A collateralized mortgage obligation (CMO) is a type of mortgage-backed security (MBS) created by dividing a pool of mortgages into multiple tranches — each with different priority, maturity, coupon, and risk characteristics. This tranching allows the issuer to tailor the cash flow characteristics to meet the needs of different investors. CMOs are issued by government-sponsored enterprises (Fannie Mae, Freddie Mac) or private entities.
The key risk unique to CMOs is prepayment risk — homeowners can pay off their mortgages early (refinancing, home sales), returning principal to investors earlier than expected. Sequential-pay (plain vanilla) CMOs direct all prepayments to the shortest tranche until it is retired, then to the next tranche. PAC (Planned Amortization Class) tranches use companion/support tranches to absorb prepayments, providing more predictable cash flows. Z-tranches (accrual tranches) receive no cash flow until all other tranches are retired; interest accrues and compounds.
Extension risk — the opposite of prepayment risk — occurs when prepayments slow (rising rate environment), extending the maturity of CMO tranches beyond expectations. The average life (weighted-average time to receive principal) is the standard CMO maturity measure.
CMOs are classified as government securities when issued/backed by GSEs, or as corporate securities when privately issued. They trade OTC and are subject to FINRA oversight when broker-dealers are involved.
> Exam tip: On the Series 7 and Series 65/66, know the difference between prepayment risk (fast prepayments shorten CMO life) and extension risk (slow prepayments lengthen it). PAC tranches reduce prepayment risk by shifting it to support tranches. Z-tranches are the most volatile and longest-dated. CMOs are considered complex products requiring suitability analysis.