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CMO / REMIC Structuring

One-line definition

A CMO (collateralized mortgage obligation), issued through a REMIC (real estate mortgage investment conduit) tax structure, carves a single pool of mortgage cash flows into multiple bonds ("tranches") with different principal-payment priority — reshaping one pass-through's prepayment risk into several bonds with different risk profiles, rather than eliminating that risk.

Vocabulary

  • Sequential-pay tranche: the simplest structure — every tranche receives interest, but principal goes entirely to the first (shortest) tranche until it's fully retired, then entirely to the second, and so on. This turns one pool's prepayment uncertainty into a set of bonds with different, more defined average lives, even though total prepayment risk across all tranches combined is unchanged.
  • PAC (Planned Amortization Class) tranche: designed to receive a predetermined principal paydown schedule as long as prepayments stay within a specified band (e.g., 90–300 PSA); a support tranche absorbs the variability outside that band, giving the PAC investor materially more certain cash flows than the underlying collateral itself has.
  • Support (companion) tranche: absorbs whatever prepayment variability the PAC tranche is structured to avoid — if the pool prepays faster than expected, the support tranche shrinks faster; if slower, it extends longer. In exchange for bearing that variability, support tranches typically offer the highest yield in the structure.
  • REMIC: the tax election that lets a CMO issuer split cash flows into multiple tranches without triggering double taxation at the entity level — a legal/tax wrapper, not a cash-flow mechanism in its own right.

Why PMs care

A CMO doesn't create or destroy prepayment risk — it redistributes it. Understanding tranche structure is what lets a PM pick the specific risk/return profile they actually want (a PAC tranche for cash-flow certainty, a support tranche for yield pickup in exchange for absorbing someone else's prepayment risk) instead of taking a generic pass-through's blended exposure. This is directly the flip side of MBS convexity: a plain pass-through's negative convexity is the sum of extension risk (support/long-sequential tranches) and contraction risk redistributed unevenly across a capital structure — a PAC tranche is specifically engineered to look less negatively convex than the collateral behind it, at the support tranche's expense.

Why this isn't implemented in src/pm

Modeling how a specific prepayment path allocates across sequential, PAC, and support tranches requires a full cash-flow waterfall engine — tracking scheduled and unscheduled principal, interest, and the specific priority rules of each tranche period by period under an assumed prepayment path — which is a materially larger project than this repo's "small transparent function" style, and the same reasoning that keeps non-agency structuring and full OAS/negative- convexity pricing conceptual-only applies here. The prepayment building blocks that would feed such a waterfall — psa_cpr, refinancing_incentive_cpr, single_monthly_mortality, and mortgage_amortization_schedule — are already implemented in prepayment models and pass-throughs; what's missing is the tranche-priority allocation logic layered on top, not the underlying cash-flow math.

Common mistakes

  • assuming a PAC tranche's stated average life is guaranteed — it's guaranteed only within the PAC band; extreme prepayment speeds outside that band (very fast or very slow) can still cause a PAC tranche to extend or contract, once the support tranche protecting it is exhausted
  • treating "senior" (paid first, sequential-pay) as synonymous with "safer" the way it is in a corporate capital structure — in a CMO, an early sequential tranche has shorter average-life uncertainty, not necessarily better credit quality (agency CMOs all carry the same agency guarantee regardless of tranche)
  • forgetting that total prepayment risk across a REMIC's tranches sums to the same total risk in the underlying collateral — structuring reallocates risk, it doesn't reduce it; if a PAC tranche looks safer, something else in the same deal is bearing correspondingly more

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