What's A Sequence Pay CMO?

Triston Martin

Nov 28, 2023

The tranches in a sequential pay collateralized mortgage obligation (CMO) are amortized in order of seniority. As long as the principal balance on each tranche of a sequential pay CMO has not been fully repaid, interest payments are made on each one.

On the other hand, the most senior tranche is the only one to receive principal payments until the loan is paid off in full. As soon as the first round of principal payments has been made, the next highest tranche receives all of the remaining principal.

How Sequential Pay CMOs Work

A mortgage-backed asset known as a collateralized mortgage obligation includes a collection of mortgages that have been pooled together and offered as an investment. CMOs get cash flows as borrowers return the mortgages that operate as collateral on these securities, organized by term and risk category.

As a result, CMOs distribute their investors' principles and interest payments following established norms and contracts. There are various tranches or groupings of mortgages, each with a different risk profile.

Sequence Pay CMOs and Investor Needs

As a result of securitization, banks transformed long-term mortgages into attractive assets with various maturities and cash flows, which was a windfall for investors and the banking system.

Senior tranche bonds might be purchased by investors with shorter investment horizons, including commercial banks, to safeguard their assets against extension risk. Pension funds and other investors with long-term investment views might shield their assets against contraction risk by acquiring bonds from more junior tranches.

Extending the Role of Sequential Pay CMOs

In the CMO industry, sequential pay CMOs are no longer the norm. PACs, TACs, companion tranches, and even interest-only and principal-only tranches are becoming increasingly commonplace in the mortgage market.

Mortgage Collateral vs. Debt Collateral

Collateralized debt obligations (CDOs) are similar to CMOs in that they are a pool of loans that are marketed as an investment instrument. However, when it comes to the types of loans in CDOs, they include anything from auto loans to credit cards to commercial loans and even mortgages. Before the global financial crisis, the value of both CDOs and CMOs peaked in 2007. When the CDO market peaked in 2007, it was valued at $1.3 trillion. However, it only had $850 million in 2013 at its peak.

The Financial Crisis and Collateralized Mortgage Obligations

Salomon Brothers first issued complicated mortgage-backed securities (CBSM) in 1983. Several factors prompted investors to focus on the CMOs rather than the soundness of the mortgages they were holding.

Much money was made by buying CMOs full of hazardous mortgages, including subprime, adjustable-rate, and mortgages held by borrowers whose income wasn't confirmed during the application process. As a contributing factor to the financial crisis of 2007-2008, CMOs have been blamed.

The Different Types of CMOS

In the most basic CMO structure, the tranches pay sequentially. Interest payments are sent to each tranche regularly, but principal payments are only made to the first tranche until it is fully repaid. The first and second tranches of the offering may last two to three years on average, the third and fourth tranches for ten to twelve years, and so on. A "sequential pay," "clean," or "plain vanilla" CMO is what you're looking for.

Classification of Amortization (PAC) Tranches: Planned

PAC tranches utilize a system akin to a "sinking fund" to construct a set principle payment schedule that directs cash-flow anomalies caused by quicker or slower expected payment away from the PAC tranche and towards another "companion" or "support" tranche. PAC tranches. A PAC tranche's yield, average life, and lockout periods are more likely to remain steady during the security's term.

Amortization Class Tranches (TAC)

As with sinking funds, TAC tranches offer a defined principal payment schedule and increased cash flow predictability, but this assurance only applies to a single prepayment rate, not a range.

Whether or not the prepayment rate is greater or lower than expected, holders of TAC bonds may receive more or less principal than the agreed-upon payment date. Priority in the CMO structure and the presence of PAC tranches affect the performance of TAC tranches. The TAC tranche's cash-flow certainty will be reduced if PACs are also present.

Tranches for Companions

A companion tranche (also known as a support bond) absorbs the prepayment variability eliminated from PAC and TAC tranches for each PAC or TAC tranche. In that case, it will be reflected in payments to the active companion tranche as additional principal. As rates grow and decline, the average life expectancy of a companion tranche might change dramatically. Companion tranches, which can increase predicted yields if prepayments are near the rate estimated at purchase, help offset this volatility.

The Z-Training (also known as Accretion Bonds or Accrual Bonds)

Z-tranches pay no interest until the lockout time ends and the principal is paid. On each payment date, the specified coupon rate is applied to the face value of the bond instead of crediting a Z-tranche with "accrued interest."

As long as the accrual period lasts, the investor does not have to worry about reinvesting at lower rates if the market yields fall. The typical lifespan of a Z-tranche is 18 to 22 years, and it is organized as the last tranche in a sequence of sequential or PAC and companion tranches.

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