A collateralized mortgage obligation (CMO) is a type of mortgage-backed security (MBS). Unlike a mortgage pass-through, in which all investors participate proportionately in the net cash flows from the mortgage collateral, with a CMO, different bond classes are issued, which participate in different components, called tranches, of the net cash flows. A CMO is any one of those bonds. The tranches are structured to each have their own risk characteristics and maturity range. In this way, investors can select a bond offering the characteristics which most closely meet their needs. Collateral for the securitization may represent a pool of mortgages, but it is often a mortgage pass-through. Many arrangements are possible. One of the simplest is a sequential pay structure comprising three or four tranches that mature sequentially. All tranches participate in interest payments from the mortgage collateral, but initially, only the first tranch receives principal payments. It receives all principal payments until it is retired. Next, all principal payments are paid to the second tranch until it is retired, and so on. This process is illustrated for a three-tranch sequential pay structure in Exhibit 1:
CMOs entail the same prepayment risk as mortgage pass-throughs. The riskiness of a specific bond depends upon how that tranch is structured and on the underlying collateral. Many different structures are used in practice, including stable PAC bonds or risky IOs and POs. There are floaters and inverse floaters. There are also Z-bonds, which are analogous to zero-coupon bonds. Like mortgage pass-throughs, CMOs typically have minimal credit risk. Either they have a high quality mortgage pass-through or similar MBS as collateral, or the collateral is bundled with suitable credit enhancement. CMOs are issued by various organizations, including Fannie Mae, Freddie Mac, investment banks, mortgage originators, insurance companies, etc.
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