each tranche retires sequentially

(One tranche has higher contraction risk and the other higher extension risk)

Z (accrual) tranche – last tranhce of sequential Pay CMO, both interest and principles are deferred until other tranches have been paid off. So it has the longest average life. So no re-investment risk until other tranches have been paid off.

B. Planned Amortization Class (PAC)

1. The most common CMO
2. There are 2 prepayment schemes (e.g. 80PSA and 200PSA, this is the collar)
3. Holder is guaranteed the minimum principle payment (scheduled + prepaid) of the 2 schemes
4. Therefore, more predictable
5. Supported by “Support tranche”
6. The PAC tranche has both lower contraction and extension risks.

The PAC tranche and Support tranche has inverse relationship in terms of the prepayment risk.

***** Prepayment risk includes extension risk and contraction risk

C: Stripped Mortgage-Backed Securities

1. Principle –Only (PO)

Receive only the principle part of the pool. Therefore, the price decreases as the interest rate increases (due to higher discount and also more future cash flow). It exhibits –ve convexity at high interest rate.

2. Interest – Only (IO)

Receive only the Interest part of the pool. The price first increases when the interest rate goes up because more interest to be collected with less prepayment. However, comes down again due to higher discount rate.

Both are more volatile than the passthrough securities because PO and IO runs in opposite direction but the combine volatility is the same as the passthrough.