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CFA Level I Exam · Mortgage-Backed Security (MBS) Instrument and Market Features

Collateralized Mortgage Obligations: Sequential, PAC and Support Tranches

Updated 7 October 2026 · Fact-checked

A collateralized mortgage obligation (CMO) splits the cash flows of a mortgage pool into tranches that take prepayment risk in different ways. In a sequential-pay CMO, tranches are retired in order. A PAC tranche follows a planned principal schedule, and support tranches absorb the prepayment variation. To solve questions, trace principal first, then ask who absorbs a change in prepayment speed.

Understand Collateralized Mortgage Obligations (CMOs)

A collateralized mortgage obligation (CMO) is a security backed by a pool of mortgage pass-through securities or mortgage loans. The CMO does not create new cash flow. It takes the interest and principal the pool produces and divides them among bond classes called tranches, each with its own rules for who gets paid first.

Why do this? A plain pass-through passes every borrower's prepayment straight to investors. Prepayments rise when mortgage rates fall and slow when rates rise. That creates two risks. Contraction risk is the risk that prepayments speed up, the bond's life shortens and you must reinvest at lower rates. Extension risk is the risk that prepayments slow down, the life lengthens and you are stuck with a below-market coupon. A CMO does not remove these risks. It moves them between tranches, so investors can pick the risk they want.

In a sequential-pay CMO, all principal (scheduled and prepaid) goes to the first tranche until it is fully paid off. Then the second tranche gets principal, and so on. Every outstanding tranche still receives its interest. The first tranche has the shortest weighted average life and the most protection from extension risk, but it carries a lot of contraction risk. The last tranche has the longest life and the most extension risk. Sequential tranches are more predictable than the pass-through as a group, but each one still varies with prepayment speed.

A planned amortization class (PAC) structure goes further. The PAC tranche is given a schedule of principal payments that holds as long as prepayment speed stays inside a range called the PAC collar (for example, between two PSA speeds). The support tranches (also called companion tranches) take the excess principal when prepayments are fast and give up principal when they are slow. So the PAC has low contraction and extension risk, and the support tranches have high contraction and extension risk. The PAC protection is not unconditional: if prepayments leave the collar, or the support tranches are used up, the PAC schedule can fail. Other tranche types, such as floating-rate tranches, exist, but the exam focus is on who bears prepayment risk.

Key formulas to remember

Sequential-pay principal rule
Principal collected → Tranche A until its balance = 0 → then Tranche B → then Tranche C
Interest is paid on each tranche's outstanding balance every period. Only principal is sequenced.
Contraction risk
Rates fall → prepayments rise → weighted average life shortens
Reinvestment is at lower rates. Among sequential tranches, the early tranches have relatively more contraction risk and less extension risk, and the later tranches the opposite. This is a relative comparison between tranches. Within a PAC structure, support tranches bear the most prepayment risk.
Extension risk
Rates rise → prepayments slow → weighted average life lengthens
Among sequential tranches, it is highest for the later tranches. Within a PAC structure, support tranches bear the most prepayment risk.
PAC protection rule
PAC schedule is met if prepayment speed stays inside the PAC collar and support tranches remain outstanding
Support tranches absorb the variation. When they are paid off, PAC protection is lost.
Risk ranking within a PAC structure
Prepayment risk: support tranche > PAC tranche
Total prepayment risk is redistributed, not eliminated.

How to solve Collateralized Mortgage Obligations (CMOs) questions

Use this method for any CMO question, whether it asks for a cash-flow allocation or a risk comparison.

  1. 1Identify the structure: sequential-pay, PAC with support, or a mix. Note the collar if one is given.
  2. 2Identify the direction of rates and what it does to prepayments: falling rates mean faster prepayments, rising rates mean slower prepayments.
  3. 3For allocation questions, list each tranche's outstanding balance and the total principal collected in the period.
  4. 4Pay principal by the rules: in a sequential structure, fill the first outstanding tranche up to its balance, then pass the remainder to the next. In a PAC structure, pay the PAC its scheduled amount inside the collar and send the excess to the support tranche.
  5. 5For risk questions, ask who absorbs the change in speed. In a sequential structure, the early tranches face contraction and the late tranches face extension. In a PAC structure, the support tranche absorbs it.
  6. 6Check the collar and the support balance: if speed is outside the collar or support tranches are gone, the PAC is exposed.
  7. 7Match your result to the three options and eliminate any that reverse the direction of the risk.

Quickest way: Who absorbs the speed change?

When to use it: Use for conceptual questions on contraction risk, extension risk and tranche comparison, where you have about 90 seconds.

  1. Write one line: rates down means fast prepayments means contraction; rates up means slow prepayments means extension.
  2. Sequential: first tranche gets principal first, so shortest life. Last tranche is paid last, so longest life and most extension risk.
  3. PAC with support: PAC is protected inside the collar. The support tranche is the shock absorber and has the most prepayment risk in that structure.
  4. Eliminate any option that says the PAC has more risk than the support tranche, or that a CMO removes prepayment risk overall.

