Collateralized Mortgage Obligations (CMOs)
Chapters in this video
- 0:00 What a CMO is and the prepayment uncertainty problem
- 1:35 The contraction risk versus extension risk split
- 2:37 PAC, TAC, and companion tranches as a tower of cups
- 5:03 Why companion tranches must protect PAC tranches
- 6:03 Z-tranches, sequential pay, and risk-yield ranking
- 7:51 The 30/360 day-count trap and cleanup calls
- 8:39 Rapid-fire exam recap
What this video covers
- Why CMOs redistribute but never eliminate prepayment risk, and how the total risk of the underlying mortgage pool stays constant
- The two directions of prepayment risk: contraction risk when rates fall and extension risk when rates rise
- Planned amortization class (PAC) tranches and their dual-sided protection against both contraction and extension risk within a prepayment band
- Targeted amortization class (TAC) tranches and their single-sided protection against contraction risk only
- Why companion (support) tranches must exist to protect PAC tranches, and why companions carry the highest risk and highest yield
- How Z-tranches (accrual tranches) work like zero-coupon bonds until all prior tranches are retired
- The 30/360 day-count convention for CMO accrued interest, and why it differs from actual/actual on Treasuries
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