From Sterwiki

A Collateralized Mortgage Obligation (CMO) is a type of Mortgage Backed Security which has been divided up into tranches. This article is essentially restricted to CMO bonds as traded in the United States of America. Every time some principal payments are made on the underlying mortgages, that principal is paid to some (or all) of the tranches. In most CMO transactions, the total balance of the tranches is equal to the total balance of the collateral, and they remain equal, as each time the balance of the collateral changes (because of the principal payments on the underlying mortgages) the total balance of the tranches is also changed.

The tranches could be made in several ways.

• Credit Tranching. Many CMO bonds are back by collateral which is issued and guranteed by the 'Federal Agencies' (Freddie Mac, Fannie Mae, or Ginnie Mae). Those which are not are called 'whole loan CMOs'. Whole loan CMOs are subjected to the risk of the home owners not paying the entire principal balance on their loans (in other words defaulting on their mortgages). This is often handled by designating some of the tranches (called 'B' pieces) to have any losses passed on to them. When a mortgage default causes a loss, the balance of one of the B pieces is reduced by the amount of the loss.
  
• Sequential Tranching (also called by time). All of the available principal payments go to the first sequential tranche, until its balance is decremented to zero, then to the second, and so on. There are several reasons that this type of tranching would be done:
  
  • The tranches could be expected to mature at very different times and therefore would have different Yields that correspond to different points on the Yield Curve.
    
  • The underlying mortgages could have a great deal of uncertainty as to when the principal will actually be received since home owners have the option to make their scheduled payments or to pay their loan off early at any time. The sequential tranches each have much less uncertainty.
    
  
  
• Parallel Tranching. This simply means tranches that pay down pro-rata. The coupons on the tranches would be set so that in aggregate the tranches pay the same amount of interest as the underlying mortgages. The tranches could be either fixed rate, or floating rate. If they have floating coupons, they would have formulas that make their total interest equal to the collateral interest. For example, with collateral that pays a coupon of 8%, you could have two tranches that each have half of the principal, one being a floater that pays libor with a cap of 16%, the other being an inverse floater that pays a coupon of 16 minus libor.
  
  • A special case of parallel tranching is known as the IO/PO split. IO and PO refer to Interest Only and Principal Only. In this case, one tranche would have a coupon of zero (meaning that it would get no interest at all) and the other would get all of the interest. These bonds could be used to speculate on prepayments. A principal only bond would be sold at a deep discount (a much lower price than the underlying mortgage) and would rise in price rapidly if many of the underlying mortgages were prepaid. The interest only bond would be very profitable if few of the mortgages prepaid, but could get very little money if many mortgages prepaid.
    
  
  
• Schedule bonds (also called PAC or TAC bonds). This type of tranching has a bond (often called a PAC or TAC bond) which has even less uncertainty than a sequential bond by being first in priority, up to a preset amount of principal, and then being last in priority. The other bond (called a companion bond) has correspondingly more uncertainty.
  

The tranches typically separate the original bond (referred to as the collateral) cashflows in time or by interest and principle.

The process of dividing an MBS into CMO tranches is referred to as structuring.

See also

• Mortgage Backed Security
  
• Securitization
  

de:Collaterlized Mortgage Obligation