Common mistakes in Collateralized Mortgage Obligations (CMOs)

  • Saying a CMO eliminates prepayment risk.

    Tranching sounds like risk reduction, so students assume the total risk shrinks.

    Fix: Remember the pool's total prepayment risk is unchanged. A CMO only redistributes it, so some tranches become safer and others riskier.

  • Thinking only the first sequential tranche gets interest or principal.

    Students mix up the principal rule with the interest rule.

    Fix: Every outstanding tranche gets interest on its balance. Only principal is paid in sequence.

  • Assuming the PAC tranche is always protected.

    The word 'planned' suggests a guarantee.

    Fix: Protection holds only while prepayment speed is inside the collar and support tranches are outstanding. Outside that, the PAC schedule can break.

  • Mixing up contraction and extension direction.

    Students forget which way rates move prepayments.

    Fix: Falling rates lead to faster prepayment and contraction. Rising rates lead to slower prepayment and extension.

  • Believing the support tranche has low risk because it is called 'support'.

    The name sounds protective.

    Fix: Support tranches protect the PAC by absorbing variation, so within a PAC structure they carry the most prepayment risk.

  • Thinking the first sequential tranche is risk-free because its life is short.

    Short life feels safe.

    Fix: The first tranche is relatively safe from extension but still has substantial contraction risk.

Worked examples

Example 1

A sequential-pay CMO has three tranches. Tranche A has $10 million outstanding, Tranche B has $60 million and Tranche C has $50 million. In the current month the pool pays $14 million of principal (scheduled plus prepaid). How much principal does Tranche B receive this month? A. $4 million B. $10 million C. $14 million

Show the solution
  1. In a sequential-pay structure, all principal goes to Tranche A until it is fully retired.
  2. Tranche A needs only $10 million to reach zero, so it receives $10 million.
  3. Remaining principal = $14 million − $10 million = $4 million.
  4. That remainder passes to Tranche B, the next tranche in line. Tranche C receives nothing.
  5. Option C ignores Tranche A. Option B is Tranche A's payment, not B's.

Answer: A. Tranche B receives $4 million.

Example 2

A CMO has a PAC tranche and a support tranche. Mortgage rates fall slightly and prepayment speed rises, but it stays inside the PAC collar. Which outcome is most likely? A. The PAC tranche's weighted average life shortens sharply while the support tranche is unchanged. B. The PAC tranche keeps its planned schedule while the support tranche's weighted average life shortens. C. Both tranches' weighted average lives lengthen.

Show the solution
  1. Falling rates mean faster prepayments, so contraction pressure rises.
  2. Speed is inside the collar, so the PAC schedule is maintained.
  3. The extra principal goes to the support tranche, which absorbs the variation, so its life shortens.
  4. Option A reverses the roles. Option C describes extension, which happens when prepayments slow.

Answer: B. The PAC tranche stays on its planned schedule and the support tranche's weighted average life shortens.

Exam tips

  • Expect conceptual questions on which tranche has the most prepayment risk. Memorise: within a PAC structure the support tranche has the most and the PAC the least; in a sequential structure, early tranches face contraction and late ones face extension.
  • For allocation questions, do the sequential fill carefully: pay the first tranche only up to its balance and pass the remainder on.
  • Watch for the phrase 'inside the collar' versus 'outside the collar'. It changes whether the PAC is protected.
  • Use the rate-direction link first: falling rates mean fast prepayment, rising rates mean slow prepayment. It eliminates two options quickly.
  • There is no penalty for wrong answers, so always pick the best option even when unsure.

Practice questions from Mortgage-Backed Security (MBS) Instrument and Market Features

Collateralized Mortgage Obligations (CMOs) in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

Collateralized Mortgage Obligations (CMOs): frequently asked questions

What is the difference between a sequential-pay tranche and a PAC tranche?

In a sequential-pay structure, principal goes to one tranche at a time in order, so each tranche still has real prepayment risk. A PAC tranche follows a planned schedule that holds within a collar of prepayment speeds. Support tranches absorb the variation that keeps the PAC on schedule.

How do support tranches reduce prepayment risk?

They do not reduce it overall. They take on the extra principal when prepayments are fast and give up principal when they are slow. This moves the risk away from the PAC tranche and onto themselves, so within a PAC structure support tranches have the most prepayment risk.

What are contraction and extension risk in a CMO?

Contraction risk is the risk that prepayments speed up when rates fall, shortening the life of the tranche and forcing reinvestment at lower rates. Extension risk is the risk that prepayments slow when rates rise, lengthening the life of the tranche while the coupon is below market rates.

Does a PAC tranche have no prepayment risk?

No. It has low risk only while prepayment speed stays inside the collar and support tranches are still outstanding. If speed moves outside the collar or the support tranches are retired, the PAC schedule can break.