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

In a sequential-pay collateralized mortgage obligation (CMO), principal payments from the underlying pass-through securities are most likely distributed to:

Principal in a sequential-pay CMO goes to the first tranche until it is fully paid off, then to the second, and so on in order. This reallocates prepayment risk across tranches, giving shorter and longer expected maturities, unlike a pass-through that pays all holders pro rata.

  1. Aall tranches pro rata according to their outstanding balances.
  2. Bthe first tranche until it is retired, and then to the next tranche in order.Correct
  3. Cthe last tranche first, because it has the longest stated maturity.

Explanation

In a sequential-pay CMO, all scheduled and prepaid principal goes to Tranche A until it is fully retired, then to B, and so on. Pro rata distribution describes a pass-through structure, not sequential-pay. The last tranche is paid last, not first.

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