Collateralized mortgage obligation (CMO)

A CMO starts with a pool of residential mortgages or mortgage-backed pass-through securities. Homeowners make monthly payments of principal and interest, and rather than passing that stream through to every investor proportionally, the issuer slices it into tranches — classes of bonds that are repaid in a defined order. Investors choose the tranche whose expected life and risk match their needs.

In a plain sequential-pay structure, all tranches receive interest, but principal payments go entirely to tranche A until it is retired, then entirely to tranche B, and so on. The result is a short-maturity class, several intermediate classes, and a long class that absorbs whatever is left. Other structures address prepayment risk more directly: planned amortization class (PAC) tranches promise a defined payment schedule within a range of prepayment speeds, with companion or support tranches absorbing the variability. The Z-tranche receives no cash at all at first, accruing interest that is added to its principal.

The central risk in a CMO is not usually default — many are backed by agency collateral — but timing. When interest rates fall, homeowners refinance and prepay, returning principal early at a moment when it can only be reinvested at lower rates (prepayment risk). When rates rise, prepayments slow and the bonds last longer than expected (extension risk). CMO interest is fully taxable at the federal, state, and local levels.

CMOs are a recurring Series 7 topic, both as a product — tranche structures, prepayment and extension risk, suitability for different investors — and as a communications topic, since FINRA imposes specific content standards on CMO sales material. The Series 6 exam covers those public communications rules as well.