So I guess the different classes have the same credit risk? Wouldnt a default of a mortgage lead to the more junior classes/tranches being paid off first? Or are the defaults reinvested in new mortgages rather than paying off the tranches? Which of the following is referred to as a sequential-pay CMO? A sequential-pay CMO is structured so that each class of bond: A) is retired sequentially. B) has different credit risk. C) receives prepayments on a sequential pro-rata basis. D) receives coupon interest payments sequentially. Your answer: A was correct! When there are prepayments, the principal in the first bond class (tranche) is reduced until it is fully retired, then the principal of the next bond class is retired, and so on.
My understanding in a sequential pay situation, the first to be paid off would have the least amount of credit risk since it’s highest priority and is guaranteed to be paid off first at their rate. I don’t think you need to consider in this at defaults being invested in new mortgages.
But if defaults are affecting the pay outs, then wouldn’t the credit risk also be different for the different classes? Therefore, the answer B would also be correct for the question above?
Yeah I see your point. Since the question didn’t look that deep maybe it’s assuming no defaults.
It will have the same credit risk because the underlying Passthrough that is used as collateral is the same, irrespective of the tranch that you are looking at. They only have different prepayment risks.
Ah, gottcha, thx
I think the mortgage pool used by CMO’s is agency backed and hence there is no (or minimal) credit risk involved, so we only need to worry about the prepayments and try repackaging them as per the investor needs into tranches. But for ABS, we need to have prepayment tranching as well as credit trancing since they have credit risk. Like consider investing in a ABS backed by Credit Card Receivable from the MACY’s store shopping-credit-card and they file a chapter-11.