Collateralized Mortgage Obligations and Prepayment Risk

Collateralized Mortgage Obligations are a type of Special Purpose Vehicle (SPV), which is separate from the entity that created it.

The CMO is created to issue securities to different investors based on a pool of mortgages owned by the SPV. All the mortgages put together are called a pool. In a CMO the investors buy the bonds issued by the CMO, and receive a periodic payment based on the preset rules.

The CMO structures its mortgage pool in such a way that it can issue bonds with different risk and return profile. So, there will be several classes of bondholders with varying maturities or different date of maturities, known as tranches.

The principal payments from the underlying pool of pass-through securities are used he investors in these bonds will want to protect themselves from the prepayment risk as well as the credit risk. While the prepayment risk cannot be eliminated, it can be distributed among the investors in such a way that one set of investors absorb more risk while the others absorb more risk. This is done through creating different tranches having different risk profiles. The different types of tranches are explained below:

Sequential Tranches

In sequential tranching, the principal payments are used to repay the bond holders in each tranche sequentially.

• Tranche I, which is also called the short term segment of the issue, is entitled to receive the net interest on the outstanding principal and all the principal payments from the mortgage pool, until it is repaid back to the person who may have initially subscribed to the same.
• Tranche II, which is also called as the intermediate term, is entitled to all the interest on the outstanding principal, and is the next in line after the Tranche I repayment, to get entitled for repayment of the principal payments from the mortgaged pool, until it is repaid back to the subscriber.
• Tranche III, which is also called as the long term tranche, receives monthly net interest and starts receiving all the principal repayments, subsequent to the complete repayment of interest and principal to Tranche I and Tranche II holders.

Because the different tranches are expected to mature at different times, they will also offer different yields.

Parallel Tranches

In parallel tranching, each tranche is paid on a pro-rata basis. So the bonds in each tranche will have a coupon rate such that the total payment from the mortgage pool is equally divided among the tranches. For example, if the collateral pool pays a coupon on 6%. The the CMO can have two tranches: one is a floater that pays LIBOR with a cap of 10%, while the other is an inverse floater that pays 10% - LIBOR.

Z-Bonds        

In this kind of a tranche structure, there is an additional tranche called Z bonds, along with the other tranches. This tranche does not receive any interest payment. The z-bond’s share of payment is instead used to repay the principal of other tranches. The Z-tranche receives the residual payments, that is, the payments are received only after all the other tranches have been fully paid.

These are the important types of tranche structures.