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FRM Part I · FRM Exam Part I · Mortgages and Mortgage-Backed Securities

In a sequential-pay collateralized mortgage obligation (CMO) with Tranches A, B and C, all principal payments from the underlying mortgage pool (scheduled and prepayments) are first directed to Tranche A. Which statement best describes the effect of this structure compared with a simple pass-through security backed by the same pool?

A sequential-pay CMO redistributes prepayment risk rather than removing it. Tranche A receives all principal first, giving it a shorter, more predictable average life, while later tranches absorb more of the variability in timing. The pool's total cash flows are unchanged, only reallocated among investors.

  1. AIt eliminates prepayment risk for the whole structure, so no investor bears it
  2. BIt redistributes prepayment risk, with Tranche A having shorter and more predictable average life and the later tranches absorbing more extension riskCorrect
  3. CIt transfers all credit risk of the pool to Tranche A because it is paid first
  4. DIt makes every tranche's average life equal to that of the underlying pool

Explanation

Sequential-pay tranching does not remove prepayment risk; it reallocates it across tranches. The early tranche receives principal first, so its average life is short and relatively stable, while later tranches bear greater extension risk when prepayments are slow and contraction risk when they are fast. Eliminating the risk is wrong because the pool's total principal timing is unchanged.

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