Questions about CDO and CMO

[cqbzxk]

Hi David, I got a problem which has confused me for a long time, what's the difference between support tranche and equity tranche? Does it true that the senior tranche in CMO will not suffer any concentration risks and extension risks, since support tranche will cover first? but the senior tranche in CDO has more concentration risks, subordinate tranche in CDO has more extension risks? thank you.

 

[ShaktiRathore]

Hi there,
In a CMO structure the principal is retired sequentially first of the senior tranche and finally of the equity tranche. Equity tranche receives payment after all the senior and subordinated tranches have received their dues. Only in the end did the equity tranche receives their dues after all the senior tranches have been paid.It has no role to play in absorbing the prepayments or late payments and support the senior tranches in facing the risks but is there in the structure facing the highest risk.
Whereas support tranche is basically for protecting the senior tranches against the contraction and extension risk. If there is a prepayment than the support tranche is absorbs these and protects the senior tranche from receiving any prepayment so that there is low prepayment risk, however if the support tranche retires due to excessive prepayment than the senior tranche faces the contraction risk because now there is no support tranche to absorb these prepayments. The question is what happens to senior tranche protection when support tranches are no longer there? Yes the senior tranches now faces the same risk as before without a support tranche. As far as extension risk is concerned its always possible that the senior tranche faces this risk due to low payments but the extension risk is the least for the senior tranches as compared to the other tranches like support or subordinated tranches.
In a CDO the senior tranches may get all their principal retired if the debt is retired sooner than later thereby the senior tranches have more contraction risk. Obviously the subordinated tranches will face extension risk if there is delayed payments. Since the senior tranche absorbs the principal first so its possible that the subordinate tranche may get their dues late than required due to low cash flows which are first used to retire the senior tranches.

thanks

 

[cqbzxk]

Thank you so much! very helpful!