CMOs originated in the USA in 1983 after they were introduced by First Boston and The Federal Home Mortgage Loan Corporation. They go through the same stages as MBSs (e.g., origination, pooling, placement of the pooled mortgages with a SPV, etc.) until the security reaches the investment bank. Instead of selling the MBS/ABS to investors and the investment bank places the security as collateral in a trust, and, essentially, splits it, offering groups of investors a series of tranches (a portion of the payments) associated with the security – a CMO. Suppose the investment bank creates three tranches. Each class has fixed coupon, which may be paid monthly, quarterly or semi-annually.
In addition, the investor is holding a bond – they are owed a certain amount. Mortgagees in the pool pay their monthly principal and interest, but there will always be some who unexpectedly prepay (or default on) the full amount of the mortgage. The investment bank issuing the CMO will pay out the interest owed to the first group, plus all the principal paid by the mortgagees, including those who have prepaid. The second class of investors is also paid the fixed interest owed, but does not get any of the principal until the first class has been paid in full and the bond retired. Likewise for the third tranche – no principal is repaid until the second class has been paid off in full, and the associated bond retired. The number of tranches can vary from 3 to 30. There can also be a zero or Z-tranche, where the investor is not paid interest9 or principal until all the other classes are retired.