Collateralized mortgage obligation

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A collateralized mortgage obligation is a type of mortgage-backed security that creates separate pools of pass-through rates for different classes of bondholders with varying maturities, called tranches. The repayments from the pool of pass-through securities are used to retire the bonds in the order specified by the bonds' prospectus.

How a simple CMO works: The investors in the CMO are divided up into three classes, called either class A, B or C investors. Each class differs in the order they receive principal payments, but receives interest payments as long as it is not completely paid off. Class A investors are paid out first with prepayments and repayments until they are paid off. Then class B investors are paid off, followed by class C investors. In this situation, class A investors bear most of the prepayment risk, while class C investors bear the least.[1]