What is a 'Sequential Pay CMO'

A sequential pay CMO, or 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 principle 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.

BREAKING DOWN 'Sequential Pay CMO'

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.

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.

  1. Collateralized Loan Obligation ...

    Collateralized loan obligations are securities backed by a pool ...
  2. Reserve Tranche

    The reserve tranche is a segment of an International Monetary ...
  3. Targeted Amortization Class - TAC

    Targeted amortization class (TAC) refers to a type of credit ...
  4. Super PO

    A super PO is a principal-only mortgage security which provides ...
  5. Asset-Backed Security - ABS

    An asset-backed security is a debt security collateralized by ...
  6. Credit Tranche

    Credit tranches are phased loans from the International Monetary ...
Related Articles
  1. Personal Finance

    Profit From Mortgage Debt With MBS

    Mortgage-backed securities can offer monthly income, a fixed interest rate and even government backing.
  2. Investing

    What is a Collateralized Loan Obligation?

    A collateralized loan obligation (CLO) is a security consisting of a pool of loans organized by maturity and risk.
  3. Investing

    What is Securitization?

    Securitization is the process of converting an asset, or group of assets, into a marketable security. Often times, the securitized assets are divided into different layers, or tranches, tailored ...
  4. Investing

    How to Save Money on Your Mortgage

    These strategies can potentially save you thousands of dollars over the length of a mortgage.
  5. Personal Finance

    How To Become a Mortgage-Backed Securities Analyst

    Specializing in structured or derivative credit products like mortgage-backed securities requires education and prior experience in the mortgage field.
  6. Personal Finance

    Ways to Be Mortgage-Free Faster

    Getting rid of this debt faster has bigger benefits than you might think.
  1. What is a tranche?

    A tranche is a security, like a collateralized mortgage obligation, that can be split up into smaller pieces and subsequently ... Read Answer >>
  2. Why do banks securitize some debts, and how do they sell them to investors?

    Learn how and why banks securitize debt, how the securitized debt is sold to other investors, and how different the different ... Read Answer >>
  3. Why do most of my mortgage payments start out as interest?

    The first thing a first-time home buyer needs to know is that over the life of the mortgage, the portions of interest to ... Read Answer >>
  4. Are all mortgage backed securities (MBS) also collateralized debt obligations (CDO)?

    Learn more about mortgage-backed securities, collateralized debt obligations and synthetic investments. Find out how these ... Read Answer >>
Hot Definitions
  1. Economies of Scale

    Economies of scale refer to reduced costs per unit that arise from increased total output of a product. For example, a larger ...
  2. Quick Ratio

    The quick ratio measures a company’s ability to meet its short-term obligations with its most liquid assets.
  3. Leverage

    Leverage results from using borrowed capital as a source of funding when investing to expand the firm's asset base and generate ...
  4. Financial Risk

    Financial risk is the possibility that shareholders will lose money when investing in a company if its cash flow fails to ...
  5. Enterprise Value (EV)

    Enterprise Value (EV) is a measure of a company's total value, often used as a more comprehensive alternative to equity market ...
  6. Relative Strength Index - RSI

    Relative Strength Indicator (RSI) is a technical momentum indicator that compares the magnitude of recent gains to recent ...
Trading Center