CMO tranches and prepayment risk
- Thread starter yickwong
- Start date
hiredguns1
New member
- Jun 18, 2026
- 0
- 0
yickwong, great question.
investors in basic pass-through securities are exposed to their proportionate share of credit and prepayment risk.
CMOs are constructed from basic mortgage pass-through securities, but divide the pass-through(s) into tranches, which are sold individually. There’s at least two basic types of tranching:
1) time tranching, in which prepayment risk is allocated disproportionately to the different tranches, and
2) credit tranching, in which default risk is allocated disproportionately to the different tranches (e.g. a senior/subordinated debt structure).
CMOs allow investors with varied tolerances for prepayment and credit risk to participate in the market for mortgage-backed securities.
These securities can be structured in several ways, but let’s examine a sequential-pay CMO for the sake of simplicity.
As homeowners begin repaying the principal balances on their mortgage loans, the most junior tranche in the CMO absorbs 100% of these scheduled principal repayments (or in the case of an unscheduled partial principal repayment, a “curtailment”), up until the junior tranche has been completely repaid. This tranche has the most prepayment risk and the least extension risk. Then the next tranche’s principal balance begins getting paid down. So on and so forth until the final, senior tranche is reached, which btw has the most extension risk (i.e. if principal payments arrive slower than expected, these folks don’t get repaid until last), and least prepayment risk. The junior tranches can be considered “support tranches” for the senior tranche.
These securities are covered in much more depth at Level II, interesting stuff.
Hopefully this helps, and I haven’t misconstrued things…
investors in basic pass-through securities are exposed to their proportionate share of credit and prepayment risk.
CMOs are constructed from basic mortgage pass-through securities, but divide the pass-through(s) into tranches, which are sold individually. There’s at least two basic types of tranching:
1) time tranching, in which prepayment risk is allocated disproportionately to the different tranches, and
2) credit tranching, in which default risk is allocated disproportionately to the different tranches (e.g. a senior/subordinated debt structure).
CMOs allow investors with varied tolerances for prepayment and credit risk to participate in the market for mortgage-backed securities.
These securities can be structured in several ways, but let’s examine a sequential-pay CMO for the sake of simplicity.
As homeowners begin repaying the principal balances on their mortgage loans, the most junior tranche in the CMO absorbs 100% of these scheduled principal repayments (or in the case of an unscheduled partial principal repayment, a “curtailment”), up until the junior tranche has been completely repaid. This tranche has the most prepayment risk and the least extension risk. Then the next tranche’s principal balance begins getting paid down. So on and so forth until the final, senior tranche is reached, which btw has the most extension risk (i.e. if principal payments arrive slower than expected, these folks don’t get repaid until last), and least prepayment risk. The junior tranches can be considered “support tranches” for the senior tranche.
These securities are covered in much more depth at Level II, interesting stuff.
Hopefully this helps, and I haven’t misconstrued things…
JoeyDVivre
New member
- Jun 18, 2026
- 0
- 0
Are CMO’s covered at all on LI? I don’t think so.
Anyway, we had this argument last year about which tranche has the most “prepayment” risk and I would have disagreed with the above answer. I think the risk you are describing as prepayment risk is “contraction risk”. “Prepayment risk” IMHO includes both contraction and extension risk. I don’t know what CFAI curriculum says it is.
Anyway, we had this argument last year about which tranche has the most “prepayment” risk and I would have disagreed with the above answer. I think the risk you are describing as prepayment risk is “contraction risk”. “Prepayment risk” IMHO includes both contraction and extension risk. I don’t know what CFAI curriculum says it is.
JoeyDVivre
New member
- Jun 18, 2026
- 0
- 0
Nope. You can leverage systematic risk pretty easily….
hiredguns1
New member
- Jun 18, 2026
- 0
- 0
True, contraction risk is the appropriate description, thanks.
Are CMO’s really excluded from the 2007 LI curriculum? In 2006, there were the following two LOS.
LOS 64.d:
Describe the types and characteristics of securities issued by federal agencies (including mortgage passthroughs and collateralized mortgage obligations).
LOS 64.e:
State the motivation for creating a collateralized mortgage obligation, describe the types of securities issued by municipalities in the United States, and distinguish between tax-backed debt and revenue bonds.
I guess the times they are changing.
Are CMO’s really excluded from the 2007 LI curriculum? In 2006, there were the following two LOS.
LOS 64.d:
Describe the types and characteristics of securities issued by federal agencies (including mortgage passthroughs and collateralized mortgage obligations).
LOS 64.e:
State the motivation for creating a collateralized mortgage obligation, describe the types of securities issued by municipalities in the United States, and distinguish between tax-backed debt and revenue bonds.
I guess the times they are changing.
