Collateralized mortgage obligations are securities issued against a pool of mortgage pass-through securities for which the cash flows have been allocated to different classes (tranches), each having a different claim against the cash flows of the pool.

As previously mentioned, some institutional investors are concerned with extension risk and other with contraction risk. The mere creation of a CMO cannot eliminate prepayment risk; it can only distribute the various forms of this risk among different classes of bondholders. The technique of redistributing the coupon interest and principal from the underlying collateral to different classes (so that a CMO results in instruments that have varying convexity characteristics more suitable to the needs and expectations of different investors) broadens the appeal of mortgage-backed products to various traditional fixed-income investors.

A tranche is a slice of the cash flows generated by a mortgage pool. The claim of each tranche is governed by a specific formula. A CMO distributes prepayment risk among tranches so as to create products that provide better matching of assets and liabilities for institutional investors.

There are many types of CMO structures; three are discussed here.

Sequential-Pay Tranches

The first generation of CMOs was structured so that each tranche would be retired sequentially; such structures are referred to as sequential-pay tranches.

In a "plain vanilla" CMO structure, there may be four tranches: A, B, C and Z. The first three tranches, with tranche A representing the shortest-maturity bond, receive periodic interest payments from the underlying collateral. Tranche Z is an accrual bond that receives no periodic interest until the other three tranches are retired.

• When principal payments (both scheduled payments and prepayments) are received by the trustee for the CMO, they are applied toward retiring the tranche A bonds.
• After all the tranche A bonds have been retired, all principal payments received are applied toward retiring tranche B bonds.
• Once all the tranche B bonds have been retired, tranche C bonds are paid off in the same fashion.
• Finally, after the first three tranches of bonds have been retired, the cash flow payments from the remaining underlying collateral are used to satisfy the obligations on the Z bonds(original principal plus accrued interest). It is also called accrual tranche.

There is some protection provided against prepayment risk for each tranche. For example, prioritizing the distribution of principal effectively protects tranche A against extension risk (the protection coming from tranches B, C and D). Similarly, tranches C and D are protected against contraction risk.

Note that tranche Z (the accrual tranche) appeals to investors who are concerned with reinvest risk. Since there are no coupon payments to reinvest, reinvestment risk is eliminated until all the other tranches are paid off.

Planned Amortization Class Tranches

A Planned Amortization Class (PAC) bond is a CMO product that was created to have a similar cash flow structure to a sinking fund corporate bond within a specified range of prepayment rates (i.e., the cash flow pattern to the bond holder is known). The cash flow for PAC bonds is more predictable because there is a principal repayment schedule that must be satisfied. PAC bondholders, therefore, have priority over all other classes in the CMO issue in receiving principal payments from the underlying collateral in order to satisfy the repayment schedule.

The greater certainty regarding the cash flow for PAC bonds comes at the expense, of course, of the non-PAC classes, called the companion or support classes.

• If the actual prepayment speed is faster than the upper limit of the PAC range, the companion bonds receive the excess. This means that the companion bonds absorb the contraction risk.

• If the actual prepayment speed is slower than the lower limit of the PAC range, then in subsequent periods the PAC bondholders have priority for principal payments (both scheduled payments and prepayments). This reduces extension risk, which is absorbed by the companion bondholders.

The upper and lower PSA levels used to construct the principal payment schedule are called the initial PAC collar. A key consideration is that prepayment protection is ensured as long as companion bonds are not fully paid off. Consequently, the degree of prepayment protection changes over time as actually prepayments occur. For example, if prepayments over the first few years are at the lower end of the initial PAC collar, there will be more companion bonds remaining, which will result in greater prepayment protection for the PAC bonds. A new collar can be calculated, which will allow PAC bondholders to realize their original principal payment schedule as long as prepayments are within the collar. This new collar is called the effective collar. The effective collar is a wider range of prepayment speeds over which the life and cash flows of a PAC are predictable. An effective collar is necessary because the capacity of the support tranche to absorb prepayments is gradually diminished over the life of the security.

Support Tranches

A companion bond or a support bond absorbs the surplus or shortfall cash flows from a pool, allowing PAC bond to have a much more predictable series of cash flows. The support tranche is exposed to both contraction and extension risks. By definition, it is exposed to the greatest amount of prepayment risk.

• If too much principal is repaid, the overage goes first to the support tranche; the protected tranche receives only the scheduled amount.
• If not enough principal is prepaid, the support tranche gets none; the protected tranche gets all or nearly all of the promised amount.

Credit Enhancements

All non-agency asset-backed securities are credit-enhanced.

External credit enhancements are financial guarantees from third parties. The most common forms are:

• Monoline insurance companies. They guarantee the timely repayment of bond principal and interest when an issuer defaults. They are so named because they provide services to only one industry.
• Letter of credit from a bank
• Guarantee by the seller of the assets.

A guarantee does not completely remove the risk of default. Rather, it partially isolates it. Many factors can force an insured bond to default.

An internal credit enhancement is a tranche design or reserve structure that protects one or all investors against losses from default.

• A senior-subordinated structure is a two-tranche structure. The senior tranche gets paid first and the subordinated tranche gets paid only if there are enough funds left after the senior is paid. The subordinated tranche absorbs the credit risk, making the senior tranche less risky than the subordinated tranche.
  The level of protection provided by the subordinated tranche changes over time due to prepayments. Prepayments change how much of the remaining pool is allocated to each of the two tranches. If the subordinated tranche gets prepaid early because of fast prepayment, the level of protection for the senior tranche declines. To guard against this problem, prepayments are allocated between the two tranches so that the percentage of the mortgage balance of the subordinated tranche to that of the mortgage balance for the entire deal, known as the level of subordination, is maintained at an acceptable level.
  A commonly used shifting interest percentage schedule is as follows:
  
  • If prepayments in month 30 are $2 million, the entire amount is paid to the senior tranche.
  • If prepayments in month 100 (year 9) are $2 million, the senior tranche gets $400,000 (20%) and the subordinated tranche gets $1.6 million.
  A structure can have more than one subordinated tranche.

• A reserve account is used by the sponsor to channel some of the pool's cash flows into a reserve to be paid out in the case of default or missed payments. Think of a reserve account as a rainy-day fund. There are two forms:
  • Cash Reserve Funds: The SPV sets aside a cash reserve, independent of underlying assets, to cover expected losses. The higher the reserve, the higher the credit rating.
  • Excess Spread Accounts: Underlying assets support a higher level of payment than that promised to security holders. For example, if gross WAC (weighted average coupon) is 8.00%, and after service fee is 7.75% (25bp for servicing the security) then the SPV may set up the ABS to pay 7.25%, using the 50bp spread to fund a reserve for expected losses.

• The amount of collateral backing the structure must be at least equal to the amount of the liability. If the amount of the collateral exceeds the amount of the liability of the structure, the deal is said to be over-collateralized. The amount of over-collateralization can be used to absorb losses. If the liability of the structure is $100 million and the collateral's value is $105 million, the first $5 million loss will not result in a loss to any of the tranches.