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Collateralized Mortgage Obligations Questions on the Series 7 Exam

CMOs, or collateralized mortgage obligations, are annoying little (or big) debt securities backed by pools of mortgages and are covered on the Series 7. What makes matters worse is that you probably won’t sell one in your entire career. However, CMOs are asset-backed securities covered on the Series 7 exam, and you need to know the basics in order to answer these questions correctly.

CMOs don’t have a set maturity date and are subject to things called extension risk and prepayment risk. Take a look at these terms:

  • Average life: The average amount of time until a mortgage is refinanced or paid off; for example, a 30-year mortgage may have an average life of 17 years

  • Prepayment risk: The risk that a tranche (slice or portion) of the loan will be called sooner than expected due to decreasing interest rates; more people refinance when interest rates are low

  • Extension risk: The risk that a tranche will be called later than expected due to a less-than-normal amount of refinancing; extension occurs when interest rates are high

CMOs are also broken down into tranches (slices) of varying maturity dates. The basic type of CMO has tranches that are paid in a specific sequence. All tranches receive regular interest payments, but only the tranche with the shortest maturity receives principal payments.

After the shortest tranche is retired, the second-shortest receives principal payments until that tranche is retired, and then the principal is paid to the next tranche. This type of structure is known as a plain vanilla offering. The following list describes other types of CMO tranches:

  • Planned amortization class (PAC) tranches: This type of CMO is the most common because it has the most certain prepayment date. The prepayment and extension risk can be somewhat negated by a companion tranche, which assumes a greater degree of the risk. Because of the relative safety of PAC tranches, they usually have the lowest yields.

  • Targeted amortization class (TAC) tranches: This CMO is the second-safest. TAC tranche-holders have somewhat less-certain principal payments and are more subject to prepayment and extension risk. TAC tranches have yields that are low but not as low as those of PAC tranches.

  • Companion tranches (support bonds): Companion tranches are included in every CMO that has PAC or TAC tranches. Companion tranches absorb prepayment risk associated with CMOs. The average life of a companion tranche varies greatly depending on interest rate fluctuations. Because more risk is associated with companion tranches, they have higher yields.

  • Z-tranches (accrual bonds): Z-tranches are usually the last tranche (they have longest maturity) in a series of PAC or companion tranches. Z-tranches don’t receive interest or principal until all the other tranches in the series have been retired. The market value of Z-tranches can fluctuate widely. Z-tranches are somewhat similar to a zero-coupon bond (which is bought at a discount and does not receive interest along the way).

  • Principal-only (PO) tranches: Principal-only tranches are purchased at a price deeply discounted below face value. Investors receive face value through regularly scheduled mortgage payments and prepayments. The market value of a PO increases if interest rates drop and prepayments increase.

  • Interest-only (IO) tranches: All CMOs with principal-only tranches also have interest-only tranches. IOs are sold at a deep discount below their expected value based on the principal amount used to calculate the amount of interest due. Contrary to PO tranches, the market value of an IO increases if interest rates increase and prepayments decrease.

  • Floating rate tranches: These tranches appear with CMOs in which the interest rates are tied to an interest rate index (for instance, London Interbank Offered Rate/LIBOR). Investors can use these investments to hedge interest rate risk on other investments.

Although there are several types of tranches, the most important ones on the Series 7 exam are the PAC, TAC, companion, and Z-tranches.

The following question tests your understanding of tranches.

Companion tranches support

I.    PO tranches

II.    PAC tranches

III.    TAC tranches

IV.    IO tranches

(A)    I only
(B)    II only
(C)    II and III only
(D)    II, III, and IV

The answer you’re looking for is Choice (C). Companion tranches absorb the prepayment risk associated with CMOs. All PAC and TAC tranches are supported by a companion tranche.

This information is a lot to take in and may be a little confusing. Remembering the basics can help you get most of the questions correct: PAC tranches are the safest; TAC tranches are the second safest; companion tranches support PAC and TAC tranches; and Z-tranches have the longest maturity.

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