Sequential Pay CMO
What Is a Sequential Pay CMO?
A sequential pay collateralized mortgage obligation (CMO) is a pooled debt instrument where the tranches are amortized arranged by seniority.
In a sequential pay CMO, every tranche receives interest payments for however long the tranche's principal amount has not been totally paid off. Be that as it may, the principal payments are received exclusively by the most senior tranche until it is totally paid off. When the initial principal payments have been retired, the next most senior tranche receives all the principal payments. The retirement of tranches go on arranged by seniority until the whole CMO has been retired. A sequential pay CMO is otherwise called a plain vanilla CMO.
How Sequential Pay CMOs Work
A collateralized mortgage obligation is a type of mortgage-backed security that contains a pool of mortgages packaged together and sold as an investment. Organized by maturity and level of risk, CMOs receive cash flows as borrowers repay the mortgages that act as collateral on these securities. Thus, CMOs disperse principal and interest payments to their investors in light of predetermined rules and agreements.
CMOs comprise of several tranches, or gatherings of mortgages, organized by their risk profiles. As complex financial instruments, tranches normally have different principal balances, interest rates, maturity dates, and capability of repayment defaults. CMOs are sensitive to interest rate changes as well as to changes in economic conditions, for example, foreclosure rates, refinance rates, and the rates at which properties are sold. Every tranche has an alternate maturity date and size and bonds with month to month coupons are issued against it. The coupon makes month to month principal and interest rate payments.
A sequential pay CMO addresses the most fundamental payment structure for a CMO or mortgage-backed security (MBS). Sequential pay was the original structure for CMOs when they were acquainted with the market during the 1980s. The sequential pay CMO was normally split into A, B, C, and Z tranches, with the Z tranche acting as the accrual tranche. Every tranche varied in its maturity and, due to changing risk levels over the long haul, every tranche generally offered an alternate coupon rate.
Sequential Pay CMOs and Investor Needs
The sequential pay CMO was a boon to investors and the banking system, as it permitted banks, through the magic of securitization, to transform long-term mortgages into attractive investments with differing maturities and cash flows. Investors with more limited investment skylines, like commercial banks, could purchase bonds from senior tranches to shield their investments from extension risk.
Investors with longer investment skylines, for example, pension funds, could shield their investments from contraction risks by purchasing bonds from additional junior tranches. Investors who were feeling especially frisky and hoping to get a higher return while facing more risk challenges track down their fix in the Z tranche. As the market matured, nonetheless, new pay structures were acquainted with better serve these contrasting investment viewpoints.
Moving Beyond Sequential Pay CMOs
Sequential pay CMOs are presently not the default structure in the CMO market. Presently it is undeniably more considered normal to see arranged amortization classes (PAC), target amortization classes (TAC), companion tranches and, surprisingly, stripped products like the interest-only and principal-only tranches.
These more specific structures closely line up with what the various gatherings of investors are searching for, leaving the sequential pay CMO seeming to be an excessively simplified and obtuse device for organizing payments on securitized mortgage pools. That is, unfortunately, the case for the majority financial innovations that appeared to be progressive in their time.
Features
- Sequential pay CMOs are the first and most fundamental type of CMO, presented during the 1980s.
- Investors with different time skylines or risk profiles can utilize a sequential pay CMO to recognize the specific tranche that turns out best for their strategy.
- A sequential pay CMO is a collateralized mortgage obligation where every tranche is amortized arranged by its seniority or maturity.
