Prepayment Tranching
The principal (and associated coupon) stream for CMO collateral can be structured to allocate prepayment risk. Investors in CMOs wish to be protected from prepayment risk as well as credit risk. Prepayment risk is the risk that the term of the security will vary according to differing rates of repayment of principal by borrowers (repayments from refinancings, sales, curtailments, or foreclosures). If principal is prepaid faster than expected (for example, if mortgage rates fall and borrowers refinance), then the overall term of the mortgage collateral will shorten, and the principal returned at par will cause a loss for premium priced collateral. This prepayment risk cannot be removed, but can be reallocated between CMO tranches so that some tranches have some protection against this risk, whereas other tranches will absorb more of this risk. To facilitate this allocation of prepayment risk, CMOs are structured such that prepayments are allocated between bonds using a fixed set of rules. The most common schemes for prepayment tranching are described below.
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