A mortgage-backed security (or an asset-backed security) can be divided into different tranches so investors can invest according to their risk appetite. When this is done with mortgages it’s called a collateralized mortgage obligation (CMO). When this is done with other types of debt (student loans, corporate debt, auto loans, etc.) it’s called a collateralized debt obligation (CDO).
Each tranche has different schedules for the return of principal, coupon rates, and the allocation of prepayment. If you’re concerned about default, you would invest in a tranche with a higher repayment priority. The Z-tranche (or Z-bond) is the riskiest because it receives cash flows last.
The CMO/CDO structure generally results in more predictable cash flows for investors because they can choose a tranche based on their desired level of risk.
Here’s an example of how this works:
1. A loan originator, such as a bank, makes loans
2. The loan originator sells the loans to a special purpose entity (SPE), which is a separate entity (the SPE is usually set up as a trust)
3. The SPE then sells debt securities (notes or bonds, called “investor certificates”) to investors. The cash inflows these investors will receive from the debt securities come from the cash inflows of the underlying assets (in this case, loans)
4. The debt securities are classified into various tranches based on (a) repayment priority and (b) credit risk (a senior tranche has a higher repayment priority and less risk). A security that is structured in tranches is a “multi-class” ABS (as opposed to a “single-class” ABS where all investors have the same claim on the underlying pool of assets)
5. A ratings agency assigns a rating to the notes/bonds based on (a) the quality of the underlying assets, (b) the securitization structure, and (c) the result of stress tests
6. The loans are usually serviced by a subsidiary of the loan originator. The subsidiary collects payments from the borrowers on behalf of the SPE in exchange for a fee
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