Collateralized Mortgage Obligation (CMO) Basics
A CMO is a mortgage-backed security made up of several classes of bonds backed by the same mortgage collateral or a group of mortgage-backed securities (MBS). The CMO is segmented into a number of different “tranches,” each with a different repayment schedule and risk. This illustration depicts a simple “Sequential” style of CMO.
Each month principal and interest from the underlying group of mortgage loans is paid into the CMO. The CMO is divided into different tranches, each of which is designated to receive interest and principal repayment in a different payment order than the other tranches. Which tranches will receive principal repayment first, second, etc. has been designed to allows greater predictability of “average life” or “maturity” ; however, yield and average life will fluctuate depending on prepayments and changes in current interest rates and may be significantly affected by such changes. It also sets various interest rates per tranche to distribute the interest coming into the CMO. Most classes / tranches of bond holders will receive interest monthly. Class A bond holders will receive principal repayments in addition to its interest payments, until Class A bonds are completely redeemed. Then Class B will receive principal until it is paid out entirely, and then Class C starts redeeming, etc.
Note that the defined classes do not, by design, use up all of the principal and interest coming into the CMO. Because we cannot predict exactly the monthly mortgage repayments or interest flows, room is left for residual cash flow to use in order to enable the defined tranches to be paid as predicted for their specific class. These residual cash flows can also be carved into various classes, which would be called “companion classes.” Companion classes are among the least predictable tranches of all.
Please contact your financial advisor for information on CMOs and how they react to different market conditions.