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Collateralized Mortgage Obligations

Collateralized Mortgage Obligations (CMOs) are similar, in structure, to mortgage-backed securities. Like mortgage-backed securities, CMOs are secured by a pool of home mortgages. The monthly principal and interest payments made by homeowners are passed along to CMO holders as principal and coupon payments. However, unlike mortgage-backed securities, CMOs control prepayment risk by dispersing principal payments in a process called tranching. Tranching consists of dividing a CMO issue into groups of bonds with specified principal payment schedules.

Consider a CMO issue with an aggregate face value of $60MM. Assume that the issue is divided into four equal tranches of bonds totaling $15MM each. To control prepayment risk, this issue can be structured so that all principal payments are dispersed to Tranche 1, first, until the tranche is paid in full. Proceeding principal payments flow to Tranche 2 until it is paid in full. Subsequently, principal payments flow to Tranche 3 and so on.

CMO Issue w/ $60 Million Face Value ↓ ↓ ↓ ↓
Tranche 1 $15MM	Tranche 2 $15MM	Tranche 3 $15MM	Tranche 4 $15MM

CMOs allow investors to choose a tranche that suits their investment horizon. Bonds in early tranches will have shorter lengths-maturity. Bonds in later tranches will have longer lengths-to-maturity.