What Is a Sequential Pay CMO?

A sequential pay collateralized mortgage obligation (CMO) is a pooled debt instrument where the tranches are amortized in order of seniority.

In a sequential pay CMO, each tranche receives interest payments as long as the tranche's principal amount has not been completely paid off. However, the principal payments are received solely by the most senior tranche until it is completely paid off. Once the initial principal payments have been retired, the next most senior tranche receives all the principal payments. The retirement of tranches continues in order of seniority until the entire CMO has been retired. A sequential pay CMO is also known as a plain vanilla CMO.

Key Takeaways

  • A sequential pay CMO is a collateralized mortgage obligation in which each tranche is amortized in order of its seniority or maturity.
  • Sequential pay CMOs are the first and most basic type of CMO, introduced in the 1980s.
  • Investors with various time horizons or risk profiles can use a sequential pay CMO to identify the particular tranche that works best for their strategy.

How Sequential Pay CMOs Work

A collateralized mortgage obligation is a type of mortgage-backed security that contains a pool of mortgages bundled together and sold as an investment. Organized by maturity and level of risk, CMOs receive cash flows as borrowers repay the mortgages that act as collateral on these securities. In turn, CMOs distribute principal and interest payments to their investors based on predetermined rules and agreements.

CMOs consist of several tranches, or groups of mortgages, organized by their risk profiles. As complex financial instruments, tranches typically have different principal balances, interest rates, maturity dates, and potential of repayment defaults. CMOs are sensitive to interest rate changes as well as to changes in economic conditions, such as foreclosure rates, refinance rates, and the rates at which properties are sold. Each tranche has a different maturity date and size and bonds with monthly coupons are issued against it. The coupon makes monthly principal and interest rate payments.

A sequential pay CMO represents the most basic payment structure for a CMO or mortgage-backed security (MBS). Sequential pay was the original structure for CMOs when they were introduced to the market in the 1980s. The sequential pay CMO was typically split into A, B, C, and Z tranches, with the Z tranche acting as the accrual tranche. Each tranche differed in its maturity and, due to varying risk levels over time, each tranche generally offered a different coupon rate.

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Collateralized Mortgage Obligation (CMO)

Sequential Pay CMOs and Investor Needs

The sequential pay CMO was a boon to investors and the banking system, as it allowed banks, through the magic of securitization, to turn long-term mortgages into attractive investments with varying maturities and cash flows. Investors with shorter investment horizons, such as commercial banks, could purchase bonds from senior tranches in order to protect their investments from extension risk.

Investors with longer investment horizons, such as pension funds, could protect their investments from contraction risks by purchasing bonds from more junior tranches. Investors who were feeling particularly frisky and looking to get a higher return while taking on more risk could find their fix in the Z tranche. As the market matured, however, new pay structures were introduced to better serve these differing investment outlooks.

Moving Beyond Sequential Pay CMOs

Sequential pay CMOs are no longer the default structure in the CMO market. Now it is far more common to see planned amortization classes (PAC), target amortization classes (TAC), companion tranches and even stripped products like the interest-only and principal-only tranches.

These more specialized structures closely align with what the different groups of investors are looking for, leaving the sequential pay CMO looking like an overly simplified and blunt tool for structuring payments on securitized mortgage pools. That is, sadly, the case for many financial innovations that seemed revolutionary in their time.