Collateralized Mortgage Obligation

A collateralized mortgage obligation (CMO):

1. A.Passes mortgage cash flows through tranchesCorrect - tranched mortgage cash flows.
2. B.Is a municipal GO bondA general obligation bond is issued by a municipality and backed by its taxing power. A CMO is a structured mortgage product whose payments come from homeowners making their loan payments, with no taxing authority behind it.
3. C.Is unsecured corporate debtUnsecured corporate debt describes a debenture, which is backed only by the issuer's general credit. The word collateralized in the name points to the opposite arrangement: an identified pool of mortgages standing behind the securities.
4. D.Is common stockA CMO investor is a lender, not an owner, and receives scheduled interest and principal rather than dividends or voting rights. The tranche structure divides those debt cash flows by timing and risk, which has no equity counterpart.

Why: A CMO channels mortgage cash flows into tranches with different maturities and risk.

A retail communication promoting collateralized mortgage obligations (CMOs) to income investors would VIOLATE FINRA standards if it:

1. A.Discloses that the CMO's yield and average life will fluctuate with prepayment ratesThis disclosure is required, not prohibited - it is the heart of CMO risk.
2. B.States that any government agency backing applies only to the face value and not to any premium paidAlso a required disclosure; it prevents investors from assuming their premium is protected.
3. C.Includes the coupon rate and final maturity of the tranche being offeredObjective terms of the specific tranche are permissible, factual content.
4. D.Compares the CMO's yield to the yield available on bank certificates of depositCorrect - CMO retail communications may not compare the product with any other investment, and the CD comparison is the classic violation.

Why: FINRA Rule 2216 prohibits comparing CMOs with any other investment vehicle, including bank certificates of deposit, because the comparison masks prepayment and extension risk. Required content runs the other way: disclose that yield and average life fluctuate with prepayments and that any government backing applies to face value only. The clue is which choice adds risk-masking content instead of risk disclosure.

A collateralized mortgage obligation is structured with a planned amortization class tranche and an associated companion (support) tranche. Adviser Halvard Bruun must place one of them with a retired client who needs a predictable average life. Which statement is correct?

1. A.The PAC has a more predictable average life because the companion absorbs prepayment variation, so the PAC suits the retiree, but the protection holds only while prepayments stay within the collar and the companion still has principal.Correct. The support tranche absorbs both fast and slow prepayments to keep the PAC on schedule, and exhausting it removes the protection.
2. B.The companion tranche has the more predictable average life, since it receives principal only on a fixed schedule.Incorrect and reversed. The companion is the residual absorber, so its average life is the LEAST predictable in the structure.
3. C.The PAC structure eliminates prepayment risk from the deal altogether, so neither tranche carries extension or contraction risk.Incorrect. Structuring reallocates prepayment risk between tranches; it cannot eliminate risk that arises from the behaviour of the underlying mortgages.
4. D.The PAC offers the higher yield, because its scheduled repayments make it the more attractive security.Incorrect. Greater certainty commands a LOWER yield. The companion bears the reallocated risk and is compensated with the higher yield.

Why: The whole point of the planned amortization class structure is to reallocate prepayment risk between two tranches rather than to eliminate it. The PAC tranche is assigned a fixed schedule of principal repayments that the deal promises to meet so long as actual prepayment speeds stay within a stated collar or band. The companion, or support, tranche is what makes that promise possible: when prepayments run fast, the companion absorbs the excess principal so the PAC keeps to its schedule, and when prepayments run slow, the companion receives principal later so the PAC still gets paid on time. The result is that the PAC has a far more predictable average life and much less exposure to both contraction risk and extension risk, while the companion absorbs a magnified version of both and is compensated with a higher yield. For a retiree who needs predictability, the PAC is the appropriate placement. It is essential to add that the protection is conditional: if prepayments move outside the collar for long enough, the companion can be exhausted, and once it is, the PAC begins to behave like an ordinary tranche.

Fairhaven Capital owns the shortest-maturity sequential-pay tranche of a collateralized mortgage obligation. Mortgage rates then fall sharply and homeowners in the underlying pool refinance far faster than the deal original assumptions contemplated. For Fairhaven tranche, the MOST likely consequence is:

1. A.principal repayment is pushed further out, leaving the tranche outstanding longer than expected - extension riskIncorrect. Extension risk arises when rates RISE and prepayments slow. Falling rates do the opposite.
2. B.the tranche stops receiving principal until every later tranche has been retiredIncorrect - this reverses the sequential-pay structure. The EARLIEST tranche receives all principal first; later tranches wait.
3. C.the tranche credit quality deteriorates, because the underlying homeowners are failing to pay as agreedIncorrect. Refinancing means the loans are paid off in full ahead of schedule. That is the opposite of default.
4. D.principal comes back much sooner than expected, forcing reinvestment of the proceeds at the new lower rates - contraction riskCorrect. Faster prepayments retire the earliest sequential tranche ahead of schedule, and the proceeds must be reinvested at the lower prevailing rates.

Why: In a sequential-pay CMO, all principal payments from the pool - scheduled and prepaid - go to the earliest tranche until it is fully retired, then to the next. When rates fall and refinancing accelerates, that principal arrives much sooner than modeled. The earliest tranche is retired early and Fairhaven must reinvest the proceeds at the new, lower rates. That is contraction risk, and it is the mirror image of extension risk, which appears when rates RISE, prepayments slow, and a tranche stays outstanding longer than expected. Refinancing is not default: the loans are paid off in full, so credit quality is unaffected.