CFA Practice Question
CFA Practice Question
Which of the following is the crux for the primary difference between mortgage passthrough certificates and collateralized mortgage obligations (CMOs). Choose the best answer.
A. Amortizing versus non-amortizing.
B. The temporal and senior/subordinate structure of principal payments.
C. The number of securitized mortgage loans comprising the pool.
Explanation: In the simplistic sense, CMOs and passthrough certificates are very similar. Both are debt securities whose principal and interest payments are based upon a pool of "securitized" mortgage loans. However, there exists an important distinction between CMOs and passthrough certificates, and this difference lies in the way that prepayment risk is shared amongst investors in these securities. Investors in passthrough certificates share prepayment risk equally, i.e. there is no senior/subordinate structure in reference to principal repayments. If the securitized mortgages underlying a passthrough certificate experience prepayments, these principal payments are allocated equally amongst the investors.
CMOs however, are characterized by a senior/subordinate structure in reference to principal repayments, and investors in CMOs do not face prepayment risk equally. When issued, CMOs are created in various classes, called "tranches," each of which has a prespecified seniority in accordance to principal prepayments. For example, suppose XYZ Mortgage Corporation issues a CMO, and this CMO is comprised of three tranches - tranche A, B, and C. Principal prepayments are to be allocated first to tranche C, and are to continue within this tranche until it has been exhausted. Once the principal of tranche C has been completely repaid, principal prepayments are to be allocated toward tranche B, and are to continue until this tranche is exhausted.
Finally, principal prepayments are then to be allocated to the remaining class - tranche A.
As you can see, investors in CMOs do not face prepayment risk equally, and this is the primary difference between passthrough certificates and collateralized mortgage obligations.
User Contributed Comments 2
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