What it means
A CMO pools mortgages or mortgage securities and splits the cash flow into several classes, called tranches. FINRA describes a CMO as a multi-class debt instrument backed by a pool of mortgage pass-through securities or mortgage loans.
The classes differ in size, coupon and expected life. In a sequential structure the rule is simple: every tranche earns interest on its remaining balance, but principal goes only to the most senior tranche first, and when it is retired the next one starts to receive all principal, and so on until the whole deal is paid off.
The borrower payments come from scheduled principal and from prepayments. When homeowners refinance or sell, principal arrives faster and the early tranches retire sooner, while when rates rise and prepayments slow, the early tranches last longer.
Investopedia notes that the structure appeared in the 1980s and was usually split into tranches A, B, C and a Z tranche. The Z tranche is an accrual tranche, which means it receives no cash interest at first.
The interest is added to its balance until the earlier tranches are paid off. The design let investors pick a time horizon.
Short-horizon buyers such as banks could choose early tranches and reduce the risk that a loan stays outstanding too long. Long-horizon buyers such as pension funds could choose later tranches, which carry more of the extension risk.
The weakness is that the later tranches take the swings in prepayments. Investopedia says newer structures, such as planned amortization classes, targeted amortization classes, companion tranches, and interest-only and principal-only strips, have become more common.
A planned amortization class tranche has a schedule that holds within a range of prepayment speeds. An investor should read the offering documents for the collateral, tranche rules and average life assumptions.
Credit quality depends on who guarantees the underlying loans, and rules and markets differ by country. Prices of CMOs can move a lot when rates change.
In practice
Real-world examples.
Example
A fictional CMO has three tranches of 100 million each and pays 5 million of principal a month in total. Tranche A receives all of it, so it is retired in 20 months (100 / 5). Tranche B then receives 5 million a month for the next 20 months.
Example
Tranche A with 100 million at a 4% coupon earns interest of 100 million x 0.04 / 12, about 333,333, in the first month. As the balance falls with each principal payment, the interest falls with it. Tranche B earns interest on its full balance meanwhile, but no principal.
Example
Prepayments rise and principal reaches 8 million a month. Tranche A is then retired in 12.5 months (100 / 8), so in month 13 it receives 4 million and tranche B receives 4 million. Faster prepayments shortened the life of A and began paying B about 8 months sooner.
Formula
Calculation
Months to retire a tranche = Tranche balance / Monthly principal paid to it. With 100 million / 5 million = 20 months.
Monthly interest = Balance x Coupon / 12. With 100 million x 0.04 / 12 = 333,333.
Z tranche accrual = Balance x Coupon / 12. With 50 million x 0.06 / 12 = 250,000, which is added to the balance to give 50.25 million.Case study
Seen in the real world.
This case study is fictional and illustrative. Omar, 60, in Doha, manages a small bank treasury and wants a mortgage-backed bond that matures in about two years. He compares tranche A and tranche C of a sequential-pay CMO. He sees that tranche A is expected to be paid off earliest, while tranche C is expected to last much longer. He asks how the expected life changes if prepayments slow.
The offering documents show that tranche A could extend if rates rise, but by much less than C. He buys tranche A and holds a small amount of a floating-rate note as well. He sets a review each quarter to check prepayment speeds. He knows the stated average life is only an estimate, not a promise.
Watch out
Common mistakes.
- Assuming a tranche will be paid on the dates in the example, when real prepayments change the timing.
- Buying a late tranche for its yield without understanding extension risk.
- Treating all CMO tranches as having the same credit risk and price behaviour.
Questions
People also ask.
What is a sequential-pay CMO?
It is a mortgage-backed security whose tranches receive principal one at a time in order of seniority.
Why is it called plain vanilla?
It is the simplest payment structure for a CMO. Newer structures add schedules and companion tranches to control prepayment risk.
What is a Z tranche?
It is an accrual tranche that gets no cash interest at first. The interest is added to its balance until the earlier tranches are paid off.
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