Collateralized Mortgage Obligations (CMOs) – Series 7 Exam
- April 1, 2025
- Posted by: 'FINRA Exam Mastery'
- Category: Finance
🏦 Collateralized Mortgage Obligations (CMOs) – Series 7 Exam
Understanding Collateralized Mortgage Obligations (CMOs) is essential for passing the Series 7 Exam, especially within the fixed income and securitized products sections. CMOs are complex instruments made from mortgage-backed securities and are designed to redistribute prepayment risk and interest rate sensitivity among different bond classes.
This guide breaks down the key characteristics, risks, and exam-relevant facts you need to know.
📘 What Are CMOs?
- A CMO is a type of mortgage-backed security (MBS)
- It is created by pooling residential mortgage loans (typically issued by GNMA, FNMA, or FHLMC)
- The pool is split into tranches (classes) with varying maturity dates and payment priorities
- Each tranche receives principal and interest payments in a structured order
🧱 Structure of a CMO
| Tranche Type | Description |
|---|---|
| Planned Amortization Class (PAC) | Offers the most predictable cash flow; first to receive principal; low prepayment risk |
| Targeted Amortization Class (TAC) | Less protection than PAC; targeted payment schedule but more exposed to prepayment risk |
| Support or Companion Tranche | Absorbs prepayment fluctuations to support PAC and TAC tranches; highest risk |
| Z-Tranche | Receives no payments until all other tranches are paid; high duration and risk |
📈 Key Characteristics
- Not backed by the U.S. Government, but often built from government agency MBS
- Subject to interest rate risk, prepayment risk, and extension risk
- Traded over-the-counter (OTC)
- Offer monthly income
- CMOs are considered derivative securities for exam purposes
🚨 Risks to Know for the Exam
| Risk Type | Explanation |
|---|---|
| Prepayment Risk | If interest rates fall, homeowners may refinance early, shortening bond life |
| Extension Risk | If interest rates rise, fewer prepayments occur, extending the life of the tranche |
| Credit Risk | Lower in agency-backed CMOs, higher in private-label CMOs |
| Liquidity Risk | Some CMO tranches may have limited resale markets |
🧠 Example Series 7 Question
Question:
Which CMO tranche is most exposed to prepayment and extension risk?
🅰️ PAC
🅱️ TAC
🅲️ Support tranche ✅
🅳️ Z-tranche
Correct Answer: 🅲️ Support tranche
Support tranches absorb excess volatility in cash flows and are the first to feel the effects of prepayment or extension risk.
📝 Important Regulatory Notes
- CMO advertisements must include the statement:
“Government agency backing applies only to the underlying securities, not to the CMO itself.” - Suitability is important — CMOs may not be appropriate for all investors due to complexity and risk
📥 Master Complex Products with Confidence
Understand how CMOs work. Know the risks and structure. Be ready for scenario-based questions.
👉 Access full Series 7 exam prep at FINRA Exam Mastery