Mortgage passthrough certificates and collateralized mortgage obligations are similar in many respects. However, these securities differ in several important aspects. Which of the following best describes the most important difference between mortgage passthrough certificates and CMOs?

Explanation: The most important difference between passthrough certificates and CMOs relates to the manner in which investors in these securities share prepayment risk. 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 in the passthrough certificates.

CMOs however, are characterized by a senior/subordinate structure in reference to principal prepayments, 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 repayments. 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.