a. CMOs are bonds or debt obligations issued by mortgage originators by offering the whole loan mortgages or mortgage pass-through securities as collateral.
b. The cash flow generated by the assets in the collateral pool is first used to pay the interest and then the principal to the CMO bondholders.
c. The CMOs are different from the traditional pass-through securities mainly due to their repayment structure. In the traditional pass-through securities, each investor receives a pro-rata distribution of any principal and interest payment (net of servicing fees) made by the homeowner. Thus, there is a risk created by the prepayment on all the securities.
d. The CMOs avoid the problems underlying pass-throughs by issuing the bonds in groups, and each group is referred to as ‘tranche’. The securities that belong to the higher tranches have a prior claim to the principal repayments received from the pool of mortgage pass-through securities. This results in redistribution of prepayment risk.
e. There are different types of CMOs, depending upon the method of tranching followed by them. They are discussed in details below:
1.1. Sequential-Pay Tranche
a. This is the most basic class within the CMO structure, which is also known as Plain Vanilla or Clean Pay Class.
b. As per this method of tranching, the principal of each class of bonds is retired in sequence; i.e. one class begins to receive the principal payments from the underlying securities only after principal on any previous class has been completely paid off.
c. While the first-class principal is being paid, the other class holders receive monthly interest payments at the coupon rates on their principals.
d. If the prepayments are faster than the prepayment rates assumed when the security is purchased (at pricing), the principal is retired earlier than expected, thereby shortening the average life of each class. Likewise, the opposite would also be true.
1.2. Planned Amortization Class (PAC) Tranche
a. This class of bonds has greater flexibility of cash flow, as PAC investors are scheduled to receive fixed principal payments known as PAC schedule, over a predetermined period of time, referred to as PAC window.
b. The greater certainty that the PAC bonds cash flows enjoy come from the non-PAC tranches, support, or companion tranches that absorb the prepayment risk.
c. If the prepayments are slow, a PAC tranche receives a greater share of principal to prevent its average life from lengthening, while an accompanying Support tranche receives less (thereby extending its average life).
Similarly, if prepayments are fast, the Support tranche receives the excess principal and experiences a shortening of average life in order to protect the PAC.
d. The PAC Bonds are protected only within a predefined PSA band. The lower and the upper PSA prepayment assumptions are referred to as the initial PAC collar or initial PAC bands.
1.3. Floating-Rate Tranche
a. Floating rate tranches carry interest rates that are tied in a fixed relationship to an interest rate index, such as London Interbank Offered Rate (LIBOR).
b. These interest rates are subject to an upper limit (cap) and sometimes to a lower limit (floor).
c. The performance of floating rate tranches also depends on the way interest rate movements affect the prepayment rates and average lives.
d. The interest rates on these tranches are stated in terms of formula based on the designated index, meaning they move up or down by more than one basis point for each basis point increase or decrease in the index. These so-called ‘super-floaters’ offer leverage when rates rise.
e. The interest rates on ‘inverse floaters’ move in a direction opposite to the changes in the designated index and offer leverage to the investors who believe that the rates may move down.
f. The potential for high coupon income can be rapidly eroded when the prepayments speed up in response to the falling interest rates.