Which of the following statements is (are) true with respect to the features of collateralized mortgage obligations (CMOs)?

I. CMOs enable the prepayment risk of the mortgage pool to be altered.
II. If the CMO is set up as sequential-pay tranches, as long as one of the tranches is receiving scheduled principal payments all the other surviving tranches may only receive interest.
III. Tranches that have shorter average lives have a much smaller extension risk than tranches with longer lives.
IV. Planned amortization class (PAC) tranches must always be issued in conjunction with support tranches that have no pre-defined schedules.

Correct Answer: II, III, and IV

I is incorrect. CMOs do not enable the prepayment risk of the mortgage pool to be altered because CMOs only distribute the prepayment risk of the mortgage pool among its various tranches. Structuring them as a CMO cannot alter the prepayment risk of the pool as a whole.

II is true. With sequential-pay tranches, only one tranche at a time may receive all scheduled and unscheduled principal payments. Hence, all the other surviving tranches simply receive the interest payments.

III is true. Tranches that have shorter average lives have a much smaller extension risk than tranches with longer lives because extension risk refers to a scenario in which prepayment rates decline as interest rates increase (causing the duration and average life of the tranche to extend during a rising-rate environment). Because tranches with shorter average lives are entitled to receive all principal repayments and prepayments first, their exposure to extension risk is minimized.

IV is true. Planned amortization class (PAC) tranches must be issued in conjunction with support tranches with no pre-defined schedules because PAC tranches specify the total amount of principal payments that will be made from a pool. In order to handle the uncertainty associated with prepayments, a support tranche is issued in conjunction with the PAC tranche, so that if monthly payments from the pool are not equal to the scheduled payments promised to PAC holders, the difference goes to or comes from payments that are otherwise earmarked for the support tranches.