I understand how the tranches are created and why they are created. Few things I want to ask:
Which tranche has principal only? Which has interest+principal? Which has only interest? Why is tranche 3 the longest maturity tranch? Why is tranche 1 the shortest maturity tranch? Which tranche has the highest prepayment risk?
CMOs can be chopped up many ways; don’t confuse one tranche scheme with another.
If the CMO is chopped into a PO tranche and an IO tranche, then, well, the PO is principal only, and the IO is interest only.
If the CMO is chopped into sequential tranches, then the A tranche gets paid off first, then the B tranche, then the C tranche. A has the highest contraction risk (risk of getting paid off sooner than expected); C has the highest extension risk (risk of getting paid off later than expected).
There are lots of other ways a CMO can be chopped up. (I analyzed these for six years at PIMCO.) These two ways are arguably the easiest.
Cool. What all do we need to know about GNMA and its cousins? Khan academy made CMOs easy for me.
And the tranche A in your case can have PO or IO or a mizture? So, what differentiates the returns of all these three tranches? The way I see it is that CMO prepayment risk is same as mortgage passthrough risk. Just that I banks divided them in a fancy way to cater to diffr people. How would they possibly allocate principle or interest to these tranches?
Mortgage passthrough prepayment risk*
In a sequential CMO, Tranche A gets principal and interest until it’s paid off. Tranche B gets interest only until A is paid off, whereupon B starts to get principal. Tranche C gets interest only until B is paid off, whereupos C starts to get principal.
Mainly that it’s a federally-related institution, and that it creates MBSs.