These are mortgage backed securities that have been created by redirecting cash flows from other mortgage securities. These are created to mitigate risk. There are many types of CMOs, such as: sequential CMOs, CMOs with accrual bonds, CMOs with floating-rate and inverse-floating-rate tranches, and planned amortization class (PAC) CMOs. We will focus on sequential CMOs.
Sequential CMOs have several tranches in a special order such that they are retired sequentially. For example, a sequential CMO has tranches A, B, C, and D.
- Periodic coupon interest is disbursed to each tranche on the basis of the amount of principal outstanding in the tranche at the beginning of the period.
- All principal payment are disbursed to tranche A until it is paid off entirely. After tranche A has been paid off, all principal payments are disbursed to tranche B until it is paid off entirely. And so on and so forth with tranches C and D as well.
We then went through a excel spreadsheet that detailed how sequential CMOs are created and paid off.
The spreadsheet is in the same MBS download that was included in a previous blog post.
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