3.3 Mortgage-Backed Securities & CMOs
Mortgage-backed securities (MBS) and CMOs offer attractive yields but introduce prepayment and extension risks. CMOs structure these cash flows into distinct tranches to meet varying investor risk appetites.
Key FINRA Exam Takeaways
- Pass-through certificates pay interest and principal MONTHLY as homeowners make mortgage payments.
- Prepayment risk: Occurs when interest rates DROP; homeowners refinance early, returning principal faster.
- Extension risk: Occurs when interest rates RISE; homeowners stay put, locking investors into below-market yields.
- Collateralized Mortgage Obligations (CMOs): Re-carve mortgage cash flows into tranches with different maturities and risks.
- PAC (Planned Amortization Class) tranches have the lowest prepayment and extension risk.
Prepayment vs. Extension Risk
When mortgage rates drop from 7% to 5%, homeowners refinance. Mortgage pools receive massive unscheduled prepayments, forcing investors to reinvest early at lower rates. When rates rise to 8%, refinancing ceases, extending the MBS life.
CMO Tranches: PAC, TAC, and Z-Tranche
PAC (Planned Amortization Class): targeted amortization schedule protected by companion/support tranches against both prepayment and extension risk. TAC (Targeted Amortization Class): protects only against prepayment risk. Z-Tranche: zero-coupon tranche that receives no payments until all prior tranches are retired.
An investor seeking monthly income from mortgage-backed securities wants to minimize both prepayment risk and extension risk. Which CMO tranche is MOST suitable?